An Associate is a long term intercompany investment and possesses the following characteristics:
Associates are accounted for using the equity method of accounting. The investing entity presents its interest in the associate's net assets and net income through a single line. On the balance sheet this is recorded as investment in associates at the cost of acquisition under long term or non current assets. There is a cash outflow to fund this purchase, so cash also decreases by the investment amount. On the P&L, the investor’s share of net income is shown as income from associates and appears just below operating profit. Every year as the associate generates profits, the investor increases the carrying value of the associate investment on the balance sheet, by its share of the associate’s net income.
Dividends received from associates don’t have any impact on the income statement as net income from associates is already accounted for on the investing company’s income statement. But dividends received, result in reducing the carrying value of the investment on the balance sheet as dividends are a return on investment. Since dividends are a receipt of cash, they are recorded as an inflow under investing cash flows. Dividends can also be treated as operating cash flows under some accounting standards.
On 31 December 2016, ABC Inc acquired a 40% interest in XYZ Inc and achieved significant influence. The cost of this investment was $1,600 and the equity of XYZ Inc was $4,000. How will this transaction be recorded in the books ABC Inc?
ABC Inc’s is purchasing a 40% ownership in XYZ. The outlay for this is $1,600 which is 40% of $4,000. This purchase is being funded by cash, therefore cash on the balance sheet will decrease by $1,600. At the same time, an investment in associates will be recognized on the assets side of the balance sheet at $1,600. There is no other change to the assets side of the balance sheet which adds up to $10,000 as before. This transaction has no impact on the total liabilities and equities side of the balance sheet.
Say after a year, XYZ Inc generates a profit of $1,000 and distributes dividends of $400. How are these results accounted for in the books of ABC Inc?
For the period 2017, ABC Inc has revenues of $10,000 and costs of $6,000. Since there is no D&A and interest expense, profit before tax comes to $4,000. At a 40% tax rate, the company’s tax expense is $1,600 and net income is $2,400.
40% of XYZ’s net income belongs to shareholders of ABC Inc and should be represented in the consolidated financials. Therefore, total net income for ABC comes to $2,800. This is the sum of $2,400, which comes from ABC’s own operations and $400 which is income from associates. Even though the associate has declared a dividend, it cannot be recognized on ABC’s income statement as this would lead to double counting.
ABC’s cash flow will begin with net income which is $2,800 and will be part of operating cash flows. But net income has non cash items which should be adjusted. Income from associates of $400 is non cash. This is just an income recognition in line with the accruals concept. Therefore, income from associates has to be subtracted from ABC’s net income on the cash flow. This gives operating cash flows of $2,400. ABC’s investment in the associate has resulted in dividend receipts of $160 i.e $40% of $400. Since this is part of investing activity and an actual cash receipt, it is shown as an inflow under investing cash flows. There is no financing activity and changes in cash come to $2,560.
On the balance sheet, change in cash is added to the opening cash balance of $3,400. This yields a closing cash balance of $5,960 on 31 Dec 2017. As per equity method of accounting, any income from associates is added to carrying value on the balance sheet and dividend receipts are subtracted. This yields an investment in associates of $1,840. There is no change to other assets. The asset side of the balance sheet totals $12,800.
There is no change to the liabilities balance. ABC’s consolidated net income of $2,800 flows through to retained earnings and is added to shareholders’ equity. This comes to $7,800. The liabilities and capital side adds up to $12,800 which equals the assets side and ABC’s balance sheet is in balance.
Under the equity method of accounting, the investing entity recognizes it’s share of net income in associates as one line item on the P&L statement. But this recording of net income is merely an accounting entry based on the accruals concept and does not represent an actual cash return for the investing entity. So how does one measure the cash return that the investing entity receives from its associate investment? Cash return for the investing entity can be measured either through dividend receipts or through disposal of ownership interest in the associate.
Investment in associates also gives rise to deferred taxes. According to GAAP, the investing company is required to record income from associates and recognize taxes when they are earned, in line with the accruals concept. But based on tax accounting, the investing entity will pay taxes only when it receives dividends or sells the investment. Since the company will owe higher actual taxes to the government in the future, a deferred tax liability or DTL is created. The DTL is calculated based on income from associates as the investing entity expects to recover these undistributed earnings through dividends in the future. If this is the case, then the DTL should take into account, DRD. In this case, DTL is calculated as Tax Rate *(1-DRD)* Income from Associates.
So what is DRD? Dividends from associates are taxed, albeit at a lower rate in the US. 80% of dividends from associate investments are exempt from taxation i.e taxes are payable on only 20% of dividend receipts from associates. This is known as dividend received deduction or DRD and the idea is to protect investors from the burden of being triple taxed. DRD covers only dividend payments from associates. Any gains related to disposal of investment in the associate are taxed fully at the investing entity level. When the earnings are ultimately distributed or the investment is liquidated in the future , the DTL is reversed.
The assumption that investing companies invest in associates at book value, is a very simplistic assumption. The reality is that most investors end up investing in associates at greater than book value.
There have to be logical reasons due to which the investor has incurred additional costs in making this investment. What could some of these reasons be?
How is the excess paid over book value, treated by the investing entity? The excess paid over book value is allocated to various assets on the associates’ balance sheet that could be potentially undervalued. These could be PP&E, Intangibles etc. Excess paid can also be allocated to goodwill. The investing entity recognizes a higher depreciation and amortisation charge on this allocation to various assets. But there is no change to underlying financials either at the investing company level or at the associate investment. These adjustments happen only in the internal working papers of the investing entity. The associate is accounted for using the equity method as before. The only change is that the investing entity simply reduces its share of income from associates, by the incremental depreciation and amortization expense that is booked to account for the excess amount paid.