Equity Method of Consolidation is used when the parent company owns between 20% and 50% of the outstanding shares of the entity (i.e. Associate). It is an accounting technique to CONSOLIDATE financial statements of companies where one company has significant influence over another company. The method allows the Parent company to INCLUDE the earnings and assets of the entity (i.e. Associate) in their Consolidated Financial Statements as a ‘single entity‘.
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Equity Method of Consolidation (As Per IAS 28) – What Is It?
It is used when the parent company owns between 20% and 50% of the outstanding shares of the entity (i.e. Associate). This means that the parent company has significant influence over the entity’s financial and operational decisions. When the parent company owns MORE than 50% of the outstanding shares, the consolidation process changes to a different method known as the Acquisition Method.
It RECOGNIZES the investment in the entity (i.e. Associate) on the parent company’s balance sheet as an asset. This investment is RECORDED at cost and is ADJUSTED annually for the parent company’s share of the entity’s earnings or losses. This adjustment is made by recording the parent company’s share of the entity’s net income or loss on the parent company’s income statement.
It REQUIRES the parent company to have a good understanding of the entity’s financial statements. This is because the parent company is responsible for making adjustments to the investment account to reflect the entity’s performance. In addition, the parent company must also be AWARE of any Dividends paid by the subsidiary.
Dividends REDUCE the Investment A/C and are recorded as a reduction in the parent company’s income.
1. Benefits Vs Limitations
There are several ‘BENEFITS’ of using the Equity Method of Consolidation.
One benefit is that it provides a more ACCURATE reflection of the parent company’s financial position. By including the entity’s (i.e. Associate) financials, the parent company can better assess the overall financial health of the consolidated entity. This can help the parent company make better financial decisions.
Another benefit is that it REDUCES the amount of work required to prepare consolidated financial statements. Since the parent company only needs to INCLUDE the entity’s (i.e. Associate) financials in their own financial statements, there is no need to prepare separate financial statements for the entity.
There are also ‘LIMITATIONS’ to the Equity Method of Consolidation.
One limitation is that it can be DIFFICULT to determine the fair market value of the investment in the entity (i.e. Associate). This can make it difficult to determine the appropriate amount of adjustments to make to the investment A/C.
The Bottom Line
The Equity Method of Consolidation is a useful accounting technique that allows the parent company to INCLUDE the earnings and assets of the entity (i.e. Associate) in their consolidated financial statements. It is particularly useful when the parent company has significant influence over the entity.
Chartered Accountant – ICAP
Bachelor of Accounting (Honours) – AeU, Malaysia