What is an associate company?
An associate company is a firm that is partly owned by a parent company but with only a minority or non-controlling stake. Essentially, it is a company in which an investor has significant influence, but not control.
Definition of significant influence
Significant influence is where a company has the power to take part in the financial and operating policy decisions of its associate investment, but not to control them.
How to identify an associate
Typically, a holding of between 20 and 50% of the voting power will indicate significant influence. This could be either directly or indirectly through other subsidiaries. Voting power often correlates to the percentage of the company that is owned. If the holding is less than 20% it is considered that the investing company does not have significant influence, unless there is an agreement that explicitly states otherwise.
In addition to voting rights percentage, the existence of significant influence by an investing company is usually evidenced in the following ways:
- The investor has a representative on the board of directors of the associate
- The investor takes part in the financial and operating decision-making process
- There are material transactions between the investor and the associate
- There is an exchange of management personnel
- Essential technical information is exchanged between the two entities
Different terms for associates
When looking at financial statements, there are a number of terms that can be used in place of the word “associate”, including “affiliate” and “equity method investment”. Moreover, these can be used interchangeably, for instance creating “equity associate”, “associate investment”, ”investments in non-controlled affiliates” and many other configurations. But all represent the same thing – an investment with a non-controlling stake.
Equity method of accounting for associates
Under the equity method of accounting, an investment in an associate is initially recorded at cost, and subsequently adjusted to reflect the associate’s net profit, and when dividends are paid out by the associate. The investment will also have to be adjusted if the associate has any other comprehensive income (OCI) that has not been shown in its profit and loss, such as a revaluation.
The share of the net profit is determined purely on the percentage of the company owned, not the percentage of voting rights or potential voting rights held.
So, let’s take a look at an associate in action. In the example below, Company A has spent 500 to buy 25% of Company B. Company B is valued at 2,000. In step 1, that investment is recognized at cost in non-current assets on the balance sheet.
In step 2, Company B has made 100k in net profit, so Company A has recognized its share in the income statement. The investment in non-current assets goes up, as does retained earnings.
In step 3, Company B has decided it’s time to pay its investors a dividend of 40. The 10 dividend received by Company A increases their cash and decreases the investment in non-current assets. In step 4 you can see the ending amount of the investment is now 515.
Exceptions to the Equity Method
There are some exceptions in following the above method when accounting for associates:
- If an investment is held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
- If the parent company is exempt from preparing consolidated financial statements, in which case the investment in associates can be presented under the cost method, rather than the equity method