f u r t h e r f e at u r e s o f c o m p a n y a c c o u n t s
Accounting for associates
Accounting for associates is very simple, in principle. The investor com-
pany, rather than putting just the cost of the investment on its balance
sheet, instead recognises its share of the net assets of the associate. By
‘its share’ I mean the percentage of the associate’s share capital that the
investor company owns. This is known as the equity method.
So if, during a year, the associate makes a profit (thereby increasing its
net assets), the investor company would make the following double entry
on its balance sheets:
Increase Share of net assets of associate
Increase Retained profit
Since the investor company’s retained profit has gone up, its P&L must
naturally reflect this. This is done as follows. The investor company’s P&L
shows the share of the associate’s operating profit, exceptional item and
interest receivable/payable. In all items below that on the P&L, the share
of the associate is aggregated with the investor company’s figures but dis-
closed in the notes.
So not only is the performance of the associate reflected in the investor
company’s accounts, but you are actually given some details about that
performance. This information is not sufficient to enable you to analyse
the associate properly, however; for that you need a copy of the associ-
ate’s own annual report.
Up to now, we have been learning about accounting on the basis that the
net assets of a company (which are equal to the shareholders’ equity) rep-
resent the value of the shares to the shareholders. Thus, if an investor
company was going to buy 20 per cent of a company, we would expect it
to pay 20 per cent of the net asset value of the company.
For all sorts of reasons, investors (both companies and individuals) often
pay more than net asset value for shares in companies. We will go into
a c c o u n t s d e m y s t i f i e d
why they do this later. For now, we can think of companies as having
various assets that are not included on their balance sheets. Such assets
might include:
An organisation of skilled employees with procedures, culture,
experience, etc.
Relationships with customers and suppliers
Brand names
These ‘hidden’ assets lead investors to pay more than net asset value. The
difference between what an investor company pays and net asset value is
known as goodwill. Think of it as representing the goodwill of the associ-
ate’s customers and suppliers towards the company.
Accounting for goodwill
So is the goodwill shown on the balance sheet?
Yes. So if a company invests, say, £12m to buy 25 per cent of a company
which has total net assets at the time of £20m, then the investor company
would have less cash assets by £12m but higher share of net assets of
associates’ by £5m (being 25 per cent of £20m) and higher goodwill by
£7m (being the £12m cash invested less the £5m that is represented by
the actual recorded net assets of the associate).
So in the jargon, we are
Crediting cash £12m
Debiting share of net assets of associates £5m
Debiting goodwill £7m
Yes. There is a further twist on this, however. The investor company is
required to treat the goodwill like any other fixed asset and depreciate it
over its useful life. This is usually called amortisation rather than depre-
ciation but it is the same thing. So if the investor company decides the
useful life of the investment is 15 years, it would have to reduce the value
of the goodwill by £467k each year for 15 years. The double entry for this
is, inevitably, retained profit, so the investor company has a cost of £467k
in its P&L every year for 15 years as a result of making this investment.

Get Accounts Demystified, 6th Edition now with O’Reilly online learning.

O’Reilly members experience live online training, plus books, videos, and digital content from 200+ publishers.