Accounts Demystified, 6th Edition

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

107

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.

Goodwill

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

108

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.