What Is Equity Method of Accounting?

Explore the equity method of accounting, its definition, application, and practical examples. Learn how companies record profits from their investments using this technique.

The equity method is an accounting technique utilized by a company to record its share of the profits and losses derived from its equity investment in another company. This method is typically applied when the investing company holds significant influence over the investee but does not control it, often indicated by ownership of 20% to 50% of the investee’s voting stock.

Mechanics of the Equity Method

Under the equity method, the initial investment is recorded at cost. Subsequently, the investment account is adjusted to reflect the investor’s share of the investee’s net income or net loss. Dividends received from the investee decrease the carrying amount of the investment.

For example, Company A invests in 30% of Company B and exerts significant influence over its operations. If Company B reports a net income of $1,000,000, Company A will recognize $300,000 in its income statement and adjust its investment account accordingly.

Initial Journal Entry

• Date: Initial Investment
• Account, Debit, Credit:
  • Investment in Company B, $X
  • Cash, $X

Subsequent Journal Entries

• Date: Recording Share of Net Income

• Account, Debit, Credit:

  • Investment in Company B, $300,000
  • Income from Equity Investment, $300,000

• Date: Recording Dividends Received

• Account, Debit, Credit:

  • Cash, $Y
  • Investment in Company B, $Y

Special Considerations

Applying the equity method requires judgment and consideration of various factors to determine the level of influence. Significant influence can manifest through representation on the board of directors, participation in policy-making processes, material transactions between the companies, and interchange of managerial personnel, among other indicators.

Practical Applications and Examples

Example 1: Investment in Associate Company

Suppose Company X acquires a 25% stake in Company Y for $500,000, evidencing significant influence without control. Over the subsequent fiscal year, Company Y reports earnings of $2,000,000 and declares dividends amounting to $200,000. Company X’s financial records would reflect:

• Share of Earnings: $500,000 (25% of $2,000,000)
• Dividends Received: $50,000 (25% of $200,000)

Entries in Company X’s financial records will include adjustments for its share of Company Y’s earnings and the received dividends.

Example 2: Influence Assessment

In practice, companies must evaluate if they possess significant influence, which isn’t solely determined by ownership percentage. Factors such as board representation, participation in decision-making, and significant transactions between the investor and investee are considered to assert influence for equity method application.

Historical Context

Originating with the establishment of accounting standards in the mid-20th century, the equity method was institutionalized to provide a more accurate representation of an investor’s stake in associate companies. It aligns with principles of accountability and transparency in financial reporting.

Comparisons and Related Terms

Cost Method vs. Equity Method

The cost method is employed when an investor lacks significant influence, typically owning less than 20% of the investee’s voting stock. Under the cost method, investments are maintained at cost, and income is recognized only when dividends are received. Conversely, the equity method continually adjusts the investment’s value based on the profits and losses of the investee.

Consolidation vs. Equity Method

When an investor controls the investee (typically over 50% ownership), it must consolidate the investee’s financial statements with its own, providing a full view of the combined entities’ financial performance. The equity method is applied when the investor does not exercise control but has significant influence.

FAQs

How does the equity method impact financial statements?

The equity method impacts both the balance sheet and income statement. The investment account on the balance sheet is adjusted for the investor’s share of investee profits and losses, while the corresponding income is reflected in the investor’s income statement.

What constitutes 'significant influence'?

Significant influence is generally recognized when an investor holds 20% to 50% of the voting stock, alongside other indicators like board representation and participation in policy-making processes. The evaluation requires professional judgment and thorough analysis.

Is goodwill considered in equity method accounting?

Yes, goodwill arising from the investment is included in the carrying amount of the investment under the equity method. It is not separately amortized but monitored for impairment over time.

When should a company switch from the equity method to consolidation?

A switch is warranted when the investor’s ownership rises above 50%, granting control over the investee. At this point, financial consolidation ensures comprehensive reporting of the overlapped operations.

Can the equity method be applied to joint ventures?

Yes, the equity method is often used to account for investments in joint ventures where joint control is established, providing a proportional representation of the joint venture’s financial activities.

Summary

The equity method of accounting offers a nuanced approach for companies with significant but non-controlling stakes in other entities. By aligning the investor’s financials with its share of the investee’s operations, this method ensures accurate, transparent reporting, aiding stakeholders in assessing the true economic impact of such investments.

References

1. Financial Accounting Standards Board (FASB). “Accounting Standards Codification (ASC) 323: Investments—Equity Method and Joint Ventures.”
2. International Accounting Standards Board (IASB). “IAS 28: Investments in Associates and Joint Ventures.”
3. Accounting Textbooks and Financial Reporting Manuals.
4. Practitioner’s Guide: Equity Method of Accounting in IFRS and US GAAP.