What Is the Equity Method of Accounting?
The equity method is an accounting technique used to record the profits earned by a company through its investment in another company.
Under the equity method of accounting, the investor company reports the revenue earned by the other company on its income statement. This amount is proportional to the percentage of its equity investment in the other company.
Key Takeaways
- The equity method of accounting is a technique used to record the profits earned by a company through its investment in another company.
- The equity method is generally used when a company holds significant influence over the company it is investing in.
- The investment is initially recorded at historical cost, and adjustments are made to the value based on the investor’s percentage ownership in net income, loss, and dividend payouts.
- Net income of the investee company increases the investor’s asset value on their balance sheet, while the investee’s loss or dividend payout decreases it.
- The investor also records the percentage of the investee’s net income or loss on their income statement.
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Understanding the Equity Method
The equity method is the standard technique used when one company, the investor, has asignificant influence over another company, the investee. When a company holds approximately 20% or more of a company’s stock, it is considered to have significant influence.
Significant influence means that the investor company can impact the value of the investee company, which in turn benefits the investor. As a result, the change in value of that investment must be reported on the investor’s income statement.
Companies with less than 20% interest in another company may also hold significant influence, in which case they also need to use the equity method. Significant influence is defined as an ability to exert power over another company. This power includes representation on the board of directors, involvement in policy development, and the interchanging of managerial personnel.
Important
Owning 20% or more of the shares in a company doesn’t automatically mean that the investor exerts significant influence. Operating agreements, ongoing litigation, or the presence of other majority stockholders may indicate that the investor doesn’t exert significant influence and that the equity method of accounting is inappropriate.
Recording Revenue and Asset Changes Under the Equity Method
The equity methodacknowledges the substantive economic relationship between two entities. The investor records their share of the investee’s earnings as revenue from investment on the income statement. For example, if a firm owns 25% of a company with a $1 million net income, the firm reports earnings from its investment of $250,000 under the equity method.
When the investor has a significant influence over the operating and financial results of the investee, this can directly affect the value of the investor’s investment. The investor records their initial investment in the second company’s stock as an asset at historical cost. Under the equity method, the investment’s value is periodically adjusted to reflect the changes in value due to the investor’s share in the company’s income or losses. Adjustments are also made when dividends are paid out to shareholders.
Using the equity method, a company reports the carrying value of its investment independent of any fair value change in the market. With a significant influence over another company’s operating and financial policies, the investor is basing their investment value on changes in the value of that company’s net assets from operating and financial activities and the resulting performances, including earnings and losses.
For example, when the investee company reports a net loss, the investor company records its share of the loss as “loss on investment” on the income statement, which also decreases the carrying value of the investment on the balance sheet.
When the investee company pays a cash dividend, the value of its net assets decreases. Using the equity method, the investor company receiving the dividend records an increase to its cash balance but reports a decrease in the carrying value of its investment. Other financial activities that affect the value of the investee’s net assets should have the same impact on the value of the investor’s share of investment. The equity method ensures proper reporting on the business situations for the investor and the investee, given the substantive economic relationship they have.
Example of the Equity Method
Assume, for example, that ABC Co. purchases 25% of XYZ Corp. for $200,000. At the end of year one, XYZ Corp. reports a net income of $50,000 and pays $10,000 in dividends to its shareholders. At the time of purchase, ABC Co. records a debit of $200,000 to “Investment in XYZ Corp.” (an asset account) and a credit in the same amount to cash.
At the end of the year, ABC Co. records a debit of $12,500 (25% of XYZ’s $50,000 net income) to “Investment in XYZ Corp.,” and a credit in the same amount to Investment Revenue. In addition, ABC Co. records a debit of $2,500 (25% of XYZ’s $10,000 dividends) to cash, and a credit in the same amount to “Investment in XYZ Corp.” The debit to the investment increases the asset value, while the credit to the investment decreases it.
The new balance in the “Investment in XYZ Corp.” account is $210,000. The $12,500 Investment Revenue figure will appear on ABC’s income statement, and the new $210,000 balance in the investment account will appear on ABC’s balance sheet. The net ($197,500) cash paid out during the year ($200,000 purchase - $2,500 dividend received) will appear in the cash flow from / (used in) investing activities section of the cash flow statement.
Alternative Methods
When an investor company exercises full control—generally over 50% ownership—over the investee company, it must record its investment in the subsidiary using a consolidation method. All revenue, expenses, assets, and liabilities of the subsidiary would be included in the parent company’s financial statements.
On the other hand, when an investor does not exercise full control or have significant influence over the investee, they would need to record their investment using the cost method. In this situation, the investment is recorded on the balance sheet at its historical cost.
Is an Investment in Another Company the Same As an Acquisition?
One company can invest in another at any amount, and it is not always considered an acquisition. It is considered an acquisition if a company buys most or all of another company’s shares (50% or more) because the investor has effectively gained control of the investment company. However, an investor company can still exert significant influence even if it owns less than 50% of the investee’s shares.
What Is the Difference Between the Equity Method and the Cost Method?
Under the equity method of accounting, dividends are treated as a return on investment. They reduce the value of the investor’s shares. The cost method of accounting, however, treats dividends as taxable income.
What Are the Advantages of Using the Equity Method?
Using the equity method of accounting provides a more complete and accurate picture of the economic interest that one company (the investor) has in another (the investee). This allows for more complete and consistent financial reports over time and gives a more accurate picture of how the investee’s finances can impact the investor’s.
The Bottom Line
When one company holds a significant investment in another, usually 20% or more, the investor company must use the equity method of accounting to report that investment on its income statement. This is done because holding significant shares in a company gives an investor company some degree of influence over the company’s profit, performance, and decisions. As a result, any profit or loss from the investment is recorded as profit or loss to the company itself.
The investment is first recorded at its historical cost, then adjusted based on the percent ownership that the investor has in net income, loss, and any dividend payments. Net income increases the value on the investor’s income statement, while both loss and dividend payouts decrease it.
