What is the Equity Method?

What is the Equity Method?

Equity accounting is an accounting process for recording investments in associated companies or entities. Companies sometimes have ownership interests in other companies. Typically, equity accounting–also called the equity method–is applied when an investor or holding entity owns 20–50% of the voting stock of the associate company. The equity method of accounting is used only when an investor or investing company can exert a significant influence over the investee or owned company.

How Does the Equity Method Work?

Unlike with the consolidation method, in using the equity method there is no consolidation and elimination process. Instead, the investor will report its proportionate share of the investee’s equity as an investment (at cost).

Profit and loss from the investee increase the investment account by an amount proportionate to the investor’s shares in the investee. It is known as the “equity pick-up.” Dividends paid out by the investee are deducted from the account.

Recording Revenue and Asset Changes Under the Equity Method

The equity method acknowledges 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.

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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, meanwhile, 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.

How to Apply the Equity Method

A number of circumstances indicate an investor’s ability to exercise significant influence over the operating and financial policies of an investee, including the following:

  • Board of Policy-making participation
  • Intra-entity transactions that are material
  • Intra-entity management personnel interchange
  • Technological dependence
  • Proportion of ownership by the investor in comparison to that of other investors

Example of the Equity Method

For example, assume ABC Company purchases 25% of XYZ Corp for $200,000. At the end of year 1, XYZ Corp reports a net income of $50,000 and pays $10,000 in dividends to its shareholders. At the time of purchase, ABC Company records a debit in the amount of $200,000 to “Investment in XYZ Corp” (an asset account) and a credit in the same amount to cash.

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At the end of the year, ABC Company records a debit in the amount 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 Company also records a debit in the amount 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

Equity represents the total amount of money a business owner or shareholder would receive if they liquidated all their assets and paid off the company’s debt. Capital refers only to a company’s financial assets that are available to spend.

Equity Method of Accounting for Investments