Accounting for investments where investor influence is substantial
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What is the Equity Method?
The equity method is a type of accounting used for intercorporate investments. It is used when the investor holds significant influence over the investee but does not exercise full control over it, as in the relationship between a parent company and its subsidiary.
In this case, the terminology of “parent” and “subsidiary” are not used, unlike in the consolidation method where the investor exerts full control over its investee. Instead, in instances where it’s appropriate to use the equity method of accounting, the investee is often referred to as an “associate” or “affiliate”.
Although the following is only a general guideline, an investor is deemed to have significant influence over an investee if it owns between 20% to 50% of the investee’s shares or voting rights. If, however, the investor has less than 20% of the investee’s shares but still has a significant influence in its operations, then the investor must still use the equity method and not the cost method.
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.
Practical Example
Lion Inc. purchases 30% of Zombie Corp for $500,000. At the end of the year, Zombie Corp reports a net income of $100,000 and a dividend of $50,000 to its shareholders.
When Lion makes the purchase, it records its investment under “Investments in Associates/Affiliates”, a long-term asset account. The transaction is recorded at cost.
| Dr. | Investments in Associates | 500,000 |
| Cr. | Cash | 500,000 |
Lion receives dividends of $15,000, which is 30% of $50,000 and records a reduction in their investment account. The reason for this is that they have received money from their investee. In other words, there is an outflow of cash from the investee, as reflected in the reduced investment account.
| Dr. | Cash | 15,000 |
| Cr. | Investments in Associates | 15,000 |
Finally, Lion records the net income from Zombie as an increase to its Investment account.
| Dr. | Investments in Associates | 30,000 |
| Cr. | Investment Income | 30,000 |
The ending balance in their “Investments in Associates” account at year-end is $515,000. It represents a $15,000 increase from its investment cost.
This reconciles with their portion of Zombie’s retained earnings. Zombie reports a net income of $100,000, which is reduced by the $50,000 dividend. Thus, Zombie’s retained earnings for the year are $50,000. Lion’s portion of the amount is $15,000.
What are the Other Possible Accounting Methods?
When an investor exercises full control over the company it invests in, the investing company may be known as a parent company to the investee. The latter is then known as a subsidiary of the parent company. In such a case, investments made by the parent company in the subsidiary are accounted for using the consolidation method.
The consolidation method records “investment in subsidiary” as an asset on the parent company’s balance sheet, while recording an equal transaction on the equity side of the subsidiary’s balance sheet. The subsidiary’s assets, liabilities, and all profit and loss items are combined in the consolidated financial statements of the parent company after the investment in subsidiary entry is eliminated.
Alternatively, when an investor does not exercise full control over the investee, and has no influence over the investee, the investor possesses a passive minority interest in the investee. In such a case, investments are accounted for using the cost method.
The cost method records the investment at cost and accounts for it depending on the investor’s historic transactions with the investee and other similar investees.
Additional Resources
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FAQs
The equity method is applied when a company's ownership interest in another company is valued at 20–50% of the stock in the investee. The equity method requires the investing company to record the investee's profits or losses in proportion to the percentage of ownership.
What is an example of the equity method? ›
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.
What is the basic equity method? ›
The equity method requires an investor to record its investment initially at cost (ASC 323-10-30-2 and ASC 805-50-30). An investor, however, may have a “basis difference” between the cost of its investment and the underlying equity in the net assets of an acquired investee.
What is equity based method? ›
The equity method is a method of accounting whereby the investment is initially recognised at cost and adjusted thereafter for the post-acquisition change in the investor's share of the investee's net assets.
What is the difference between cost method and equity method? ›
The cost method treats any dividends as income and can be taxed. On the hand, the equity method does not record dividends as income but rather as a return on investment and reduces the listed value of the investor's company shares. Accounting methods are typically used to record the value of the assets in a company.
How do you use the equity method? ›
When using the equity method, an investor recognizes only its share of the profits and losses of the investee, meaning it records a proportion of the profits based on the percentage of ownership interest. These profits and losses are also reflected in the financial accounts of the investee.
What do equity methods do? ›
Equity Methods provides valuation, financial reporting, and human resources advisory services related to equity compensation and other complex securities. At Equity Methods, we believe in the power of compensation to advance a company's strategy.
When to use equity method vs consolidation? ›
Assessing the Level of Ownership and Influence
- The equity method applies when the investor owns 20-50% of the voting shares and exerts significant influence but does not fully control the investee. ...
- Full consolidation applies when the investor owns >50% of the voting shares and has outright control over the investee.
The equity method of accounting GAAP rules allow investors to record profits or losses in proportion to their ownership percentage. It makes periodic adjustments to the asset's value on the investor's balance sheet to account for this ownership.
What is equity formula? ›
The balance sheet provides the values needed in the equity equation: Total Equity = Total Assets - Total Liabilities. Where: Total assets are all that a business or a company owns. This includes money, investments, equipment, or anything that has value and can be exchanged for cash.
Equity is equal to total assets minus its total liabilities. These figures can all be found on a company's balance sheet for a company. For a homeowner, equity would be the value of the home less any outstanding mortgage debt or liens.
What does owning 20 percent of a company mean? ›
A 20% stake means that one owns 20% of a company. With respect to a corporation, this means holding 20% of the issued and outstanding shares. It does not mean that one is entitled to 20% of the profits. Even if an early stage company does have profits, those typically are reinvested in the company.
What is an equity approach? ›
Equality assumes that everybody is operating at the same starting point and will face the same circ*mstances and challenges. Equity recognizes the shortcomings of this “one-size-fits-all” approach and understands that different levels of support must be provided to achieve fairness in outcomes.
Is the equity method fair value? ›
If the company owns less than 20% of the outstanding shares for the company they invested in, then the fair value method (i.e., cost method) is used. If the company owns between 20% to 50% of the outstanding shares, then the equity method is used.
What is the cost of equity method? ›
What Is the Cost of Equity? The cost of equity is the return that a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return.
Can an equity method investment be negative? ›
If the investor is required to continue recording its share of equity method investee losses, it should present any losses that exceed its equity method investment balance (negative equity method investment) as a liability.
What is an example of an equity strategy? ›
Some prominent examples include value investing, growth investing, dividend investing, momentum trading, and sector rotation. Every equity strategy possesses its own set of unique characteristics, risk profiles, and investment criteria.
What is an example of using equity? ›
For example, if your home is worth $400,000 and you still owe $220,000, your equity is $180,000. The great thing is that you can use equity as security with most lenders. This means you can borrow against your equity to fund life's big purchases, such as: buying an investment property.
What are 2 examples of equity? ›
What Are Equity Examples? Equity is anything invested in the company by its owner or the sum of the total assets minus the sum of the company's total liabilities. E.g., Common stock, additional paid-in capital, preferred stock, retained earnings, and the accumulated other comprehensive income.
What is an example of calculating equity? ›
How Is Equity Calculated? Equity is equal to total assets minus its total liabilities. These figures can all be found on a company's balance sheet for a company. For a homeowner, equity would be the value of the home less any outstanding mortgage debt or liens.
