The equity method is an essential accounting technique that allows a company to accurately record profits earned through its investments in other companies. This method is particularly useful when the investor company holds significant influence over the investee. In this article, we delve deeper into the equity method of accounting, providing insights, examples, and key takeaways to enhance your understanding.
Understanding the equity method
The equity method is a fundamental accounting technique used by companies to account for their investments in other companies, particularly when they have significant influence over the investee. In essence, it allows the investor to recognize its share of the investee’s earnings as revenue on its income statement.
Significant influence criteria
For a company to apply the equity method, it must meet the threshold for “significant influence,” which is typically considered to be an ownership of 20% to 50% of the investee’s stock. Significant influence implies the ability to exert power over the investee, such as representation on the board of directors, involvement in policy development, or interchange of managerial personnel.
Recording revenue and asset changes
Under the equity method, the investor records its initial investment in the investee’s stock at historical cost. Subsequently, adjustments are made to this value based on the investor’s percentage ownership in the investee’s net income, losses, and dividend payouts.
For example, if a company owns 25% of another company with a net income of $1 million, it would report $250,000 as earnings from its investment under the equity method.
When the investor’s significant influence affects the investee’s operating and financial results, the value of the investor’s investment is adjusted. This adjustment is made to reflect changes due to the investor’s share in the company’s income or losses, as well as dividends paid out to shareholders.
For instance, if the investee reports a net loss, the investor records its share of the loss as “loss on investment” on its income statement, which also decreases the carrying value of the investment on its balance sheet.
Example of the equity method
Let’s illustrate the equity method with an example. Suppose ABC Company purchases 25% of XYZ Corp’s stock for $200,000. At the end of the first year, XYZ Corp reports a net income of $50,000 and pays $10,000 in dividends to its shareholders.
Initially, ABC Company records a debit of $200,000 to “Investment in XYZ Corp” (an asset account) and a credit in the same amount to cash.
At year-end, ABC Company 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. ABC Company also 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 balance in the “Investment in XYZ Corp” account is now $210,000. The $12,500 Investment Revenue figure appears on ABC’s income statement, and the new $210,000 balance in the investment account is reflected on ABC’s balance sheet. The net cash paid out during the year ($200,000 purchase – $2,500 dividend received) is reported in the cash flow from investing activities section of the cash flow statement.
When an investor company has full control, typically over 50% ownership of the investee company, it must use a consolidation method to record its investment. This method includes all revenue, expenses, assets, and liabilities of the subsidiary 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, which involves recording the investment on the balance sheet at its historical cost.
Frequently asked questions
What is the difference between the equity method and consolidation method?
The equity method is used when an investor has significant influence, typically owning 20% to 50% of the investee’s stock. It records the investor’s share of the investee’s earnings as revenue. In contrast, the consolidation method is used when an investor has full control, usually over 50% ownership, and includes all financials of the subsidiary in the parent company’s statements.
Can the equity method be used for less than 20% ownership?
While it’s less common, the equity method can still be used if the investor demonstrates significant influence over the investee, even with less than 20% ownership. Factors like board representation and policy influence may contribute to significant influence.
What are the accounting implications of using the equity method?
Under the equity method, the investor’s income statement reflects its share of the investee’s earnings or losses. The balance sheet shows the investment at cost adjusted for the investor’s share of earnings and losses. Additionally, dividends received reduce the investment account.
How does the equity method impact financial statement users?
Users of financial statements, such as investors and analysts, can assess the investee’s performance and the investor’s financial health through the equity method. It provides insight into the investee’s profitability and the investor’s level of influence.
What happens when the investee reports a net loss under the equity method?
When the investee reports a net loss, the investor records its share of the loss as “loss on investment” on its income statement. This also decreases the carrying value of the investment on its balance sheet.
Is the equity method the only accounting method for investments?
No, there are other methods, such as the cost method and the fair value method. The choice depends on the level of influence and control the investor has over the investee. The equity method is specific to situations where the investor holds significant influence.
Can an investor apply the equity method to investments in foreign entities?
Yes, the equity method can be applied to investments in foreign entities if the investor has significant influence. However, additional considerations may arise, such as foreign currency translation, which can impact the equity method application.
Are there any disclosure requirements related to the equity method?
Yes, companies using the equity method must typically disclose the nature and extent of their investments, the financial statements of the investee, and information about contingent liabilities and commitments related to the investee.
What is the significance of the “significant influence” threshold in the equity method?
The “significant influence” threshold, often set at 20% to 50% ownership, determines whether the equity method is applicable. It reflects the level of control and influence an investor has over the investee’s operations and financial decisions.
- The equity method is used to account for investments when a company has significant influence over another company.
- Significant influence is typically determined by ownership of 20% to 50% of the investee’s stock.
- Under the equity method, the investor records its initial investment at historical cost and adjusts it based on its share of the investee’s income, losses, and dividends.
- Net income of the investee increases the investor’s asset value, while losses or dividend payouts decrease it.
- Proper application of the equity method ensures accurate reporting of the investor and investee’s financial situations.