Understanding the Equity Method
The equity method is an accounting technique used by a company to record the profits earned through its investment in another company. With 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 Insights
- The equity method is employed to value a company’s investment in another company when it holds significant influence over the entity it is investing in.
- Significant influence typically starts at a 20% ownership threshold.
- The investment is initially recorded at historical cost, with periodic adjustments based on the investor’s share in net income, loss, and dividend payouts.
- Net income of the investee company increases the investor’s asset value on their balance sheet, while losses or dividend payouts decrease it.
- The investor also reports the investee’s net income or loss proportionally on their income statement.
Grasping the Dynamics of the Equity Method
The equity method is a go-to technique when one company, being the investor, holds a significant influence over another company, termed the investee. Owning about 20% or more of a company’s stock usually signifies significant influence. Evidently, this influence allows the investor company to affect the value inferred from the investee, necessitating it to report these influence-driven changes on its income statement.
In certain scenarios, companies owning less than 20% of another entity might still exhibit significant influence. This is gauged by variables such as representation in the board of directors, involvement in policy development, and management interchange.
However, simply owning 20% or more of the shares doesn’t indisputably translate to significant influence. Contextual elements such as operational agreements, ongoing litigation, or major stockholders’ dominance might invalidate the presumption of significant influence, making the use of the equity method inappropriate.
Reflecting Revenue and Asset Adjustments Under the Equity Method
The equity method accentuates the tangible economic synergy between two entities. The investor records their stake of the investee’s earnings as investment revenue on the income statement. For instance, if a company holds 25% of another entity with a $1 million net income, utilizing the equity method, they would report $250,000 as earnings from their investment.
When substantial influence by the investor company helps shape the operational and financial results of the investee, it can profoundly affect the investment’s value. Initially, the investor records this investment as an asset at historical cost. Periodic adjustments in the investment’s value reflect the investor’s share of the investee’s income or losses. These are also modified when dividends are dispensed to shareholders.
Recognizing any net losses reported by the investee, the investor company records its share of these losses as “loss on investment” on the income statement. Likewise, the carrying value of the investment on the balance sheet decreases.
When fund dividends are received, while the investor’s immediate cash balance increases, there’s a resultant decrease in the carrying value of its investment. Financial activities influencing changes in net assets of the investee company impact the value of the investor’s equity share similarly. This method ensures thorough economic event reporting, reflecting the stakeholders’ intertwined fiscal relationships.
Practical Example of the Equity Method
Consider ABC Company acquiring 25% of XYZ Corp at the cost of $200,000. At the close of year one, XYZ Corp reports a $50,000 net income and issues $10,000 in dividends to shareholders. ABC Company initially makes an asset account entry of a $200,000 “Investment in XYZ Corp” with an equivalent cash credit.
At year-end, ABC logs a $12,500 debit (25% of XYZ’s $50,000 net income) to “Investment in XYZ Corp,” balancing it with a credit to Investment Revenue. Additionally, ABC records a $2,500 cash debit accounting for 25% of the $10,000 dividends, balanced with a credit to “Investment in XYZ Corp.” Consequently, the “Investment in XYZ Corp” account now has a $210,000 balance. The $12,500 Investment Revenue features on ABC’s income statement while the revised $210,000 account balance appears in ABC’s balance sheet. The net outflow ($197,500 - $200,000 purchase against a $2,500 dividend received) features in the cash flow statement under investing activities.
Exploring Alternative Methods
In instances where an investor exercises full control, surpassing 50% ownership over an investee, consolidative methods come into play—the entire revenue, expenses, assets, and liabilities of the subsidiary encapsulate within the parent company’s financial reports.
On opposing grounds, where full control or significant influence isn’t substantial, recording investments leverage the cost method, capturing the investment at its historical cost on the balance sheet.
Clarifying Investments Against Acquisitions
Investments by a company in another entity, independent of the amount, assertions an acquisition if ownership crosses the 50% threshold, conceding control. Investors holding under 50% can still exert substantial influence, articulating distinct financial results and operating policies deciphered through the equity method.
Contrasting Equity Method with Cost Method
By equity method norms, dividends mirror a return on investment, reducing share value. The contrast lies in the cost method positioning dividends as taxable income.
Harvesting Benefits from the Equity Method
Drafting a holistic financial epoch, the equity method signifies the economic interest of an investor vis-à-vis the investee, delivering an immersive and coherent trove of financial reporting that elegantly converses how the financial elects of the investee permeate the investor.
Concluding Thoughts
Typically holding 20% or more investment stakes, the equity method furnishes an empirically backed financial surveillance, echoing profit, performance insight equivalence from investee to investor. Initial costing syncs with ownership-based income, loss projections, dividend managing TTL economic reflection for audience comprehension.
Related Terms: cost method, consolidation method, significant influence, parent company.
References
- PricewaterhouseCoopers. “12.8 Equity Method”.
- Association of International Certified Professional Accountants. “Determining Significant Influence for Equity Method Investees It’s Not Just Owning 20% of the Stock”, Pages 3-4.
- Association of International Certified Professional Accountants. “Determining Significant Influence for Equity Method Investees It’s Not Just Owning 20% of the Stock”, Page 4-5.
