Understanding investment accounting methods can be confusing for many finance professionals.
Luckily, this post clearly explains the equity method investment formula, providing actionable insights you can apply for improved financial reporting.
You'll discover what the equity method is, how to calculate it, record journal entries, compare it to other methods like cost and consolidation, adhere to accounting standards, and more through practical examples.
Introduction to Equity Method of Accounting for Investments
The equity method of accounting is used when an investor has significant influence over an investee company but does not have majority control. This method requires the investor to record its share of the investee's earnings and losses on its income statement, with a corresponding adjustment to the carrying value of the investment on its balance sheet.
Understanding the Equity Method of Accounting
The equity method is an accounting approach whereby the investment is initially recorded at cost but is subsequently adjusted to reflect the investor's share of the investee's net income or loss. The investor reports its share of the investee's net income or loss in its income statement, and the carrying value of the investment on the investor's balance sheet is also adjusted accordingly.
Key things to know about equity method accounting:
- Used when an investor can exert significant influence over the investee, generally when ownership is 20% to 50%
- Investor records its share of investee's net income/loss on its income statement
- The investment asset account on investor's balance sheet reflects its share of income/losses of investee
The equity method provides more accurate reporting than other methods like the cost method, since the investor's net income reflects its share of the investee's operational results each period.
Criteria for Applying the Equity Method
The equity method investment accounting is applied when:
- The investor has significant influence over the investee. This usually means the investor owns 20-50% of the investee company's stock.
- The investee is not a subsidiary or joint venture. If the investee is a majority-owned or controlled subsidiary, consolidation method would apply instead.
- The investment enables the investor to influence financial and operating policies of investee.
Meeting the above criteria requires an investor to use the equity method of accounting for recording income and losses from its investment. This provides a more accurate picture of financial performance than other methods.
What is the equity method of investment accounting?
The equity method is an accounting technique used by a company to record the profits earned through its investment in another company. Here is a brief overview of how it works:
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The equity method applies when an investor company holds significant influence over the investee company, usually from a 20% to 50% ownership stake.
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Instead of reporting the investment at cost or fair value, the investor company reports its share of the investee's net income or loss on its income statement.
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The amount of the investee's income or loss to record is based on the percentage of ownership - e.g. 40% ownership = record 40% of investee's net income for the period.
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The investment asset account on the investor's balance sheet is adjusted each period to reflect the investor's share of income or loss from the investee.
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If the investee pays dividends, the dividend amount reduces the carrying value of the investment on the investor's books.
So in summary, the equity method allows the investor to recognize its share of investee income directly on its financial statements, rather than just holding the investment at cost. This reflects the significant influence over the investee company.
The equity method investment formula to calculate the investor's share of income is:
Investor's Share of Investee's Net Income = Ownership Percentage x Investee's Net Income
For example, if the investor owns 30% of the investee, and the investee reports $100,000 net income, the investor would report $30,000 as its share of the investee's income for the period.
The equity method provides more accurate reporting than other methods like the cost method. However, there are some complexities involved in applying it properly in practice.
What are investments accounted for under the equity method?
Investments accounted for under the equity method include situations where an investor holds significant influence over the investee company. Significant influence generally means the investor owns 20-50% of the voting stock in the investee.
Some key things to know about equity method investments:
- The investor initially records the investment at cost and adjusts the carrying amount each period to reflect its share of the investee's net income or loss.
- The investor's income statement reflects its share of the investee's net income or loss. The investor does not record dividends received as income.
- The equity method serves as a middle ground between consolidating the investee's financial statements (for majority-owned subsidiaries) and accounting for the investment as a simple passive holding (for minor investments below 20%).
- Equity method investments are tested periodically for impairment. An impairment loss is recorded if the investment's fair value falls below book value and is considered other-than-temporary.
So in summary, the equity method applies when an investor can exercise significant influence over the operating policies of the investee company. The investor then accounts for its share of the investee's income and adjusts the carrying value of the investment accordingly each period.
What is the equity method of ASC 323?
The equity method of accounting is a way for an investor to account for an investment in another company when the investor has significant influence over the investee. The FASB Accounting Standards Codification (ASC) 323 outlines the guidance for applying the equity method.
Here are some key points about the equity method under ASC 323:
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The equity method is used when an investor has significant influence over the investee, generally defined as owning 20-50% of the voting stock.
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Under the equity method, the investment is initially recorded at cost on the investor's balance sheet.
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The investor's share of the investee's net income or loss is recorded in the income statement and the carrying value of the investment is adjusted each period.
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Dividends received from the investee reduce the carrying value of the investment.
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The equity method serves as a middle ground between consolidating the investee's financial statements (for majority ownership) and accounting for the investment using the cost method (for ownership under 20%).
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Key rationale is that significant influence means the investor should recognize their proportionate share of the investee's earnings.
So in summary, ASC 323 mandates the equity method for investments that meet the criteria for significant influence. This gives a more accurate picture of the investor's share of the profits and losses in the investee company.
What is the equity method of JV accounting?
The equity method of accounting is used when an investor has significant influence over the investee company, but does not have majority control. Significant influence typically means the investor owns 20-50% of the investee.
With the equity method, the initial investment is recorded at cost on the investor's balance sheet. The investor's share of the investee's earnings or losses are then recorded in the income statement and added to or subtracted from the investment account on the balance sheet.
For example, if Company A purchases 40% of Company B for $100,000, Company A would make the following entry:
Investment in Company B $100,000
Cash $100,000
If Company B then earns $50,000 in net income for the year, Company A would record their share of 40% or $20,000 as follows:
Investment in Company B $20,000
Equity Income $20,000
The equity method allows the investor to recognize its share of the profits and losses of the investee. This helps reflect the true performance of the investment over time.
The equity method differs from the cost method, where earnings are not recognized, and from full consolidation, where 100% of the investee's accounts are combined with the investor's. The equity method applies when significant influence over the investee exists without outright control.
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Breaking Down the Equity Method Investment Formula
The equity method is an accounting technique used by investors to account for investments in which they exert significant influence over the investee company. The equity method investment formula helps capture the investor's share of the investee's earnings.
Initial Investment and the Equity Method Formula
When an investor makes an initial investment under the equity method, they record the investment at cost. For example, if Company A purchases 25% ownership in Company B for $100,000, Company A would make the following journal entry:
Investment in Company B $100,000
Cash $100,000
The initial investment is recorded at historical cost on Company A's balance sheet.
Investor's Share of Earnings and Equity Method Formula
Under the equity method, the investor then adjusts the investment balance each period to account for its share of the investee's net income or loss. The formula is:
Investor's Share of Earnings = Investee's Net Income x Investor's Ownership Percentage
For example, if Company B reported net income of $200,000 for the year, Company A would record $50,000 as its share of Company B's earnings (25% x $200,000). The journal entry would be:
Investment in Company B $50,000
Income $50,000
This increases the investment account on Company A's balance sheet.
Investee's Net Income and Investor's Balance Sheet
By recording its proportional share of the investee's earnings, the investor is able to reflect the increasing value of its investment over time. The equity method provides a more accurate picture on the balance sheet compared to other methods like the cost method.
The equity method investment account will continue to be updated each period based on the investee's financial performance. This impacts the asset value on the investor's balance sheet.
Recording Equity Method Investment Journal Entries
Initial Recognition of Equity Method Investment
When a company first acquires an equity investment that qualifies for the equity method, it records the initial cost of the investment as an asset on the balance sheet. The corresponding journal entry is a debit to the equity investment asset account and a credit to cash or payables, depending on how the investment was acquired.
For example, if Company A purchases a 25% ownership share of Company B for $100,000, the journal entry would be:
Equity Investment in Company B $100,000
Cash $100,000
This establishes the initial carrying value of the equity investment on Company A's books.
Reflecting Share of Investee's Earnings
Under the equity method, the investor records its proportionate share of the investee's net income or loss as part of its own earnings. The investor's ownership percentage is used to determine its allocable share of the investee's profit or loss each period.
The journal entry to record the investor's share of the investee's net income involves debiting Equity Income and crediting the Equity Investment account. For example, if Company A determined its 25% share of Company B's net income was $10,000 for the year, the journal entry would be:
Equity Income $10,000
Equity Investment in Company B $10,000
This increases the carrying value of the investment and reports equity income to represent the investor's return. If the investee had a net loss, equity income would show a negative amount instead.
Dividends and the Impact on Retained Earnings
When the investee pays dividends, the investor company cannot record dividend income like a typical stock investment. Instead, the dividends reduce the carrying value of the equity investment on the investor's books.
For example, if Company B pays $5,000 in dividends and Company A is entitled to 25% of those dividends based on its ownership percentage, Company A would make this journal entry:
Equity Investment in Company B $5,000
Cash $5,000
The credit to cash reflects the actual dividends received, while the debit to the investment account reduces the carrying value. This aligns with the equity method principle that the investment account should reflect the investor's claim on the investee's book value.
In terms of retained earnings, the investor's share of the investee income increases retained earnings, while dividends from the investee reduce retained earnings. The equity income and dividend amounts flow through to the investor's equity section accordingly.
Comparing Equity Method to Cost and Consolidation Methods
Equity Method vs Cost Method in Accounting
The key difference between the equity method and cost method is in how the investor accounts for its share of the investee's earnings.
With the equity method, the investor recognizes its proportionate share of the investee's net income or loss in its income statement. The investor's share of the investee's earnings increases the investment account on the balance sheet, and dividends received from the investee reduce the investment account.
In contrast, under the cost method, the investor only recognizes dividends received from the investee as income. The investee's earnings are not included in the investor's income. The investment account on the investor's balance sheet is carried at cost and only adjusted for dividends received.
So in summary:
- Equity method - investor recognizes share of investee's earnings
- Cost method - investor does not recognize share of investee's earnings
The equity method is generally used when the investor has significant influence over the investee, whereas the cost method is used when the investor does not have significant influence.
Consolidation Method vs Equity Method of Accounting
The key difference between the consolidation method and equity method lies in the presentation of the investee company's financial statements.
Under the consolidation method, the investor essentially combines its financial statements with the investee's as if they were a single economic entity. The consolidated statements report 100% of the investee's assets, liabilities, revenues and expenses rather than just the investor's share.
In contrast, under the equity method, the investee's accounts are not combined with the investor's accounts. The investor reports its share of the investee's net assets and net income as single line items on its balance sheet and income statement respectively. There is no detailed breakdown of the investee's accounts.
Another key difference relates to minority interest. Under the consolidation method, minority interest represents the portion of the subsidiary's equity that is not owned by the parent. Minority interest is presented as a separate component within equity on the consolidated balance sheet.
The equity method does not have a minority interest component. Only the parent company's investment in and share of the subsidiary's income is recognized.
In summary, the consolidation method combines all accounts while the equity method shows a single investment account. Only consolidation has minority interest.
Adhering to IFRS and GAAP: Equity Method of Accounting
This section examines the requirements for equity method accounting under International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP).
Equity Method of Accounting Under GAAP
The equity method of accounting is used under U.S. GAAP when an investor has significant influence over an investee. Significant influence is presumed with an ownership stake between 20-50%.
The key guidelines for applying the equity method under GAAP include:
- The initial investment is recorded at cost. Any difference between the cost and the investor's share of net assets is accounted for similar to a consolidation.
- The investor's share of the investee's net income increases the investment account. The investor's share of net losses and dividends decreases the investment account.
- The investor reports its share of the investee's net income/loss on its income statement.
- The equity method investment is shown as a single-line item on the balance sheet.
Overall, the equity method allows the investor to record its share of income/losses without having to fully consolidate the investee's financial statements.
Equity Method of Accounting IFRS Considerations
Under IFRS, the equity method is referred to as the equity accounted investments method. The criteria for applying this method is similar to GAAP:
- Ownership stake allows for significant influence but not control (usually 20-50% ownership).
- Investment gives rise to returns and risk exposure associated with an equity stake rather than a debt stake.
However, there are some key differences in how the equity method is applied under IFRS:
- Goodwill related to the investment is included in the carrying amount rather than tested separately for impairment.
- IFRS does not provide special guidance for transactions between an investor and investee. The investor should not recognize its share of any profit/loss from the transaction until realized through an arm's length transaction with a third party.
- An investor's share of losses are allocated similar to a consolidation, even if the losses exceed the carrying amount of the investment on the investor's books.
So while the rationale for equity method accounting is similar between GAAP and IFRS, there are notable differences in its application worth considering.
Practical Examples of Equity Method Accounting
This section provides real-world scenarios to illustrate how the equity method of accounting is applied in practice.
Equity Method of Accounting Example: Initial Investment
Here is a hypothetical example of the journal entries for an initial investment under the equity method:
- Company A purchases 40% of Company B's stock for $100,000.
- Company B has total stockholders' equity of $300,000 at the time of purchase.
- Company A's share of Company B's book value is 40% * $300,000 = $120,000.
The journal entry for Company A would be:
| Account | Debit | Credit |
|---|---|---|
| Investment in Company B | $100,000 | |
| Cash | $100,000 |
To align the initial investment to Company A's share of book value:
| Account | Debit | Credit |
|---|---|---|
| Investment in Company B | $20,000 | |
| Equity Investments Adjustment | $20,000 |
The $20,000 represents the difference between the initial investment ($100,000) and Company A's share of book value ($120,000). This aligns the investment account balance to equity method accounting rules.
Ongoing Application of Equity Method Formula
Here is an example of applying the equity method formula to record Company A's share of Company B's net income:
- Company B reports net income of $50,000 for the year
- Company A owns 40% of Company B
- Therefore, Company A's share of Company B's net income is 40% * $50,000 = $20,000
The journal entry would be:
| Account | Debit | Credit |
|---|---|---|
| Investment in Company B | $20,000 | |
| Equity Investments Income | $20,000 |
This records Company A's $20,000 proportional share of Company B's net income for the year. The investment account balance is increased to continue reflecting Company A's share of ownership of Company B under the equity method.
Conclusion: Synthesizing Equity Method Investment Insights
Recap of Equity Method Investment Formula and Entries
The equity method investment formula calculates an investor's share of the investee's net income based on the percentage of ownership. The formula is:
Investor's Share of Net Income = Percentage Ownership x Investee's Net Income
The corresponding journal entries are:
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When the investment is initially recorded, debit the investment asset account and credit cash for the amount invested.
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Each period, debit the investment account and credit equity method investment income for the investor's proportional share of the investee's net income.
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Also, adjust the investment account balance and equity method investment income for any dividends declared by the investee.
Final Thoughts on Equity Method vs Other Accounting Approaches
The equity method is appropriate when an investor holds significant influence over the investee, generally 20-50% ownership. For controlling interests above 50%, use consolidation method. For ownership below 20% with no significant influence, use the cost method.
Compared to the cost method, the equity method better reflects economic reality by showing the investor's share of income. The consolidation method fully combines financial statements. The equity method strikes a balance between the two.
Considerations for Applying Equity Method of Accounting
When applying the equity method, accountants should:
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Carefully assess the level of ownership and influence to determine if equity method is applicable.
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Review investee financial statements and disclosures to accurately calculate proportional net income and equity changes.
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Record equity method journal entries each reporting period without fail.
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Disclose equity method investments properly in financial statement footnotes.
Following these best practices will result in proper accounting treatment under the equity method.
