Accounting for joint ventures can be complex. Many companies struggle to determine the appropriate method.
This article will clearly explain equity method investments - from key definitions to real world examples to the accounting entries required.
You'll learn the key differences between equity and cost methods, when to use each, and how to account for dividends, impairments and other transactions under the equity method.
Introduction to Equity Method Investments
Equity method investments represent a company's investment in a joint venture or other entity where it holds significant influence but does not have majority control. This method of accounting is commonly used when two companies collaborate on a major project or enter a new market together through a partnership.
Defining Equity Method Investments
The equity method requires the investing company to record its initial investment at cost. Subsequently, the carrying amount of the investment is adjusted periodically to reflect the investing company's share of the joint venture's net income or loss. The investor's income statement reflects its share of the joint venture's net income or loss.
Reasons Companies Use Equity Method Investments
There are several strategic reasons companies enter into equity method joint ventures:
- Access new markets: Combining resources with a local or specialized partner can help enter new regional markets.
- Leverage expertise: Partnering with a company with specialized knowledge or technology can be mutually beneficial.
- Pool resources: Sharing costs and risks on major investments or projects expands possibilities.
- Strategic growth: Partnerships support overall business growth and diversification goals.
Understanding Equity Method Investments
An example helps illustrate the accounting:
- Company A invests $100,000 for a 40% stake in Company B.
- Company B reports $200,000 in net income for the year.
- Company A would report $80,000 income on its investment in Company B (40% * $200,000).
The equity method investment appears on Company A's balance sheet, and the shared income flows through to Company A's income statement.
Equity Method Investments: PwC and EY Perspectives
As per EY and PwC guidelines, companies should carefully assess if significant influence exists based on voting rights and board representation. Ongoing documentation and analysis are needed to apply the equity method appropriately. Disclosures should provide details on the joint venture activity and performance.
Is a joint venture accounted for on equity method?
In accordance with ASC 323-30-25-1, investors in partnerships, unincorporated joint ventures, and limited liability companies (LLCs) should generally account for their investment using the equity method of accounting by analogy if the investor has the ability to exercise significant influence over the investee.
Some key points on accounting for joint ventures using the equity method:
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The equity method is used when an investor has significant influence over the investee, usually from a 20-50% ownership stake. This allows the investor to account for its share of the joint venture's income and losses on its own financial statements.
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Under the equity method, the initial investment is recorded at cost. The carrying amount is then increased or decreased each period to account for the investor's proportional share of the joint venture's net income or loss.
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The investor's share of the joint venture's profits increases the investment account. Dividends received from the investee reduce the carrying amount of the investment.
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The equity method investment is tested periodically for impairment. An impairment loss is recorded if the carrying amount exceeds the fair value and is considered other-than-temporary.
So in summary, yes, investments in joint ventures are generally accounted for using the equity method when the investor can exercise significant influence over the venture. This method essentially allows the investor to report its share of the joint venture's performance.
What is the method of accounting for investment in joint venture?
Since a joint venture cannot be a subsidiary of any of its investors, and the investors all participate in the management of the joint venture, an investment in a joint venture is generally accounted for under the equity method of accounting pursuant to ASC 323.
The equity method is an accounting approach whereby the investment is initially recorded at cost and is then subsequently adjusted to reflect the investor's share of the joint venture's net income or loss. The investor's share of the joint venture's profits increases the investment account, while the investor's share of any losses decreases the investment account.
Key things to know about the equity method:
- The investor's share of the joint venture's net income or loss is reported on the investor's income statement each period. This impacts the investor's net income.
- The initial investment is recorded at cost.
- The investment account on the investor's balance sheet is increased or decreased each period to reflect the investor's allocated share of income or losses.
- Dividends received from the investment reduce the carrying value of the investment.
- The equity method investment may need to be tested for impairment if events or changes in circumstances indicate that the carrying amount may exceed the fair value. An impairment charge would be recorded if necessary.
So in summary, under the equity method the investor recognizes its share of the joint venture's income/losses in its financial statements. The investment account is also adjusted periodically to reflect these amounts allocated based on the ownership percentage.
How do I record an investment in JV?
When a company invests in a joint venture (JV) using the equity method of accounting, they record the investment on the balance sheet as an asset. Here is how to account for an equity method JV investment:
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Initial Investment - Record the initial purchase of shares in the JV as an investment asset on the balance sheet. Debit "Equity Method Investments" and credit Cash.
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Share of JV Earnings - Each reporting period, record the investor's share of the JV's net income or loss. Debit "Equity in Earnings of JV" and credit "Equity Method Investments". This impacts the income statement.
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Share of Other Comprehensive Income - If the JV has items of other comprehensive income (OCI), such as foreign currency translation adjustments, record the investor's share of these items in the investor's OCI.
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Cash Dividends Received - If the JV pays dividends to the investor, the investor debits Cash and credits "Equity Method Investments" to reduce their investment balance.
The equity method allows the investor to maintain influence over the JV while still treating it as an investment. Key things to remember are to pick up the periodic share of income/losses and reduce the investment balance for dividends received. Disclosures about the details of equity method investments are also required under IFRS and US GAAP.
How do you account for equity method investments?
The investment is first recorded at its historical cost, then adjusted based on the percent ownership the investor has in net income, loss, and any dividend payments.
Here is a summary of how to account for equity method investments:
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Initial recording: The investment is recorded at the cost at the date of acquisition. This establishes the initial carrying value.
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Income statement impacts: The investor's share of the investee's net income or loss increases or decreases the investment account. The investor records its share of the investee's net income or loss in its income statement.
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Dividend payments: Cash dividends received from the investee reduce the carrying amount of the investment.
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Additional investments or dispositions: If the investor acquires additional common stock of the investee, the investment account is increased. If the investor sells some of its investment, a gain or loss may need to be recognized.
To illustrate, if an investor owns 30% of an investee and the investee reports net income of $100,000, the investor would increase its investment account by $30,000 (30% x $100,000) and report investment income of $30,000.
The equity method provides an accurate picture of an investor's share of income and losses from its investment. Following these steps ensures the investment account reflects claims on the book value of the investee.
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Determining the Appropriate Accounting Method
This section delves into the criteria for selecting between the equity method and other accounting approaches, such as the cost method.
Equity Method vs Cost Method: Key Differences
The key differences between the equity method and the cost method for accounting for investments include:
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Recognition of earnings: The equity method recognizes a portion of the investee's earnings in the income statement, while the cost method only recognizes earnings through dividends received.
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Measurement: The equity method investment balance reflects changes in the investee's book value, while the cost method investment balance remains at historical cost.
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Consolidation: The equity method investment is shown as a single line item on the balance sheet, while the cost method shows individual assets and liabilities.
In summary, the equity method more accurately portrays economic reality by reflecting ongoing earnings and book value changes in the investment account.
Ownership Percentage Threshold
The equity method typically applies when an investor owns 20-50% of the voting stock or otherwise exhibits significant influence over the investee. Ownership under 20% generally indicates the investment is passive, warranting use of the cost method instead.
Assessing the Level of Influence
Even minority stakes may warrant equity method accounting if certain factors indicate the ability to impact the investee's financial decisions, including:
- Representation on the investee's board of directors
- Participation in investee policy-making processes
- Interchange of managerial personnel
- Technological dependency
- Extent of ownership by an investor in relation to other shareholdings
Applicability to Specific Entity Types
In addition to corporations, the equity method is commonly used for investments in partnerships, limited liability companies (LLCs), and joint ventures when the ownership threshold and influence criteria are met.
Accounting for Equity Method Investments Under IFRS
This section discusses the specific guidelines and procedures for equity method accounting as per the International Financial Reporting Standards (IFRS).
Equity Method of Accounting IFRS Framework
The IFRS framework provides guidance on when and how to apply the equity method for accounting for investments in associates and joint ventures. Key standards include:
- IFRS 11 Joint Arrangements - Defines joint control and classification of joint arrangements.
- IAS 28 Investments in Associates and Joint Ventures - Covers application of the equity method.
- IFRS 12 Disclosure of Interests in Other Entities - Details disclosure requirements.
The equity method is applied when an investor has significant influence over the investee. This is generally presumed with a shareholding between 20-50%.
Initial Purchase and Investment Balance
The initial investment is recognized at cost as an asset on the balance sheet. Any premium or discount on acquisition is amortized over the life of the investment:
- Investment = Cost of acquisition + Directly attributable costs
- Premium/Discount amortized to P&L over investment life
Example:
- Investment of $500,000 made for 25% interest
- Fair value of share $550,000 => $50,000 premium
- Premium amortized over 5 years ($10,000 to P&L per year)
Ongoing Adjustments to Recognize Share of Profits/Losses
After initial recognition, the carrying amount is adjusted to recognize the investor's share of the associate's profits or losses after acquisition.
- Investor recognizes share of associate's net income/loss based on ownership
- Associate's accounting policies must be adjusted to those of investor
- Amortization of premium/discount also recognized
Example:
- Original investment of $500,000 for 25% share
- Associate reports net income of $200,000 this year
- Investor recognizes $50,000 share of income (25% x $200,000)
- Investment balance increased to $550,000
Accounting for Dividends and Other Distributions
Cash dividends received from the associate reduce the carrying amount of the investment. Stock dividends may increase the number of shares used to calculate ownership percentage.
- Cash dividends = reduction in investment account
- Stock dividends/splits = may change ownership % and share of income
Careful tracking of changes in ownership percentage is necessary over the investment life.
Equity Method Investment Disclosures and Tax Treatment
Exploring the requirements for financial disclosures and the tax implications associated with equity method investments.
Equity Method Investment Disclosure Examples
Companies must disclose certain information related to their equity method investments in the footnotes of their financial statements. Some key disclosure examples include:
- The name of each investee and percentage ownership interest
- The accounting policies used for equity method accounting
- The difference, if any, between the amount at which an investment is carried and the amount of underlying equity in net assets
- The aggregate fair value of each identified investment for which a quoted market price is available
For example, Starbucks may disclose in the financial statement footnotes:
Starbucks maintains a 50% equity interest in Starbucks Japan. This investment is accounted for under the equity method of accounting. The carrying value of Starbucks' investment was $100 million at year end, which approximated Starbucks' 50% share of Starbucks Japan's equity.
Testing for and Measuring Impairment Losses
Companies must periodically test their equity method investments for impairment if events or changes in circumstances indicate that the fair value of the investment has declined below carrying value.
An impairment loss exists when the fair value is below carrying amount for a prolonged period (generally defined as 9 months). Impairment losses are recorded in net income, reducing the carrying amount of the investment.
For example, if Starbucks determines their share of Starbucks Japan's net assets declined from $100 million to $80 million in value, and this decline is considered "prolonged", they would book a $20 million impairment charge.
Goodwill and Excess Fair Value Allocations
When an equity method investment is acquired, any premium paid over book value typically represents acquired goodwill and/or the fair value of identifiable assets that are not reflected on the investee's balance sheet.
For example, if Starbucks Japan had a book value of $50 million but Starbucks paid $100 million for their 50% interest, $25 million would likely be allocated to goodwill and $25 million allocated to identifiable intangible assets like trademarks.
These excess values are generally disclosed in the footnotes rather than recognized on the investor's balance sheet. The investor amortizes excess values through their periodic recognition of equity method earnings.
Equity Method Investment Tax Treatment
For tax purposes, equity method investments are generally treated similarly to dividends from subsidiaries. Investors recognize their share of investee profits as taxable income, even if profits are not distributed as dividends.
However, differences can exist between the accounting and tax carrying values where book-tax differences were embedded in the investee's net assets at acquisition. This can result in deferred taxes for the difference between accounting income and taxable income from the equity investment.
Investors are also required to periodically test their tax basis in equity investments and record any deferred tax assets/liabilities related to declines in value below tax basis.
Transitioning Between Equity and Other Accounting Methods
This section addresses the process and implications of moving to or from the equity method of accounting for investments.
Loss of Significant Influence Threshold
The equity method is discontinued if the investor's stake falls below 20% or it loses board representation and other influence. According to IFRS, the 20% threshold serves as an indicator for significant influence, which is required for the equity method.
If the investment level drops below this point, the company would switch to accounting for the investment using the cost method. This means the investment would be carried at cost on the balance sheet, rather than reflecting the investor's share of the associate's net assets.
Switching to the Cost Method
Changing from the equity method to the cost method has major balance sheet implications related to the investment's reported value.
When transitioning methods, the carrying amount of the investment on the date significant influence is lost serves as the cost basis going forward. Any difference between this carrying value and the fair value of the retained interest is recognized as a gain or loss in net income.
For example, if an equity method investment with a carrying amount of $1 million drops to a 15% interest, with a fair value of $800,000, the company would book a $200,000 loss on the change in accounting method.
Requalifying for the Equity Method
A company may subsequently requalify to use the equity method after a period where the cost method applied.
According to FASB guidance, the equity investment is remeasured at fair value when significant influence is reestablished. However, any fair value adjustments previously recognized during the cost method period remain as part of the investment's carrying amount.
Only the investor's share of earnings or losses after requalifying for the equity method is recognized going forward, starting from the carrying amount on that date.
Key Takeaways and Summary
In summary, properly accounting for equity method investments requires understanding the criteria for use, mechanics of the equity method, and complexities around valuation, impairment, and discontinuation.
Core Principles and Objectives
The equity method is fundamentally about recognizing an investor's share of an associate's performance in cases where significant influence exists. Key principles include:
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The investor holds 20-50% ownership of the associate company. This suggests significant influence without outright control.
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The investment is initially recorded at cost and adjusted periodically to recognize the investor's share of the associate's earnings or losses.
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The earnings or losses of the associate directly impact and are reflected in the investor's financial statements.
The objective is to account for significant influence over an investment using the equity method rather than just fair value or cost approaches.
Main Transactions and Events to Consider
From initial recording to ongoing profit/loss recognition to distributions and discontinuation, properly processing key events is critical. Main transactions include:
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Initial investment - Recorded at cost at time of acquisition. Any difference between cost and underlying book value of net assets is goodwill.
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Profit/loss allocation - Investor's share of periodic associate earnings/losses adjusts investment account.
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Distributions - Payments from associate reduce the investment account.
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Discontinuation - If significant influence is lost, equity method is discontinued. Investment is recorded at fair value with gain/loss recognition.
Role of Judgment and Estimates
Applying standards like impairment tests and assessing the level of influence involves significant management judgment. Examples include:
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Determining level of influence based on % ownership and other factors. Judgment required.
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Impairment testing - is there objective evidence of impairment in the investment? Management must assess.
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Fair value estimates if the equity method is discontinued. Assumptions and estimates involved.
Proper application requires judgment and reasoned estimates by management.
