When investing in another company, properly accounting for that investment can get complicated. Most would agree that understanding the differences between the equity method and the consolidation method is critical.
In this post, I'll clearly explain the key distinctions between these two accounting approaches. You'll learn when each one applies, how to apply them properly, and how to evaluate their respective impacts.
First, we'll look at the fundamental differences between the equity method and full consolidation. Then, we'll walk through real-world examples to see these methods in action. By the end, you'll understand exactly when and how to use each approach for invested companies based on the level of ownership and influence.
Introduction to Equity and Consolidation Methods
The equity method and consolidation method are two accounting approaches for reporting investments in other companies. The key difference lies in the level of control or influence the investing company (parent company) has over the company it is investing in (investee).
The equity method applies when the parent company holds significant influence over the investee, usually indicated by owning 20-50% of the investee's stock. The parent company records its proportionate share of the investee's net income and other comprehensive income on its income statement. The investment balance on the parent company's balance sheet is also adjusted each period to reflect its share of income/losses and dividends paid.
In contrast, the full consolidation method applies when the parent company has a controlling financial interest, typically ownership of >50% of the investee's stock. The investee's assets, liabilities, revenues and expenses are combined with the parent company's financial statements on a line-by-line basis. Intercompany transactions and balances are eliminated upon consolidation. Non-controlling interests of other shareholders in the subsidiary are reported separately.
In summary, the equity method applies to investments where the parent has significant influence but not outright control, while full consolidation applies when the parent controls the subsidiary's finances and operations. The choice of accounting method depends on the level of ownership and control.
When using the equity method and when consolidation is required?
The equity method of accounting is used when an investor holds significant influence over the investee company, but does not have majority control. Significant influence typically means the investor owns 20-50% of the investee's voting shares. In contrast, the full consolidation method is used when the investor has over 50% ownership and effective control of the investee.
Some key differences between the two methods:
Equity Method
- Investor records its share of the investee's net income/loss on its income statement
- Investor's balance sheet shows the investment account at cost plus accumulated earnings less dividends
- No line-by-line consolidation of assets, liabilities, revenues and expenses
- Used when investor has significant influence but <50% ownership
Full Consolidation Method
- Investor fully consolidates the investee's financial statements on a line-by-line basis
- Assets, liabilities, revenues and expenses are combined with the investor's
- Intercompany balances and transactions are eliminated upon consolidation
- Non-controlling interest shows the portion of net assets owned by other shareholders
- Used when investor has >50% ownership and effective control
In summary, the equity method applies when an investor can influence the investee's financial and operating policies, whereas full consolidation applies when the investor controls the investee company. Understanding the level of ownership and influence is key to selecting the appropriate accounting method.
When would you use the equity method?
The equity method is applied when a company owns between 20-50% of the voting stock of another company, known as the investee. This level of ownership indicates the investing company has significant influence over the investee, but not outright control.
Some key situations where the equity method would be used:
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Company A acquires 30% ownership in Company B. Company A would account for this investment using the equity method since they hold significant influence but do not have majority control.
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A joint venture where two companies each own 50% would qualify for the equity method. Neither company controls the joint venture outright, so it does not qualify for full consolidation.
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An investor actively participates on the board of directors of an investee that they have 35% ownership in. Their voting power and board involvement indicates significant influence, making the equity method appropriate.
In essence, the equity method applies when an investor can influence the operating or financial decisions of an investee, but lacks outright control. It accounts for the investor's proportionate share of the investee's income and losses on their financial statements. This provides more insight than alternative methods into the performance of strategic investments.
What is the difference between proportionate consolidation and equity method?
The key difference between the equity method and proportionate consolidation lies in the level of control and influence the investing company has over the investee.
Equity Method
The equity method is used when the investing company owns between 20-50% of the voting shares of the investee and has significant influence but does not have control. The investor records its share of the investee's net income and other comprehensive income in its income statement and balance sheet. The investment is initially recorded at cost and adjusted periodically to reflect the investor's share of the investee's earnings and losses. Dividends received from the investee reduce the carrying amount of the investment.
Proportionate Consolidation
Proportionate consolidation is used when the investor has joint control over the investee, typically through a contractual arrangement. The investor consolidates its proportionate share of the investee's assets, liabilities, revenues and expenses line-by-line into its financial statements. Items in the consolidated financial statements are recorded according to the investor's ownership percentage in the jointly controlled entity.
The key deciding factors are the level of control and consolidation method to apply. Significant influence leads to equity method, while joint control requires proportionate consolidation.
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What is the difference between the equity method and the cost method?
The key difference between the equity method and the cost method lies in how the investor company accounts for and records the earnings of the investee company.
Equity Method
- The equity method is used when the investor company holds significant influence over the investee company, usually owning 20-50% of the investee's shares.
- The investor company records a proportionate share of the investee's earnings and losses on its income statement.
- The amount recorded is based on the percentage of shares the investor owns. For example, if the investor owns 30% of the investee, they record 30% of the investee's net income.
- Dividends received from the investee company are recorded by the investor as a reduction in the investment account rather than as dividend income.
Cost Method
- The cost method is used when the investor company holds less than 20% of the investee and has little influence.
- Only the initial investment is recorded on the books. Investments are recorded at cost with no recognition of any share of investee earnings or losses.
- Dividends received from the investee company are recorded as income by the investor company.
In summary, under the equity method, the investor recognizes its share of investee income/losses, while under the cost method the investor does not. The choice of method depends on the investor's level of influence over the investee.
Delving into the Equity Method
The equity method is an accounting technique used by investors to account for investments in which they exert significant influence over the investee company.
Accounting for Investor's Proportionate Share of Net Income
When the equity method is used, the investor's investment account on the balance sheet is adjusted periodically to reflect the investor's share of the investee's net income or losses. Specifically:
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The investment account is increased by the investor's proportional share of the investee's net income for the period. For example, if the investor owns 30% of the investee and the investee reports $100,000 of net income, the investor would increase its investment account by $30,000 (30% x $100,000).
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The investment account is decreased by the investor's proportional share of any net losses reported by the investee over the period. Dividends received from the investee also reduce the investment account balance.
By adjusting the investment account in this manner, the investor is, in effect, recognizing its share of the profits and losses of the investee company.
Equity Method on Balance Sheets and Income Statements
On the investor's balance sheet, the investment account balance reflects the initial investment amount, adjusted over time by the equity method. The income statement impact is that the investor's proportional share of the investee's net income or net loss is reported on the investor's income statement, rather than just dividend income.
So the equity method impacts both the investor's balance sheet (investment account) and income statement (net income). The investee company continues to have its own, stand-alone financial statements.
Journal Entry Examples for the Equity Method
Here are some examples of journal entries under the equity method:
- Initial investment - Debit Investment Account, Credit Cash
- Proportional share of investee's net income - Debit Investment Account, Credit Equity in Investee Income
- Proportional share of investee's net loss - Debit Equity in Investee Loss, Credit Investment Account
- Dividends received from investee - Debit Cash, Credit Investment Account
These journal entries serve to update the investment account balance over time and record the investor's proportional share of income or losses from the investee.
Applying the Consolidation Method
The consolidation method combines the financial statements of a subsidiary with those of its parent company. This provides a comprehensive view of the financial position and operating results of the group as a whole.
Merging Balance Sheet Items for Full Consolidation
When applying the full consolidation method:
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The assets and liabilities of the subsidiary are combined with those of the parent company at their carrying values.
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Intercompany balances and transactions between the parent and subsidiary are eliminated.
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Non-controlling interests (also called minority interests) are reported to reflect portions of subsidiaries not owned by the parent.
By consolidating balance sheets in this manner, users get an accurate picture of the group's total assets, liabilities, and equity.
Integrating Income Statement Items in Consolidation
Similarly, the full consolidation method merges the income statement accounts of the parent and subsidiaries, including:
- Revenues
- Expenses
- Gains
- Losses
The net income attributable to non-controlling shareholders is deducted to derive the net income attributable to the parent company's shareholders.
This gives statement users a clear view of the total earnings generated by the consolidated entity during the period.
Evaluating the Impact of Consolidation on Financial Ratios
Applying the full consolidation method can significantly impact financial ratios compared to the parent company's standalone financial statements. For example:
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Return on assets (ROA) and return on equity (ROE) may vary as the asset and equity bases change.
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Profit margins may fluctuate due to subsidiaries' earning levels.
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Leverage ratios will alter due to consolidated debt, assets, and equity amounts.
Careful financial analysis is required to fully grasp performance after consolidation.
Comparing Equity and Consolidation Methods in Practice
Assessing the Level of Ownership and Influence
The key factor in determining whether to use the equity method or full consolidation is the level of ownership and influence the investing company has over the investee.
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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. This method records the initial investment at cost and adjusts it based on the investor's share of the investee's earnings or losses.
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Full consolidation applies when the investor owns >50% of the voting shares and has outright control over the investee. This combines the assets, liabilities, revenues and expenses of the subsidiary with the parent company's financials.
So if ownership is <20%, the cost method is used. Between 20-50%, equity method is applied if significant influence can be exerted. And over 50% necessitates full consolidation as it represents outright control.
Distinguishing Between Investments in Joint Ventures and Subsidiaries
The equity method is commonly applied for investments in joint ventures and associates where there is shared control between multiple investors:
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A joint venture is a partnership where two or more firms collaborate on a project while maintaining separate identities. As each party only exerts partial control, the equity method is suitable for recording income and losses.
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An associate is a company in which the investor has significant influence but not outright control. Associates are also accounted for using the equity method rather than full consolidation.
In contrast, subsidiaries represent parent-controlled entities where there is a clear parent-subsidiary relationship. Here the parent has outright control so full consolidation applies.
Navigating the Change from Equity Method to Consolidation
As ownership percentages fluctuate over time, a switch between the equity method and full consolidation may be required. For example:
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If ownership in an associate increases from 30% to 55%, it likely moves from equity method to full consolidation as majority control is attained.
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Or if a parent sells some subsidiary shares such that ownership decreases from 60% to 45%, this would require a switch from consolidation to the equity method.
In such cases, balanced assessment of the updated ownership level and degree of control is crucial to determine the appropriate transition of accounting methods.
Conclusion: Deciding Between Equity Method and Consolidation
In summary, the choice between the equity method vs consolidation depends on the investor's level of control and ownership in the investee. Both serve important purposes for accurately reporting results of operations and financial position.
Recap of Equity Method vs Consolidation Method
The equity method applies to investments where the investor holds significant influence over the investee, usually from a 20-50% ownership stake. This method records the investor's proportionate share of the investee's net income as investment income on the investor's books. The investee and investor retain separate financial statements.
In contrast, full consolidation combines the investor and investee financial statements when the investor holds a controlling interest, usually over 50% ownership. All assets, liabilities, revenues and expenses are combined. Consolidation shows the financial results as if the two entities were one.
So in summary:
- Equity method - Investor has significant influence (20-50% ownership typically)
- Full consolidation - Investor has controlling interest (over 50% ownership)
Seeking Expertise in Complex Investment Accounting
Applying the equity method or full consolidation involves in-depth accounting expertise. Factors like percentage ownership, voting interests, board seats, and contractual terms all determine the appropriate method.
Given this complexity, it is wise for management and investors to consult accounting professionals when making an investment and determining the optimal accounting approach. Their guidance can ensure financial reporting complies with GAAP, IFRS or other standards.
Relying on experts can also help avoid unintended consolidation or adverse impacts on financial statements. They can provide ongoing support as investment terms evolve over time as well.
