Readers likely agree that accounting for equity investments can be complex.
This article clearly explains the equity method of accounting, including key concepts, differences from other methods, and real world examples.
You will learn the fundamentals of equity method accounting, from initial recording to subsequent measurement and adjustments. We compare the equity method to the cost method, cover tax and international accounting implications, reporting requirements, and provide illustrative case studies.
Introduction to Equity Method Accounting
The equity method is an important accounting technique used by companies to reflect their investment in other entities. It is applied when an investor has significant influence over the investee company. This introduction provides an overview of the equity method and why it matters for accurate financial reporting.
Understanding the Equity Method
The equity method is an accounting approach whereby the investment is initially recorded at cost but is then adjusted periodically to reflect the investor's share of the investee's profits or losses. The key steps are:
- The investment is first recorded at acquisition cost
- The investor's share of the investee's profits increase the investment (as income)
- The investor's share of any dividends received from the investee reduce the investment
- Any adjustments to reflect the investor's share of the investee's losses also reduce the investment
So under the equity method, the investment account reflects both the initial cost and the post-acquisition change in the investor's share of net assets of the investee.
Criteria for Using the Equity Method
The equity method applies when an investor has 'significant influence' over the investee. Significant influence generally means the investor holds 20-50% of the voting shares.
Specific criteria for applying the equity method include:
- Owning 20-50% shareholding/voting rights in the investee
- Having significant representation on the investee's board of directors
- Being party to significant transactions with the investee
- Possessing essential technical information relied on by the investee
If the investor's stake is less than 20%, the investment is accounted for at fair value. And ownership above 50% leads to full consolidation.
Goals of the Article
This article aims to help readers understand key aspects of equity method accounting. It will cover:
- The mechanics of how the equity method works
- When the equity method is required under accounting standards
- How to calculate and record equity method journal entries
- Differences between the equity method and other accounting for investments
With this foundation, readers should gain competence in applying the equity method in practice.
Is equity method accounting the same as cost?
No, the equity method and cost method of accounting for investments are not the same. Here are some key differences:
- Accounting Treatment: The equity method records the initial investment at cost and adjusts the carrying value of the investment based on the investor's share of the investee's income, losses, and dividends. The cost method records the investment at cost with dividends treated as income.
- Income Recognition: Under the equity method, the investor recognizes its share of the investee's net income or loss in its income statement. The cost method only recognizes dividends received as income.
- Asset Value: The equity method investment balance on the balance sheet reflects the initial cost adjusted for the investor's share of income/losses and reduced by dividends. The cost method investment balance only changes if there is an additional investment or full/partial write-down.
So in summary, the key difference is the equity method dynamically accounts for the investor's share of the investee's earnings while the cost method does not. The choice of accounting depends on the level of influence - equity method for significant influence, cost method for no/low influence.
What is the equity method of accounting?
The equity method of accounting is an accounting technique used by investors to account for investments in which they have significant influence over the investee company but do not fully control it.
Some key things to know about the equity method:
- It applies when an investor owns 20-50% of the voting shares of the investee company
- The investor's share of the investee's net income or net loss is recorded on the income statement
- The investor's share of other comprehensive income items is recorded directly in equity
- The investment balance on the investor's books is adjusted periodically to reflect their share of income/losses and dividends paid
So in essence, under the equity method, the investor is recording their share of the profits or losses of the investee company. This gives a more accurate picture of the investor's income compared to other methods like the cost method.
The equity method has implications for the investor's financial statements and ratios. For example, return on equity (ROE) will be impacted because net income includes the investor's share of the investee's income. Care must be taken when analyzing financial statements of a company using the equity method.
Some key differences between the equity method and the cost method of accounting for investments include:
- Cost method: Does not account for periodic income/losses. Only impacts investor books when dividends are paid or impairment charge is recorded.
- Equity method: Investor books reflect periodic investee income/losses. More accurate picture of investment performance.
In summary, the equity method provides a better accounting view compared to other methods when an investor owns 20-50% and has significant influence over the investee company. Understanding the mechanics and implications of this method is important for accurate financial analysis.
How do you explain equity in accounting?
Equity represents the residual value of a company's assets after subtracting all liabilities. It reflects the net worth or book value that would be returned to shareholders if the company was liquidated and all debts paid off.
There are a few key things to know about equity in accounting:
- Equity = Assets - Liabilities: This basic accounting equation shows that equity is equal to everything the company owns (assets) minus everything it owes (liabilities).
- It's a measure of residual ownership: Equity holders have a residual claim on assets after creditors get paid. So equity represents the shareholders' stake in the company based on initial investments and any retained earnings.
- It's increased by profits/investments: Equity grows when a company makes profits (which boost retained earnings) or receives cash investments from shareholders (which increases contributed capital).
- It's decreased by losses/dividends: On the flip side, equity shrinks if a company takes losses or pays dividends to shareholders from retained earnings.
So in summary, equity essentially reflects owner's funds in the business. It's a core accounting concept that connects a company's funding from owners and its residual assets after settling debts. Tracking equity is vital to assess the net worth and health of a business over time.
What is equity method versus consolidation?
The main difference between the equity method and consolidation is the level of ownership and control a company has over the investment.
Equity Method Key Points:
- Used when a company owns between 20-50% of another company's stock
- The investment is initially recorded at cost
- The investor's share of the investee's profits and losses are recognized in the income statement and added to/deducted from the investment account
- Only the investor's proportional share of the investee's earnings are recognized - there is no line-by-line consolidation
Consolidation Key Points:
- Used when ownership exceeds 50%
- Entails fully combining the financial statements of the two entities
- All assets, liabilities, revenues and expenses are combined on a line-by-line basis
- Intercompany balances and transactions are eliminated
- Non-controlling interest is reported for portions not owned
In summary, the equity method is simpler, only recording proportional earnings. Consolidation offers full control and requires detailed combination of accounts, including elimination entries. The 50% ownership threshold determines which method a company should apply for its investments.
Fundamentals of Equity Method Accounting
Equity method accounting is used to account for investments in associates or joint ventures. It requires the investor to recognize its share of the investee's net income or loss in the income statement, and its share of other comprehensive income in equity.
Equity Method Investment Basics
The equity method is applicable when an investor has significant influence over the investee. Significant influence usually means the investor owns 20-50% of the voting shares.
The key steps in equity method accounting are:
- Record initial investment at cost
- Adjust carrying amount each period for the investor's share of income, losses and distributions
- Report investor's share of income or loss in income statement
- Report share of other comprehensive income in equity
Equity Method Accounting Journal Entries
Here are some common journal entries under the equity method:
Initial investment
Dr. Investment in Associate Co. $100,000
Cr. Cash $100,000
Subsequent share of income
Dr. Investment in Associate Co. $8,000
Cr. Income from Associate Co. $8,000
Share of loss
Dr. Loss from Associate Co. $5,000
Cr. Investment in Associate Co. $5,000
Share of other comprehensive income
Dr. Investment in Associate Co. $3,000
Cr. Other Comprehensive Income $3,000
Cash distribution received
Dr. Cash $10,000
Cr. Investment in Associate Co. $10,000
Equity Method Formula
The formula to calculate an investor's share of income or loss is:
Investor's Share of Income = Investee's Net Income x Investor Ownership Percentage
For example, if the investee reports net income of $100,000 and the investor owns 30% of the voting shares, the investor's share of income would be $30,000 ($100,000 x 30%).
The equity method carrying amount on the balance sheet is adjusted each period to reflect the investor's share of income or losses and any distributions received.
Initial Recognition and Measurement
Recording the Initial Investment
When a company purchases an equity investment that gives them significant influence over the investee, they account for the investment using the equity method. To initially record the investment, the investing company makes a debit to an asset account such as Investments in Affiliates for the purchase price paid for the investee's shares. They will also credit Cash to reduce their cash balance by the amount paid.
For example, if Company A purchases 30% ownership in Company B for $300,000, the journal entry would be:
Investments in Affiliates $300,000
Cash $300,000
This records the initial equity method investment at cost on Company A's books.
Determining the Cost of Investment
The cost of an equity method investment includes the amount paid for the investee's stock as well as any direct costs related to acquiring the investment. This initial cost establishes the investment account's beginning balance.
Direct acquisition costs may include:
- Investment banking fees
- Legal fees
- Accounting fees
- Valuation fees
For example, if Company A paid $300,000 for shares of Company B plus $10,000 in legal fees, the initial cost basis would be $310,000.
The initial cost forms the basis for calculating the periodic equity method income or loss to be recognized by the investor. Understanding the composition of the initial cost is important for properly accounting for the investment over time.
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Subsequent Measurement and Adjustments
Equity method investments are adjusted over time to reflect the investor's share of the investee's profits and losses. This helps account for changes in the value of the investment.
Profit and Loss Recognition
The investor records its share of the investee's net income or loss as investment income on its income statement. The amount recognized is based on the percentage ownership in the investee. For example, if the investor owns 30% of the investee, it recognizes 30% of the investee's net income or loss.
The investment account on the investor's balance sheet is also adjusted each period. The carrying amount of the investment is increased by the investor's share of the investee's income, or decreased by the investor's share of the investee's losses.
Adjustments for Dividends and Other Distributions
Cash dividends or other distributions received from the investee reduce the carrying amount of the investment on the investor's books. This properly reflects that a portion of the investment has been returned to the investor in the form of dividends.
For example, if the investor receives a $100,000 cash dividend and currently has a $1,000,000 carrying value for the investee investment, the carrying value would be reduced to $900,000 to reflect the return of capital.
Impairment Considerations
Equity method investments must be evaluated each reporting period to assess whether impairment indicators are present. Common indicators include operating losses by the investee or other significant events that negatively impact the investee's fair value.
If impairment exists, the investor must calculate its share of the impairment loss and record an impairment charge to reduce the carrying amount of the investment. Ongoing operating losses may require recording additional impairment charges in subsequent periods.
Equity Method vs Cost Method
The equity method and cost method are two different accounting approaches for valuing investments in other entities. The key differences between them are:
Differences in Recognition and Measurement
- The equity method recognizes the initial investment at cost and adjusts the carrying value based on the investor's share of the investee's income, losses and dividends. The investor's share of the investee's earnings and losses are recognized in the income statement.
- The cost method records the initial investment at cost and only recognizes income from the investment to the extent dividends are received. The investee's earnings and losses are not recognized by the investor.
Under the equity method, the investment asset is adjusted periodically to reflect the investor's share of the investee's earnings or losses. This causes the investment balance to fluctuate over time. Under the cost method, the investment remains at the acquisition cost amount on the balance sheet unless dividends are received or impairment is recognized.
Impact on Financial Statements
The different approaches can have the following impacts on the investor's financial statements:
- Income Statement - As noted above, the equity method investment flows the investor's share of the investee's net income/loss into the income statement each period. The cost method only recognizes dividend income received, so earnings may be more volatile under the equity method.
- Balance Sheet - The investment account balance fluctuates under the equity method but generally remains static under cost method, except for dividends and impairments.
- Cash Flow Statement - Cash flows between the investor and investee are reflected differently. Under the equity method, these are mostly operating cash flows. Under the cost method, dividends received are investing cash inflows.
So in summary, the equity method shows the investor's share of the investee's performance while the cost method does not. This can impact earnings trends, balance sheet presentation, and cash flow classification.
Tax Implications of Equity Method Investments
Equity Method Investment Tax Treatment
The equity method of accounting has important tax considerations. While the investor company reports its share of the investee's net income on its income statement, this income may not be taxable.
Some key points on the tax treatment of equity method investments:
- The investor generally does not recognize taxable income from an equity method investment until dividends are received. This creates a deferred tax asset/liability related to the investment.
- Differences between income for accounting purposes and tax purposes lead to temporary differences. This includes undistributed earnings of investees.
- Tax implications depend on whether the investment is in a corporation or flow-through entity like a partnership. Flow-through income may be currently taxable.
- Gains and losses on the sale of an equity method investment receive capital or ordinary tax treatment depending on the specifics.
Proper tax planning and tracking of differences between accounting income and taxable income are important when using the equity method. Consultation with a tax advisor is recommended.
Deferred Taxes and Equity Method
The use of the equity method often results in deferred tax assets or liabilities on the balance sheet of the investor. This occurs due to timing differences between when net income is recognized for accounting purposes versus when it becomes taxable.
Some examples include:
- Undistributed earnings: The investor has income for accounting purposes but has not yet received taxable dividends. This creates a deferred tax liability.
- Excess distributions: If more dividends are distributed than cumulative equity earnings, this leads to a deferred tax asset.
- Impairments: An impairment write-down creates a deductible temporary difference and deferred tax asset.
Tracking differences between book and tax income is essential. The equity method investor needs procedures to estimate:
- Income expected to be undistributed each period
- Income expected to be distributed in future periods
- Any impairment write-downs for accounting purposes that are deductible for tax purposes
By accurately estimating deferred tax impacts, the proper accounting can be achieved. This leads to correct tax provision and balance sheet presentation.
International Accounting Standards: Equity Method of Accounting IFRS
The equity method is an accounting approach for certain investments whereby the investment is initially recorded at cost but is subsequently adjusted based on the investor's share of the investee's profits or losses. The equity method serves as a middle ground between consolidating the investee's financial statements and accounting for the investment based solely on its fair value.
Under IFRS, the equity method is applied when the investor has significant influence over the investee. Significant influence is presumed with a shareholding between 20-50%, unless it can be clearly demonstrated not to exist.
IFRS Requirements for Equity Method
The key requirements for applying the equity method under IFRS are:
- The investor must have significant influence over the investee, generally established with a 20-50% ownership interest.
- The investment must be classified as an associate or joint venture on acquisition.
- The equity method is applied from the date significant influence arises until the date it ceases.
- The investor's share of the investee's post-acquisition profits or losses is recognized in profit or loss.
- Distributions received from the investee reduce the carrying amount of the investment.
- Adjustments to the carrying amount may also be required for changes in the investee’s equity.
Comparing IFRS and US GAAP Equity Accounting
While IFRS and US GAAP have similar principles for equity method accounting, some key differences include:
- Ownership threshold: IFRS uses 20-50% to indicate significant influence while US GAAP uses 20% or greater.
- Classification: IFRS differentiates between an "associate" and a "joint venture" whereas US GAAP refers only to "equity method investments."
- Impairment testing: IFRS requires testing equity method investments for impairment. US GAAP has no such requirement.
- Presentation: IFRS requires separate presentation of equity method earnings and dividends. US GAAP allows a choice of presentation.
So in summary, while the fundamental mechanics are similar between IFRS and US GAAP, IFRS provides more definitive guidance on significant influence and classification and requires specific impairment testing and presentation of equity method investees.
Reporting and Disclosure Requirements
Equity method investments have specific reporting and disclosure requirements under accounting standards. These ensure transparency and allow financial statement users to properly evaluate a company's investment holdings.
Financial Statement Presentation
When a company uses the equity method to account for an investment, the investment asset is presented as a single line item called "Investments in Equity Method Investees" on the balance sheet.
On the income statement, the investor's share of the investee's net income or loss is presented as a single line item called "Equity in Earnings/Losses of Investee".
These single line presentations simplify the financial statements while still providing insight into the performance of equity method investments.
Note Disclosures
Under the equity method, companies must disclose additional details about equity method investments in the notes to the financial statements.
Typical disclosures include:
- The name and percentage ownership of each equity method investee
- The accounting policies used by the investee to generate financial information
- Summarized financial information about each investee, including assets, liabilities, and net income
- The difference between the carrying amount of each investment and the investor's share of the investee's net assets
- The unrealized gains/losses recognized from the investee's earnings
These disclosures provide transparency into the details of a company's equity method investments that are not apparent on the face of the financial statements. They give financial statement users a clearer picture of the economics and performance of these types of investments.
Real-World Examples of Equity Method Accounting
Equity method accounting can be complex, but analyzing real-world examples helps illustrate the key concepts. Here are some case studies and lessons learned from companies applying the equity method.
Case Studies
Company A invested $1 million for a 40% stake in Company B. Here is how Company A accounted for this investment:
- Recorded $1 million investment on its balance sheet under Investments
- As Company B earns income, Company A records 40% of that income on its income statement under Income from Equity Method Investments
- The investment balance on Company A's balance sheet is adjusted (upwards or downwards) periodically to reflect Company A's share of Company B's income/losses
For example, if Company B earned $200,000 in the first year:
- Company A would record $80,000 (40% x $200,000) as income that year
- The $1 million investment would be adjusted to $1.08 million on Company A's balance sheet
This shows how the equity method allows the investing company to recognize its share of the income from its investment.
Company C used the equity method to account for its 30% investment in Company D, which was experiencing losses. Here is how the accounting worked:
- Company C originally invested $500,000 for a 30% stake in Company D
- In the first year, Company D had losses of $100,000
- Company C recorded 30% of those losses or $30,000 on its income statement
- The $500,000 investment was reduced to $470,000 on Company C's balance sheet
This example demonstrates how the equity method handles losses - the investor's share of losses reduces the carrying value of the investment on their balance sheet.
Lessons Learned
Key takeaways from real-world equity method accounting:
- It allows investors to recognize income/losses from investments where they have significant influence
- The investment balance sheet amount fluctuates over time as the investee's income/losses are recorded
- Both profits (income) and losses reduce the investment account balance
- Careful tracking of percentages owned, income, losses, dividends is needed
Seeing the equity method used in practice helps clarify exactly how this accounting treatment works. The examples illustrate the underlying concepts and mechanics.
Conclusion: Synthesizing the Equity Method
Key Takeaways
The equity method is an important accounting technique for investments when an investor has significant influence over the investee. Key takeaways include:
- The equity method is used when an investor owns 20-50% of the voting shares of an investee. This indicates significant influence over the investee's operations.
- Under the equity method, the investment account is increased/decreased to recognize the investor's share of the investee's income/losses.
- The investor's share of the investee's profits increases the investment account. The investor's share of losses decreases the investment account.
- Equity method accounting better reflects the investor's interest in the investee compared to the cost method or fair value method.
- Complex aspects include how to account for dividends, impairments, disposals, indirect ownership structures, and equity method journal entries.
Final Thoughts
The equity method is an important technique in accounting for investments. It is commonly applied when an investor owns a significant stake in an investee, demonstrating influence over financial and operating policies. Equity method accounting leads to a more accurate representation on the balance sheet and income statement from period to period. While complex in practice, the underlying principles help account for an investor's share of income/losses in the ongoing operations of an investee.
