The equity method

Equity Method Overview

The equity method of accounting is used to account for an organization’s investment in another entity (the investee). This method is only used when the investor has significant influence over the investee. Under this method, the investor recognizes its share of the profits and losses of the investee in the periods when these profits and losses are also reflected in the accounts of the investee. Any profit or loss recognized by the investing entity appears in its income statement. Also, any recognized profit increases the investment recorded by the investing entity, while a recognized loss decreases the investment.

The equity method is only used when the investor can influence the operating or financial decisions of the investee. If there is no significant influence over the investee, the investor instead uses the cost method to account for its investment.

Equity Method Application

A number of circumstances indicate an investor’s ability to exercise significant influence over the operating and financial policies of an investee, including the following:

  • Board of directors representation
  • Policy-making participation
  • Intra-entity transactions that are material
  • Intra-entity management personnel interchange
  • Technological dependence
  • Proportion of ownership by the investor in comparison to that of other investors

If the investor has 20% or more of the voting stock of the investee, this creates a presumption that, in the absence of evidence to the contrary, the investor has the ability to exercise significant influence over the investee. Conversely, if the ownership percentage is less than 20%, there is a presumption that the investor does not have significant influence over the investee, unless it can otherwise demonstrate such ability. Substantial or even majority ownership of the investee by another party does not necessarily preclude the investor from also having significant influence with the investee.

If an investor owns 20% or more of an investee’s voting stock, it may still not exercise significant influence over the investee (though predominant evidence to the contrary is needed to prove the point). The following is a non-inclusive list of indicators that an investor may be unable to exercise significant influence:

  • The investee’s opposition to the investor’s influence, as evidenced by lawsuits or complaints to regulatory authorities.
  • The investor signs an agreement to surrender significant rights as a shareholder.
  • Another group of shareholders have majority ownership, who operate it without regard to the investor’s views.
  • The investor is unable to obtain sufficient information to apply the equity method.
  • The investor is unable to obtain representation on the investee’s board of directors.

Equity Method Accounting

Under the equity method, the investor begins as a baseline with the cost of its original investment in the investee, and then in subsequent periods recognizes its share of the earnings or losses of the investee, both as adjustments to its original investment as noted on its balance sheet, and also in the investor’s income statement.

The share of the investee’s earnings that the investor recognizes is calculated based on the investor’s ownership percentage of the investee’s common stock. When calculating its share of the investee’s earnings, the investor must also eliminate intra-entity profits and losses. Further, if the investee issues dividends to the investor, the investor should deduct the amount of these dividends from the carrying amount of its investment in the investee.

If the investee records adjustments in other comprehensive income, then the investor should record its share of these adjustments as changes to the investment account, with corresponding adjustments in equity. An investee’s potential adjustments to other comprehensive income include these items:

  • Unrealized gains and losses on available-for-sale securities
  • Foreign currency items
  • Gains and losses, prior service costs or credits, and transition assets or obligations related to pension and other post-retirement benefits

If the investee is not timely in forwarding its financial results to the investor, then the investor can calculate its share of the investee’s income from the most recent financial information it obtains. If there is a time lag in receiving this information, then the investor should use the same time lag in reporting investee results in the future, in order to be consistent.

Equity Method Example

ABC International acquires a 30% interest in Blue Widgets Corporation. In the most recent reporting period, Blue Widgets recognizes $1,000,000 of net income. Under the requirements of the equity method, ABC records $300,000 of this net income amount as earnings on its investment (as reported on the ABC income statement), which also increases the amount of its investment (as reported on the ABC balance sheet).