What Is Equity Method?
The equity method is an accounting technique used to account for investment in another company when the investor has "significant influence" over the investee's operating and financial policies, but does not have control. This falls under the broader category of financial accounting. Typically, significant influence is presumed when an investor owns between 20% and 50% of the voting stock of the investee company, though other factors can indicate its presence even outside this range17. Under the equity method, the initial cost of the investment is recorded as an asset on the investor's balance sheet and subsequently adjusted to reflect the investor's proportionate share of the investee's net income or losses. When the investee declares dividends, the investor reduces the carrying amount of its investment, as dividends received are considered a return of capital, not income.
History and Origin
The concept behind the equity method has evolved over time to address how companies should account for holdings that grant substantial, but not controlling, power. In the United States, the Accounting Principles Board (APB) formalized the equity method with the issuance of APB Opinion No. 18 in 1971. This opinion established the "one-line consolidation" premise, aiming to provide investors with a better reflection of the underlying nature of their investments in associates and joint ventures16.
Internationally, the equity method was introduced into International Accounting Standards (IAS) in 1976 as part of IAS 3, Consolidated Financial Statements. Its requirements were later moved to IAS 28, Accounting for Investments in Associates, in 1989, and subsequently renamed IAS 28, Investments in Associates and Joint Ventures, in 2003 and 2010 to reflect its expanded application to joint ventures15. The Financial Accounting Standards Board (FASB) continues to issue guidance, such as Accounting Standards Codification (ASC) Topic 323, which provides comprehensive rules for applying the equity method under U.S. Generally Accepted Accounting Principles (GAAP)14.
Key Takeaways
- The equity method is used when an investor has significant influence (typically 20-50% ownership) but not control over an investee.
- The investment is initially recorded at cost on the investor's balance sheet.
- The investor's share of the investee's net income increases the investment's carrying value and is recognized as income.
- Dividends received from the investee reduce the investment's carrying value, as they are considered a return of the investment, not new income.
- This method aims to provide a more accurate representation of the economic relationship between the investor and investee than the cost method or fair value method when significant influence exists.
Formula and Calculation
The equity method involves adjustments to the initial investment cost. The primary adjustments are for the investor's share of the investee's net income (or loss) and dividends.
Initial Investment:
Subsequent Adjustments:
Where:
- (\text{Investment Carrying Amount}_{\text{Start}}) is the carrying value of the investment at the beginning of the period.
- (\text{Investee Net Income}) is the investee's reported net income for the period.
- (\text{Ownership Percentage}) is the investor's percentage of ownership in the investee.
- (\text{Investee Dividends}) are the total dividends declared by the investee during the period.
The investor's share of the investee's net income is recognized on the investor's income statement.
Interpreting the Equity Method
Interpreting financial statements prepared using the equity method requires understanding that the investor's reported income includes its share of the investee's earnings, even if those earnings have not been distributed as dividends. This means the investor's reported net income may not directly correspond to the cash flows received from the investee. The investment line item on the investor's balance sheet reflects the initial cost plus its share of undistributed earnings, providing a continuously updated value that approximates the investor's proportional ownership of the investee's equity.
This method is designed to provide a more comprehensive view of the economic substance of the relationship, as it recognizes the investor's influence over the investee's operations and financial results. Analysts should consider the components of the investment's carrying value and the nature of the underlying investee's business when evaluating the investor's financial health.
Hypothetical Example
Assume Company A acquires 30% of Company B's voting stock for $1,000,000 on January 1. Company A determines it has significant influence over Company B.
-
Initial Recognition:
On January 1, Company A records the investment on its balance sheet:
Debit: Investment in Company B - $1,000,000
Credit: Cash - $1,000,000 -
Investee Net Income:
During the year, Company B reports a net income of $500,000. Company A's share is 30% of $500,000, which is $150,000.
Company A updates its investment and recognizes income:
Debit: Investment in Company B - $150,000
Credit: Equity in Earnings of Company B (Income Statement) - $150,000 -
Investee Dividends:
Later in the year, Company B declares and pays $100,000 in dividends. Company A's share is 30% of $100,000, which is $30,000.
Company A records the dividend as a reduction of its investment:
Debit: Cash - $30,000
Credit: Investment in Company B - $30,000 -
Year-End Carrying Value:
At the end of the year, the carrying value of Company A's investment in Company B would be:
$1,000,000 (Initial Cost) + $150,000 (Share of Net Income) - $30,000 (Share of Dividends) = $1,120,000.
Practical Applications
The equity method is a fundamental component of financial accounting for companies with certain types of external investment interests. It is broadly applied in situations where one company holds a minority stake (typically 20% to 50%) in another entity and can exert significant influence over its strategic operating and financial decisions, without having full control. This includes investments in joint ventures and associates.
For instance, a corporation might use the equity method to account for its investment in a strategic partner that it doesn't fully own but with whom it collaborates closely on product development or market entry. Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) have specific reporting requirements for equity method investees, particularly when such investments are deemed "significant" based on certain financial tests, necessitating additional disclosures in financial statements13. This ensures transparency for investors and creditors regarding the impact of these non-controlled but influential holdings on the reporting entity's financial position and performance.
Limitations and Criticisms
While the equity method aims to provide a more representative view of an investment than the cost method, it faces several limitations and criticisms. One primary concern is that it does not reflect the fair value of the investment, as the carrying amount is based on historical cost adjusted by retained earnings, rather than current market prices12. This can lead to a discrepancy between the book value and the actual economic value of the investment, potentially obscuring insights for investors11.
Another critique revolves around the "one-line consolidation" approach, where only the investor's share of the investee's net income appears on the income statement, and the entire investment is a single line item on the [balance sheet](https://diversification.com/term/balance sheet). This aggregation can obscure the detailed financial performance and individual assets and liabilities of the underlying investee, making it challenging for users of financial statements to conduct in-depth analysis10. Some argue that this approach leads to "paper profits" because income is recognized even if no cash dividends are received9.
Furthermore, determining "significant influence" can be subjective. While a 20-50% voting stock ownership is a common guideline, other factors such as board representation, material intercompany transactions, or technological dependency can indicate significant influence, even with lower ownership percentages7, 8. This subjectivity can lead to inconsistencies in application. Additionally, the equity method typically requires adjustments for amortization of basis differences, including positive or negative goodwill, adding complexity to the accounting process6.
Equity Method vs. Consolidation Method
The key distinction between the equity method and the consolidation method lies in the degree of control an investor exercises over another entity.
Under the equity method, an investor has "significant influence" over the investee's operating and financial policies but does not have control. This typically corresponds to an ownership stake of 20% to 50% of the investee's voting stock. In this scenario, the investor's investment is reported as a single line item on the balance sheet, adjusted for its share of the investee's net income and dividends. The investee's individual assets, liabilities, revenues, and expenses are not combined with those of the investor.
In contrast, the consolidation method is applied when an investor has "control" over another entity, usually indicated by an ownership of more than 50% of the voting stock. When consolidation is applied, the investor (parent company) combines all the assets, liabilities, revenues, and expenses of the investee (subsidiary) with its own to produce a single set of consolidated financial statements4, 5. This approach reflects the economic reality that the parent and subsidiary operate as a single economic unit, even if they are legally separate entities. Any portion of the subsidiary not owned by the parent is presented as a non-controlling interest within the consolidated financial statements.
FAQs
When is the equity method typically used?
The equity method is typically used when an investor company holds between 20% and 50% of the voting stock of another company, indicating that the investor can exercise "significant influence" over the investee's financial and operating policies, but does not have outright control3.
How does the equity method affect the investor's financial statements?
Under the equity method, the initial investment is recorded as an asset on the investor's balance sheet. The investor's proportionate share of the investee's net income increases the investment's carrying value and is recognized as income on the investor's income statement. Conversely, dividends received from the investee reduce the investment's carrying value.
Does the equity method reflect the fair value of the investment?
No, the equity method does not directly reflect the fair value of the investment. It is an accrual-based accounting method that adjusts the initial cost by the investor's share of the investee's retained earnings. Market fluctuations in the investee's stock price are generally not incorporated into the investment's carrying amount under this method1, 2.