Equity method of accounting

What Is the Equity Method of Accounting?

The equity method of accounting is an accounting technique used by a company, known as the investor, to record its investments in another company, the investee, when the investor has significant influence over the investee's operating and financial policies. This level of influence typically exists when the investor owns between 20% and 50% of the investee's voting stock. Under this method, the investment is initially recorded at cost and subsequently adjusted to reflect the investor's share of the investee's profits or losses. The equity method falls under the broader category of Financial Accounting, providing a detailed representation of an investor's economic interest in an investee. This approach contrasts with simply holding an investment as a financial asset, as it acknowledges a deeper relationship and operational impact. The equity method of accounting is specifically designed to provide a more accurate picture of the economic substance of the relationship between the investor and the investee than other accounting methods.

History and Origin

The development of accounting standards for investments like the equity method reflects the evolving complexity of corporate structures and intercompany relationships. Over time, as businesses formed various strategic alliances, joint ventures, and partial ownership stakes, a need arose for a method that could accurately represent an investor's proportional share of an investee's performance without requiring full Consolidated Financial Statements.

The International Accounting Standards Board (IASB) plays a significant role in governing the equity method through IFRS standards. Specifically, IAS 28, "Investments in Associates and Joint Ventures," outlines the application of the equity method. IAS 28 was originally adopted by the International Accounting Standards Committee in April 1989 and revised by the IASB in December 2003, and then again in May 2011, to refine how companies account for investments in associates and joint ventures⁹, ¹⁰. These revisions aimed to clarify the principles for applying the equity method and improve the understandability of the standard⁸.

Key Takeaways

• The equity method is applied when an investor holds significant influence (generally 20%-50% ownership) over an investee.
• The investment is initially recorded at cost and then adjusted for the investor's share of the investee's net income or losses.
• Dividends received from the investee reduce the carrying value of the investment on the investor's Balance Sheet.
• It provides a more accurate reflection of the investor's economic interest than simply holding a passive investment.
• This method is required under both GAAP (Generally Accepted Accounting Principles) and IFRS for appropriate investments.

Formula and Calculation

The core principle of the equity method is to adjust the initial cost of the investment based on the investor's share of the investee's subsequent earnings and dividends.

The carrying value of the investment using the equity method is calculated as follows:

Where:

• Initial Cost: The original amount paid for the investment.
• Investor's Share of Investee's Net Income: The investor's percentage ownership multiplied by the investee's Net Income for the period. This amount increases the investment's carrying value and is recognized in the investor's Income Statement.
• Dividends Received: Cash distributions from the investee to the investor. These reduce the carrying value of the investment because they represent a return of the investment, not an increase in its value.

Interpreting the Equity Method

Applying the equity method means that the investor's share of the investee's net income increases the investment account on the investor's Balance Sheet and is reported as a single line item in the investor's Income Statement. Conversely, losses reduce both the investment account and the income statement. Dividends received from the investee are not recognized as income but rather as a reduction in the investment's carrying amount, reflecting a return of capital. This approach ensures that the investor's financial statements reflect the proportional performance and equity changes of the investee, providing users with a more comprehensive view of the investor's economic exposure and returns from such strategic alliances.

Hypothetical Example

Assume Company A acquires 30% of Company B for $1,000,000 on January 1. Company A determines it has significant influence over Company B, necessitating the use of the equity method.

• Year 1:

  • Company B reports a Net Income of $200,000.
  • Company A's share of Company B's net income: 30% * $200,000 = $60,000.
  • Company A increases its investment account by $60,000 and recognizes $60,000 in its income statement.
  • Company B declares and pays $50,000 in dividends.
  • Company A's share of dividends: 30% * $50,000 = $15,000.
  • Company A reduces its investments account by $15,000.

• End of Year 1 Investment Carrying Value:

  • Initial Cost: $1,000,000
  • Plus: Share of Net Income: $60,000
  • Minus: Share of Dividends: $15,000
  • Ending Carrying Value: $1,000,000 + $60,000 - $15,000 = $1,045,000

The investment in Company B would be reported at $1,045,000 on Company A's balance sheet, and Company A's income statement would include $60,000 from the equity in earnings of Company B.

Practical Applications

The equity method of accounting is widely used in corporate Financial Reporting for various types of investments, particularly those involving strategic alliances, such as joint ventures and investments in associates. For instance, a pharmaceutical company might use the equity method to account for its stake in a biotech startup where it has a significant, but not controlling, interest and collaborates on research and development.

Regulatory bodies also mandate its use under specific conditions. In the United States, the Securities and Exchange Commission (SEC) through Regulation S-X, specifically Rule 3-09, requires public companies to provide separate audited financial statements for significant equity method of accounting investees, especially if the investment or income derived from it exceeds certain significance thresholds (e.g., 20% of the investor's total assets or income)⁵, ⁶, ⁷. For example, FMC Corporation, a global agricultural sciences company, mentions in its 10-K filings how it assesses the significance of its equity method investments in accordance with Rules 3-09 and 4-08(g) of Regulation S-X to determine reporting requirements³, ⁴. This ensures transparency and provides investors with crucial information about the performance and financial position of these important non-controlled entities.

Limitations and Criticisms

While the equity method of accounting provides a more comprehensive view than the cost method, it has limitations. One common criticism is that the carrying value of the investment on the Balance Sheet may not reflect its true Fair Value. Because the investment is adjusted based on the investee's accounting profit, it does not necessarily capture market fluctuations or the actual economic value of the underlying assets.

Furthermore, the equity method can obscure the individual line items of the investee's financial performance, as only the investor's share of net income is typically presented as a single line on the investor's income statement. This "one-line consolidation" can reduce transparency compared to full Consolidated Financial Statements, where every asset, liability, revenue, and expense of the subsidiary is combined with the parent company's. There are ongoing discussions and proposed amendments to standards like IAS 28 to address some of these application questions and improve the understandability of the equity method, though a fundamental review of its underlying principles is still debated¹, ². For example, issues around contingent consideration and changes in ownership interests continue to be points of clarification within accounting standards.

Equity Method of Accounting vs. Consolidation

The primary distinction between the equity method of accounting and consolidation lies in the degree of control an investor has over an investee.

While the equity method recognizes the investor's proportional share of the investee's earnings, it does not combine the detailed financial statements. In contrast, consolidation treats the parent and subsidiary as a single economic unit, requiring the complete combination of their financial statements and the elimination of all intercompany transactions. This distinction is crucial for understanding how different levels of ownership and influence impact Financial Reporting.

FAQs

What is "significant influence" in the context of the equity method?

Significant influence generally means the power to participate in the financial and operating policy decisions of an investee, but not control or joint control over those policies. It is presumed to exist if the investor holds 20% or more of the investee's voting power, but it can also be established through other means, such as representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or provision of essential technical information.

When is the equity method typically used?

The equity method of accounting is used when an investor owns a significant portion of another company's voting stock, usually between 20% and 50%, and has the ability to exert significant influence over the investee. It is commonly applied to investments in associates and joint ventures.

How do dividends affect the investment under the equity method?

Under the equity method, dividends received from the investee are treated as a return of the investment, not as income. Therefore, they reduce the carrying value of the investment account on the investor's balance sheet. This prevents double-counting of income, as the investor's share of the investee's net income has already increased the investment.

Can the equity method result in a negative investment balance?

Yes, if the investor's share of losses from the investee exceeds the carrying amount of the investment, the investment balance can become negative. However, typically, an investor would cease recognizing its share of losses when the investment balance reaches zero, unless the investor has made other commitments or has a legal obligation to cover the investee's losses.

Is the equity method permitted under both GAAP and IFRS?

Yes, the equity method of accounting is a recognized accounting standard under both GAAP (e.g., ASC 323) in the United States and IFRS (IAS 28) internationally. Both sets of standards provide guidance on when and how to apply this method to financial assets where significant influence exists.