What is the Equity Method?
The equity method is a type of accounting used for intercorporate investments. This method is used when the investor holds significant influence over the investee but does not exercise full control over it, as in the relationship between a parent company and its subsidiary. In this case, the terminology of “parent” and “subsidiary” are not used, unlike in the consolidation method where the investor exerts full control over its investee. Instead, in instances where it’s appropriate to use the equity method of accounting, the investee is often referred to as an “associate” or “affiliate”.
Although the following is only a general guideline, an investor is deemed to have significant influence over an investee if it owns between 20% to 50% of the investee’s shares or voting rights. If, however, the investor has less than 20% of the investee’s shares but still has a significant influence in its operations, then the investor must still use the equity method and not the cost method.
How does the equity method work?
Unlike with the consolidation method, in using the equity method there is no consolidation and elimination process. Instead, the investor will report its proportionate share of the investee’s equity as an investment (at cost). Profit and loss from the investee increase the investment account by an amount proportionate to the investor’s shares in the investee. This is known as the “equity pick-up.” Dividends paid out by the investee are deducted from this account.
Lion Inc. purchases 30% of Zombie Corp for $500,000. At the end of the year, Zombie Corp reports a net income of $100,000 and a dividend of $50,000 to its shareholders.
When Lion makes the purchase, it records its investment under “Investments in Associates/Affiliates”, a long-term asset account. The transaction is recorded at cost.
|Dr.||Investments in Associates||500,000|
Lion receives dividends of $15,000, which is 30% of $50,000, and records a reduction in their investment account. The reason for this is that they have received money from their investee. In other words, there is an outflow of cash from the investee, as reflected in the reduced investment account.
|Cr.||Investments in Associates||15,000|
Finally, Lion records the net income from Zombie as an increase to its Investment account.
|Dr.||Investments in Associates||30,000|
The ending balance in their “Investments in Associates” account at year-end is $515,000. This represents a $15,000 increase from their investment cost.
This reconciles with their portion of Zombie’s retained earnings. Zombie has Net Income of $100,000, which is reduced by the $50,000 dividend. Thus, Zombie’s retained earnings for the year are $50,000. Lion’s portion of this $50,000 is $15,000.
What are the other possible accounting methods?
When an investor exercises full control over the company it invests in, the investing company may be known as a parent company to the investee. The latter is then known as a subsidiary of the parent company. In such a case, investments made by the parent company in the subsidiary are accounted for using the consolidation method.
The consolidation method records “investment in subsidiary” as an asset on the parent company’s balance sheet, while recording an equal transaction on the equity side of the subsidiary’s balance sheet. The subsidiary’s assets, liabilities, and all profit and loss items are reported in the consolidated financial statements of the parent company.
Alternatively, when an investor does not exercise full control over the investee, and has no influence over the investee, the investor possesses a passive minority interest in the investee. In such a case, investments are accounted for using the cost method.
The cost method records the investment at cost and accounts for it depending on the investor’s historic transactions with the investee and other similar investees.
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