Equity Method

Accounting for investments where investor influence is substantial

What is the equity method?

The equity method is a type of accounting used in investments. This method is used when the investor holds significant influence over investee, but does not exercise full control over it, as in the relationship between parent and 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, the investee is often referred to as “associate” or “affiliate”

Although the following is only a practical guideline, an investor is deemed to have significant influence over an investee if it owns 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 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 in the consolidation method, there is no consolidation and elimination process. Instead, the investor will report a 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.

 

Simple Example

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. This transaction is recorded at cost.

Dr.Investments in Associates500,000
Cr.Cash500,000

 

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.

Dr.Cash15,000
Cr.Investments in Associates15,000

 

Finally, Lion records the net income from Phoenix as an increase to its Investment account.

Dr.Investments in Associates30,000
Cr.Investment Revenue30,000

 

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 Phoenix’s retained earnings. Phoenix has Net Income of 100,000, which is reduced by the 50,000 dividend. Thus, Phoenix’s retained earnings for the year is 50,000. Lion’s portion of this 50,000 is 15,000.

 

What are the other accounting methods?

When an investor exercises full control of the company it invests in, the investing company may be known as a parent company to the investee. The latter is then known as the subsidiary. 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 balances, while recording an equal transaction in 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.

Alternatively, when an investor does not exercise full control of the investee, and has no influence over the investee, the investor possesses a minority passive interested in the investee. In such a case, investments will be accounted for using the cost method.

The cost method records the investment at cost, and accounts for it depending on the investors historic transactions with the investee and other investees.

 

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