Equity Method of Accounting

Definition

The equity method is used to account for investments in other entities when the investor has significant influence but not control over the investee. It typically applies when ownership is between 20% and 50% of voting stock, though significant influence can exist with a smaller stake (or be absent with a larger stake). Under this method, the investor records its share of the investee’s profits and losses and adjusts the carrying value of the investment accordingly.

Key takeaways

• Applies when an investor has significant influence (commonly presumed at 20%–50% ownership).
• Initial investment is recorded at cost; thereafter the carrying value is adjusted for the investor’s share of the investee’s profits, losses, dividends, and other comprehensive income.
• Dividends received reduce the carrying value of the investment rather than being recognized as income.
• Used for joint ventures and strategic partnerships; sits between cost/market accounting for minority stakes and consolidation for controlling interests.
• Accounting guidance includes ASC 323 (U.S. GAAP) and IAS 28 (IFRS).

How it works

Significant influence can be evidenced by board representation, participation in policy decisions, material intercompany transactions, or technological dependence. Accounting standards generally presume significant influence at 20% ownership, but firms must evaluate influence facts and circumstances case by case.

When the equity method applies:
* The investor records the initial investment at cost on the balance sheet.
* After acquisition, the investor recognizes its proportional share of the investee’s net income or loss on its income statement.
* The carrying amount of the investment on the investor’s balance sheet increases by the investor’s share of earnings and decreases by the investor’s share of losses and by dividends received.
* The investor also recognizes its share of the investee’s other comprehensive income (OCI) in its own OCI.
* If the investor paid more than the investee’s book value, the excess (basis difference) is allocated to identifiable assets (and possibly goodwill) and amortized or tested as required.
* The investment must be tested for impairment; a permanent decline in value is written down to fair value.

Recording and statement effects

• Initial recognition: Record the investment at acquisition cost (including transaction costs) on the balance sheet.
• Subsequent measurement: Adjust carrying value by the investor’s share of the investee’s net income or loss.
• Income statement: Report the investor’s proportionate share of the investee’s net income (loss).
• Dividends: Treat dividends as reductions of the investment’s carrying value, not as income.
• Other comprehensive income: Include the investor’s share of the investee’s OCI items.
• Basis differentials and goodwill: Allocate purchase-price excess to identifiable assets and goodwill; handle according to applicable rules (amortization, impairment testing).
• Impairment: Write down the investment if declines in fair value are judged to be other-than-temporary.

Illustrative example

Assume Investor A buys a 30% interest in Company B for $6,000,000.

Year 1
* Company B reports net income of $2,000,000 and pays total dividends of $500,000.
* Investor A recognizes 30% × $2,000,000 = $600,000 as investment income on its income statement and increases the investment carrying value by $600,000.
* Investor A receives 30% × $500,000 = $150,000 in cash dividends; these reduce the investment carrying value by $150,000.
* Year‑end carrying value = $6,000,000 + $600,000 − $150,000 = $6,450,000.

Year 2
* Company B reports a net loss of $1,000,000 and pays no dividends.
* Investor A recognizes 30% × $1,000,000 = $300,000 loss, reducing the carrying value.
* Year‑end carrying value = $6,450,000 − $300,000 = $6,150,000.

Impairment
* If management determines the investment’s fair value is now $5,500,000 and the decline is permanent, Investor A records an impairment loss of $650,000 and writes the carrying value down to $5,500,000.

Comparison with other methods

• Cost method / fair value method: Used for passive minority investments (typically <20%)—income is recognized when dividends are declared (cost) or changes in fair value are recognized (fair value through profit or loss or OCI).
• Consolidation: Used when the investor controls the investee (commonly >50% ownership); the investee’s assets, liabilities, revenues, and expenses are combined with the investor’s financials.

Bottom line

The equity method aligns accounting with the economic reality of significant influence without control. It attributes the investor’s proportional share of the investee’s results to the investor’s financial statements and adjusts the carrying value of the investment accordingly, avoiding double‑counting of income and providing a clearer picture of the investor’s economic exposure.