Equity Accounting

Equity Accounting: A Clear Overview

Key takeaways

• Equity accounting (the equity method) records an investor’s share of an investee’s profits or losses on the investor’s income statement and adjusts the carrying amount of the investment on the balance sheet.
• It is typically applied when the investor has significant influence over the investee—commonly presumed at 20–50% ownership of voting stock.
• If influence is lacking, the cost method or fair value method is used; if control exists (usually >50%), the investee is consolidated as a subsidiary.

What is equity accounting?

Equity accounting is an accounting method used to reflect an investor’s economic interest in another company. Under this method, the investor recognizes its proportionate share of the investee’s net income or loss on its own income statement and adjusts the carrying value of the investment on its balance sheet accordingly.

How it works

• Initial investment: recorded as an asset on the investor’s balance sheet at cost.
• Periodic recognition: the investor records its share of the investee’s profits or losses in its income statement for each reporting period, proportional to its ownership percentage. Profits increase the carrying amount of the investment; losses decrease it.
• Dividends: rather than being recorded as income (as under the cost method), dividends received from the investee generally reduce the carrying amount of the investment.

Accounting rules for the equity method are prescribed under U.S. GAAP and IFRS; certain specifics can differ between the frameworks.

Investor influence: the central consideration

Equity accounting applies when the investor exerts significant influence over the investee’s financial or operating policies. Indicators of significant influence include:
* Representation on the investee’s board of directors
* Participation in policy-making decisions
* Material intercompany transactions
* Interchange of management personnel
* Technology sharing or other significant technical dependency
* Relative ownership position compared with other investors

A holding of 20% or more of voting stock generally creates a presumption of significant influence (unless clear evidence contradicts this). Holdings below 20% generally do not indicate influence unless demonstrable facts show otherwise. There are no absolute rules—large institutional investors can exert influence beyond their percentage ownership.

Equity method vs. cost (and fair value) methods

• Equity method: used when the investor has significant influence (typically 20–50%). Investor recognizes share of investee’s earnings and adjusts the investment’s carrying value.
• Cost method: used when the investor lacks significant influence. The investment is carried at historical cost; the investor recognizes dividend income, and the carrying amount remains at cost unless impaired.
• Fair value method: smaller holdings may be reported at fair value with changes recognized in earnings or other comprehensive income depending on classification.
• Control (usually >50%): results in consolidation of the investee’s financial statements into the investor’s statements.

Limitations and critiques

• Limited forward-looking insight: the equity method records historical earnings and changes in the investee’s net assets but may not provide clear guidance about future cash flows available to the investor.
• Lack of control over investee assets: the investor does not direct how the investee uses its assets and only receives cash from dividends when declared.
• Measurement and judgment: determining significant influence can require subjective assessment and judgment.

Bottom line

The equity method provides a way to reflect an investor’s meaningful influence over an investee by recognizing the investor’s share of the investee’s profits or losses and updating the investment’s carrying amount. It occupies a middle ground between passive investment accounting (cost or fair value) and full consolidation of subsidiaries, and its applicability hinges primarily on the level of influence rather than a single numeric threshold.