Equity method

Definition

The equity method is an accounting technique used to recognize the investment value of a company in another company when it has significant influence over that company, typically defined as owning 20% to 50% of its voting stock. This method allows the investor to record its share of the investee's profits and losses, which directly affects the investment's carrying amount on the balance sheet. It highlights the financial relationship between the investor and investee, reflecting how their operations impact each other financially.

5 Must Know Facts For Your Next Test

1. Under the equity method, an investor recognizes its proportionate share of the investee's earnings and losses on its income statement, affecting net income.
2. The carrying amount of the investment is adjusted based on the investor's share of the investee's profits or losses, which impacts balance sheet reporting.
3. Dividends received from the investee reduce the carrying amount of the investment under the equity method, rather than being recognized as income.
4. This method is often used in joint ventures or partnerships where significant influence exists but not full control.
5. If the investor's ownership percentage changes, it may need to switch from equity method accounting to either cost method or consolidation, depending on the level of influence or control.

Review Questions

• How does the equity method impact the income statement and balance sheet of an investor?
  • The equity method impacts the income statement by allowing the investor to recognize its share of the investee's profits and losses, which can directly affect net income. On the balance sheet, the carrying amount of the investment is adjusted to reflect these earnings or losses. This creates a direct link between the financial performance of both companies, emphasizing their interconnected operations.
• Discuss how dividends received from an investee are treated under the equity method and why this treatment is significant.
  • Under the equity method, dividends received from an investee are not recorded as income but instead reduce the carrying amount of the investment. This treatment is significant because it reflects that these dividends are a return on investment rather than profit. By reducing the carrying amount, it ensures that only profits from ongoing operations impact income reporting, providing a clearer picture of financial performance.
• Evaluate how changes in ownership percentages affect the application of the equity method and subsequent financial reporting.
  • Changes in ownership percentages can necessitate a shift in accounting methods for an investor. If ownership falls below 20%, for example, it may switch to cost method accounting where only dividends are recognized as income. Conversely, if ownership increases above 50%, consolidation becomes necessary. These shifts alter how financial relationships are reported and can significantly impact both current and future financial statements, reflecting different levels of influence or control over operations.

Related terms

significant influence: The power to participate in the financial and operating policy decisions of an investee without having control over those policies.

investee: A company in which an investor holds a stake, allowing the investor to exercise significant influence over its operations.

consolidation: The process of combining the financial statements of two or more entities into one set of financial statements, typically used when one entity controls another.