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📈financial accounting ii review

Equity method

Written by the Fiveable Content Team • Last updated September 2025
Written by the Fiveable Content Team • Last updated September 2025

Definition

The equity method is an accounting technique used to record investments in associated companies where the investor has significant influence, typically defined as owning 20% to 50% of the voting stock. This method allows the investor to recognize their share of the investee's profits and losses, impacting the investor's balance sheet and income statement directly.

5 Must Know Facts For Your Next Test

  1. Under the equity method, the initial investment is recorded at cost and subsequently adjusted for the investor's share of the investee's profits or losses.
  2. Dividends received from an investee reduce the carrying amount of the investment when using the equity method.
  3. The equity method requires an investor to recognize their proportionate share of any other comprehensive income (OCI) items from the investee.
  4. Changes in fair value do not affect the carrying amount of the investment under the equity method until sold or deemed impaired.
  5. It is important to periodically assess whether an investment still qualifies for the equity method based on changes in ownership percentage or influence.

Review Questions

  • How does an investor determine whether to apply the equity method for an investment?
    • An investor applies the equity method when they have significant influence over an investee, usually indicated by owning 20% to 50% of its voting stock. Significant influence can also arise from other factors such as board representation or participation in policy decisions. If ownership changes, such as increasing or decreasing shares, it may impact whether the equity method remains appropriate.
  • What are the accounting implications of using the equity method on financial statements?
    • Using the equity method affects both the balance sheet and income statement of the investor. The investment is initially recorded at cost and later adjusted for share of profits or losses. This means that if the investee performs well, it increases the value of the investment on the balance sheet while simultaneously increasing reported income. Conversely, losses from the investee decrease both income and investment value, which can significantly impact overall financial performance.
  • Evaluate how changes in ownership percentages can affect the application of the equity method and consolidation requirements.
    • When an investor’s ownership percentage changes, it can shift how they account for their investment. If ownership rises above 50%, control is established, necessitating consolidation instead of using the equity method. Conversely, if ownership drops below 20%, significant influence is lost, meaning they may need to switch to fair value accounting. These shifts can have profound impacts on financial reporting and investors' perceptions of financial health, requiring careful analysis by management and stakeholders.