Equity method

Definition

The equity method is an accounting technique used to record investments in associates and joint ventures, where the investor holds significant influence, typically defined as owning 20% to 50% of the investee's voting stock. Under this method, the investor recognizes its share of the investee's profits or losses in its financial statements, adjusting the carrying amount of the investment accordingly. This approach reflects the economic reality of the relationship between the investor and the investee, emphasizing the investor's ability to influence financial and operational decisions.

5 Must Know Facts For Your Next Test

1. Under the equity method, the investment is initially recorded at cost and subsequently adjusted for the investor's share of the investee's profits or losses.
2. Dividends received from the investee reduce the carrying amount of the investment on the investor's balance sheet.
3. The equity method requires periodic reassessment of whether significant influence exists, particularly if ownership levels change.
4. When an investee incurs losses that exceed its investment's carrying amount, further losses may not be recognized unless additional funding is provided by the investor.
5. The equity method is particularly relevant for reporting under both IFRS and US GAAP, though specific requirements may vary between these frameworks.

Review Questions

• How does the equity method reflect the economic relationship between an investor and its associates or joint ventures?
  • The equity method captures the economic reality by recognizing the investor's share of profits or losses from associates and joint ventures directly in its income statement. This approach highlights that while the investor does not control these entities, it holds significant influence over their operations and decisions. As a result, fluctuations in the investee's performance directly impact the investor's financial results, ensuring that investors are accurately informed about their investments' health.
• Discuss how dividends from an associate affect an investor's financial statements under the equity method.
  • Dividends received from an associate or joint venture reduce the carrying amount of the investment on the investor’s balance sheet when using the equity method. This treatment reflects that dividends represent a return on investment rather than income since they are drawn from profits already recognized in prior periods. By decreasing the carrying value, it maintains a consistent representation of how much of the investee’s equity remains with the investor after distributions.
• Evaluate how changes in ownership stakes influence the application of the equity method for accounting investments.
  • Changes in ownership stakes can significantly impact whether an investor applies the equity method. If an investor increases its stake to acquire significant influence (20% or more), it must switch from cost method accounting to equity method accounting. Conversely, if ownership decreases below this threshold, it must discontinue using the equity method and may revert to a cost basis. These transitions require careful evaluation of how these changes affect financial reporting and require adjustments to past income recognition based on new ownership levels.

Related terms

Associate: An entity in which an investor has significant influence, usually indicated by ownership of 20% to 50% of the voting stock.

Joint Venture: A business arrangement in which two or more parties agree to pool their resources for a specific project while maintaining their separate identities.

Significant Influence: The power to participate in financial and operating policy decisions of an investee but not control them, typically associated with owning 20% to 50% of voting shares.