Equity method

Definition

The equity method is an accounting technique used to assess the value of an investment in a company in which the investor holds significant influence, typically defined as owning 20% to 50% of the voting stock. This method recognizes the investor's share of the investee's profits and losses on its income statement, and adjusts the carrying value of the investment accordingly. By using this method, companies provide more transparency about their financial relationships and obligations with associated entities.

5 Must Know Facts For Your Next Test

1. Under the equity method, the investor records its share of the investee's net income or loss as an increase or decrease in the investment account on its balance sheet.
2. Dividends received from the investee reduce the carrying amount of the investment under the equity method, rather than being recognized as income.
3. This method is particularly important for financial reporting as it provides a clearer picture of an investor's economic interest in an investee.
4. If an investor loses its significant influence over an investee, it must discontinue using the equity method and switch to either the cost method or consolidation, depending on ownership percentage.
5. The equity method requires extensive disclosure in financial statements about the nature of relationships with investees, including details on ownership percentage and relevant financial results.

Review Questions

• How does the equity method impact the financial reporting of an investor with significant influence over an investee?
  • The equity method significantly affects financial reporting by allowing investors to recognize their proportionate share of an investee's profits or losses directly on their income statement. This means that fluctuations in the investee's performance will be reflected in the investor’s financial results, giving stakeholders a clearer view of economic ties. Additionally, changes to the carrying amount of the investment on the balance sheet occur through earnings adjustments and dividends received, providing transparency about financial relationships.
• Discuss how significant influence is determined and why it is crucial for applying the equity method.
  • Significant influence is typically determined when an investor owns between 20% and 50% of an investee's voting stock. This level of ownership indicates that the investor has enough power to participate in making decisions but does not control them outright. Recognizing significant influence is crucial because it dictates whether the equity method or other accounting treatments should be applied, affecting how investments are reported and evaluated in financial statements.
• Evaluate how discontinuing the equity method affects both investors and their investees in terms of financial reporting and investor relations.
  • Discontinuing the equity method can have profound effects on both investors and their investees. For investors, transitioning to a different accounting method often results in a sudden change in how investment values are recorded, which can lead to less favorable perceptions if profits are no longer directly reflected on their income statements. For investees, losing significant influence can alter their financial reporting dynamics as well. They may experience decreased scrutiny from former investors and could see changes in shareholder relationships as their performance becomes less impactful on investors' financial outcomes. Overall, these shifts can lead to adjustments in business strategies and communication efforts between involved parties.

Related terms

Significant Influence: The ability of an investor to affect decisions made by the investee, often indicated by ownership of 20% to 50% of voting stock.

Consolidation: The process of combining the financial statements of a parent company and its subsidiaries into one comprehensive set of financial statements.

Investee: A company in which an investor holds an ownership interest, and may be subject to the equity method if significant influence exists.