Equity method of accounting

Definition

The equity method of accounting is a financial reporting approach used for investments where the investor has significant influence over the investee, typically represented by owning between 20% and 50% of the voting stock. This method recognizes the investor's share of the investee's profits or losses, impacting the investor's income statement and balance sheet, reflecting both investing activities and consolidation practices in financial statements.

5 Must Know Facts For Your Next Test

1. Under the equity method, investments are initially recorded at cost and subsequently adjusted for the investor’s share of profits or losses from the investee.
2. Dividends received from the investee reduce the carrying amount of the investment rather than being recognized as income.
3. This method is preferred over full consolidation when an investor has significant influence but does not have control over the investee.
4. Adjustments to the investment’s carrying value may also occur due to other comprehensive income items from the investee, such as foreign currency translation adjustments.
5. The equity method requires disclosure of certain information about investees in the notes to financial statements, including the nature and extent of significant influence.

Review Questions

• How does the equity method of accounting reflect an investor's share of an investee's profits or losses?
  • The equity method accounts for an investor’s share of an investee's profits or losses by adjusting the carrying amount of the investment on the balance sheet. If the investee earns profits, that amount increases the investment’s carrying value on the investor's balance sheet and is reflected in their income statement. Conversely, if the investee incurs losses, this reduces both the investment's carrying value and reported income.
• Discuss how dividends received under the equity method differ from traditional investment accounting.
  • Under traditional investment accounting, dividends are recognized as income when received. However, under the equity method, dividends reduce the carrying amount of the investment instead. This approach reflects that dividends are a return on investment rather than income earned from operational activities. Therefore, investors do not recognize dividend income; they only adjust their investment account when dividends are distributed by the investee.
• Evaluate how significant influence is determined in relation to applying the equity method, and its implications for financial reporting.
  • Significant influence is typically assessed based on ownership percentage—generally between 20% and 50% of voting stock—or other factors like board representation or participation in policy-making. When significant influence is established, it affects how an investor reports its financial results using the equity method, ensuring that they accurately reflect their economic interest in an investee. This connection can impact reported earnings and total assets on financial statements, highlighting both accountability and transparency in financial reporting.

Related terms

Significant Influence:

The power to participate in the financial and operating policy decisions of an entity, typically indicated by ownership of 20% to 50% of the voting stock.

Consolidated Financial Statements: Financial statements that present the assets, liabilities, equity, income, and cash flows of a parent company and its subsidiaries as a single entity.

Investment Income: Income earned by an investor from their investment holdings, including dividends and the investor's share of the investee's profits when using the equity method.