Understanding the Equity Method of Accounting

Jan Strandberg
December 24, 2021
5 min read

The equity method of accounting is a popular way for companies to record investments in other companies, allowing them to reflect partial ownership and exert some control over the investee's financial decisions. Here, we will help you understand the basics of the equity method, its principles, how it is different from other accounting methods, and its impact on financial statements. We will also cover some examples of real-world applications and common challenges that often come up.

Basics of the Equity Method of Accounting

Definition and Purpose

The equity method of accounting is a way of treating investments in which the investor exerts significant control over the investee but doesn't own the majority of the company. It is used to reflect the investor's portion of the investee's profits and losses on the investor's financial statements. This distinguishes it from accounting methods that focus on the cost of the investment or market value.

When an investor holds between 20 to 50 percent of the voting stock and can exert influence over the investee's decision-making process, they use the equity method. However, it is important to note that the exact threshold can vary depending on the jurisdiction's regulations and company policies. Companies often use the equity method when they own substantial portions of other companies but do not control them fully.

The equity method is an important tool for investors to track their investments and understand their financial performance. By using this method, investors can get a more accurate picture of their investment's worth and the impact it has on their overall financial health.

When to Use the Equity Method

The equity method is commonly used in situations where an investor has significant influence over an investee but does not have full control. This can occur when an investor holds a substantial portion of another company's shares, but not enough to control it completely.

For example, if a company holds 30 percent of another company's shares and has a seat on its board of directors, it may use the equity method to account for its investment. By doing so, it can reflect its share of the investee's profits and losses on its financial statements, giving a more accurate picture of its overall financial health.

Key Principles and Assumptions

The equity method follows certain principles and assumptions that guide its application. Firstly, the investment is initially recorded at the investor's cost, and this becomes its basis in accounting for it over time. Secondly, the investor records its share of the investee's profits and losses on its income statements, reflecting partial ownership. Lastly, dividends declared by the investee reduce the investment value on the balance sheet while increasing the investor's cash account. These principles and assumptions represent the foundation of how the equity method functions.

It is important to note that the equity method is not the only way to account for investments. Other methods, such as the cost method or fair value method, may be more appropriate depending on the circumstances. However, the equity method is a widely used and accepted accounting practice that can provide valuable insights into an investor's financial performance.

Comparing the Equity Method to Other Accounting Methods

When it comes to accounting for investments, there are several methods that companies can use. Each method has its own set of rules and requirements, and the choice of method depends on the level of ownership and influence the investor has over the investee. In this article, we will compare the equity method to three other commonly used accounting methods: the cost method, the consolidation method, and the fair value method.

Cost Method

The cost method is a simple accounting method that is used when the investor has no significant influence over the investee. Under this method, the investment is recorded on the balance sheet at its original cost and is only adjusted if there is evidence of impairment. For income reporting purposes, the investor does not include the results of the investee's operations in its financial statements.

One advantage of the cost method is that it is easy to apply and does not require a lot of record-keeping. However, it may not provide a true picture of the investor's financial position, as it does not reflect any changes in the value of the investment over time.

Consolidation Method

The consolidation method is used when the investor owns more than 50 percent of the voting stock in the investee. Under this method, the investor combines the results of the investee with its own financial statements, reflecting 100 percent ownership. The investment is first recorded at the investor's cost, and any additional amounts paid above that cost are recorded as goodwill.

The consolidation method provides a more accurate picture of the investor's financial position, as it reflects the investor's full ownership of the investee. However, it requires more record-keeping and can be complex to apply, especially if the investee has subsidiaries of its own.

Fair Value Method

The fair value method reports investments at their current market values for each reporting period. This method reflects changes in market value, rather than profits and losses of the investees. The method assumes that owners of such investments will not exert significant control over investee decisions or that the ownership interests are temporary.

The fair value method provides a more accurate picture of the value of the investment, as it reflects changes in market conditions. However, it requires more record-keeping and can be subject to volatility, as market conditions can change rapidly.

Equity Method

The equity method is used when the investor has significant influence over the investee, but does not own a controlling interest. Under this method, the investor records its share of the investee's profits and losses on its own income statement, and records the investment on its balance sheet at its original cost, adjusted for any changes in the investee's net assets.

The equity method provides a more accurate picture of the investor's financial position, as it reflects the investor's share of the investee's profits and losses. It also requires less record-keeping than the consolidation method, as the investor does not need to combine the investee's financial statements with its own.

Overall, the choice of accounting method depends on the level of ownership and influence the investor has over the investee, as well as the investor's reporting needs and record-keeping capabilities. Each method has its own advantages and disadvantages, and it is important for companies to carefully consider their options before making a decision.

Step-by-Step Process for Applying the Equity Method

The equity method is an accounting technique used by investors to account for their investments in other companies. It is used when the investor has significant influence over the investee, but not control. The equity method is commonly used when the investor owns between 20% and 50% of the investee's shares.

Identifying the Investee

The first step in applying the equity method is identifying the investee and assessing the level of influence. The investor must have an equity stake in the investee, which can be in the form of common stock or other equity instruments. The level of influence is determined by the percentage of shares owned by the investor. If the investor owns between 20% and 50% of the investee's shares, they are considered to have significant influence over the investee.

It is important for the investor to understand the investee's business and financials before investing. The investor should research the investee's industry, competitors, financial statements, and management team to determine if it is a good investment.

Calculating Initial Investment

The initial investment is recorded on the balance sheet at the investor's cost. This cost is composed of the price paid for the shares of stock and any additional costs incurred in obtaining the investment. The investor must also add any additional investment or subtract any dividends received from the investee.

For example, if the investor purchases 30% of the investee's shares for $100,000 and pays $5,000 in fees to their broker, the initial investment would be recorded as $105,000.

Recording Equity Income and Dividends

Equity income is the investor's proportional share of the investee's earnings or losses, and dividends represent the investor's proportional share of the investee's distributions of earnings to equity investors. The investor records the equity income on their income statement and retains the dividends received as cash, which is added to the cash account on the balance sheet.

It is important for the investor to keep track of the investee's financial statements and performance to accurately record equity income and dividends. The investor should also communicate with the investee's management team to stay informed about any changes in the investee's business or financials.

Adjusting for Impairment and Disposal

The investor assesses the investment for impairment periodically. If the investee's fair value drops below its book value, the investor must reduce their investment value on the balance sheet. When disposing of the investment, the investor must remove the investment's book value from their balance sheet and record the proceeds from the sale as cash inflows.

It is important for the investor to monitor the investee's financials and industry to determine if impairment is necessary. The investor should also consider the reason for disposing of the investment and the potential impact on their portfolio.

In conclusion, the equity method is a useful accounting technique for investors with significant influence over their investees. By following the step-by-step process for applying the equity method, investors can accurately account for their investments and make informed decisions about their portfolio.

Impact of the Equity Method on Financial Statements

The equity method is a type of accounting used when an investor has significant influence over an investee. Under this method, the investor records their investment as an asset on their balance sheet and recognizes their share of the investee's earnings or losses on their income statement. In this way, the equity method provides a way for investors to reflect their economic interest in the investee's performance.

Balance Sheet Implications

When an investor uses the equity method, they initially record the investment's cost on the balance sheet. This amount includes any fees or commissions paid to acquire the investment. As time goes on, the investor adjusts the balance sheet to reflect any additional investments made in the investee or any dividends received.

One important aspect of the equity method is that the investor must regularly review the investment for any impairment charges. If the investee's performance declines, the investor may need to reduce the investment's carrying value on their balance sheet to reflect the decrease in value. This adjustment is recorded as an expense on the income statement and reduces the investor's net income for the period.

Income Statement Implications

The equity method requires the investor to recognize their share of the investee's earnings or losses on their income statement. This amount is calculated based on the investor's ownership percentage in the investee. For example, if the investor owns 30% of the investee, they would recognize 30% of the investee's net income on their income statement.

It's important to note that the equity income recognized on the income statement is not the same as dividends received. Rather, it reflects the investor's proportional share of the investee's earnings. This means that even if the investee does not pay any dividends, the investor may still recognize equity income on their income statement.

Cash Flow Statement Implications

The equity method also has implications for the investor's cash flow statement. Any cash dividends received from the investee are recorded as an inflow of cash in the operating activities section of the cash flow statement. Additionally, any purchase or sale of the investment is also recorded as a cash inflow or outflow, respectively.

Another important aspect of the equity method is that the investor must record their share of the investee's capital expenditures as a cash outflow on their cash flow statement. Capital expenditures are investments made by the investee in long-term assets, such as property, plant, and equipment. By recording their share of these expenditures as a cash outflow, the investor is able to reflect the true economic impact of the investment on their cash position.

Real-World Examples and Case Studies

The equity method is an important accounting technique used to reflect significant influence over an investee. It is widely used in various industries and investment types, and can be a valuable tool for investors looking to generate consistent returns and exercise control over strategic decisions.

Successful Application of the Equity Method

One example of successful use of the equity method is in Berkshire Hathaway's investment in Coca-Cola. Berkshire Hathaway reports this investment using the equity method, reflecting significant control over its strategic decisions. This investment generates consistent returns as Coca-Cola remains a popular consumer brand in the market.

Another example is the investment made by Google in 2005 in Chinese search engine Baidu. Google used the equity method to report its investment, which allowed it to exercise significant control over Baidu's strategic decisions. This investment proved to be successful as Baidu's market share grew rapidly, and Google was able to generate significant returns on its investment.

Common Challenges and Pitfalls

One of the common challenges in applying the equity method is accurately assessing the level and scope of influence over the investee. This often arises in situations where other investors or stakeholders hold significant minority stakes in the investee, creating conflicts of interest and accountability. In such cases, it is important to carefully evaluate the level of control and influence that each investor holds, and to ensure that the reporting accurately reflects this.

Additionally, impairment charges can also be a significant issue, particularly when the underlying market conditions or operating environment changes significantly. Impairment charges occur when the carrying value of the investment exceeds its fair value, and can result in significant losses for the investor. It is important to regularly evaluate the fair value of the investment and to adjust the carrying value accordingly.

Lessons Learned from Notable Cases

One notable example of challenges arising from using the equity method was in the case of Enron. The company used SPEs to park liabilities and inflate earnings, and the use of the equity method enabled it to bypass traditional accounting standards. This approach ultimately led to the company's downfall, highlighting the importance of adhering to ethical and transparent business practices when applying the equity method.

Another example is the case of Walmart's investment in its Indian joint venture, Bharti Walmart. Walmart used the equity method to report its investment, but faced significant challenges due to regulatory restrictions and cultural differences. The joint venture ultimately failed, and Walmart was forced to exit the Indian market. This case highlights the importance of carefully evaluating the risks and challenges associated with an investment, and of ensuring that the reporting accurately reflects the underlying realities of the investment.

Frequently Asked Questions about the Equity Method

The equity method is a popular accounting technique used by investors to account for their investments in other companies. This method is commonly used when an investor has significant influence over the investee, but not enough to control it outright. Here are some frequently asked questions about the equity method:

How Does the Equity Method Affect Taxes?

Investors using the equity method can defer taxes on income generated from the investment, although they must recognize that income on their tax returns when received. This means that they can delay paying taxes on the income until they actually receive it. Investors may also claim a tax deduction for any losses on their equity investments, which can help offset other taxable income.

It is important to note that the tax implications of the equity method can vary depending on the specific circumstances of the investment and the investor's tax situation. Investors should consult with a tax professional to fully understand the tax implications of using the equity method.

What Are the Limitations of the Equity Method?

While the equity method can be a useful accounting technique, it is not suitable for every investment or situation. It assumes that the investor receives adequate information from the investee and exercises substantial control over it, which may not always be the case. If the investor does not have enough influence over the investee, the equity method may not accurately reflect the investor's financial position.

Additionally, the equity investment may represent a small portion of the investor's portfolio, and the gains or losses may not be significant enough to warrant the application of the equity method. In these cases, the investor may choose to use a different accounting method.

How Do International Accounting Standards Treat the Equity Method?

International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS) allow for the equity method's application, and it is generally similar to the US GAAP. However, there may be some differences in the specific requirements or thresholds used to trigger its use, depending on the jurisdiction and company policy.

It is important for investors to understand the accounting standards that apply to their investments, especially if they have investments in multiple countries or jurisdictions. Working with a knowledgeable accounting professional can help ensure compliance with all applicable standards and regulations.

Conclusion

Key Takeaways

The equity method is an accounting approach that enables investors to reflect partial ownership and control over an investee's operations. It works great when the investor can exert significant control, and the investment is long-term. The method has implications on the balance sheet, income statement, and cash flow statement, and it may affect taxes.

Future Developments and Trends in Equity Accounting

The rapid pace of technological innovation and increasing global investment opportunities means that the equity method and other accounting approaches will continue to evolve and change. We can expect to see greater emphasis on transparency, accountability, and ethical leadership in the application of the equity method. Additionally, new metrics and reporting paradigms will emerge to capture the full range of risks and returns associated with equity investments.

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Jan Strandberg
December 24, 2021
5 min read

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