Understanding the Equity Method

Understanding the Equity Method

I want you to know that companies use the equity method of accounting to report their investments in other entities where they have significant influence but not a controlling interest.

You see, companies use this method to record profits earned through investments in other businesses where they hold significant influence but don't have control. When a company owns between 20% and 50% of another company's voting shares, accounting standards typically require using this method to accurately reflect their financial relationship.

This accounting technique is commonly used for joint ventures and strategic partnerships in industries like telecommunications, pharmaceuticals, and financial services, where companies want to collaborate and share resources without assuming complete operational control. The equity method provides a more accurate representation of the investor's financial interest than other methods like cost accounting or mark-to-market valuation.

The equity method sits between full consolidation (used when a company owns more than 50% of another) and more straightforward accounting approaches for minority investments. It recognizes that significant influence—through board representation, policy involvement, or substantial intercompany transactions—deserves distinct financial reporting that reflects this special relationship.

Key Takeaways

Let me outline the essentials for you: the equity method applies when an investor company has significant influence (typically 20% or more ownership) over another company, but without a controlling interest. This is common in the case of joint ventures or strategic partnerships, where the investor company maintains board representation and policy influence without day-to-day operational control. Under this method, the investing company initially records the investment at cost and subsequently adjusts this value to reflect its proportionate share of the investee's earnings or losses. The equity method better reflects economic reality than the cost method or mark-to-market in these types of situations.

How The Equity Method Works

The equity method better reflects how an investor company can exert significant influence over an investee's operations without needing controlling interest. Significant influence can emerge, for instance, when an investor gains board representation and participates in policymaking by conducting substantial inter-company transactions or when the investee becomes technologically dependent.

According to accounting standards like ASC 323 in U.S. GAAP or international accounting standard 28 in the international financial reporting standards, companies are required to use the equity method for investments where they hold 20% or more of another company's voting stock because this ownership level creates a presumption of significant influence. Companies must disclose details about equity method investments in the notes to financial statements, including the name of each investee and the percentage of ownership interest.

Companies use the equity method for joint ventures and strategic partnerships because it allows them to exert significant influence without taking on complete management responsibilities and operational risks. This is commonly seen, for instance, in industry sectors like telecommunications, pharmaceuticals, energy, and financial services, where collaboration allows companies to pool resources and expertise and share risks while maintaining their own corporate or brand identities.

The equity method differs from alternative accounting treatments for reporting investments. For instance, when ownership stakes fall below the 20% mark, companies usually apply the cost method or mark-to-market accounting to record minority investments at either their historical cost or current fair market value. Alternatively, when companies control over 50% of another entity, they might use consolidation accounting, which integrates both companies' financial statements to portray them as one economic entity.

Tip on Application

Here's a key point: a company may apply the equity method with less than 20% ownership when it can show it has a significant influence over another company. It can also not use the equity method if it owns more than 20% equity if the company doesn't have this influence over another.

Recording Changes on Financial Statements

The equity method impacts several key financial statements in specific ways. For initial recognition, the investor company records its initial investment at cost on the balance sheet, including the purchase price of the shares and transaction costs.

Following the initial investment, the investor recalibrates the investment's book value according to their share of the investee's reported profits or losses. On the income statement, the investor reports its proportional share of the investee's net income (or losses, as the case may be) in the appropriate section.

For balance sheet adjustments, the value of the investment listed on the balance sheet rises according to the investor's portion of the investee's profits (or falls in line with its share of losses). This running snapshot tracks how the investee's performance changes the value of the investor's investment over time.

Dividend treatment means the investor does not record any dividends received from the investee as income but instead reduces the investment's carrying value on the balance sheet. Because the investor already accounted for the income source of those dividends in its financial statements, this avoids double-counting.

The investor also records its share of changes to the investee's other comprehensive income (which includes adjustments for foreign currency translations and unrealized gains and losses on certain securities). When an investor company pays above the book value of net assets acquired for the other company, the surplus is considered goodwill for accounting purposes, and must be accounted for through basis differentials that affect future equity method adjustments.

Periodic reviews must be conducted to assess potential impairment of the investment. The investment requires a write-down to its fair value if the market value drops below book value and this drop becomes permanent.

Important Note on Dividends

Under the equity method, dividends are treated as a return on investment that reduces the value of the investor’s shares. Meanwhile, the cost method of accounting treats dividends as taxable income.

Example of Using the Equity Method

Suppose the hypothetical TechInvest Corp., a large technology company, purchases 30% of a startup, Software Innovations Inc., for $6 million on Jan. 1, 2025. Here's how it would work under this accounting method.

For the initial investment, TechInvest records the investment as an asset valued at $6 million on its balance sheet.

In year 1 performance, in 2025, Software Innovations reports a net income of $2 million and pays $500,000 in dividends to shareholders. TechInvest would make the following accounting entries: recognition of income where TechInvest recognizes 30% of Software Innovations' net income: $2,000,000 × 30% = $600,000. This appears on TechInvest's income statement and increases the assets side of the balance sheet by the same amount.

For dividend treatment, TechInvest receives 30% of the dividends: $500,000 × 30% = $150,000. This cash inflow reduces the asset account on the balance sheet by $150,000 (i.e., it's not double-counted as income). The year-end balance sheet value would be $6,000,000 (initial investment) + $600,000 (share of income) - $150,000 (dividends) = $6,450,000.

In year 2, handling losses: in 2026, Software Innovations experienced an unexpected downturn and reported a net loss of $1 million while forgoing its dividend. TechInvest would record the recognition of loss: 30% of Software Innovations' net loss: $1,000,000 × 30% = $300,000 loss. This appears as a loss on TechInvest's income statement and decreases the asset account on the balance sheet. The year-end balance sheet value would be $6,450,000 (previous balance) - $300,000 (share of loss) = $6,150,000.

In an impairment scenario, suppose at the end of 2026, TechInvest determines that Software Innovations has experienced a permanent decline in fair value because it's lost key clients and its core technology is obsolete. It now values its investment at $5.5 million. TechInvest would recognize an impairment loss of $650,000 ($6,150,000 - $5,500,000) and write down the investment to $5.5 million.

The Bottom Line

The equity method of accounting offers a fair way for investor companies to account for their financial stake in companies they significantly influence but do not outright control. This accounting approach better reflects the true economic nature of the investment relationship as it attributes a proportional slice of the investee's profits and losses to the investor company, unlike basic cost accounting methods.