Handbook: Equity method of accounting

The proceeds of an IPO distributed to the parent are tax free if the cash distributed is less than the value of the parent’s investment in the stock of the controlled subsidiary, because it is considered a return of capital. Under the equity method of accounting for investments, the company is required to reflect its percentage share of the profit or losses from the investment in each period. The equity method is applied when the investor has the ability to apply significant influences to the operating and financing decisions of the investee. Unfortunately, the precise point at which one company gains that ability is impossible to ascertain. Although certain clues such as membership on the board of directors and the comparative size of other ownership interests can be helpful, the degree of influence is a nebulous criterion. When a question arises as to whether the ability to apply significant influence exists, the percentage of ownership can be used to provide an arbitrary standard.

Company B is considered an unconsolidated subsidiary of Company A in such circumstances, from Company A’s perspective, but could be a freestanding, publicly traded corporation. A company is generally considered to have significant influence, but not control, when it owns 20% – 50% of the voting interest in the unconsolidated subsidiary. The company does not actually record the subsidiary’s assets and liabilities on its balance sheet.

Potential variations

The equity method is an accounting technique used by a company to record the profits earned through its investment in another company. With the equity method of accounting, the investor company reports the revenue earned by the other company on its income statement, in an amount proportional to the percentage of its equity investment in the other company. Other gains and losses not arising from operation may be added (or treated in the balance sheet). Finally, deducting tax and any planned dividends yields profits retained for the year, which can be used to finance future investments. In the statement of cash flows, the initial investment is recognized as investing cash outflows.

Parent Co. would record a change only if it sold some of its stake in Sub Co., resulting in a Realized Gain or Loss. You subtract this “Equity Investments” line item when calculating Enterprise Value because it counts as a non-core-business asset. That’s a separate and more complicated topic, so we’re going to focus on just the equity method here. We should note that these types of transactions often impact multiple periods until the transaction cycle is fully complete.

Techniques of equity value definition in private equity and venture capital

On 1 January 20X0, Entity A acquires a 25% stake in Entity B for $150m and applies the equity method. Entity B’s net assets, according to its financial statements, total $350m, approximating their fair value. Moreover, Entity B owns an internally generated brand with an indefinite useful life, valued at $100m. Consequently, any eventual dividend received from Little is a reduction in the investment in Little account rather than a new revenue. The balance in this investment account rises when the investee reports income but then falls (by $12,000 or 40 percent of the total distribution of $30,000) when that income is later passed through to the stockholders. Notwithstanding that some have advocated eliminating the equity method of accounting, its principles have remained intact – often bending, but not yet breaking – as the capital markets evolve.

If there is no significant influence over the investee, the investor instead uses the cost method to account for its investment. Entity A records the change in net assets attributed to its holding in its P/L. An investment accounted for using the equity method is initially recognised at cost. The term ‘at cost’ is not defined in IAS 28, and a discussion similar to that in IAS 27 applies here as well. During the year ended 31 December 20X1, Entity B generated net income of $10m and paid dividends of $7m. In addition, Entity A must account for the $0.25m of additional depreciation charge on the fair value adjustment on real estate when applying the equity method.

The Equity Method of Accounting: Final Thoughts

It is known as the “equity pick-up.” Dividends paid out by the investee are deducted from the account. Under equity accounting, the biggest consideration is the level of investor influence over the operating or financial decisions of the investee. When there's a significant amount of money invested in a company by another company, the investor can exert influence over the financial and operating decisions, which ultimately impacts the financial results of the investee.

• Equity investments are evaluated for impairment anytime impairment factors are identified that might indicate that the fair value of the asset is not recoverable.
• The difference is that it’s only for this minority stake and doesn’t represent all the shareholders in the other company.
• This article discussed the fundamentals of the equity method accounting for investments.
• An investee that is accounted for under the equity method may report in the currency of a hyperinflationary economy.
• FASB has issued guidance on dealing with equity method accounting for investments.
• When a company holds approximately 20% to 50% of a company's stock, it is considered to have significant influence.

However, it can come up, especially if you’re in an industry or region where joint ventures and partnerships are common, or if you have more work experience. The equity method is used when one company has “significant influence,” but not control, over another company. CPAs who have equity method of accounting had exposure to equity method accounting will hopefully find that the above discussion comports with their thoughts and presumptions. Those less familiar with the topic may benefit from the concise and brief examples above that can explain this complicated area of accounting.

Evaluating indicators of significant influence

The equity method is a type of accounting used for intercorporate investments. It is used when the investor holds significant influence over the investee but does not exercise full control over it, as in the relationship between a parent company and its subsidiary. For example, when the investee company reports a net loss, the investor company records its share of the loss as “loss on investment” on the income statement, which also decreases the carrying value of the investment on the balance sheet. The FASB has made sweeping changes in the last two decades to the accounting for investments in consolidated subsidiaries and equity securities. However, it has left the accounting for equity method investments largely unchanged since the Accounting Principles Board released APB 18 in 1971.

At the end of the year, Zombie Corp reports a net income of $100,000 and a dividend of $50,000 to its shareholders. Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University. Other short-term borrowings, e.g. those that have a maturity period of three months or less. The goal of security valuation is to determine the intrinsic https://www.bookstime.com/ value of a firm or its securities. © 2023 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG global organization of independent member firms affiliated with KPMG International Limited, a private English company limited by guarantee. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity.

When an investor exercises full control over the company it invests in, the investing company may be known as a parent company to the investee. In such a case, investments made by the parent company in the subsidiary are accounted for using the consolidation method. The equity method is only used when the investor can influence the operating or financial decisions of the investee.

The investor’s share of the investee’s OCI is calculated and recorded similarly. The investor calculates their share of the investee’s OCI activity based on their proportionate share of common stock or capital. The investor records OCI activity directly to their equity method investment account, with the offset recorded to their OCI account. Only investments in the common stock of a corporation or capital investments in a partnership, joint venture, or limited liability company qualify as equity investments and are eligible for the equity method of accounting. The investor determines that it should account for this investment under the equity method of accounting.

When do you apply the equity method?

For a comprehensive discussion of considerations related to the application of the equity method of accounting and the accounting for joint ventures, see Deloitte’s Roadmap Equity Method Investments and Joint Ventures. During the first year and second years, JV XYZ has net losses of $80,000 and $120,000, respectively. The companies each apply their ownership interest, 25%, to JV XYZ’s first year and second year losses to determine their proportionate share of losses to record in current period earnings. Each company’s share of the losses is $20,000 ($80,000 x 25%) for the first year and $30,000 ($120,000 x 25%) for the second year. From time to time, the investee may issue cash dividends or distributions to its owners.

The initial measurement and periodic subsequent adjustments of the investment are calculated by applying the ownership percentage to the net assets, or equity, of the partially owned entity. Because the investor does not own the entire company, they are only entitled to assets, liabilities, and earnings or losses that represent their portion of ownership. An investment in another company is recorded as an asset on the balance sheet, just like any other investment. An equity method investment is valued as of a specific reporting date with any activity related to the investment recorded through the income statement. Once an equity method investment is recorded, its value is adjusted by the earnings and losses of the investee, along with dividends/distributions from the investee. Accounting for equity method investments can be quite complicated, but this article summarizes the basic accounting treatment to give you a high level understanding.

Loss making associate or joint venture

Our objective with this publication is to help you make those critical judgments. We provide you with equity method basics and expand on those basics with insights, examples and perspectives based on our years of experience in this area. We navigate scope, deconstruct initial measurement, and examine subsequent measurement – including how to analyze complex capital structures, demystify dilution transactions and outline presentation, disclosure and reporting considerations. When it comes to confusing accounting topics, partial stakes in other companies and the equity method of accounting consistently rank near the top of the list. This article discussed the fundamentals of the equity method accounting for investments.