Equity Method vs. Fair Value Method: Key Differences

Companies frequently invest in the securities of other entities for strategic reasons. When these investments are made, accounting rules dictate how they must be reported on the investor’s financial statements, and the treatment hinges on the level of influence the investor can exert. The two primary methods for investments that do not result in full control are the equity method and the fair value method. Each is applied under different circumstances and results in a different financial reporting outcome.

The Equity Method of Accounting

The equity method of accounting is used when an investor has “significant influence” over an investee’s operating and financial policies. Significant influence is presumed to exist when the investor holds between 20% and 50% of the investee’s voting stock. This ownership threshold is a guideline, as influence can also be demonstrated through factors like representation on the board of directors or participation in policy-making.

Under this method, the investment is initially recorded on the investor’s balance sheet at its original cost. This value is then adjusted each reporting period. When the investee reports net income, the investor increases the carrying value of its investment by its proportionate share of those earnings and recognizes this amount as investment income.

Conversely, if the investee incurs a net loss, the investor’s investment account is decreased by its share of that loss. Dividends received from the investee are not treated as income. Instead, they are considered a return of capital and decrease the carrying value of the investment account, which prevents double-counting the earnings.

The investment must also be tested for impairment if its fair value falls below its carrying amount, which could lead to a write-down.

The Fair Value Method of Accounting

The fair value method is the prescribed accounting treatment for investments when the investor does not have significant influence over the investee, which applies to ownership stakes of less than 20%. Under this approach, the investment is viewed more passively, with the focus on its current market worth. An investment is initially recorded at its purchase price and then adjusted to its current fair value each reporting period in a process called “marking-to-market.”

Any unrealized gains or losses from the mark-to-market adjustment are recognized directly in the investor’s net income for the period. For example, if an investment purchased for $50,000 is worth $60,000 at the end of the quarter, the company reports a $10,000 unrealized gain on its income statement.

In contrast to the equity method, dividends received from the investee are recorded as income. This treatment reflects the nature of the investment as a holding intended to generate returns through dividends or market appreciation, rather than through influencing the investee’s operations.

Key Distinctions in Application and Reporting

The primary difference between the methods lies in the level of influence an investor holds, with the 20% ownership mark being the general dividing line. This distinction drives all other differences in financial reporting. On the balance sheet, the valuation of the investment diverges significantly between the two approaches.

Under the equity method, the investment is carried at its initial cost, adjusted for the cumulative share of the investee’s profits or losses, and reduced by any dividends received. Under the fair value method, the investment is reported at its current market value at the end of each reporting period, reflecting its immediate liquidation value.

The impact on the income statement is also different. The equity method requires the investor to recognize its share of the investee’s net income or loss. The fair value method instead impacts the income statement through dividend income and the reporting of unrealized gains or losses from market price changes.

The Fair Value Option

Accounting standards provide a choice known as the Fair Value Option (FVO). This option allows a company to irrevocably elect to account for an investment using the fair value method even if it would otherwise qualify for the equity method. This means a company with a 25% ownership stake can choose to use the fair value method instead.

The decision to elect the FVO is strategic and must be made when the investment is first acquired. A motivation for this option is accounting simplification, as the fair value method can be less complex to apply than the equity method. Companies might also elect the FVO to better reflect an investment’s economic reality, especially if it is managed on a fair value basis.

By reporting the investment at fair value, the financial statements may provide a more current picture of the investment’s worth and its contribution to the investor’s performance. Once this election is made, it cannot be reversed for that specific investment.