How to Calculate Equity Accounting With an Example

The equity method of accounting is a financial reporting technique used by companies to account for investments in other entities. This method applies when an investor holds significant influence but not outright control over the investee. It aims to provide a more accurate representation of the investor’s financial interest by incorporating the investor’s share of the investee’s earnings or losses directly into its financial statements.

Determining When Equity Accounting Applies

The equity method applies based on “significant influence” rather than control. An investor is generally presumed to have significant influence over an investee if it owns between 20% and 50% of the investee’s voting stock. This percentage range serves as a guideline, as other factors can also indicate significant influence, even with a lower ownership percentage.

Common indicators of significant influence include representation on the investee’s board of directors, participation in policy-making, material intercompany transactions, or the interchange of managerial personnel. If these indicators are present, the equity method should be applied. Conversely, if an investor owns less than 20% of the voting stock, significant influence is presumed not to exist, unless evidence proves otherwise.

Initial Recognition of the Investment

When an investor initially acquires an investment to be accounted for under the equity method, it records the investment at its original cost. This cost includes the purchase price of the shares along with any direct costs specifically attributable to the acquisition. The investment is presented as a single amount on the investor’s balance sheet.

For example, if an investor purchases a 30% stake in another company for $500,000, the initial journal entry is:

Debit: Investment in Investee – $500,000
Credit: Cash – $500,000

Adjusting the Investment for Investee’s Performance

After initial recognition, the investment account is periodically adjusted to reflect the investor’s proportionate share of the investee’s net income or loss. When the investee reports net income, the investor increases the carrying value of its investment account and recognizes its share as “Equity in Earnings of Investee” on its income statement. This adjustment ensures the investor’s financial statements reflect the economic benefits derived from the investee’s profitability.

Conversely, if the investee reports a net loss, the investor decreases the investment account by its proportionate share of that loss. This adjustment results in an “Equity in Loss of Investee” on the investor’s income statement, reflecting the negative impact of the investee’s performance.

For example, if an investor owns 30% of an investee that reports a net income of $100,000, the investor’s share is $30,000 ($100,000 x 30%). The journal entry is:

Debit: Investment in Investee – $30,000
Credit: Equity in Earnings of Investee – $30,000

If the investee instead reported a net loss of $50,000, the investor’s share is $15,000 ($50,000 x 30%). The journal entry is:

Debit: Equity in Loss of Investee – $15,000
Credit: Investment in Investee – $15,000

Adjusting the Investment for Dividends Received

Dividends received from an investee under the equity method are not recognized as income. Instead, they are considered a return of the investor’s capital and reduce the investment account’s carrying value on the balance sheet. This approach avoids double-counting, as the investor has already recognized its share of the investee’s earnings that generated those dividends.

When dividends are received, the investor increases its cash balance and decreases the investment in investee account. This reflects the outflow of cash from the investee and the corresponding reduction in the investor’s stake.

For instance, if an investor owns 30% of an investee that declares and pays $50,000 in dividends, the investor receives $15,000 ($50,000 x 30%). The journal entry to record this dividend receipt is:

Debit: Cash – $15,000
Credit: Investment in Investee – $15,000

Illustrative Calculation Example

Consider Investor Company, which acquires a 25% ownership stake in Associate Corp. on January 1, 2024, for $800,000.

On January 1, 2024, Investor Company records the initial investment:

Debit: Investment in Associate Corp. – $800,000
Credit: Cash – $800,000

During 2024, Associate Corp. reports a net income of $200,000. Investor Company’s share of this income is $50,000 ($200,000 x 25%), which increases the investment account and is recognized on the income statement.

Debit: Investment in Associate Corp. – $50,000
Credit: Equity in Earnings of Associate Corp. – $50,000

The investment account balance now stands at $850,000 ($800,000 + $50,000). On December 15, 2024, Associate Corp. declares and pays dividends totaling $100,000. Investor Company receives $25,000 ($100,000 x 25%), which reduces the investment account.

Debit: Cash – $25,000
Credit: Investment in Associate Corp. – $25,000

After this dividend, the investment account balance becomes $825,000 ($850,000 – $25,000). In 2025, Associate Corp. experiences a net loss of $80,000. Investor Company’s share of this loss is $20,000 ($80,000 x 25%), which decreases the investment account.

Debit: Equity in Loss of Associate Corp. – $20,000
Credit: Investment in Associate Corp. – $20,000

The investment account balance is now $805,000 ($825,000 – $20,000). On July 1, 2025, Associate Corp. pays another round of dividends amounting to $40,000. Investor Company receives $10,000 ($40,000 x 25%).

Debit: Cash – $10,000
Credit: Investment in Associate Corp. – $10,000

The final investment account balance for Investor Company at this point is $795,000 ($805,000 – $10,000). Over the period, Investor Company recognized total equity in earnings of $50,000 and total equity in loss of $20,000, resulting in a net equity in earnings of $30,000. The investment account balance decreased from the initial $800,000 to $795,000 due to the net effect of earnings, losses, and dividends.