How to Calculate Equity Method Income

The equity method of accounting is used by companies to recognize income from investments in other entities. This method reflects an investor’s share of an investee company’s earnings, providing a more comprehensive view of the investment’s performance than simply accounting for dividends received.

When Equity Income Applies

Equity income becomes relevant when an investor holds “significant influence” over an investee company, typically indicated by ownership of 20% to 50% of the investee’s voting stock. This influence allows the investor to participate in the investee’s operating and financial policy decisions, even without full control.

While the 20-50% ownership range is a common guideline, significant influence can sometimes exist with less than 20% ownership, or not exist with more than 20% ownership, depending on specific facts and circumstances. Factors such as board representation, participation in policy-making, material intra-entity transactions, or interchange of managerial personnel can indicate significant influence. When an investor does not have significant influence, other accounting methods, like the cost method or fair value method, are typically used.

Key Information for Calculation

Before calculating equity income, an investor needs to gather specific financial data from the investee company. This includes the investor’s precise percentage of ownership in the investee. For example, if an investor holds 30% of the voting shares, this percentage will be crucial for the calculation.

The investee company’s net income or net loss for the relevant accounting period is also a fundamental input. This figure represents the investee’s overall profitability or unprofitability during that time. Additionally, any dividends declared and paid by the investee company to its shareholders, including the investor, must be identified. These three data points form the basis for determining the investor’s equity income.

Steps to Calculate Equity Income

Calculating equity income begins with the investor determining its proportionate share of the investee’s net income or loss. This is achieved by multiplying the investee’s reported net income (or loss) by the investor’s ownership percentage. For instance, if an investee reports $100,000 in net income and the investor owns 30%, the investor’s share of income is $30,000. This amount increases the investor’s investment account on the balance sheet and is recognized as income on its income statement.

Dividends received from the investee are treated differently under the equity method. Unlike direct income recognition, dividends received reduce the carrying value of the investor’s investment account. This is because dividends are considered a return of the capital invested, rather than a new earning. For example, if the investor receives $5,000 in dividends, the investment account is reduced by this amount.

The final equity income figure recognized by the investor reflects its share of the investee’s net income, adjusted for the impact of dividends. The overall effect is that the investor’s investment balance increases by its share of the investee’s undistributed earnings.

Common Adjustments to Equity Income

Equity income calculations often require adjustments beyond the basic share of net income and dividends to accurately reflect the investment’s value. One common adjustment involves the amortization of fair value differences that arise when an investor acquires an equity method investment. If the purchase price exceeds the investor’s proportionate share of the investee’s book value, the investor amortizes this difference over the useful life of the related assets, which reduces the equity income recognized.

Impairment losses on the investment also necessitate adjustments. An investor must assess its equity method investment for impairment if events or circumstances suggest that the carrying amount may not be recoverable. If a decline in value is determined to be “other than temporary,” an impairment charge is recorded, reducing the investment’s carrying amount and impacting the investor’s reported equity income.

Changes in the investor’s ownership percentage, such as through the sale of a portion of the equity method investment, also require adjustments. If an investor sells part of its interest but retains significant influence, a gain or loss may be recognized based on the difference between the selling price and the carrying amount of the portion sold.