The Core Equity Method Journal Entries

The equity method is an accounting approach for investments where the investor holds significant influence over the investee’s policies. Significant influence is presumed when an investor owns between 20% and 50% of an investee’s voting stock, but other factors like board representation are also considered. The investment is recorded at cost and adjusted each period for the investor’s share of the investee’s profits or losses. This method treats the investment as a single line item on the balance sheet and its income as a single line on the income statement.

The Initial Investment Journal Entry

The initial purchase is recorded by debiting the “Investment” account for the total purchase price and crediting the “Cash” account for the same amount. After this entry, the investor must compare the purchase price with the book value of their share of the investee’s net assets. For example, if an investor pays $500,000 for a 30% stake in a company with net assets of $1,500,000, the investor’s share of the book value is $450,000.

In this case, the investor paid $50,000 more than the book value. This excess payment must be allocated to specific assets or to goodwill. The investor identifies any of the investee’s assets with a fair market value higher than their book value. If the investee owns equipment undervalued by $100,000, the investor’s 30% share is $30,000. This amount is assigned to the equipment, with the remaining $20,000 allocated to goodwill.

Journal Entries for Ongoing Operations

Recording Share of Net Income or Loss

When the investee reports net income, the investor increases its investment account and recognizes income. For example, if an investor owns 40% of an investee that earns $200,000 in a year, the investor’s share is $80,000. The journal entry is a debit to “Investment in Affiliate” for $80,000 and a credit to “Equity in Affiliate Income” for $80,000. This process aligns with the accrual basis of accounting, recognizing income when the investee earns it.

If the investee incurs a net loss, the investor must record its share. If the same 40% owner’s investee had a net loss of $50,000, the investor’s share is $20,000. The journal entry would be a debit to “Equity Loss from Affiliate” for $20,000 and a credit to “Investment in Affiliate” for $20,000.

Recording Dividends Received

Dividends received from the investee are not recorded as income under the equity method. Instead, they are treated as a return of capital, which reduces the carrying value of the investment account. This is because the investor has already recognized its share of the income as it was earned by the investee.

For instance, if the investee with the $200,000 profit pays a total cash dividend of $40,000, the 40% investor would receive $16,000. The journal entry is a debit to “Cash” for $16,000 and a credit to “Investment in Affiliate” for $16,000. The net effect on the investment account is an increase from the share of income and a decrease from the dividend received.

Adjustments for Purchase Price Differences

The initial comparison of purchase price to book value has ongoing accounting consequences. The portion of the excess purchase price allocated to specific, depreciable assets must be accounted for over time through amortization. This process reduces the income the investor recognizes from the investment each period, correcting for the investee’s lower depreciation expense.

Using the earlier example, $30,000 of the excess cost was allocated to undervalued equipment. If that equipment has a remaining useful life of 10 years, the investor must record an additional $3,000 of expense each year. The journal entry for this adjustment is a debit to “Equity in Affiliate Income” and a credit to the “Investment in Affiliate” account for $3,000.

The portion of the excess purchase price allocated to goodwill is not amortized. Instead, it is subject to an annual impairment test, and a loss is recorded if the value of the goodwill has declined.

Journal Entry for the Sale of the Investment

When an investor sells an equity method investment, the investment’s carrying value must first be updated. All adjustments for the investor’s share of income or loss, dividends, and amortization up to the date of sale must be recorded.

The journal entry for the sale removes the investment from the balance sheet and recognizes any gain or loss. The “Cash” account is debited for the sale proceeds, and the “Investment in Affiliate” account is credited for its final carrying value.

The difference between the cash received and the investment’s carrying value determines the gain or loss. If cash received is greater than the carrying value, a “Gain on Sale of Investment” is credited. If cash is less than the carrying value, a “Loss on Sale of Investment” is debited. For example, if an investment with a final carrying value of $550,000 is sold for $600,000, the entry is a debit to Cash for $600,000, a credit to Investment in Affiliate for $550,000, and a credit to Gain on Sale of Investment for $50,000.