What Is Equity Accounting and How Does It Work?

Equity accounting, often called the equity method, is a method companies use to report their financial stake in another business. It applies when an investing company has significant influence, but not control, over an investee company. This accounting approach ensures that the investor’s financial statements provide a clearer picture of the economic relationship. It differs from simply recording an investment at its initial cost because it considers the ongoing performance of the investee.

Criteria for Applying Equity Accounting

The application of equity accounting requires “significant influence” over an investee company. This means the investor can participate in the investee’s financial and operating policy decisions, without controlling them. While ownership of 20% to 50% of the investee’s voting stock is a common indicator, other factors can establish or prevent significant influence, even outside this range.

Significant influence can be shown through:

• Representation on the investee’s board of directors.
• Participation in policy-making processes, such as dividend declarations or major operational changes.
• Material intercompany transactions.
• An interchange of managerial personnel or providing essential technical information.

When an investor holds significant influence, the investee’s financial performance directly impacts the investor’s economic position. The equity method allows the investor to recognize its share of the investee’s profits or losses directly in its own financial statements. This ensures the investor’s reported earnings reflect the economic reality of its involvement with the investee.

Mechanics of Equity Accounting

The initial step in applying equity accounting involves recording the investment at its cost on the investor’s balance sheet. This initial cost includes the purchase price of the shares plus any directly attributable costs. For example, a $1,000,000 investment would initially be recorded as a debit of $1,000,000.

Following the initial recording, the investment’s carrying value is adjusted to reflect the investor’s share of the investee’s net income or loss. When the investee reports net income, the investor increases its investment carrying value and recognizes its proportionate share as “equity in earnings of investee” on the income statement. Conversely, if the investee incurs a net loss, the investor’s proportionate share reduces the investment carrying value and is recognized as an “equity in loss of investee” on the income statement.

Dividends received from the investee are treated as a return of the investment. When the investee declares and pays dividends, the investor reduces the carrying value of its investment account by the amount of dividends received. This reflects that distributed earnings are no longer retained. Dividends received do not impact the investor’s income statement directly under this method.

Other adjustments can also affect the investment carrying value. Adjustments may occur if the purchase price includes amounts allocated to identifiable assets or liabilities with fair values different from their book values; these differences may be amortized over their useful lives. The investor’s share of the investee’s other comprehensive income or loss can also adjust the investment balance.

Financial Statement Presentation

On the balance sheet, an investment accounted for under the equity method is presented as a single, non-current asset. It is labeled as:

• Investment in Associate
• Investment in Unconsolidated Subsidiary
• Investment in Equity Method Investee

Its value fluctuates over time, reflecting initial cost, the investor’s share of earnings or losses, and dividends received. This single line item encapsulates the investor’s net interest in the investee.

On the income statement, the investor’s share of the investee’s net income or loss is reported as a single line item. This line item is described as:

• Equity in Earnings of Unconsolidated Affiliates
• Investment Income
• Share of Earnings of Investee

This amount directly contributes to the investor’s net income for the period.

Regarding the cash flow statement, the impact of equity method investments is seen in two areas. Cash dividends received from the investee are reported within the operating activities section. The “equity in earnings” recognized on the income statement is a non-cash item and is adjusted for in the operating activities section. This adjustment removes the non-cash earnings from net income to arrive at cash flow from operations.

Comparing Investment Accounting Methods

Investment accounting methods are chosen based on the degree of influence or control an investor has over another entity. The cost method is used for passive investments, where the investor holds less than 20% of the investee’s voting stock and lacks significant influence. Under this method, the investment is recorded at its original cost and remains at that value. Only dividends received from the investee are recognized as income by the investor.

In contrast, consolidation is applied when an investor has control over an investee, which occurs with ownership exceeding 50% of the voting stock. Control means the investor has the ability to direct the investee’s financial and operating policies. Under consolidation, the investor combines its financial statements line-by-line with those of the investee, presenting them as a single economic entity. This method provides the most comprehensive view of the combined operations.

The equity method fits between these two extremes, reflecting situations where an investor has significant influence but not outright control. While the cost method treats investments as simple assets that generate dividend income, and consolidation merges financial statements, the equity method acknowledges a deeper economic relationship without full integration. It provides a nuanced financial picture, recognizing a proportionate share of the investee’s underlying performance. The chosen accounting method therefore directly communicates the nature and extent of the investor’s relationship with the investee.