When a business (investor) invests in the shares of another business (investee) and is in a position to exert significant influence over the investee but does not have a controlling interest, then it uses the equity method to account for the investment.
Significant influence refers to the ability of the investor to participate in the policy making decisions of the investee business. A major indicator of significant influence is an equity interest of more than 20% but less than 50%.
For example, if the investee makes a profit it increases in value and the investor reflects its share of the increase in the carrying value shown on its investment account. If the investee makes a loss it decreases in value and the investor reflects its share of the decrease in the carrying value shown on its investment account.
Likewise if the investee pays a dividend to shareholders its retained earnings, equity and net assets decrease in value and again the investor reflects its share of this decrease in the carrying value shown on the investment account.
In summary the carrying value shown on the investors equity method investment account is calculated as follows.
Cost + Share of net income - Share of net loss - Dividend received = Carrying value of investment
Equity Method Example
Suppose a business (the investor) buys 25% of the common stock of another business (the investee) for 220,000 in cash. The investor is deemed to exert significant influence over the investee and therefore accounts for its investment using the equity method of accounting.
Initial Equity Method Investment
The first of the equity method journal entries to be recorded is the initial cost of the investment of 220,000.
| Account | Debit | Credit |
|---|---|---|
| Equity method investment | 220,000 | |
| Cash | 220,000 | |
| Total | 220,000 | 220,000 |
Equity Method Goodwill
It should be noted that the initial cost might include equity method goodwill. Providing no other asset adjustments are required the goodwill is the difference between the value placed on the investee business and the book value of the underlying assets.
In this example, assuming the value of the underlying assets are 770,000, the goodwill is calculated as follows.
Value of investee business = 220,000 / 25% = 880,000 Book value of underlying assets = 770,000 Goodwill = 880,000 - 770,000 = 110,000 Investor share = 25% x 110,000 = 27,500
The investor share of the equity method goodwill of 27,500 is part of the initial cost of the investment of 220,000 and is included in the debit entry to the investment account. Equity method goodwill is not amortized.
Share of Net Income
Suppose in the first year the investee generates a net income of 140,000. The investors share of this net income is 35,000 (25% x 140,000).
Under the equity method the investee business has increased in value and the investor reflects its share of this increase in the investment account with the following journal entry.
| Account | Debit | Credit |
|---|---|---|
| Equity method investment | 35,000 | |
| Equity method income | 35,000 | |
| Total | 35,000 | 35,000 |
The debit entry increases the balance sheet carrying value of the investment by the share of net income. The credit entry reflects the income in the income statement of the investor.
The carrying value of the investment shown on the investment account is now as follows.
| Amount | |
|---|---|
| Initial investment cost | 220,000 |
| + Share of net income | 35,000 |
| Carrying value | 255,000 |
Equity Method Dividend
The investee subsequently declares and pays a dividend of 22,000 to its shareholders of which the investor is entitled 5,500 (25% x 22,000).
The investor records the receipt of its share of dividend with the following bookkeeping journal entry.
| Account | Debit | Credit |
|---|---|---|
| Cash | 5,500 | |
| Equity method investment | 5,500 | |
| Total | 5,500 | 5,500 |
The receipt of the dividend causes the cash balance of the investor to increase. The other side of the entry is not to dividend income but is a credit to the investment account in the balance sheet.
By using the equity method the investor has already reflected its share of income in its income statement in the previous journal. When the dividend is paid the value of the investee business decreases and the investor reflects its share of the decrease in the investment account.
The carrying value of the investment shown on the balance sheet is summarized as follows.
| Amount | |
|---|---|
| Initial investment cost | 220,000 |
| + Share of net income | 35,000 |
| – Dividend received | -5,500 |
| Carrying value | 249,500 |
Share of Loss
In the next period the investee makes a loss of 60,000 of which the investors share is 15,000 (25% x 60,000). Under the equity method the investor records their share of loss using the following journal entry.
| Account | Debit | Credit |
|---|---|---|
| Equity method investment | 15,000 | |
| Equity method income | 15,000 | |
| Total | 15,000 | 15,000 |
The loss decreases the value of the investee business and the investor reflects their share of this decrease with the credit entry to the equity method investment account. The debit entry to the equity method income account reflects the share of the loss recognized by the investor.
At the end of the period the investment account equity method carrying value is as follows.
| Amount | |
|---|---|
| Initial investment cost | 220,000 |
| + Share of net income | 35,000 |
| – Dividend received | -5,500 |
| – Share of net loss | -15,000 |
| Carrying value | 234,500 |
Summary
The equity method of accounting is necessary to reflect the economic reality of the investment transaction. If the investor was able to use the cost method and was in a position to exert significant influence over say the dividend distribution policy, then it could determine whether or not to declare a dividend from the investment and manipulate the amount of dividend income included in its earnings for the year. By using the equity method the investor reflects any earnings, dividends and changes in the value of the investee as they arise in the investment account.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.