What is the Equity Method?
The equity method is an accounting approach used for investments where the investor has significant influence over the investee but does not have full control, as would be the case in a parent-subsidiary relationship. Unlike the consolidation method, which applies to subsidiaries, the equity method is used for investments in associates or affiliates—entities where the investor can influence financial and operating policies but does not control them.
While a general guideline suggests that ownership between 20% and 50% of an investee’s shares or voting rights indicates significant influence, this is not an absolute rule. Even if an investor holds less than 20%, other factors—such as board representation, participation in policy-making, or material transactions—can still establish significant influence, requiring the use of the equity method instead of the cost method.
How Does the Equity Method Work?
Under the equity method, the investor does not consolidate the investee’s financials. Instead, the investment is recorded at cost and subsequently adjusted for the investor’s proportional share of the investee’s profits or losses. This adjustment is known as the “equity pick-up.” The investee’s earnings increase the investment account, while dividends paid out by the investee reduce it, since dividends represent a return of investment rather than additional income.
Practical Example
Suppose Lion Inc. acquires 30% of Zombie Corp for $500,000. At year-end, Zombie Corp reports a net income of $100,000 and declares dividends of $50,000 to its shareholders.
- Initial Investment – Lion records the purchase under the “Investments in Associates” account as a long-term asset:
Dr. Investments in Associates 500,000 Cr. Cash 500,000 - Dividends Received – Lion receives 30% of the $50,000 dividends, amounting to $15,000. This reduces its investment balance:
Dr. Cash 15,000 Cr. Investments in Associates 15,000 - Share of Net Income – Lion records 30% of Zombie Corp’s $100,000 net income, which is $30,000, as an increase in its investment:
Dr. Investments in Associates 30,000 Cr. Investment Income 30,000
At year-end, Lion’s investment balance is:
$500,000 (initial investment) + $30,000 (income) – $15,000 (dividends) = $515,000
This aligns with Zombie’s retained earnings, calculated as:
$100,000 (net income) – $50,000 (dividends) = $50,000 retained earnings
Lion’s 30% share of this retained amount is $15,000, which matches the net increase in its investment balance.
Other Accounting Methods for Investments
- Consolidation Method: Used when the investor has full control (typically more than 50% ownership). The parent company fully consolidates the subsidiary’s financials, combining its assets, liabilities, revenues, and expenses into a single set of statements, eliminating the investment in subsidiary account.
- Cost Method: Used when the investor holds a passive minority interest (typically below 20%) and has no significant influence. The investment is recorded at cost, and income is recognized only when dividends are received, with no proportional recognition of investee profits.
The choice of method depends on the level of control and influence the investor has over the investee, ensuring that financial statements reflect the true nature of the investment relationship.
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