What Is Equity Accounting?
Equity accounting (the equity method) is the accounting technique used when an investor company has significant influence—but not outright control—over another company (the investee). Instead of recording the investment at cost and recognizing only dividend income, the investor reports its share of the investee’s profits and losses on its income statement and adjusts the carrying amount of the investment on the balance sheet to reflect those results. Typical practice is to apply the equity method when ownership of voting stock is roughly 20–50%, although legal ownership is not the sole determinant and other indicators of influence also matter (Investopedia; PwC).
Key features
– Investment is initially recorded at cost as a noncurrent asset on the investor’s balance sheet.
– Investor recognizes its proportionate share of the investee’s net income (or loss) in its own income statement each period.
– Dividends received reduce the carrying amount of the investment (they are treated as a return of capital, not income).
– Adjustments may be required for the investor’s share of amortization of identifiable fair-value adjustments and for impairment losses.
– If investor obtains control (>50% or otherwise), consolidation (full consolidation) replaces the equity method; if investor loses significant influence, fair-value or cost accounting applies (Investopedia; PwC).
When to use the equity method
– Presumed significant influence: investor owns 20%–50% of voting stock (presumption rebuttable).
– Even with less than 20%, equity method may apply if other indicators of influence exist (board representation, participation in policy setting, material intercompany transactions, technological dependence, provision of essential financing, etc.).
– If investor controls the investee, consolidation is required; if investor has little or no influence, cost or fair-value accounting is used (Investopedia; PwC).
Practical steps for applying the equity method (step-by-step)
1. Assess influence each reporting period
– Review share ownership, board seats, contract terms, intercompany relationships and other indicators of significant influence. Document the assessment. (PwC)
2. Measure initial investment and allocate purchase price
– Record investment at acquisition cost.
– If acquisition cost exceeds the investor’s share of the investee’s identifiable net assets, allocate the excess to identifiable assets (and liabilities) based on fair value; any residual is goodwill. Amortize the portion allocated to depreciable/amortizable assets over their useful lives; goodwill is not amortized but tested for impairment (US GAAP/IFRS differences exist—see guidance from PwC). (PwC)
3. Record share of investee net income (or loss) each period
– Calculate investor’s percentage × investee net income (after tax).
– Journal entry: debit Investment in Affiliate; credit Equity in Earnings of Affiliate (or “Share of profit of associates” under IFRS). This increases both net income and the carrying amount of the investment.
Example: Investor owns 30% of Investee. Investee net income = $200. Investor’s share = $60. Entry:
– Debit Investment $60; Credit Equity in Earnings $60.
4. Record dividends as reductions to the carrying amount
– When the investee pays dividends, the investor records cash received and reduces the investment balance by the investor’s share of dividends. No dividend income is recognized under the equity method.
– Example: Investee dividend $50; investor receives $15 (30%). Entry: Debit Cash $15; Credit Investment $15.
5. Adjust for amortization of fair-value allocable amounts
– If part of purchase price was allocated to depreciable/amortizable assets (e.g., equipment, identifiable intangible assets), the investor’s share of the investee’s amortization reduces the investor’s share of earnings and the investment carrying amount accordingly.
6. Test for impairment and recognize losses beyond carrying amount
– If indicators of impairment exist (sustained declines in investee performance, legal/regulatory changes, etc.), measure recoverable amount and book an impairment loss to reduce the investment carrying amount. Under both IFRS and US GAAP, impairment rules and triggers differ—consult standards and firm guidance (PwC; CPA Journal).
7. Eliminate unrealized intercompany profits when relevant
– If there are intercompany sales between investor and investee (inventory, property), unrealized profits should be eliminated to the extent of the investor’s ownership percentage until realized by external sales.
8. Disclose required information
– Typical disclosures include carrying amount of equity investments, investor’s percentage ownership, summarized financial information of investees (net income, assets, liabilities), restrictions on investee’s distributable earnings, and effects of unrealized intercompany profits (PwC).
Sample end-of-period carrying amount calculation
Beginning carrying amount
+ investor’s share of investee net income (increase)
− investor’s share of dividends received (decrease)
− investor’s share of amortization of allocated fair-value excess
− impairment losses
= Ending carrying amount
Common journal entries (summary)
– Acquisition: Debit Investment; Credit Cash (or other consideration).
– Share of investee profit: Debit Investment; Credit Equity in Earnings.
– Dividends received: Debit Cash; Credit Investment.
– Amortization of fair-value allocation: Debit Equity in Earnings (or reduce equity income); Credit Investment (or accumulate amortization).
– Impairment: Debit Loss on Investment; Credit Investment.
Practical examples and considerations
– Upstream vs. downstream sales: If investee sells to investor (downstream) and the investor holds the inventory, the investor must eliminate unrealized profits in proportion to ownership. If investor sells to investee (upstream), the investor’s share of investee profit may include unrealized profits until those goods are sold to third parties.
– Change in ownership or influence: If significant influence is lost, remeasure the remaining investment at fair value and recognize any difference in earnings. If control is gained (consolidation), apply acquisition accounting and convert the carrying amount using the acquisition method (PwC).
Advantages and limitations
Advantages:
– Reflects economic reality when investor has significant influence.
– Provides a better view of the investor’s exposure to the investee’s results than the cost/dividend method.
Limitations and problems:
– Equity earnings are backward-looking and may not provide forward guidance.
– Determination of “significant influence” can be subjective and fact-specific.
– Intercompany transactions can complicate measurement of true economic results and lead to potential manipulation of reported earnings.
– Complexity around fair-value allocations, amortization and impairment can increase audit and disclosure burden (Investopedia; CPA Journal; AB Magazine).
Regulatory guidance and further reading
– Investopedia — overview and practical discussion of equity accounting.
– PwC — detailed technical guidance on the equity method, purchase price allocations and related adjustments.
– CPA Journal — discussion of practical issues and complexities of equity method accounting.
– AB Magazine — commentary on challenges and “problem child” aspects of the equity method.
References
– Investopedia. “Equity Accounting.” https://www.investopedia.com/terms/e/equityaccounting.asp
– PricewaterhouseCoopers (PwC). “Equity Method” (technical guidance). https://www.pwc.com
– CPA Journal. “Equity Method Accounting.” https://www.cpajournal.com
– AB Magazine. “Equity Method: The Problem Child.” (publication)
If you’d like, I can:
– Walk through a full numerical example with purchase price allocation and amortization, or
– Prepare ready-to-use journal entry templates and disclosure checklists tailored to US GAAP (ASC 323) or IFRS (IAS 28). Which would be most useful?