Key takeaways
– The equity method is used when an investor has significant influence over, but does not control, an investee—typically presumed when ownership of voting stock is 20%–50%. (Presumption may be rebutted; influence can exist with 50%), consolidation is required; if the investor does not have significant influence, use the cost method or fair-value/mark-to-market method as applicable.
2. Initial recognition
– Record the investment at cost (purchase price plus directly attributable transaction costs) on the balance sheet as a noncurrent asset.
3. Subsequent measurement
– Recognize the investor’s proportionate share of the investee’s net income or loss in the investor’s income statement (commonly labelled “equity in earnings of investee”) and increase (for income) or decrease (for loss) the carrying amount of the investment by the same amount.
– When the investee pays dividends, record cash received and reduce the carrying amount of the investment (dividends are treated as a return of investment under the equity method, not as income).
– If the purchase price exceeds the investor’s proportionate share of the investee’s identifiable net assets, allocate the excess to identifiable assets (including intangible assets) and goodwill as necessary; amortize or depreciate those step-up amounts and adjust the investor’s share of the investee’s earnings accordingly.
– Test the investment for impairment when indicators exist; recognize impairment losses in profit or loss and reduce the carrying amount. [PwC; IAS 28]
Practical steps — a checklist for applying the equity method
1. Confirm significant influence (document indicators).
2. Record purchase:
– Dr Investment in Associate (cost)
– Cr Cash (or consideration given)
3. Each reporting period:
a. Obtain investee’s financial results.
b. Compute investor’s share: investor% × investee net income (or loss).
c. Record investor’s share of profit/loss:
– For profit: Dr Investment in Associate; Cr Equity in Earnings of Investee (or Investment income)
– For loss: Dr Equity in Loss of Investee; Cr Investment in Associate
d. If investee pays dividends:
– Dr Cash; Cr Investment in Associate
e. Adjust for amortization of any fair-value step-ups:
– Reduce investor’s share of reported investee earnings by amortization of step-up assigned to amortizable assets.
4. Monitor for indicators of impairment; if impaired, recognize loss:
– Dr Impairment Loss; Cr Investment in Associate
5. Prepare required disclosures in notes: name of investee, ownership %, carrying amount, summarized financial information (per applicable GAAP/IFRS).
Journal-entry examples (general)
– Initial purchase: Dr Investment in Associate $X / Cr Cash $X
– Recognize share of investee profit: Dr Investment $A / Cr Equity in Earnings $A
– Receive dividend: Dr Cash $D / Cr Investment $D
– Recognize impairment: Dr Loss on Investment $I / Cr Investment $I
Recording changes on financial statements — where items appear
– Balance sheet: investment shown as noncurrent asset (carrying amount changes with share of earnings, dividends, impairment, and amortization adjustments).
– Income statement: investor’s share of investee net income (or loss) reported separately (often below operating income) as equity in earnings (loss) of investee.
– Cash flow statement: classification of cash flows (dividends from associates) depends on the reporting framework—check local GAAP/IFRS guidance for operating vs investing classification. (Practice varies; verify applicable standards.) [ASC 323 / IAS 7 guidance]
– Notes to financial statements: required disclosures include investee names, ownership percentage, carrying amount, reasons for non-use of equity method if ownership suggests it, summarized financial information for associates and joint ventures, and details of commitments/contingencies.
Important considerations and exceptions
– The 20% rule is a presumption, not an absolute: evidence of significant influence may exist below 20%; conversely, ownership above 20% does not automatically require equity method if significant influence is absent (for example, when protective rights prevent influence). [AICPA; IAS 28]
– Joint ventures: equity method is commonly used for certain joint ventures (under IFRS, many joint ventures use the equity method; under U.S. GAAP, variable interest entity or joint-control guidance may apply).
– Purchase accounting allocation: if an investor pays more than its proportionate share of book value, allocate the excess to specific assets/liabilities; amortize amortizable amounts and reflect the amortization in the investor’s share of investee earnings.
– Impairment: recognize when carrying amount is not recoverable; testing and measurement requirements depend on applicable GAAP/IFRS.
– Changes in ownership: movement into control (>50%) typically requires consolidation from the date control is obtained; deconsolidation or change to cost/fair-value accounting may be required if influence changes.
Example — TechInvest Corp. and Software Innovations Inc.
Facts:
– TechInvest purchases 30% of Software Innovations for $6,000,000 on Jan. 1, 2025.
– Software Innovations reports net income of $2,000,000 in 2025 and pays total dividends of $500,000.
– In 2026, Software Innovations reports a net loss of $1,000,000 and pays no dividends.
– At the end of 2026, TechInvest determines there is an impairment and values the investment at $5,500,000.
Accounting for TechInvest:
1. Initial investment (1/1/2025):
– Dr Investment in Associate $6,000,000
– Cr Cash $6,000,000
2. Year 1 (2025)
– TechInvest’s share of 2025 net income = 30% × $2,000,000 = $600,000
– Dr Investment $600,000
– Cr Equity in Earnings of Investee $600,000
– TechInvest’s share of dividends = 30% × $500,000 = $150,000
– Dr Cash $150,000
– Cr Investment $150,000
– Carrying amount at year-end 2025 = $6,000,000 + $600,000 − $150,000 = $6,450,000
3. Year 2 (2026)
– TechInvest’s share of 2026 loss = 30% × ($1,000,000) = ($300,000)
– Dr Equity in Loss of Investee $300,000
– Cr Investment $300,000
– Carrying amount before impairment = $6,450,000 − $300,000 = $6,150,000
4. Impairment (end 2026)
– Carrying amount $6,150,000; recoverable/fair value $5,500,000 → impairment $650,000
– Dr Impairment Loss $650,000
– Cr Investment in Associate $650,000
– Carrying amount after impairment = $5,500,000
The bottom line
The equity method provides a middle ground between simple cost/fair-value accounting for passive investments and full consolidation for controlled subsidiaries. It reflects the economic reality when an investor significantly influences an investee: the investor’s income statement reflects a proportionate share of the investee’s performance, and the balance sheet reflects changes in the carrying amount of the investment rather than treating dividends as income. Applying the method requires careful assessment of influence, proper allocation of purchase price, ongoing adjustments for the investor’s share of results, and impairment assessment. Follow the requirements and disclosure rules of the applicable accounting framework (U.S. GAAP ASC 323 or IFRS IAS 28) and document the evidence of significant influence. [ASC 323; IAS 28; PwC]
Selected references and guidance
– Investopedia — Equity Method (Paige McLaughlin): https://www.investopedia.com/terms/e/equitymethod.asp
– IAS 28 — Investments in Associates and Joint Ventures (IFRS Foundation): https://www.ifrs.org/issued-standards/list-of-standards/ias-28-investments-in-associates-and-joint-ventures/
– PwC — Equity method investments and joint ventures (technical guidance and examples): (see PwC accounting guidance on equity method investments and joint ventures)
– AICPA / Association resources — Determining “Significant Influence” for Equity Method Investees: (see professional guidance and practice aids on indicators of significant influence)
(For implementation, consult the detailed guidance in ASC 323 and IAS 28 as well as firm or national auditing/accounting counsel to ensure compliance with the applicable reporting framework.)
Recording the rest of the TechInvest example (complete journal entries), then adding more sections, examples, practical steps, and a concluding summary.
Detailed continuation of the TechInvest / Software Innovations example
Background recap
– TechInvest Corp. buys 30% of Software Innovations Inc. for $6,000,000 on Jan 1, 2025.
– TechInvest applies the equity method (30% ownership = presumptive significant influence).
– Software Innovations’ results:
– 2025 net income = $2,000,000; dividends declared and paid = $500,000.
– 2026 net loss = $1,000,000; no dividends paid.
– After 2026, TechInvest determines Software Innovations’ fair value is $5,500,000 and that the decline is other-than-temporary (impairment).
Step-by-step accounting entries and carrying value tracking
1) Initial acquisition (Jan 1, 2025)
– Dr Investment in Associate (Software Innovations) 6,000,000
– Cr Cash 6,000,000
Carrying value on TechInvest books after acquisition = $6,000,000
2) Recognition of share of 2025 net income (equity pick-up)
– TechInvest’s share = 30% × $2,000,000 = $600,000
– Dr Investment in Associate 600,000
– Cr Equity in earnings of investee (Income statement) 600,000
Carrying value after equity pick-up = 6,600,000
3) Receipt of dividends in 2025
– TechInvest’s share of dividends = 30% × $500,000 = $150,000
– Under the equity method, dividends are treated as a return of investment (reduce investment), not dividend income.
– Dr Cash 150,000
– Cr Investment in Associate 150,000
Carrying value after dividend = 6,450,000
4) Recognition of share of 2026 net loss (equity pick-down)
– TechInvest’s share = 30% × (–1,000,000) = –300,000
– Dr Loss on equity investment (Income statement) 300,000
– Cr Investment in Associate 300,000
Carrying value after 2026 loss = 6,150,000
5) Impairment at end of 2026
– TechInvest determines the investment’s recoverable amount is $5,500,000 and the decline is other-than-temporary.
– Carrying value before impairment = 6,150,000
– Impairment loss = 6,150,000 – 5,500,000 = 650,000
– Dr Impairment loss on investment (Income statement) 650,000
– Cr Investment in Associate 650,000
Carrying value after impairment = 5,500,000
Notes on presentation:
– Equity in earnings (or loss) of investee is typically shown as a single line item on the investor’s income statement (often “Equity in earnings of affiliates/associates”).
– The investment appears as a noncurrent asset on the balance sheet at its carrying amount after cumulative equity adjustments and impairment write-downs.
– Dividends received are investing cash inflows in the cash flow statement (not operating cash inflows), although presentation practices can vary by jurisdiction.
Additional sections, practical steps, and examples
When to use the equity method — checklist of indicators of significant influence
Accounting standards (ASC 323 under U.S. GAAP; IAS 28 under IFRS) set a 20% ownership presumption of significant influence, but influence can exist at lower or higher ownership levels. Consider the equity method when one or more of the following apply:
– Ownership of 20%–50% of voting rights (presumption of significant influence).
– Board representation on the investee.
– Participation in policymaking or material transactions between investor and investee.
– Technical dependency or essential supply/customer relationships.
– Provision of key personnel or other managerial/operational interdependence.
– Ability to influence dividend policy, procurement, financing, or budgeting decisions.
Practical steps to implement the equity method (operational checklist)
1. Assess whether significant influence exists (document the facts).
2. Determine initial measurement: record the investment at cost (including transaction costs) on acquisition date.
3. Maintain a schedule of the investment carrying amount and reconcile it each reporting period.
4. Each reporting period:
– Recognize investor’s share of investee net income (Dr Investment / Cr Equity in earnings).
– Recognize investor’s share of investee net loss (Dr Equity loss / Cr Investment).
– Reduce investment for dividends received (Dr Cash / Cr Investment).
– Adjust for amortization of fair value differentials (if purchase price allocation identified intangible assets or fair value differences on net assets).
5. Test for impairment when indicators exist; if impaired, write down to recoverable amount and recognize impairment loss.
6. Disclose required information in notes (nature of business relationship, ownership percentage, the name of investee, summarized financial info, etc.).
7. If investor’s influence is lost (e.g., sale, dilution), stop using equity method and measure any retained interest at fair value; recognize gain/loss on disposition.
8. Consider tax effects and disclosure requirements.
Accounting for fair-value differences and purchase price allocation
– When the acquisition cost differs from the investor’s share of investee book equity, the investor must allocate that difference to identifiable assets and liabilities (including intangible assets) and amortize or depreciate the allocated amounts over their useful lives.
– Example: TechInvest paid $6M for 30%, implied full equity value = $20M. If TechInvest’s share of net assets per book was $18M × 30% = $5.4M, the excess $0.6M could be attributable to undervalued intangibles to be amortized, or other fair-value adjustments.
Example: Less than 20% ownership but significant influence
Scenario:
– Investor A owns 15% of Company B.
– Investor A has two board seats (out of seven), is the primary supplier of a core component, and participates in policy decisions.
Conclusion: Despite owning <20%, Investor A may still apply the equity method because significant influence exists.
Practical documentation: Board minutes, supply/contract agreements, and governance arrangements should be maintained to support the accounting policy choice.
Example: Disposition and loss of significant influence
Scenario:
– TechInvest sells half its stake in Software Innovations at the end of 2027, reducing its ownership from 30% to 12%.
Accounting consequences:
1) At the date influence is lost, measure any retained interest at fair value (12% stake measured at fair value).
2) Recognize a gain or loss on the portion disposed of: proceed less carrying amount of portion disposed.
3) Any subsequent holdings are accounted for under an appropriate method (cost, fair value through profit or loss, or other) depending on classification and standard.
Example journal entries (conceptual):
– Dr Cash (proceeds)
– Dr/Cr Investment in Associate (remove carrying amount of disposed portion)
– Dr/Cr Gain on disposal (Income statement)
– Then set retained 12% stake to fair value and record under new classification.
Joint ventures and proportional consolidation
– Under IFRS (post-IFRS 11), the equity method is required for joint ventures (proportional consolidation is not permitted for joint ventures except in limited historical contexts).
– Under U.S. GAAP, equity method is used for entities in which the investor has significant influence or for certain joint ventures.
– Distinguish joint control (joint venture) vs. significant influence (associate) and apply the appropriate standard.
Impairment — indicators, measurement, and presentation
Indicators of impairment:
– Sustained adverse changes in market, technological obsolescence, loss of key customers or management, regulatory changes.
Measurement:
– Under U.S. GAAP (ASC 323/ASC 360 depending), if objective evidence of impairment exists, measure the impairment loss as the difference between carrying amount and fair value, recognizing loss in earnings.
– Under IFRS (IAS 28 combined with IAS 36), test for impairment at investee level or investor’s portion as required and recognize impairment losses if recoverable amount is lower than carrying amount.
Presentation:
– Impairment losses reduce the carrying value of the investment and are typically recognized in the income statement.
How equity-method investments affect financial analysis and ratios
– Return on Assets (ROA): Investment carrying value increases assets; equity in earnings increases net income — effect on ROA depends on relative magnitudes.
– Leverage ratios: Large equity investments increase total assets, potentially lowering leverage ratios (debt/asset) if financed with equity or cash.
– Earnings quality: Equity pick-up can produce sizable single-line income items that can be volatile or difficult to forecast compared with consolidated net income.
– Cash flow: Equity earnings are noncash until dividends are received; dividends are classified as investing cash inflows.
Disclosure requirements (typical, non-exhaustive)
– Name and summarized financial information for material associates/joint ventures (e.g., total assets, liabilities, revenue, profit/loss).
– Ownership percentage and nature of relationship.
– Methods used for recognition and any significant judgments (e.g., why equity method is applied when ownership is 50% or obtains control by other means), move from equity method to consolidation. At the date control is obtained, measure the subsidiary’s identifiable assets, liabilities, and noncontrolling interest per consolidation rules; eliminate equity investment against investee equity.
– Transition from consolidation to equity method (loss of control but retained significant influence): Recognize fair value of retained interest and account for remaining interest under the equity method (gain/loss recognized on deconsolidation per relevant GAAP).
Sources and further reading
– PwC, “Equity method investments and joint ventures” (guidance and practical examples).
– IFRS Foundation, IAS 28 — Investments in Associates and Joint Ventures.
– FASB ASC 323 — Investments—Equity Method and Joint Ventures.
– AICPA, “Determining ‘Significant Influence’ for Equity Method Investees: It’s Not Just Owning 20% of the Stock.”
Concluding summary
The equity method is a critical accounting approach for investments in entities where an investor can exert significant influence but does not control the investee. It provides more economically meaningful reporting than simple cost or market measurement by reflecting the investor’s share of the investee’s profits and losses, adjusting the investment’s carrying value accordingly, and treating dividends as returns of capital. Proper application requires careful assessment of influence, diligent tracking of carrying values, recognition of equity pick-up entries and dividends, consideration of fair-value allocations and amortizations, testing for impairment, and clear disclosures. Companies must also be prepared to change accounting treatment if their level of influence changes (acquisition of control, loss of influence, or sale). Following the operational checklist and documenting judgments will help ensure consistent, compliant financial reporting.
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