Equity Method

What Is the Equity Method?

The equity method is an accounting technique utilized by a company to record the profits earned through its investment in another company. With the equity method of accounting, the investor company reports the revenue earned by the other company on its income statement, in an amount proportional to the percentage of its equity investment in the other company.

Figuring out the Equity Method

The equity method is the standard technique utilized when one company, the investor, has a critical influence over another company, the investee. At the point when a company holds roughly 20% to half of a company's stock, having critical influence is thought of. Companies with under 20% interest in another company may likewise hold huge influence, in which case they additionally need to utilize the equity method.

Critical influence is defined as an ability to apply power over another company. This power remembers representation for the board of directors, contribution in policy development, and the exchanging of managerial staff.

Recording Revenue and Asset Changes Under the Equity Method

The equity method recognizes the considerable economic relationship between two elements. The investor records their share of the investee's earnings as revenue from investment on the income statement. For instance, in the event that a firm possesses 25% of a company with a $1 million net income, the firm reports earnings from its investment of $250,000 under the equity method.

At the point when the investor has a critical influence over the operating and financial consequences of the investee, this can straightforwardly influence the value of the investor's investment. The investor records their initial investment in the subsequent company's stock as a asset at historical cost. Under the equity method, the investment's value is occasionally adjusted to mirror the changes in value due to the investor's share in the company's income or losses. Changes are likewise made when dividends are paid out to shareholders.

Utilizing the equity method, a company reports the carrying value of its investment independent of any fair value change in the market. With a critical influence over another company's operating and financial policies, the investor is basing their investment value on changes in the value of that company's net assets from operating and financial activities and the subsequent exhibitions, including earnings and losses.

For instance, when the investee company reports a net loss, the investor company records its share of the loss as "loss on investment" on the income statement, which likewise diminishes the carrying value of the investment on the balance sheet.

When the investee company delivers a cash dividend, the value of its net assets diminishes. Utilizing the equity method, the investor company getting the dividend records an increase to its cash balance be that as it may, in the mean time, reports a lessening in the carrying value of its investment. Other financial activities that influence the value of the investee's net assets ought to samely affect the value of the investor's share of investment. The equity method guarantees appropriate reporting on the business situations for the investor and the investee, given the meaningful economic relationship they have.

Illustration of the Equity Method

For instance, expect ABC Company purchases 25% of XYZ Corp for $200,000. Toward the finish of year 1, XYZ Corp reports a net income of $50,000 and delivers $10,000 in dividends to its shareholders. At the hour of purchase, ABC Company records a debit in the amount of $200,000 to "Investment in XYZ Corp" (an asset account) and a credit in a similar amount to cash.

Toward the year's end, ABC Company records a debit in the amount of $12,500 (25% of XYZ's $50,000 net income) to "Investment in XYZ Corp", and a credit in a similar amount to Investment Revenue. Likewise, ABC Company additionally records a debit in the amount of $2,500 (25% of XYZ's $10,000 dividends) to cash, and a credit in a similar amount to "Investment in XYZ Corp." The debit to the investment increases the asset value, while the credit to the investment diminishes it.

The new balance in the "Investment in XYZ Corp" account is $210,000. The $12,500 Investment Revenue figure will show up on ABC's income statement, and the new $210,000 balance in the investment account will show up on ABC's balance sheet. The net ($197,500) cash paid out during the year ($200,000 purchase - $2,500 dividend received) will show up in the cash flow from/(utilized in) investing activities section of the cash flow statement.

Alternative Methods

At the point when an investor company exercises full control, generally more than half ownership, over the investee company, it must record its investment in the subsidiary utilizing a consolidation method. All revenue, expenses, assets, and liabilities of the subsidiary would be remembered for the parent company financial statements.

Then again, when an investor doesn't exercise full control or have huge influence over the investee, they would have to record their investment utilizing the cost method. In this situation, the investment is recorded on the balance sheet at its historical cost.

Features

• Net income of the investee company increases the investor's asset value on their balance sheet, while the investee's loss or dividend payout diminishes it.
• The threshold for "huge influence" is generally a 20-half ownership.
• The equity method is utilized to value a company's investment in another company when it holds huge influence over the company it is investing in.
• The investor likewise records the percentage of the investee's net income or loss on their income statement.
• Under the equity method, the investment is initially recorded at historical cost, and changes are made to the value in view of the investor's percentage ownership in net income, loss, and dividend payouts.