Equity Accounting Method: What It Is, Plus Investor Influence

ABC should record the stock dividend received from DEF with a memorandum entry that reduces the unit cost of all DEF stock owned. Additional items may be presented, if relevant to an understanding of the entity’s financial position. Deferred tax may not be reclassified as a current asset/liability if an entity adopts the current/non-current approach. This section concentrates on the accounting requirements on profit-seeking enterprises. Many financial crises in a number of countries led to the tightening of law and in some countries the setting up of bodies of accounting regulators to determine external accounting disclosure and valuation methods.

The cost method specifies recording the investment at the purchase price or historical cost and recording any activity in the income statement. Cost method investments are not adjusted for the earnings or losses of the investee, but may be analyzed for impairment. An investor may sell part of its interest in a 100% owned foreign equity investment but maintain its significant influence. Consider the example of an initial investment of $1,000, and a sale price of $1,200 for 70% of investment. The investor has recorded $400 (credit) in retained earnings and $100 (credit) in CTA/OCI (due to FX translation) in its consolidated financial statements. The initial investment is recorded as an asset on the investing company’s balance sheet.

Initial Measurement of Equity Method Investments

Alternatively, when an investor does not exercise full control over the investee, and has no influence over the investee, the investor possesses a passive minority interest in the investee. Although the following is only a general guideline, an investor is deemed to have significant influence over an investee if it owns between 20% to 50% of the investee’s shares or voting rights. If, however, the investor has less than 20% of the investee’s shares but still has a significant influence in its operations, then the investor must still use the equity method and not the cost method. When an investor acquires 20% or more of the voting stock of an investee, it is presumed that, without evidence to the contrary, that an investor maintains the ability to exercise significant influence over the investee.

• Rather, the investor should evaluate all facts and circumstances related to the investment when assessing whether the investor has the ability to exercise significant influence.
• This is because the net income attributable to non-controlling interest of the investee’s group will never accrue to the investor.
• However, it can come up, especially if you’re in an industry or region where joint ventures and partnerships are common, or if you have more work experience.
• Company A records its proportionate share of the subsidiary’s earnings as an increase to the Investment in Affiliate account on its balance sheet.
• This limits the statistical analysis that can be applied to the accounting reports of companies.
• The proceeds of an IPO distributed to the parent are tax free if the cash distributed is less than the value of the parent’s investment in the stock of the controlled subsidiary, because it is considered a return of capital.
• The Discounted Cash Flow model and its variants use the future cash flows to the firm in calculating the intrinsic value.

When considering the questions in the flowchart, an investor must take into account the specific facts and circumstances of its investment in the investee, including its legal form. The two red circles in the flowchart highlight scenarios in which the equity method of accounting would be applied. Some of the more challenging aspects of applying the equity method of accounting and accounting for joint ventures are discussed next. We have discussed the 50% ownership threshold for consolidation accounting for an investment and the 20% ownership threshold for accounting as an equity method investment. General practice is to treat investments between 20-50% as eligible for the equity method of accounting, while also using the various other criteria to support the correct accounting method.

Equity method of accounting — Research project

While there are presumptions in ASC 323 related to whether an investor has the ability to exercise significant influence over an investee, an entity must consider other factors, such as the following, in making this determination. The following is a hypothetical set of facts related to the formation of a joint venture and the subsequent activity and transactions related to that venture. We will use this example to demonstrate the equity method of accounting for an investment that is a joint venture. The investor records their investment after either the common stock or capital investment is acquired and when they have the ability to significantly influence the financial and operating policies of the investee. Consider an example where the investor has a 40% equity investment in a foreign entity, which has a book value of $4,600, and accounts for it based on the equity method.

Assume an investor invested €25 million to buy 25% of a private company, presenting a business plan up to year 5 as presented in Fig. All investments in the stock of another company—where ownership is no more than 50 percent—must be accounted for in one of three ways depending on the degree of ownership and the intention of the investor. If the investor has made adjustments to OCI for the equity investment, the accumulated balance, or accumulated OCI (AOCI), the investment must also be reduced for the disposed portion of the investment. If only a portion of the investment is being disposed of, the AOCI related to the equity investment is reduced by the same percentage. On the contrary, if the investor’s percentage of ownership increases but the investor continues to use the equity method, it will retain its CTA/OCI and continue to calculate the CTA/OCI based on the new percentage of ownership. At the end of the year, 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 the same amount to Investment Revenue.

AccountingTools

Dividends or distributions received from the investee decrease the value of the equity investment as a portion of the asset the investor owns is no longer outstanding. Once an entity has determined that they hold an equity investment, they must determine whether the investment should be accounted for under ASC 323 or one of the other US GAAP subtopics providing guidance on the accounting treatment of investments. Consider an example where an investor acquires 10% equity in a foreign investee for $1,000 and accounts for it under the fair value method. The investor acquires an additional 10% investment in the investee for $1,100 at the end of the period and determines that it should account for the investment based on the equity method because it has significant influence over the investee. The purpose of equity accounting is to ensure that the investor’s accounts accurately reflect the investee’s profit and loss. A recognized profit increases the investment’s worth, while a recognized loss decreases its value accordingly.

Conversely, when an ownership position is less than 20%, there is a presumption that the investor does not exert significant influence over the investee unless it can otherwise demonstrate such ability. At the end of year 1, XYZ Corp reports a net income of $50,000 and pays $10,000 in dividends to its shareholders. At the time 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 the same amount to cash. Any goodwill created in an investment accounted for under the equity method is ignored. While the introduction of the https://www.bookstime.com/ improved consistency, numerous criticisms remain. Some argue that just including one line isn’t enough, as that doesn’t accurately reflect the economic substance of the transaction, as in the Marks & Spencer example given earlier.

The Presumption of Significant Influence

Notably, there’s no explicit guidance regarding which section of the P/L should include the share of profit or loss from equity-accounted investments. Consequently, different entities have adopted varying methods (e.g., within operating income, just before the income tax charge, etc.). The IASB plans to standardise these divergent approaches as part of its Primary Financial Statements project. Upon further investigation, the student discovered that the agreement with Ocado was a joint venture between the two entities and as such, no revenue was recorded in the Marks & Spencer group figures. Instead, the equity method of accounting is used for the joint venture, in accordance with IFRS 11, Joint Arrangements. GAAP, unless signs of significant influence are present, an investor owning less than 20 percent of the outstanding shares of another company reports the investment as either a trading security or available-for-sale security.

The concepts above are implemented in the following comprehensive example, where we assume a simplified P&L and balance sheet to focus on key takeaways, which are highlighted in yellow. In some cases, the deferred tax liability related to undistributed earnings from an equity investment can grow quite large over time. Monetizing the investment after the DTL has grown large can trigger a large tax bill that (i) must be weighed against the benefits of monetization, and (ii) may limit the investor’s strategic options with respect to the disposition of the stake. PNC Financial faced this dilemma in evaluating monetization options for its sizeable investment in BlackRock.

Big recognizes its portion of Little’s $200,000 net income as soon as it is earned by the investee. Because earning this income caused Little Company to grow, Big increases its investment account to reflect the change in the size of the investee. In instances where the investor owns less than 20% of an entity, the guidance requires demonstration of actively influencing the financial and operating policies of the investee to apply the equity method. The investor can demonstrate active influence by some of the examples presented above, but the above list is not all-inclusive. In summary, 20% ownership is only an indicator that significant influence over financial and operating policies of another entity may exist.

In June 2022, FASB halted a four-year effort to revamp how companies account for goodwill, with some board members indicating that the case made for a revision was not strong enough to justify an overhaul. Interestingly, substantial or even majority ownership of an investee by another party does not necessarily prohibit the investor from also having significant influence with the investee. For instance, many sizable institutional investors may enjoy more implicit control than their absolute ownership level would ordinarily allow.