Equity Method of Accounting: Definition and Practical Examples Financial Terms Explained

The intangible assets had an intercompany profit margin, so we had to strip that out on consolidation—kind of tedious, Partnership Accounting but definitely necessary for correct statements. During the first year and second years, JV XYZ has net losses of $80,000 and $120,000, respectively. The companies each apply their ownership interest, 25%, to JV XYZ’s first year and second year losses to determine their proportionate share of losses to record in current period earnings.

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After the adjustment, Big, the investor, reports earnings from this equity investment of $46,000 ($48,000 — $2,000). The income accrual is reduced because a portion of the inter­company gross profit is considered unrealized. When the investor eventually consumes or sells the $15,000 in merchandise, the preceding journal entry is reversed. In this way, the effects of the transfer are reported in the proper accounting period when the profit is earned by sales to an outside party. Application of the equity method causes the investment account on the investor’s balance sheet to vary directly with changes in the investee’s equity. As an illustration, assume that an investor acquires a 40 percent interest in a business enterprise.

Initial Measurement Methods

The ability to affect these decisions demonstrates the investor’s significant influence over the investee. As per ASC 323 guidelines, when an investor disposes of an equity investment in proportion or full, it will be recorded as a sale. If the investor sells a portion of the investment, it will equity method of accounting reduce the equity investment also.

• Each reporting period, you adjust the carrying amount of the investment to factor in your share of the investee’s profits or losses.
• You have significant influence if you hold between 20% and 50% of the voting common stock of the investee, but it’s not the only indicator.
• The investor records its share of the investee’s profits and losses as a single line item on its income statement.
• For instance, if an investor sells an investment for $1,100,000 and the book value is $1,266,000, they’ll recognize a loss on the sale of $166,000.
• This example is more complex than real-life scenarios because no companies change their ownership in other companies by this much each year.

Investment Income for Equity Method Investments

• The equity method of accounting is a crucial tool for investors to accurately reflect their equity investments in financial statements.
• An impairment loss is recognized when the decline in value is considered “other than temporary.” This analysis requires evaluation of the investee’s future cash flows and market conditions.
• Along the way, you remove effects of intercompany trading and reflect any minority interest in equity.
• At the highest level of ownership and control, a parent company consolidates the subsidiary under the appropriate consolidation model.
• But can one firm exert “control” over another firm absent an interest of more than 50 percent?

Consequently, when the investor applies the equity method, reporting of the related profit on intercompany transfers is delayed until the buyer’s ultimate disposition of the goods. When the inventory is eventually consumed within operations or resold to an unrelated party, the original sale is culminated and the gross profit is fully recognized. Many equity acquisitions establish ties between companies to facilitate the direct purchase and sale of retained earnings inventory items. For example, The Coca-Cola Company recently disclosed that it sold $5,125 billion of syrup and concentrate to its 36 percent-owned investee Coca-Cola Enterprises, Inc.

• The equity method is a way to account for investments in other companies, like joint ventures.
• Over the years businesses and finances have become increasingly complex and, in the early 2000s, FASB introduced the variable interest entity (VIE) model and specific accounting guidance for its unique circumstances.
• The carrying value of the investment shown on the balance sheet is summarized as follows.
• In such scenarios, the fair value of the equity investment will be recorded as the carrying value of the investment asset going forward.
• Yes, dividends reduce the investment account since they represent a return on the invested capital.

Changes in Ownership

The equity method is typically applied in situations where an investor has significant influence over the investee, which is generally indicated by the investor owning between 20% and 50% of the voting shares of the investee. However, this percentage can vary depending on the specific circumstances, such as the presence of other factors like board representation, contractual agreements, or other methods of exercising influence. Disposal of equity investment may lead to the reduction of shareholding significantly so that it no longer qualifies for equity accounting. In such scenarios, the fair value of the equity investment will be recorded as the carrying value of the investment asset going forward.

In calculating those assets and liabilities, the company lists all income and expenses from the joint venture and includes them on its balance sheet and income statement. If a firm comes to a point where it no longer maintains a significant level of control over the joint venture, the equity method can no longer be used. At that point, a new value is recorded in the company’s profit and loss records, determined on the basis of the current cost. To calculate the equity method, multiply the percentage of ownership by the net income of the subsidiary, as seen in Company A’s 40% share of Company B’s $50,000 net income.