The Equity Method in Accounting
The Equity Method is a tool of accounting used by companies to record their equity investments in a separate company or entity which becomes their associate company or joint venture company. With the help of the equity method, the investor company (holding or parent company) values its investment and its share in the profits and losses of the investee company.
According to both accounting standards (US GAAP and IFRS), a holding company must use the equity method when it has a substantial (but less than majority) share in the subsidiary company and/or it has a significant influence over the operational activities of the subsidiary company.
If an investor holds, directly or indirectly (eg through subsidiaries), 20 per cent or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. Conversely, if the investor holds, directly or indirectly (eg through subsidiaries), less than 20 per cent of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated.
In the above text "significant influence" over the operational activities of the subsidiary is usually evidenced in one or more of the following ways:
• Representation on the board of directors or equivalent governing body of the investee;
• Interchange of managerial personnel (exchange of managerial staff);
• Participation in policy-making processes, including participation in decisions about dividends or
other distributions;
• Material transactions between the investor and the investee (significant intra-company transaction); or
• Provision of essential technical information (e.g., the subsidiary company’s reliance on the technology of holding company).
RECORDING UNDER EQUITY METHOD
The substantial equity investments made by the public company in a separate company having less than majority shares (20% - 50%) but significant control over the activities of the associate company are recorded under the equity method of accounting.
According to IAS-28 [Investments in Associates and Joint Ventures (2011)], the investments at the time of acquisition must be initially recorded at cost and then they must be adjusted for any changes that occurr after the acquisition. The profits and losses are adjusted according to the investor company’s share in the associate company. An increase in the profit increases the investment and income while a loss decreases the investment and the income so as the other comprehensive income (OCI) also increases the other comprehensive income, they all are recorded corresponding to the share of the investor company.
EXAMPLE OF RECORDING AN INVESTMENT UNDER THE EQUITY METHOD
Have a look at an example for understanding the recording procedure of the investment under the Equity Method. Let’s assume the following things happen:
- On January 1, 2018, ABC Company acquires 30,000 shares (20% of the XYZ Company) for a cost of $20 per share.
- At the end of the year 2018, the XYZ Company reports an income of $200,000 while ABC Company’s share is 20% or $40,000.
- At the beginning of the next year on January 20, 2019, XYZ Company announces a cash dividend of $40,000, ABC Company received 20% or $8,000.
- At the end of the year 2019, the XYZ Company reports a net loss of $50,000 in which ABC’s share is 20% that is $10,000.
| Jan 1st, 2018 |
Equity investment |
$600,000 |
|
|
Cash |
|
$600,000 |
| Dec 31st, 2018 |
Equity investment |
$40,000 |
|
|
Revenue from investment |
|
$40,000 |
| Jan 20th, 2019 |
Cash |
$8,000 |
|
|
Equity investment |
|
$8,000 |
| Dec 31st, 2019 |
Loss on investment |
$10,000 |
|
|
Equity investment |
|
$10,000 |
EM - ONE LINE CONSOLIDATION
In the above example you can see why the Equity Method is also known as "One Line Consolidation". In this respect it is simpler and quite different from the Consolidation Method in which all the financial aspects (such as increase or decrease in the assets and liabilities, realized or unrealized gain or loss and changes in amortization and goodwill, etc.) of the associate company, are reported in the financial statements of the investor company.
The Equity Method only reports the net effect of the financials of the associate company as a single line item on the financial statements of the investor company.
In the Income Statement, the financial effect of the associate company is reported as a one-line amount of Revenue from investment and in the Balance Sheet, it is reported as a one-line amount of equity investment.
Sources:
Book: Barry J. Epstein, Eva K. Jermakowicz, (2008) "Wiley IFRS 2008: Interpretation and Application of International Financial reporting standards", 2008, pp. 372.
Book: Aileen Pierce, Niamh Brennan, (2003) "Principles and Practice of Group Accounts: A European Perspective ", 2003, pp. 16.
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