This lesson discusses the equity method of accounting, an accounting methodology for equity investments in which the investor company can exercise significant influence over the investee company but does not control it.
Questions from the Cubicle
You are a junior accountant at XYZ Co., which is considering making an equity investment in ABC Co.'s stock. Tom, a junior investments associate, knocks on your cubicle wall.
''I have a question for you,'' Tom says. ''I understand the accounting implications of our planned equity investment in ABC may change if we acquire 20 percent or more of ABC's voting power instead of the 15 percent we originally planned upon. Can you explain that threshold and what the accounting implications are for us if we cross it?''
''Sure,'' you tell Tom. ''Acquiring 20 percent of ABC implies we will be able to exercise 'significant influence' over ABC, and that allows us to use the equity method of accounting for the investment. That implied influence changes how and when we recognize income with respect to the investment.''
''I thought we just marked our investments to market each quarter. What does the equity method mean for our investment in ABC?''
''That's the fair value method of accounting,'' you respond. ''It is one of three methodologies used under both U.S. Generally Accepted Accounting Principles ('US GAAP') and International Financial Reporting Standards ('IFRS') to account for equity investments. The applicable method generally depends on the percentage of interest acquired:
Fair Value - equity investments less than 20 percent of total control
Equity Method - equity investments between 20 and 50 percent of voting power
Consolidation of the investee - equity investments of greater than 50 percent, a level that means the investor 'controls' the investee.
The significant influence we are implied to have over ABC justifies a more robust accounting for the investment but not enough to warrant consolidating ABC into our financials. Current US GAAP (but not IFRS) gives us the option to use fair value accounting for investments that would otherwise be accounted for under the equity method, but that's a controversial topic and a decision for the CFO.''
''Ok,'' Tom replies, ''just in case, can you give me a rundown of the accounting under the equity method?''
Equity Method of Accounting
''Basically,'' you respond, ''the accounting is as follows'':
We will initially record the ABC investment at cost, just as we would under the fair value method.
But rather than adjusting the carrying value of the investment for changes in value, we will adjust the carrying value of the investment for our percentage share of ABC's net income or loss each reporting period.
Then, if we receive dividends, we will reduce the carrying value by the amount of the dividend. But we won't recognize income for the dividend because the dividend would just be a distribution of the accumulated earnings we already picked up.
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''The equity method, in other words, recognizes income on the investment when earned by the investee company rather than waiting for dividends. Thus, the carrying value will represent our equity in the investee. This is justified because of the influence we are assumed to be able to exercise over the investee. Without this influence, the equity method would not be justified under accrual accounting principles. Under current guidance, if for some reason we cannot exercise significant influence, we would not need to use the equity method.''
''Let me walk you through an example. Suppose we acquire 20 percent of ABC for $10,000,000. ABC subsequently earns $2,000,000 and pays a dividend of $1,000,000. We would'':
Record the investment as an asset at a carrying value of $10,000,000.
Record our share of ABC's income - 20 percent of $2,000,000 or $400,000 - as investment income and increase the investment's carrying value to $10,400,000.
Record our share of the dividend - 20 percent of $1,000,000 or $200,000 as a cash receipt and a corresponding reduction in the investment's carrying value to $10,200,000.
''Thank you,'' Tom tells you. ''This has been very helpful. I will get back to you once we determine what percentage of ABC we will be acquiring.''
This lesson introduced the equity method of accounting, a method of accounting used for equity investments of between 20 and 50 percent total interest in the investee company. At this level of ownership, an investor is deemed to be able to exercise significant influence over the investee, justifying the more robust accounting. Under the equity method, investments are recorded at cost, then increased (or decreased) for the investor's share of the investee's net income (or loss), and reduced by any dividends. The goal is for the carrying value to reflect the investor's equity interest in the investee.
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