What it means
The company you own a slice of is called an associate, and the test that triggers equity accounting is significant influence rather than outright control. A board seat, involvement in policy decisions or a substantial shareholding all point towards influence, which is why the 20% threshold is a guide rather than a hard rule.
Mechanically the investment starts at cost. Each period the investor adds its share of the associate's profit, or subtracts its share of a loss, then deducts any dividends received, because a dividend simply hands back value that has already been counted.
This one-line treatment keeps the investor's own revenue and cost lines clean: none of the associate's sales appear in the investor's turnover. Managers reading the accounts need to know this, otherwise they wonder why a highly profitable associate does nothing at all for the top line.
Losses need care. The investor's share of losses reduces the carrying amount until it reaches zero, after which further losses are generally not recognised unless the investor has guaranteed the associate's obligations.
Separately, if the associate's prospects deteriorate, an impairment test may force the carrying amount down below the running total. Joint ventures are normally equity accounted too, so the method turns up whenever two businesses share a project company.
It is the standard treatment under both IFRS and US GAAP, which makes it one of the more portable pieces of accounting knowledge to carry between markets.
In practice
Real-world examples.
Example
A regional brewer owns 35% of a bottling company it helped set up. Each year it books its share of the bottler's profit as a single income line and increases the carrying value of the investment, without a drop of the bottler's revenue appearing in the brewer's sales figure.
Example
An engineering group holds 40% of a joint venture building a water treatment plant. The venture makes losses in its first two construction years, so the group's share of those losses steadily reduces the investment's carrying amount on its balance sheet.
Example
A media company sells part of its stake in a production house, dropping from 45% to 12% and giving up its board seat. Because significant influence is gone, it stops equity accounting and reclassifies the remaining holding as an ordinary financial investment.
Formula
Calculation
Closing carrying amount = opening carrying amount + (ownership % x associate's profit for the period) - (ownership % x dividends declared by the associate).
Suppose an investor buys 30% of an associate for $5,000,000. In the first year the associate reports a profit of $2,000,000 and declares total dividends of $500,000. The investor's share of profit is 30% x $2,000,000 = $600,000, which is added to the carrying amount and shown as a single line of income in the profit and loss account.
Its share of dividends is 30% x $500,000 = $150,000, which arrives as cash and is therefore deducted from the carrying amount. The closing figure is $5,000,000 + $600,000 - $150,000 = $5,450,000. Note the gap that matters most in practice: the investor reports $600,000 of profit but banks only $150,000 of cash, so the reported earnings cannot all be paid out as dividends by the investor.Case study
Seen in the real world.
Larkspur Foods is an illustrative, invented company used here to show the method in action. It paid $5,000,000 for 30% of a cold storage operator, took one of five board seats, and had a genuine say in pricing and capital spending, so its auditors confirmed significant influence and equity accounting applied.
In year one the operator earned $2,000,000 and declared $500,000 of dividends. Larkspur's accounts showed $600,000 of share of associate profit and a carrying amount that rose to $5,450,000, while only $150,000 of cash actually landed in its bank account.
The finance director had to explain this repeatedly to the sales team, who could not understand why group revenue had not grown. The illustrative point is that equity accounting boosts reported profit and net assets while leaving revenue and, more importantly, operating cash flow untouched.
Watch out
Common mistakes.
- Believing the 20% shareholding threshold is an automatic rule. It is a presumption that can be rebutted either way, and the real test is whether the investor has significant influence.
- Treating share of associate profit as available cash. Only the dividends actually declared and paid reach the investor's bank account.
- Adding the associate's revenue into group turnover. Equity accounting is deliberately a one-line method and never brings the associate's sales or costs into the investor's income statement.
Questions
People also ask.
What is the difference between equity accounting and consolidation?
Consolidation combines every line of a controlled subsidiary and then removes the outside shareholders' portion, while equity accounting shows an associate as a single investment line plus a single profit line.
What happens if the associate keeps making losses?
The carrying amount is reduced to zero and further losses are usually not recognised, unless the investor has a legal or constructive obligation to fund them.
Does equity accounting apply to joint ventures?
Yes, under current standards joint ventures are equity accounted in the same way as associates, rather than being proportionately consolidated.
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