What it means
Imagine your company owns 30% of a supplier. You cannot dictate its decisions, but you probably sit on its board and have a real say.
Accounting standards say that in this situation the investment should not simply sit at its purchase price, because your results are genuinely tied to how the supplier performs. Under the equity method the investment starts on the balance sheet at cost.
Each year the investor adds its percentage share of the investee's net income, which also appears as a single line in the investor's income statement. When the investee pays a dividend, the investor reduces the carrying value, because cash received is a return of part of the investment rather than new income.
The method sits between two other approaches. With a small holding and no real influence, the investment is normally measured at fair value.
With control, usually more than 50%, the investor consolidates, meaning it combines the other company's assets, liabilities, revenues and costs line by line into its own statements. The 20% mark is a guide, not a hard rule.
Significant influence can be shown by board representation, involvement in policy decisions or material transactions between the two businesses, so a holder of 18% might still use the method while a holder of 25% without influence might not. For analysts, the equity method creates a gap between profit and cash, because the investor reports a share of profit that may never be paid out as a dividend.
It is worth checking cash flow to see what has actually been received. Impairment is a further point to watch.
If the investee's value falls well below the carrying amount and the fall looks lasting, the investor must write the investment down. This keeps the balance sheet honest and prevents a stake from being carried at a figure the business could never realise.
In practice
Real-world examples
Example 1
A retail group owns 35% of a logistics joint venture. It reports its share of the venture's profit as one line in its income statement rather than combining every truck and warehouse into its own accounts. Its balance sheet shows one net investment figure instead of the venture's detailed assets.
Example 2
A pharmaceutical company holds 25% of a smaller research partner and has two seats on its board. The holding is accounted for under the equity method because it clearly influences strategy. A holding without influence would instead be measured at fair value.
Example 3
A property developer owns 40% of a hotel owned together with two other investors. When the hotel makes a $500,000 loss, the developer reduces its investment by $200,000, its 40% share of the loss. The reduction appears in the developer's income statement as a share of loss from the investment.
Think of it
Equity method adjusts your investment account for your share of the company's profits or losses.
Formula
Calculation
Ending carrying value = Initial cost + Share of investee net income - Dividends received
Stonebridge Holdings buys 30% of Alder Components, a fictional supplier, for $3,000,000. In the first year Alder reports net income of $1,000,000, so Stonebridge's share is $1,000,000 x 30% = $300,000. Alder pays total dividends of $400,000, so Stonebridge receives $400,000 x 30% = $120,000. The ending carrying value is $3,000,000 + $300,000 - $120,000 = $3,180,000. Stonebridge reports $300,000 of investment income, even though only $120,000 arrived as cash.Case study
Seen in the real world
Meridian Foods is an illustrative, fictional company that bought 28% of a packaging firm called Clearpack for $4,200,000. The finance team initially left the stake at cost, reasoning that Meridian did not run Clearpack.
Their auditors pointed out that Meridian held two board seats and bought most of Clearpack's output, which amounted to significant influence. The investment had to be restated under the equity method, adding Meridian's share of Clearpack's profit each year.
In the illustrative restatement, the carrying value rose from $4,200,000 to $4,830,000 over three years as Clearpack's profits were recognised, less dividends. The change improved reported earnings, but the CFO also showed the board a cash view, since only part of that profit had arrived as dividends. The CFO also added a note to the accounts explaining the difference between profit recognised and cash received, so readers would not be misled.
Watch out
Common mistakes
- Recording dividends received from the investee as income, when under the equity method they reduce the carrying value of the investment.
- Applying a rigid 20% to 50% test and ignoring evidence of influence or lack of it.
- Treating the investor's share of profit as cash, when only dividends actually bring cash into the business.
Questions
People also ask
What happens if the investee makes a loss?
The investor reduces the investment by its share of the loss, and normally stops recording further losses once the carrying value reaches zero.
How is the equity method different from consolidation?
The equity method shows a single net investment line, while consolidation combines all of the other company's assets, liabilities, income and costs.
Where does the equity method appear in the accounts?
The investment is shown as one asset on the balance sheet, and the share of profit is shown as one line in the income statement.
Watch