Equity accounting: how does it measure up?

Instead, the investor will report its proportionate share of the investee’s equity as an investment (at cost). The equity method is an accounting technique used to record the profits earned by a company through its investment in another company. He is very particular about his investments and has managed to create a small portfolio of nine stocks. He decides to learn equity analysis and starts by taking a small online course, where he learns about both the fundamental and technical approaches of equity analysis.

Initial Measurement of Equity Method Investments

In summary the carrying value shown on the investors equity method investment account is calculated as follows. Equity accounting reflects a measurement approach as well as a consolidation approach. Equity accounting was originally used as a consolidation technique for subsidiaries at a time when acquisition accounting was considered inappropriate because it showed assets and liabilities not owned by the reporting entity. The concepts above are implemented in the following comprehensive example, where we assume a simplified P&L and balance sheet to focus on key takeaways, which are highlighted in yellow. These single line presentations simplify the financial statements while still providing insight into the performance of equity method investments. When a company uses the equity method to account for an investment, the investment asset is presented as a single line item called “Investments in Equity Method Investees” on the balance sheet.

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We compare the equity method to the cost method, cover tax and international accounting implications, reporting requirements, and provide illustrative case studies. On 1 January 20X1, Entity A acquired a 25% interest in Entity B for a total consideration of $50m and applies the equity method in accounting for it. These assets include real estate with a carrying amount of $20m and a fair value of $35m, with a remaining useful life of 15 years. For other assets and liabilities, the carrying amount is roughly equivalent to their fair value. Without the relevant information the subsidiary provides, be it details relating to income/profit for the year or even dividends, the equity accounting method cannot be undertaken. Hence, there is a significant dependence on the subsidiary company to gain the relevant information so that the parent company can undertake the necessary equity accounting.

Adjustments for Dividends and Other Distributions

At the end of the period the investment account equity method carrying value is as follows. The IASB feels including this option in IAS 27 would not involve any additional procedures because the information can be obtained from the consolidated financial statements by applying IFRS 10 and IAS 28. Equity method accounting can be complex, but analyzing real-world examples helps illustrate the key concepts. Here are some case studies and lessons learned from companies applying the equity method.

A very different approach than the fundamental analysis is the technical analysis. Significant influence refers to the ability of the investor to participate in the policy making decisions of the investee business. A major indicator of significant influence is an equity interest of more than 20% but less than 50%. Investments accounted for at cost and classified as held for sale are accounted for in accordance with IFRS 5, Non-current Assets Held for Sale and Discontinued Operations.

Investee’s dividends and distributions.

Conversely, when an ownership position is less than 20%, there is a presumption that the investor does not exert significant influence over the investee unless it can otherwise demonstrate such ability. Under equity accounting, the biggest consideration is the level of investor influence over the operating or financial decisions of the investee. When there’s a significant amount of money invested in a company by another company, the investor can exert influence over the financial and operating decisions, which ultimately impacts the financial results of the investee. Lion receives dividends of $15,000, which is 30% of $50,000 and records a reduction in their investment account. In other words, there is an outflow of cash from the investee, as reflected in the reduced investment account. Unlike with the consolidation method, in using the equity method there is no consolidation and elimination process.

• These assets include real estate with a carrying amount of $20m and a fair value of $35m, with a remaining useful life of 15 years.
• When an investor exercises full control over the company it invests in, the investing company may be known as a parent company to the investee.
• This cost includes expenditures directly attributable to the acquisition of the asset, such as legal fees, transfer taxes, and other transaction costs.
• For example, if the investee reports net income of $100,000 and the investor owns 30% of the voting shares, the investor’s share of income would be $30,000 ($100,000 x 30%).

8.2 Equity method—potential voting rights

By using the equity method the investor reflects any earnings, dividends and changes in the value of the investee as they arise in the investment account. It is commonly applied when an investor owns a significant stake in an investee, demonstrating influence over financial and operating policies. Equity method accounting leads to Accounting For Architects a more accurate representation on the balance sheet and income statement from period to period. While complex in practice, the underlying principles help account for an investor’s share of income/losses in the ongoing operations of an investee. The share of an investee’s profit or loss and OCI is determined based on its consolidated financial statements. This includes the investee’s consolidated subsidiaries and other investments accounted for using the equity method (IAS 28.10).

• Respondents felt it was important for the IASB to establish a clear conceptual basis for the equity method.
• There is some doubt about the objective of separate financial statements, as they are not required in International Financial Reporting Standards (IFRS).
• This is done because holding significant shares in a company gives an investor company some degree of influence over the company’s profit, performance, and decisions.
• Equity Accounting refers to a form of accounting method used by various corporations to maintain and record the income and profits that it often accrues and earns through the investments and stake-holding that it buys in another entity.
• Although the 2024 exposure draft does not explicitly define this formula, it is consistent with the IFRS 3 requirements.
• FASB has issued guidance on dealing with equity method accounting for investments.

The main difference between the equity method and consolidation is the level of ownership and control a company has over the investment. None of the circumstances listed previously are necessarily determinative with respect to whether the investor is able or unable to exercise significant influence over the investee’s operating and financial policies. Rather, the investor should evaluate all facts and circumstances related to the investment when assessing whether the investor has the ability to exercise significant influence.

Equity Accounting vs. Cost Method

The equity method is an accounting approach for certain investments whereby the investment is initially recorded at cost but is subsequently adjusted based on the investor’s share of the investee’s profits or losses. The equity method serves as a middle ground between consolidating the investee’s financial statements and accounting for the investment based solely on its fair value. The share of the investee’s profits that the investor recognizes is calculated based on the investor’s ownership percentage of the investee’s common stock. When calculating its share of the investee’s profits, the investor must also eliminate intra-entity profits and losses.

The investor has recorded $400 (credit) in retained earnings and $100 (credit) in CTA/OCI (due to FX translation) in its consolidated financial statements. The investor determines that it should account for this investment under the equity method of accounting. The initial measurement reflects that there are basis differences of $300 in this transaction, consisting of $100 unrecorded intangible assets (customer relationship) and $200 goodwill. FASB has issued guidance on dealing with equity method accounting for investments. This article expounds on the fundamental concepts of equity method accounting; its objective is to provide an accounting context and a general framework for equity method accounting. It has eschewed a detailed deliberation on tax accounting issues, but it has discussed certain tax accounting concepts that are an integral part of financial accounting.