What is the Equity Method?
The equity method is how a company accounts for an investment in another entity when it holds significant influence — typically 20% to 50% ownership — but not full control. Instead of just recording dividends as income, the investor adjusts the investment's carrying value for its share of the investee's profits and losses.
Under the equity method, an investor records its investment at cost and then increases or decreases that carrying value by its proportional share of the investee's net income or loss, reducing it for dividends received.
- •Significant influence but no control
- •Investment adjusted for share of net income
- •Dividends reduce carrying value
- •Investee losses reduce carrying value
- •No significant influence
- •Investment stays at cost or fair value
- •Dividends recorded as income
- •Investee's profit/loss not recognized
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Step-by-step worked examples
Company A buys 30% of Company B for $200,000. Company B reports net income of $60,000 and pays $15,000 in dividends. Find the carrying value at year-end.
Share of net income = 30% × $60,000 = $18,000 Share of dividends = 30% × $15,000 = $4,500 Carrying value = $200,000 + $18,000 − $4,500 = $213,500
Company X holds 25% of Company Y, initial cost $500,000. Company Y reports a net loss of $40,000 and pays no dividends. What is the new carrying value?
Share of net loss = 25% × $40,000 = $10,000 Carrying value = $500,000 − $10,000 = $490,000
An investor owns 40% of an associate, initial investment $1,200,000. The associate earns $300,000 net income and distributes $50,000 in dividends total. Compute the carrying value.
Share of net income = 40% × $300,000 = $120,000 Share of dividends received = 40% × $50,000 = $20,000 Carrying value = $1,200,000 + $120,000 − $20,000 = $1,300,000
Flashcards
Quick quiz
Q1.An investor owns 35% of a company. The investee earns $100,000 net income. By how much does the investment's carrying value increase?
Q2.Under the equity method, dividends received from the investee are recorded as:
Q3.The equity method is typically used when ownership is:
Q4.If the investee reports a net loss, the investor's carrying value:
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Common mistakes
Recording all dividends received as investment income. — Correct: Dividends reduce the carrying value; only the share of net income is income.
Applying the equity method to any investment over 10% ownership. — Correct: The equity method applies specifically when there is significant influence, typically 20%–50%.
Ignoring investee losses because 'we didn't receive cash'. — Correct: Losses reduce the carrying value even without any cash outflow.
Consolidating the investee's full balance sheet under the equity method. — Correct: The equity method reports a single net investment line, not full consolidation.
FAQ
What is the equity method?
The equity method is an accounting approach for investments where the investor has significant influence (usually 20%-50% ownership), adjusting the investment's value for its share of the investee's profit or loss.
What is the equity method formula?
Carrying Value = Initial Cost + (Ownership % × Investee Net Income) − Dividends Received.
What are examples of the equity method?
A company buying a 30% stake in a supplier and adjusting its investment account for 30% of the supplier's annual net income is a classic equity-method example.
How do you calculate the equity method investment balance?
Start with the initial cost, add your ownership share of the investee's net income, and subtract dividends received during the period.