Equity Method Accounting: Definition & Intercorporate Investments

The equity method is a type of accounting used for intercorporate investments. It is used when the investor holds significant influenceInvestor InfluenceThe level of investor influence a company holds in an investment transaction determines the method of accounting for said private investment. The accounting for the investment varies with the level of control the investor possesses. over the investee but does not exercise full control over it, as in the relationship between a parent company and its subsidiary. In this case, the terminology of “parent” and “subsidiary” are not used, unlike in the consolidation method where the investor exerts full control over its investee. Instead, in instances where it’s appropriate to use the equity method of accounting, the investee is often referred to as an “associate” or “affiliate”.

 

 

Although the following is only a general guideline, an investor is deemed to have significant influence over an investee if it owns between 20% to 50% of the investee’s shares or voting rights. If, however, the investor has less than 20% of the investee’s shares but still has a significant influence in its operations, then the investor must still use the equity method and not the cost method.Cost MethodThe cost method of accounting is used for recording certain investments in a company's financial statements. The investment is recorded at historical cost

 

How Does the Equity Method Work?

Unlike with the consolidation methodConsolidation MethodThe consolidation method is a type of investment accounting used for incorporating and reporting the financial results of majority owned investments., in using the equity method there is no consolidation and elimination process. Instead, the investor will report its proportionate share of the investee’s equity as an investment (at cost). Profit and loss from the investee increase the investment account by an amount proportionate to the investor’s shares in the investee. It is known as the “equity pick-up.” Dividends paid out by the investee are deducted from the account.

 

Practical Example

Lion Inc. purchases 30% of Zombie Corp for $500,000. At the end of the year, Zombie Corp reports a net incomeNet IncomeNet Income is a key line item, not only in the income statement, but in all three core financial statements. While it is arrived at through of $100,000 and a dividend of $50,000 to its shareholders.

When Lion makes the purchase, it records its investment under “Investments in Associates/Affiliates”, a long-term asset account. The transaction is recorded at cost.

Dr.Investments in Associates500,000Cr.Cash500,000

 

Lion receives dividends of $15,000, which is 30% of $50,000 and records a reduction in their investment account. The reason for this is that they have received money from their investee. In other words, there is an outflow of cash from the investee, as reflected in the reduced investment account.

Dr.Cash15,000Cr.Investments in Associates15,000

 

Finally, Lion records the net income from Zombie as an increase to its Investment account.

Dr.Investments in Associates30,000Cr.Investment Revenue30,000

 

The ending balance in their “Investments in Associates” account at year-end is $515,000. It represents a $15,000 increase from its investment cost.

This reconciles with their portion of Zombie’s retained earnings. Zombie reports a net income of $100,000, which is reduced by the $50,000 dividend. Thus, Zombie’s retained earnings for the year are $50,000. Lion’s portion of the amount is $15,000.

 

 

What are the Other Possible Accounting Methods?

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. The latter is then known as a subsidiary of the parent company. In such a case, investments made by the parent company in the subsidiary are accounted for using the consolidation method.

The consolidation method records “investment in subsidiary” as an asset on the parent company’s balance sheet, while recording an equal transaction on the equity side of the subsidiary’s balance sheet. The subsidiary’s assets, liabilities, and all profit and loss items are combined in the consolidated financial statements of the parent company after the investment in subsidiary entry is eliminated.

Alternatively, when an investor does not exercise full control over the investee, and has no influence over the investee, the investor possesses a passive minority interestMinority Interest in Enterprise Value CalculationEnterprise Value has to be adjusted by adding minority interest to account for consolidated reporting on the income statement. in the investee. In such a case, investments are accounted for using the cost method.

The cost method records the investment at cost and accounts for it depending on the investor’s historic transactions with the investee and other similar investees.

 

Additional Resources

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• Private EquityPrivate Equity Career ProfilePrivate equity analysts & associates perform similar work as in investment banking. The job includes financial modeling, valuation, long hours & high pay. Private equity (PE) is a common career progression for investment bankers (IB).  Analysts in IB often dream of “graduating” to the buy side,
• Investment MethodsInvestment MethodsThis guide and overview of investment methods outlines they main ways investors try to make money and manage risk in capital markets. An investment is any asset or instrument purchased with the intention of selling it for a price higher than the purchase price at some future point in time (capital gains), or with the hope that the asset will directly bring in income (such as rental income or dividends).
• Public SecuritiesPublic SecuritiesPublic securities, or marketable securities, are investments that are openly or easily traded in a market. The securities are either equity or debt-based.
• Debt ScheduleDebt ScheduleA debt schedule lays out all of the debt a business has in a schedule based on its maturity and interest rate. In financial modeling, interest expense flows