The term equity method refers to an accounting approach used when an investor has controlling interest or significant influence over another company. In practice, the equity method is used by companies that have a significant economic interest in another. This accounting method requires companies to periodically adjust their net assets as the value of this economic interest changes over time.
Unlike marketable securities, which are short term investments, an ownership interest in another company represents a long-term investment. Generally, ownership falls into three categories: controlling interest, significant influence, and passive interest. Controlling interest occurs when the investor holds more than 50% of the voting stock issued by a company, while significant influence occurs when the investor holds between 20% and 50% of the voting stock.
When a company has controlling interest or significant influence over another, it is required to use the equity method of accounting. This method requires the investor (company) to record the initial investment at cost. Subsequent adjustments are made periodically to recognize a proportional share of the investee's (associated company's) net income as an increase to their investment, while a loss and the payment of dividends would decrease the value of the investment.
This gain or loss appears as a single line item on the investor's income statement. Additional detail is available in IAS 28 Investments in Associates and Joint Ventures and IFRS 12 Disclosure of Interests in Other Entities.
On January 1, Company A acquired 1,000,000 shares of Company XYZ's common stock for $20.00 per share. This acquisition represented 40% of the voting stock of Company XYZ. The journal entry to record the initial investment in Company XYZ would be:
|Long-Term Investment in Company XYZ||$20,000,000|
At yearend, Company XYZ reported net income of $4,000,000 and paid a dividend of $0.50 per share. Using the equity method, Company A would make the following journal entry to record its share of Company XYZ's net income ($4,000,000 x 40%, or $1,600,000):
|Long-Term Investment in Company XYZ||$1,600,000|
|Revenue from Investment||$1,600,000|
While the following entry would be used to recognize the payment of a dividend ($0.50 per share x 1,000,000, or $500,000):
|Long-Term Investment in Company XYZ||$500,000|