The equity method is a method of accounting used to account for investments in associates, which are companies in which the investor holds a significant, but not controlling, stake. Under the equity method, the investor records its investment in the associate at cost, and then recognizes its share of the associate’s profits or losses as they are earned.
For example, suppose Company A holds a 20% stake in Company B. Under the equity method, Company A would initially record its investment in Company B at cost, and then each year, it would recognize its share of Company B’s profits or losses on its own income statement. So if Company B earned a profit of $100,000 in a given year, Company A would recognize a $20,000 profit on its own income statement. Conversely, if Company B incurred a loss of $50,000 in a given year, Company A would recognize a $10,000 loss on its own income statement.
The equity method is used to account for investments in associates because it more accurately reflects the investor’s economic interest in the associate, as the investor shares in the associate’s profits and losses. It is also a more conservative method of accounting, as it does not allow the investor to recognize the full value of its investment in the associate until the investment is sold or otherwise disposed of.
There are a few key considerations to keep in mind when using the equity method of accounting:
The equity method should only be used for investments in associates, not for investments in subsidiaries or joint ventures. Subsidiaries and joint ventures are accounted for using the consolidated financial statements method.
The investor must have significant influence over the associate in order to use the equity method. This typically means the investor holds at least a 20% stake in the associate.
The equity method requires the investor to adjust the carrying value of its investment in the associate each year to reflect its share of the associate’s profits or losses. This can result in changes to the value of the investment over time.
Here is an example of how the equity method would be applied:
Suppose Company A holds a 25% stake in Company B and initially records its investment in Company B at a cost of $500,000. In the first year, Company B earns a profit of $200,000. Under the equity method, Company A would recognize a profit of $50,000 ($200,000 x 25%) on its own income statement. At the same time, Company A would also adjust the carrying value of its investment in Company B to reflect its share of the profit, increasing the value of the investment to $525,000 ($500,000 + $25,000).
In the second year, Company B incurs a loss of $100,000. Under the equity method, Company A would recognize a loss of $25,000 ($100,000 x 25%) on its own income statement. At the same time, Company A would also adjust the carrying value of its investment in Company B to reflect its share of the loss, decreasing the value of the investment to $500,000 ($525,000 – $25,000).
Overall, the equity method is a useful tool for accounting for investments in associates and accurately reflecting the investor’s economic interest in the associate. It is important to understand the specific requirements and considerations of the equity method in order to correctly apply it in practice.