Definition
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.
Explanation
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.
Example
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:
Debit | Credit | |
Long-Term Investment in Company XYZ | $20,000,000 | |
Cash | $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):
Debit | Credit | |
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):
Debit | Credit | |
Cash | $500,000 | |
Long-Term Investment in Company XYZ | $500,000 |
Related Terms
The term marketable securities, held-to-maturity is used to describe investments in debt securities that a company intends, and is able, to hold for their full term.
Moneyzine EditorFebruary 8th, 2024
The term marketable securities, available-for-sale is used to describe investments in debt and equity securities that a company does not intend to trade for profit or hold until maturity. In practice, marketable securities that are "available-for-sale" are those that are not classified as either "trading" or "held-to-maturity." Marketable securities are a subset of short-term investments; as such, they appear on the company's balance sheet and are classified as a current asset.Moneyzine EditorSeptember 20th, 2023
The term marketable securities, trading is used to describe investments in debt and equity securities that a company intends to buy and sell for profit. Marketable securities, including common stocks and bonds purchased for the purpose of trading, are typically held for a period of less than three months.Moneyzine EditorFebruary 8th, 2024- The financial accounting term ownership interest is used to describe the degree to which one company has acquired common stock in another. Ownership interest generally falls into three categories: controlling, significant influence, and passive.Moneyzine EditorSeptember 20th, 2023
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The term cost method refers to an accounting approach used when an investor has passive interest in another company. In practice, the cost method is used when an investor (company) does not have a controlling interest or is unable to exert significant influence over the investee, but has made a long-term investment in that company.Moneyzine EditorJanuary 12th, 2024- The term revenue from investments in stock refers to an approach companies can use to determine when to record income generated by their investments in common stock. There are several methods a company can use to account for these long and short-term investments. Each method has a slightly different approach to account for a stock's change in value or dividends received.Moneyzine EditorSeptember 21st, 2023
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