Equity Method

What Does Equity Method Mean?

Equity method is an approach used for accounting a company that has invested in another company’s securities or stocks. It must be noted, though, that this accounting method is only applicable when an investing company has a substantial influence over the investee’s financial or operational aspects.

Divestopedia Explains Equity Method

The equity method of accounting is only applicable in certain circumstances. Sometimes companies make investments by buying another company‘s stock. These investments may come in the form of preferred stock, common stock or other types of equity interests such as common trust funds. If an investing company owns a significant part (20-50%) of another company’s stock, or exercises a considerable amount of influence over the investee’s financial or operational procedures, then the equity method of accounting is used by the investing company.

When using the equity method of accounting, an investing company initially records its stock investment and then periodically adjusts it according to the changes that may happen with the stock. By buying a company’s stock, the investor now shares the investee’s profits or losses.

For example, Company A invested in Company B by acquiring 40% of the latter’s securities on January 1 for $40,000. During Company B’s year-end earnings analysis, it reported $200,000 as net income. By using the equity method, Company A now records $80,000 as its earnings on investment, which will then be reflected in the company’s income statement. In the third fiscal quarter, Company B announced a dividend of $1,000 and declared it paid by November 15 of the same year. Company A will now record $400 as a decrease on their investment account.

The journal entries for Company A would look like the following:

Account: Investment in Company B

Recording Investment

Recording Equity Income

Recording Cash Dividend