Equity Method: Pizza Investment Balance Sheet Explained

The equity method of accounting is a technique used to record the profits earned by a company through its investment in another company. It is used when an investor company has significant influence over the company it is investing in, typically owning between 20% and 50% of the stock. In this scenario, the investor company reports the revenue earned by the other company on its income statement, in proportion to its percentage of equity investment. This method acknowledges the substantive economic relationship between the two entities and is used to ensure that the investor's accounts accurately reflect the investee's profits and losses.

How is the equity method defined?

The equity method is an accounting technique used for intercorporate investments. It is used when the investor company holds a significant influence over the company it is investing in, but does not exercise full control over it. This is usually the case when a company holds 20-50% of the investee company's stock or voting rights.

The equity method is used to record the profits earned by a company through its investment in another company. The investor company reports the revenue earned by the investee company on its income statement. This amount is proportional to the percentage of its equity investment in the investee company. The investment is initially recorded at historical cost, and adjustments are made to the value based on the investor's percentage ownership in net income, loss, and dividend payouts.

Net income of the investee company increases the investor's asset value on their balance sheet, while the investee's loss or dividend payout decreases it. The investor also records the percentage of the investee's net income or loss on their income statement.

The equity method acknowledges the substantive economic relationship between two entities. The investor records their share of the investee's earnings as revenue from investment on the income statement. For example, if a firm owns 25% of a company with a $1 million net income, the firm reports earnings of $250,000 under the equity method.

The equity method is also used when an investor has less than 20% interest in another company but still holds significant influence. Significant influence is defined as the ability to exert power over another company, including representation on the board of directors, involvement in policy development, and the interchanging of managerial personnel.

What are the purposes of the equity method?

The equity method is an accounting technique used for intercorporate investments. It is used when the investor holds significant influence over the investee but does not exercise full control over it. This is often the case in the relationship between a parent company and its subsidiary. In this scenario, the terminology of "parent" and "subsidiary" is not used; instead, the investee is referred to as an "associate" or "affiliate".

The equity method is deemed appropriate when an investor holds between 20% and 50% of the investee's shares or voting rights. However, if the investor owns less than 20% but still exerts significant influence, then the equity method is still required. Significant influence is defined as the ability to exert power over another company, which can include representation on the board of directors, involvement in policy development, and the interchanging of managerial personnel.

The equity method acknowledges the substantive economic relationship between the investor and the investee. The investor records their share of the investee's earnings as revenue from investment on their income statement. The investment is initially recorded at historical cost, and adjustments are made based on the investor's percentage ownership of net income, loss, and dividend payouts. Net income of the investee increases the investor's asset value, while loss or dividend payout decreases it.

The equity method provides a more complete and accurate picture of the economic interest that one company (the investor) has in another (the investee). It allows for more consistent financial reporting over time and gives a clearer understanding of how the investee's finances can impact the investor.

What constitutes investor influence?

The level of investor influence a company holds over its investment determines the method of accounting for said private investment. Investor influence is constituted by the amount of control an investor exerts over their invested companies. This can be in the form of majority ownership or minority interest.

Majority ownership exists when an investor holds more than 50% of a company's shares, giving them effective control of the company. Minority active interest exists when an investor holds 20-50% of the company's shares, allowing them to influence management decisions but not control them entirely. Minority passive ownership interest exists when an investor holds less than 20% of the company's shares, giving them no significant influence over the company.

It is important to note that these are simply guidelines, and there may be circumstances where these guidelines do not apply. For example, an investor with less than 20% ownership may still hold significant influence if they participate in management, policy-making processes, and inter-company transactions.

The equity method of accounting is generally used when a company holds significant influence over the company it is investing in. This is usually the case when a company owns 20% or more of another company's stock. However, owning 20% or more does not automatically mean the investor exerts significant influence, as other factors such as operating agreements, ongoing litigation, or the presence of other majority shareholders may reduce their influence.

Significant influence is defined as the ability to exert power over another company, including representation on the board of directors, involvement in policy development, and the interchange of managerial personnel. This level of influence allows investors to impact the value of the company they are investing in, which benefits the investor. As a result, the change in value of that investment must be reported on the investor's income statement.

How does the equity method work?

The equity method is an accounting technique used for intercorporate investments. It is used when the investor holds significant influence over the investee but does not exercise full control over it. In this case, the terminology of "parent" and "subsidiary" is not used, unlike in the consolidation method where the investor exerts full control over the 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".

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.

Under the equity method of accounting, the investor company reports the revenue earned by the investee on its income statement. This amount is proportional to the percentage of its equity investment in the other company. The investment is initially recorded at historical cost, and adjustments are made to the value based on the investor’s percentage ownership in net income, loss, and dividend payouts.

Net income of the investee company increases the investor’s asset value on their balance sheet, while the investee’s loss or dividend payout decreases it. The investor also records the percentage of the investee’s net income or loss on their income statement.

Unlike with the consolidation method, 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.

The equity method of accounting GAAP rules allow investors to record profits or losses in proportion to their ownership percentage. It makes periodic adjustments to the asset’s value on the investor’s balance sheet to account for this ownership. The purpose of equity accounting is to ensure that the investor’s accounts accurately reflect the investee’s profit and loss. A recognized profit increases the investment’s worth, while a recognized loss decreases its value accordingly.

How does the equity method differ from other accounting methods?

The equity method is an accounting technique used to record the profits earned by a company through its investment in another company. It is generally used when the investor company holds significant influence over the company it is investing in, usually owning 20-50% of the stock.

The equity method differs from other accounting methods, such as the consolidation method and the cost method, in the following ways:

Equity Method vs Consolidation Method

When an investor company exercises full control over the company it has invested in, the consolidation method is used. In this case, the investor company is referred to as the "parent company" and the company it has invested in is referred to as the "subsidiary". The financial statements of the subsidiary are combined with those of the parent company, and all revenue, expenses, assets, and liabilities of the subsidiary are included in the parent company's financial statements.

In contrast, the equity method is used when the investor company holds significant influence over the investee but does not exercise full control. In this case, the terminology of "parent" and "subsidiary" is not used, and the investee is often referred to as an "associate" or "affiliate". There is no consolidation and elimination process, and the investor reports its proportionate share of the investee's equity as an investment (at cost).

Equity Method vs Cost Method

The cost method is used when an investor does not exercise full control or have significant influence over the company it has invested in. In this case, the investment is recorded on the balance sheet at its historical cost, and the investor does not recognize the earnings of the investee. Instead, the investor recognizes dividend income when the investee distributes dividends.

On the other hand, the equity method makes periodic adjustments to the value of the asset on the investor's balance sheet to reflect changes in the value of the investment due to the investor's share in the company's income or losses. The investment is initially recorded at historical cost, but this value is adjusted based on the investor's percentage ownership in net income, loss, and dividend payouts.

Frequently asked questions