LEVEL II
The equity method of accounting is used when an investor has significant influence on the investee, and reflects the economic reality of this relationship. This video explains the accounting principles involved in the equity method of accounting.
Equity Method for Ownership Interest between 20% to 50%
When the ownership interest is between 20% to 50%, the investor generally has significant influence on the investee, which means that the financial and operating performance of the investee is partly influenced by the investor. The equity method reflects the economic reality of this relationship and provides a more objective basis for reporting investment income.
How Equity Method Works
The equity method works by recording the initial investment at cost on the investor’s balance sheet as a non-current asset. In subsequent periods, the proportionate amount of the associate’s profits or losses is used to adjust the carrying value of the investment account. This same amount is also reported in the investor’s income statement.
Treatment of Dividends and Distributions
Dividends or other distributions received from the investee reduce the investment account, and are not reported in the investor’s income statement. This is because under the equity method, dividends from associates are treated as a return of capital, not as income.
One-Line Consolidation
The equity method is often referred to as “one-line consolidation” because the investor’s proportionate ownership interest in the assets and liabilities of the investee is disclosed as a single line item on its balance sheet, and the investor’s share of the revenues and expenses of the investee is disclosed as a single line item on its income statement.
Effect of Losses on Equity Method
If the investee makes a loss and the carrying value of the investment account is less than the proportionate loss, the standard procedure is to reduce the investment account to zero, so the investor records a loss on its income statement. The equity method is halted when the investment account reaches zero, and the share of losses not recognised are simply recorded to be recovered in future periods.
Excess Purchase Price and Goodwill
In the real world, the cost to acquire shares of an investee is often greater than the book value of those shares. In such cases, the excess purchase price has to be allocated to the investee’s identifiable assets and liabilities based on their fair values first. Only the remainder is considered goodwill.
Amortisation and Impairment of Goodwill
In subsequent periods, the excess allocated to the non-current assets is expected to be amortised, while goodwill is reviewed for impairment on a regular basis, and written down for any identified impairment.
Conclusion
Under the equity method, the initial cost of the investment is recorded on the balance sheet as a non-current asset. If there is excess purchase price above the book value of the shares, it must first be attributed to the fair values of identifiable assets above their book values, and the remaining recorded as goodwill. In subsequent periods, the proportionate profit or loss is recorded on the income statement, less the amortisation of the excess purchase price, and less any impairment of goodwill identified.
