Question

Describe the equity method of accounting?

Answer 1

Equity Method Accounting

Under the equity method, the investor begins as a baseline with the cost of its original investment in the investee, and then in subsequent periods recognizes its share of the profits or losses of the investee, both as adjustments to its original investment as noted on its balance sheet, and also in the investor’s income statement.

The share of the investee’s profits that the investor recognizes is calculated based on the investor’s ownership percentage of the investee’s common stock. When calculating its share of the investee’s profits, the investor must also eliminate intra-entity profits and losses. Further, if the investee issues dividends to the investor, the investor should deduct the amount of these dividends from the carrying amount of its investment in the investee.

If the investee records adjustments in other comprehensive income, then the investor should record its share of these adjustments as changes to the investment account, with corresponding adjustments in equity. An investee’s potential adjustments to other comprehensive income include these items:

• Unrealized gains and losses on available-for-sale securities

• Foreign currency items

• Gains and losses, prior service costs or credits, and transition assets or obligations related to pension and other post-retirement benefits

If the investee is not timely in forwarding its financial results to the investor, then the investor can calculate its share of the investee’s income from the most recent financial information it obtains. If there is a time lag in receiving this information, then the investor should use the same time lag in reporting investee results in the future, in order to be consistent.

Equity Method Example

ABC International acquires a 40% interest in Blue Widgets Corporation. In the most recent reporting period, Blue Widgets recognizes $1,000,000 of net income. Under the requirements of the equity method, ABC records $400,000 of this net income amount as earnings on its investment (as reported on the ABC income statement), which also increases the amount of its investment (as reported on the ABC balance sheet).