Equity method is the process of treating equity investments (usually 20–50%) of companies. The investor keeps such equities as an asset.
Summarize how a company uses the Equity Method to record their investment in another company
- Equity method in accounting is the process of treating equity investments, usually 20–50%, in associate companies. The investor keeps such equities as an asset.
- The investor’s proportional share of the associate company’s net income increases the investment; net loss, and proportional payment of dividends, decreases it.
- Typically, equity holders receive voting rights on certain issues, residual rights, meaning that they share the company’s profits, and are allowed to recover some of the company’s assets in the event that it folds (although they generally have the lowest priority in recovering their investment).
- Pension funds: A pension fund is any plan, fund, or scheme which provides retirement income.
- mutual funds: A mutual fund is a type of professionally-managed collective investment vehicle that pools money from many investors to purchase securities.
Equity method in accounting is the process of treating equity investments, usually 20–50%, in associate companies. The investor keeps such equities as an asset. The investor’s proportional share of the associate company’s net income increases the investment; a net loss, or proportional payment of dividends, decreases the investment. In the investor’s income statement, the proportional share of the investee’s net income or net loss is reported as a single-line item.
An equity investment generally refers to the buying and holding of shares of stock by individuals and firms in anticipation of income from dividends and capital gains. Typically, equity holders receive voting rights, meaning that they can vote on candidates for the board of directors (shown on a proxy statement received by the investor) as well as certain major transactions. Equity holders also receive residual rights, meaning that they share the company’s profits, as well as the right to recover some of the company’s assets in the event that it folds—although they generally have the lowest priority in recovering their investment. It may also refer to the acquisition of equity (ownership) participation in a private (unlisted) company or a startup company. When the investment is in infant companies, it is referred to as venture capital investing and is generally regarded as a higher risk than investment in listed going-concern situations.
Equities held by private individuals are often held as mutual funds or as other forms of collective investment schemes, many of which have quoted prices that are listed in financial newspapers or magazines. Mutual funds are typically managed by prominent fund management firms, such as Schroders, Fidelity Investments, or The Vanguard Group. Such holdings allow individual investors to obtain diversification of the fund(s) and to make use of the skill of the professional fund managers in charge of the fund(s). An alternative, which is usually employed by large private investors and pension funds, is to hold shares directly. In the institutional environment, many clients who own portfolios have what are called segregated funds, as opposed to or in addition to the pooled mutual fund alternatives.
A calculation can be made to assess whether an equity is over- or under-priced, compared with a long-term government bond. This is called the Yield Gap or Yield Ratio. It is the ratio of the dividend yield of an equity and that of the long-term bond.
20-50% of overall shares in a firm is referred to as a minority interest, which is a non-controlling position from a strategic frame.
Understand the role minority interest shareholders hold in decision-making, and the accounting method used to report it
- Holding company shares in an organization technically imparts voting rights to the shareholder, though the percentage of the organization owned impacts the scale of this influence.
- Ownership between 20-50% is referred to as a minority interest in the organization, and must be reported using the equity method.
- In regards to control, minority interest is a not a controlling position in the firm. In most situations, 51% ownership is required (majority).
- However, a minority interest stakeholder may be consulted on certain strategic decisions and may be on the board of directors.
- minority interest: Ownership between 20-50% in an organization.
Holding shares in an organization grants a certain level of voting rights and ownership of that organization. This becomes particularly relevant when ownership of the firm reaches or exceeds 20% of the overall value of the organization. Over 50% ownership indicates an actual transfer of ownership, often recorded as a subsidiary by the owning party.
The space between 20% and 50% has specific guidelines in regards to reporting, ownership, and the assessment of control. This is referred to as an associate company, and must be reported utilizing the equity method.
The Equity Method
This is the method used to record an investment at the level of an associate company (20-50% ownership). This is considered an asset on behalf of the investor, and reported accordingly. An investment’s percentage ownership of the company appreciates when the net income increases and depreciates when it decreases. This share is reported on the investor’s income statement as a single-line item.
Control of an organization is in the hands of the owners. The owners, in most publicly traded situations, are represented by the individual who hold significant percentages of the overall organization’s value. In a situation where an individual or organization owns more than 20% and less than 50% of the overall shares, this control is referred to as a minority interest.
Owning 50% or more of the shares is a majority interest, granting the owner volume control over significant organizational decisions. However, a minority interest is still a primary shareholder that will (in most situations) have influence on the decisions being made at the strategic level.
Generally speaking, minority interest is still non-controlling interest. 51% is required to make substantial decisions regarding the organization itself. That being said, a minority interest is still a significant share of the organization. As a result, it is not uncommon for minority interest shareholders to hold a seat on the board of directors, or to be consulted regarding the decisions.
Reporting Equity Investments
Investments recorded under the equity method usually consist of stock ownership of a company between 20% to 50%.
Explain why a company would use the Equity Method to determine how to report their 20-50% investment
- When the amount of stock purchased is between 20% and 50% of the common stock outstanding, the purchasing company’s influence over the acquired company is often significant and the investor participates in business decision-making.
- Under the equity method, the purchaser records its investment at the original cost. The balance of the investment increases by the pro-rata share of the investee’s income and decreases by the pro-rata share of dividends declared by the subsidiary.
- At the time of purchase, goodwill can arise from the difference between the cost of the investment and the book value of the underlying assets.
- FASB: The Financial Accounting Standards Board (FASB) is a private, not-for-profit organization whose primary purpose is to developgenerally accepted accounting principles (GAAP) within the United States in the public’s interest.
- pro-rata: in proportion to some other factor, such as shares owned
- pro forma income: a statement of the company’s revenue while excluding “unusual and nonrecurring transactions” when stating how much money the company actually made
Reporting Stock Investments of 20-50% of Equity
When the amount of stock purchased is between 20% and 50% of the common stock outstanding, the purchasing company’s influence over the acquired company is often significant. The deciding factor, however, is significant influence or the ability for the investor to have a say in business decisions made by company owners. If other factors exist that reduce the influence, or if significant influence is gained at an ownership of less than 20%, the equity method may be appropriate. FASB interpretation 35 (FIN 35) underlines the circumstances where the investor is unable to exercise significant influence).
To account for this type of investment, the purchasing company uses the equity method. Under the equity method, the purchaser records its investment at the original cost. The balance of the investment increases by the pro-rata share of the investee’s income and decreases by the pro-rata share of dividends declared by the subsidiary.
An example of how to apply the equity method to a stock investment — assume ABC Corporation purchases 30% of XYZ Corporation (or 80,000 shares) and can exercise significant influence. The market price of the stock is USD 1. At the end of 201X, XYZ earns net income of 100,000 and declares a dividend of USD 1 per share. The following journal entries are made by ABC to record the investment in XYZ:
Journal entry for the stock investment purchase:
- DR – Investment in XYZ Corporation USD 80,000 (80,000 shares * USD 1 market price/share)
- CR – Cash USD 80,000
Journal entry to account for the pro-rata share of XYZ annual income:
- DR – Investment in XYZ Corporation USD 30,000 (100,000 net income *.30)
- CR – Equity in XYZ Corp. Income USD 30,000
Journal entry to account for the pro-rata share of XYZ dividends:
- DR – Dividends Receivable 80,000 (80,000 shares * USD 1 dividend per share)
- CR – Investment in XYZ Corporation 80,000
Goodwill and Equity Investments
At the time of purchase, goodwill can arise from the difference between the cost of the investment and the book value of the underlying assets. The component that can give rise to goodwill is: the difference between the fair market value of the underlying assets and their book value.
Goodwill is no longer amortized under U.S. GAAP (FAS 142) of June 2001. Companies objected to the removal of the option to use pooling-of-interests, so amortization was removed by the Financial Accounting Standards Board as a concession. As of January 1, 2005, it is also forbidden under International Financial Reporting Standards. Goodwill can now only be impaired under these GAAP standards.
To test goodwill for impairment, companies are now required to determine the fair value of the reporting units, using the present value of future cash flow, and compare it to their carrying value (book value of assets plus goodwill minus liabilities). If the fair value is less than carrying value (impaired), the goodwill value needs to be reduced so that the fair value is equal to the carrying value. The impairment loss is reported as a separate line item on the income statement, and the new adjusted value of goodwill is reported in the balance sheet.