What is the 'Equity Method'
The equity method is an accounting technique used by firms to assess the profits earned by their investments in other companies. The firm reports the income earned on the investment on its income statement, and the reported value is based on the firm's share of the company assets. The reported profit is proportional to the size of the equity investment.
BREAKING DOWN 'Equity Method'The equity method is the standard technique used when one company has significant influence over another. When a company holds approximately 20 to 25% or more of another company's stock, it is considered to have significant control, which signifies the power one company can exert over another company. This power includes representation on the board of directors, partaking in company policy development and the interchanging of managerial personnel. If a firm owns 25% of a company with a $1 million net income, the firm reports earnings of $250,000.
When the equity method is used to account for ownership in a company, the investor records the initial investment in the stock at cost and that value is periodically adjusted to reflect the changes in value due to the investor's share in the company's income or losses.
Investment Adjustment by Earnings
The equity method used to account for a company's investment in another company acknowledges the substantive economic relationship between the two entities. When a company, the investor, has a significant influence on the operating and financial results of another company, the investee, it can directly impact the value of the investor's investment. With an investment holding above 20%, the investor usually records its share of the investee's earnings as revenue from investment, which increases the carrying value of the investment.
Investment Adjustment by Losses
When the investee company reports a net loss, the investor company records its share of the loss as loss on investment, which decreases the carrying value of the investment. Using the equity method, a company reports the carrying value of its investment independent of any fair value change in the market. With a significant influence over another company's operating and financial policies, the investor is basing its investment value on changes in the value of that company's net assets from operating and financial activities and the resulting performances, including earnings and losses.
Investment Adjustment by Dividends
When the investee company pays a cash dividend, it decreases the value of its net assets. Using the equity method, the investor company receiving the dividend records an increase to its cash balance but, meanwhile, reports a decrease to the carrying value of its investment. Other financial activities that affect the value of the investee's net assets should have the same impact on the value of the investor's share of investment. The equity method ensures proper reporting on the business situations for the investor and the investee, given the substantive economic relationship they have.