Loading the player...

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.

RELATED TERMS
  1. Return on Market Value of Equity ...

    Return on market value of equity (ROME) is a comparative measure ...
  2. Adjusted Net Asset Method

    A business valuation procedure used in acquisition accounting ...
  3. Market Value Of Equity

    The total dollar market value of all of a company's outstanding ...
  4. Adjusted Net Worth

    A method for valuing an insurance company using capital values, ...
  5. Relative Value

    A method of determining an asset's value that takes into account ...
  6. Pooling Of Interests

    A method of accounting that allows the balance sheets of two ...
Related Articles
  1. Investing

    Accounting For Intercorporate Investments

    Understanding these investments is key to determining the value and future prospects of any business.
  2. Investing

    Explaining Market Value of Equity

    Market value of equity is the total value of all the outstanding stock as measured in the stock market at a particular time.
  3. Investing

    Company Clone Cost Reveals True Value

    Find out how calculating a reproduction cost for a company can beat out the dividend discount model.
  4. Investing

    The Difference Between Enterprise Value and Equity Value

    Enterprise value calculates a business’s current value, while equity value offers a snapshot of that business’s current and potential future value.
  5. Financial Advisor

    Value Investing Strategies in a Volatile Market

    Volatile markets are a scary time for uneducated investors, but value investors use volatile periods as an opportunity to buy stocks at a discount.
  6. Investing

    Market Value Versus Book Value

    Understanding the difference between book value and market value is a simple yet fundamentally critical component to analyze a company for investment.
RELATED FAQS
  1. How does a company record profits using the equity method?

    Understand what the equity method of accounting is and what it's used for. Learn how a company record profits using the equity ... Read Answer >>
  2. What is the difference between market capitalization and equity?

    Understand the difference between market capitalization and equity, two primary measurements used to evaluate the worth of ... Read Answer >>
  3. How should I analyze a company's financial statements?

    Discover how investors and analysts use a company’s financial statements to evaluate a company's financial health and investment ... Read Answer >>
  4. Why would a value investor be drawn to the financial services sector?

    Understand the nature of businesses in the financial services sector, and learn why they are appealing investments for value ... Read Answer >>
  5. Why is it important for an investor to understand business accounting?

    Learn to understand why it is important for an investor to understand business accounting to perform investment and credit ... Read Answer >>
  6. What is the difference between a company's book value per share and its intrinsic ...

    Book value and intrinsic value are two ways to measure the value of a company.In simple terms, book value is based on the ... Read Answer >>
Hot Definitions
  1. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  2. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  3. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  4. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  5. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  6. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
Trading Center