Explore the equity method used by companies to value their investment in other entities when they hold substantial influence, usually determined by a 20-50% ownership stake. Uncover the intricacies of recording initial investments, adjustments based on net income, loss, dividends, and how they affect a company's balance sheet and income statement.
Key Insights
- The equity method is used to value a company's investment in another company when it has significant influence, typically defined as a 20-50% ownership stake.
- Initial investment under the equity method is recorded at the historical cost.
- Adjustments to the value of the investment are made based on the investor's percentage ownership in net income, loss, and dividends of the company it has invested in.
- The investee company's net income increases the investor's asset value on their balance sheet, while a loss or dividend payout by the investee decreases it.
- The percentage of the investee's net income or loss is also recorded by the investor on their income statement.
- An example scenario provided shows the process of recording the investment, dividends, and net income, demonstrating how these factors influence the "Investments in Associates" account on the investor's balance sheet.
Equity Method Basics
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When to Use
Investor owns 20-50% of investee with significant influence.
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Initial Recording
Investment recorded at cost on the balance sheet.
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Periodic Updates
Investor's share of investee's net income flows to investor's income statement.
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Dividends
Reduce the investment account on receipt; not income.
- The equity method is used to value a company's investment in another company when it holds significant influence over the company it is investing in
- The threshold for "significant influence" is commonly a 20-50% ownership
- Under the equity method, the investment is initially recorded at historical cost, and adjustments are made to the value based on the investor's percentage ownership in net income, loss, and dividend payouts
- Net income of the investee company increases the investor's asset value on their balance sheet, while the investee's loss or dividend payout decreases it
- The investor also records the percentage of the investee's net income or loss on their income statement
Example:
Tiger Inc. Purchases 30% of Panther Corp for $500,000. At the end of the year, Panther Corp reports a net income of $100,000 and a dividend of $50,000 to its shareholders.
When Tiger makes the purchase, it records its investment under “Investments in Associates/Affiliates”, a long-term asset account. The transaction is recorded at cost.
Tiger receives dividends of $15,000, which is 30% of $50,000 and records a reduction in their investment account. The reason for this is that they have received money from their investee. In other words, there is an outflow of cash from the investee, as reflected in the reduced investment account.
Finally, Tiger records the net income from Panther as an increase to its Investment account.
The ending balance in their “Investments in Associates” account at year-end is $515,000. It represents a $15,000 increase from its investment cost.
This reconciles with their portion of Panther’s retained earnings. Panther reports a net income of $100,000, which is reduced by the $50,000 dividend. Thus, Panther’s retained earnings for the year are $50,000. Tiger’s portion of the amount is $15,000.
