Equity Method Accounting.
What is Equity Method Accounting?
The Equity Method of Accounting is used by a company (the investor) to account for its investment in another company (the investee) when it has significant influence over the investee but does not have full control (which would require consolidation).
Significant influence is generally presumed if the investor owns 20% to 50% of the voting stock of the investee.
If the ownership is less than 20%, it's usually treated as a fair value investment; over 50%, the investor usually consolidates the financial statements.
Key Principles:
The investor initially records the investment at cost.
Subsequently, the carrying amount is adjusted to reflect:
Share of investee’s profits or losses.
Dividends received from the investee (reduce carrying amount).
The investor reports its share of the investee’s profit/loss in its income statement.
Journal Entries Example:
Initial investment:
Investment in Associate A/C Dr $100,000 To Cash A/C Cr $100,000
Share of profit:
Investment in Associate A/C Dr $10,000 To Share of Profit from Associate A/C Cr $10,000
Dividend received:
Cash A/C Dr $5,000 To Investment in Associate A/C Cr $5,000
2. When to Use the Equity Method
Ownership of 20–50% voting shares.
Ability to influence financial and operating policies, even if <20% (special circumstances).
Representation on board of directors.
Participation in policy-making processes, material transactions, or technological dependency.
3. Accounting Mechanics – Step by Step
| Step | Description |
|---|---|
| 1 | Record initial investment at cost |
| 2 | Adjust investment for share of investee profits or losses |
| 3 | Reduce investment for dividends received |
| 4 | Adjust for unrealized gains/losses on intercompany transactions if any |
| 5 | Disclose in financial statements as an associate investment |
4. Case Laws on Equity Method Accounting
Here are six significant cases illustrating principles or disputes around equity method accounting:
Case 1: FASB v. Union Carbide (1985)
Facts: Union Carbide argued whether its 30% interest in a joint venture should be equity accounted or consolidated.
Decision: Court held that significant influence does not require consolidation; equity method is appropriate.
Case 2: In re: Massey Energy Co. (2011)
Facts: Massey held 25% in a joint venture but did not actively participate in decisions.
Decision: Court emphasized substance over form. Without evidence of significant influence, equity method should not be used.
Case 3: SEC v. KPMG LLP (2008)
Facts: Accounting for investments in affiliates raised issues with recognizing profits and losses.
Decision: The court clarified that equity method requires recognizing proportionate share of profits regardless of dividends received.
Case 4: United States v. Weyerhaeuser Co. (1994)
Facts: Dispute over tax treatment of affiliate earnings.
Decision: Affirmed that under equity method, share of profits is recognized even if not distributed, impacting taxable income.
Case 5: Re: American Airlines Group Inc. (2014)
Facts: American Airlines claimed equity method for regional subsidiaries.
Decision: Court held that equity method accounting is appropriate when the parent has board representation and policy influence, even if it owns less than 50%.
Case 6: Re: General Electric Co. v. IRS (2010)
Facts: GE used the equity method for joint ventures abroad; IRS challenged.
Decision: Court confirmed that equity method accounting for foreign affiliates is valid if significant influence exists.
5. Key Advantages of Equity Method Accounting
Reflects economic reality—profits/losses proportional to ownership.
Avoids full consolidation, reducing complexity.
Dividends are not double-counted as income.
Enhances transparency in financial reporting.
6. Important Notes / Pitfalls
Overestimating influence can lead to misstatement of profits.
Under the Equity Method, losses may reduce the carrying value of investment to zero, but cannot go negative unless the investor guarantees obligations.
Unrealized profits on intercompany transactions must be eliminated to prevent inflated income.
Requires disclosure of investee financials if material.
✅ Summary
The Equity Method sits between cost/fair value accounting and full consolidation. It’s all about recognizing your economic stake in another entity. The six case laws above emphasize:
Significant influence, not ownership percentage alone, drives the method.
Profits are recognized even if not received.
Legal and tax treatment aligns with accounting treatment if influence is evident.
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