Equity Earnings 

Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority and you can order it here)  

Also called indirect, unreported, or undisclosed earnings, that part of the surplus earnings of  a subsidiary company, over and above dividend payments, not reported by the parent company.  Most of the large corporations hold or control through full, majority, joint (half, third, quarter, etc.) or minority stock ownership in subsidiary is or affiliated companies.  Unless the ownership of such subsidiary is a majority interest, the parent company cannot under proper accounting principles consolidate the earnings of a subsidiary or subsidiaries in the income account of the parent company, but only such part of such earnings as may be actually paid to the parent organization as dividends.  When earnings of subsidiaries are consolidated in the income account of the parent organization, the proportion of earnings applicable to the minority interest must be deducted.

Under Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock,” the investor company owning a block of voting stock in an investee corporation other than a subsidiary should carry the investment on its books on the equity method (cost basis or market value basis should not be used) if the percentage of ownership is a majority interest or if the percentage of ownership held is not a majority interest but is sufficient in fact to influence the operating or financial decisions of the investee corporation.  Under the equity method, the investor corporation records the initial investment in the investee stock at cost, and then adjusts such carrying value, increasing or decreasing it, by the percentage of ownership applied to undistributed earnings of the investee (dividends received from the investee reduce the carrying amount of the investment).

Under the Internal Revenue Code, and subject to regulations, an affiliated group of corporations has the privilege of choosing to be taxed as a single unit by filing a consolidated return rather than separate returns.  The code specifically defines an affiliated group to exist when (1) at least 80% of all classes of voting power stock and at least 80% of each class of nonvoting stock of each affiliated corporation (except the common parent corporation) is owned directly by one or more of the other affiliated corporations which may be included; and (2) the common parent corporation owns directly 80% of all classes of the voting stock and at least 80% of each class of nonvoting stock of at least one of the other corporations which may be included.  (Stock does not include nonvoting preferred stock.)  Consolidated returns are advantageous if some of the affiliated corporations which may be included have losses, which in consolidation will offset profits of the other affiliated corporations.  But once a consolidated return is filed, the affiliated group must continue to file consolidated returns unless the IRS concurs in discontinuing such returns.

Even where the parent corporation does not report earnings on a consolidated basis, the security analyst will be interested in total earnings, including equity of the parent in undistributed earnings of subsidiaries.  To illustrate the nature of equity earnings, the following example is given.

A parent company owns 800,000 shares of a subsidiary having 1,000,000 shares (its sole capitalization) outstanding.  The subsidiary earns $5 million in a given year and pays $3 in dividends, or $3 million.  The parent company thereby receives $2,4 million from its subsidiary which is taken up in the parent company’s income account and reported accordingly.  Such report, however, does not disclose full earnings, since the surplus earnings in excess of the subsidiary’s parent company for the year in question are equal to its proportionate ownership in the $2 million earned but not disbursed.  This proportionate interest or equity earnings is 80% of $2 million, or $1.6 million.  Such equity earnings must be added to the actually reported earnings of the parent company to measure its full earning power.

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