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Equity Method of Accounting 

Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

A method of accounting for investments in common stock where the investor owns more than 20% of the outstanding voicing stock of another company and can exercise significant influence.  When an investor corporation can exercise significant influence over the operations and financial policies of an investee corporation, generally accepted accounting principles require that the investment in the investee be reported using the equity method.  Significant influence can be determined by such factors as representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, and technological dependency.  It is presumed that an investor can exercise significant influence if he or she owns 20% to 25% of the outstanding common stock of the investee, unless evidence to the contrary is available.

The equity method of accounting for common stock investments reflects the economic substance rather than the legal form that underlies the investment in common stock of another company.  When the equity method of accounting is used, the investor initially records the investment in the stock of an investee at cost.  The investment account is then adjusted to recognize the investor’s share of the income or losses of the investee after the date of acquisition when it is earned by the investee.  Such amounts are included when determining the net income of the investor in the period they are reported by the investee.  This procedure reflects accrual-basis accounting in that revenue is recognized when earned and losses when incurred.  Dividends received from an investee reduce the carrying amount of the investment and are not reported as dividend income.  As a result of applying the equity method, the investment account reflects the investor’s equity in the underlying net assets of the investee.  As an exception to the general rule of revenue recognition, revenue is recognized without a change in working capital.

In the investor’s income statement, the proportionate share of the investee’s net income is reported as a single-line item, except where the investee has extraordinary items that would be material in the investor’s income statement.  In such a case, the extraordinary item would be reported in the investor’s income statement as extraordinary.  Intercompany profits and losses are eliminated.  Any excess of price paid for the shares over the underlying book value of the net assets of the subsidiary purchased must be identified (for example, purchased goodwill) and, where appropriate, amortized or depreciated.

When an investor owns more than 50% of the outstanding common stock of an investee and so can exercise control over the investee’s operations, consolidated financial statements for the affiliated group are normally presented.

Investments in unconsolidated subsidiaries are reported in consolidated financial statements by the equity method.  In unconsolidated financial statements of a parent company, investments in subsidiaries are reported by the equity method.

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