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Equity Method of Accounting
Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
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
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.