An investor may acquire enough ownership in the stock of another company to permit the exercise of ”significant influence” over the investee company. For example, the investor has some direction over corporate policy and can sway the election of the board of directors and other matters of corporate governance and decision making. Generally, this is deemed to occur when one company owns more than 20% of the stock of the other. However, the ultimate decision about the existence of significant influence remains a matter of judgment based on an assessment of all facts and circumstances. Once significant influence is present, generally accepted accounting principles require that the investment be accounted for under the equity method. This differs from the methods previously discussed, such as those applicable to trading securities or available-for-sale securities. Market-value adjustments are usually not utilized when the equity method is employed. In global circles, the term “associate investment” might be used to describe equity method investments.

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With the equity method, the accounting for an investment tracks the “equity” of the investee. That is, when the investee makes money (and experiences a corresponding increase in equity), the investor will record its share of that profit (and vice-versa for a loss). The initial accounting commences by recording the investment at cost:

 

Recording Investment at Cost Journal entry

 

Next, assume that Legg reports income for the three-month period ending June 30, 20X3, in the amount of $10,000. The investor would simultaneously record its “share” of this reported income as follows:

 

Investment Income Journal entry

 

Importantly, this entry causes the Investment account to increase by the investor’s share of the investee’s increase in its own equity (i.e., Legg’s equity increased $10,000, and the entry causes the investor’s Investment account to increase by $2,500), thus the name “equity method.” Notice, too, that the credit causes the investor to recognize income of $2,500, again corresponding to its share of Legg’s reported income for the period. Of course, a loss would be reported in the opposite fashion.

When Legg pays out dividends (and decreases its equity), the investor will need to reduce its Investment account as shown below.

 

Dividend Journal entry

 

The above entry is based on the assumption that Legg declared and paid a $4,000 dividend. This treats dividends as a return of the investment (not income, because the income is recorded as it is earned rather than when distributed). In the case of dividends, consider that the investee’s equity reduction is met with a corresponding proportionate reduction of the Investment account on the books of the investor.

 

Did you learn?
Describe the equity method of accounting for an investment in stock, and be able to provide a comprehensive illustration.
What is the rationale for the equity method?