Equity Method - Online Tutor, Practice Problems & Exam Prep

When a company acquires 20-50% of another company, it uses the equity method for accounting. This involves recognizing a share of the investee's net income or loss proportional to ownership. Key journal entries include recording the purchase, recognizing investment income, adjusting for dividends received (which reduce the investment), and finally, recording the sale of the investment. The gain or loss on sale is determined by comparing the selling price to the book value of the investment. Understanding these concepts is crucial for accurate financial reporting under GAAP.

Significant Influence and the Equity Method

Now let's talk about a different type of accounting when we buy a significant amount of a company. We're going to use the equity method to account for this investment. Let's check it out. So when we have significant influence over a company, we're going to have to use what GAAP requires, the equity method, okay? So let's talk about influence real quick. First, we're going to have situations where we have no influence and this is where we just buy a few shares of stock, okay? So no influence is less than 20% ownership. We have less than 20% ownership, we don't really have any sway in their decision-making. Okay? And this is where we're going to use the cost method to deal with these investments. So that's where we would label them as trading securities, available for sale, held to maturity. Those type of investments that you have no influence over the company. So think about it. You'd own just a few shares in that situation, right? 20% of a company might sound pretty big or maybe like 15%, right? That still sounds pretty big, but we've kind of got this bright line where we say more than 20%, that's where we say we have significant influence. Okay? So we're going to say between 20-50% ownership. So now if you own 30%, 40%, or 50% of the company, at these points, you're going to use what's called the Equity Method. And that's what we're going to focus on in this section. Okay? So we're focusing on these situations where you have significant influence. Compare that to a Controlling Influence. So Controlling Influence is where you have more than 50%. So you have 51%. Right? More than 50%, 51%, 52%, 100%. That's when you're going to use consolidation. Consolidation accounting, okay? So let's think about this equity method. When you own 30 or 40% of the company, remember when you have common stock, you're going to be able to vote for who's on the board of directors of the company. So if you have enough shares of stock, you're going to have some influence over who's going to be on that Board of Directors. So you can vote for your pal to be on the Board of Directors and have some influence over what's going on there. When you have controlling interest, when you have 51% of the vote, well, you have the majority, right? You're going to be able to say everyone who is on the Board of Directors, you're going to have control over that. That's when you have a controlling interest. Okay? So here we're in the situation where we have significant influence. We're able to influence some of the decision-making of the company. So we're going to use the equity method of accounting. We're no longer going to do trading security, held to maturity. We're going to use a special form to account for this investment called the equity method. So let's check out what the situations that happen in Equity Method. We're going to have 4 common journal entries that we're going to learn about. So when we do the Equity Method, we're going to have the purchase of the investment just like we're used to. There's nothing crazy about the purchase, but we're going to purchase enough shares to have significant influence. So generally, what they're going to show you is you buy a certain amount of shares and there's another amount of shares outstanding in the company and you're going to have to deduce, hey, we bought a significant portion of this company based on the percentage of the total shares that you bought, okay? So we'll see an example of that. But the purchase of the investment is very simple. You purchase it at cost, right? You purchase it and you say whatever we paid for it, that is the journal entry we're going to make. Then we're going to have the net income or the loss of the investee. This is going to be our investment income. Okay? We're going to earn investment income based on the net income of the investee. So this is where it gets different. The company that we bought, say we bought a subsidiary company. When we buy their stock, they're going to earn net income and since we own such a big portion of their company, we're going to assume that from their net income, there's a portion of that that's ours because we own so much of it. We own a percentage of that equal to our ownership percentage. So we're going to earn investment income based on their net income. So that's a big difference there. Now dividends received, this is different as well. When we receive dividends in this case, it's going to lower our investment, okay? So dividends that we receive lower the value of our investment, okay? And we'll see an example for that. And what we have to make as a difference is that these dividends received are not investment income. Okay? So when we were dealing with trading securities, available for sale securities, when we received dividends, we said, hey, that's dividend revenue. Well, in this case, that's not how we deal with it. Okay? So that's a big difference here is that the dividends received are not income and they are going to just be a reduction of our investment, so we'll see that as well. And then finally, we sell the investment, right? We sell the investment and we might have a gain or a loss when we sell the investment. Okay? And that's going to be the difference between what's on our books and what we sell it for. Cool? So that's an overview of what we're going to learn now, alright? So we're going to go through each of these journal entries and see how the equity method flows. We're generally, once you get down with these 4 journal entries, you're going to be pretty solid with the equity method. Okay? So we're just going to purchase the investment, we're going to earn investment income, we're going to receive dividends that reduce our investment, and then we're going to sell the investment eventually. Cool? Alright. Let's go ahead and start with those journal entries in the next video.

Purchasing Equity Method Investments

So let's start with the purchase journal entry. On January 1st, Year 1, Big Old Company purchased 50,000 shares of Small Boy Companies, 125,000 outstanding shares of common stock at a market price of $25 per share. So notice they told us the amount of shares we bought and the amount outstanding. So if we bought 50,000 shares out of 125,000 shares outstanding, that means we bought 40% of the company, right? 50,000 divided by 125 equals 0.4, which is 40% of the company. Okay? So since we bought 40%, which is between the 20% to 50% threshold, we have to use the equity method, right? We're going to use the equity method. Okay? So, the next thing we need to know is how many shares we bought? We bought 50,000 shares at a price of $25, so how much did we spend? Remember, that's what's important for our journal entry is the total amount. 50,000 times 25 equals $1,250,000, so that's the amount of our asset. So what we're going to do is we're going to have an asset for the investment and we're going to call it Equity Method Investment or something like that. I don't feel like writing out "Equity Method" every time, so I'm going to say EM Investment. Okay? And this is the debit because we're creating an asset for this investment of $1,250,000. So the EM Investment, let me write that a little closer, that's our debit, and how did we buy this? We bought it with cash, right? So we're going to credit cash for $1,250,000. Okay. So this journal entry is pretty similar to things we're used to. Nothing too crazy here. We're purchasing something, but we have to create the asset and get rid of the cash. So we're going to have our investment increase by $1,250,000 and our cash is going to decrease by the same amount. So our net assets, our total assets stay the same amount here, right? We didn't have any increase in the total asset amount. We just bought some investment with some cash. Alright. This journal entry is pretty easy. Let's go ahead and move on to the next journal entries. But I want you to remember, this is always important. You always want to calculate the percentage of your ownership because you're going to be using that percentage throughout all the journal entries, okay? So we own 40% of the company. Let's check out how that affects our journal entries.

Investment Income for Equity Method Investments

So, our next journal entry is for our investment income. The company that we bought shares of is going to be earning net income or it could have a net loss, possibly, right? But let's focus on a net income first. When it has net income, well, a percentage of that net income is ours, and that's based on our percent ownership, right? We saw in this case that we had 40% of the company owned, so 40% of Small Boy Company reported net income of 560,000. This is the company that we bought, right? We bought Small Boy Company, 40% of their company. And they had net income of 560,000, so 40% of that net income is ours. Let's see how much that comes out to. 560,000 times 40%, 0.4. Let's find out what that number is. It comes out to 224,000. Okay? So 224,000 is our investment income. But notice what we do in this situation. Whenever we get investment income, we're going to increase our investment account by that amount. So, we're going to debit the equity method investment account, which remember, this is an asset. So we're increasing the value of the asset by 224,000. We didn't receive cash or anything, right? This is net income of that company, so we're increasing the value of our asset. This is almost like we're increasing the retained earnings of our asset here. If you think of it as like this subsection of your balance sheet with its own retained earnings, there were earnings that it had, and it's going to increase the value of this asset. Cool? So the equity method investment is 224,000 and we are going to credit investment income right here, this is going to the income statement. The income statement is going to show that we earned 224,000 and it's going to show this as income to our company in our non-operating section. It'll show this income. Cool?

So, we saw that our investment increases by 224,000 which is the amount of the net income attributable to us. Let me get out of the way. The investment income goes to our income statement and it increases our net income, so it's going to increase our equity by 224,000. Cool? Alright. Notice this is very different than what we were doing when we had our cost method investments in trading securities and available-for-sale securities and things like that. We never did anything like this. So this is very different. I want you guys to be familiar with this. It's not too difficult; you just have to become familiar with these different rules, okay? So this is what happens with investment income. Let's try investment loss next.

Investment Loss for Equity Method Investments

So now we'll have a situation where the company that we bought their stock has a loss, instead of having net income during the year, that company can have a loss. Let's see what happened in that situation. On December 31st, year 2, Small Boy Company reported a net loss of $100,000. Since we own 40% of the company, we own 40% of their net loss. 100,000 times 0.4 is equal to a $40,000 loss, right? We had an investment loss this period. If you think about it, it's like the retained earnings of our company has decreased because we've lost some money out of this investment.

So this $40,000 loss, we're going to do exactly the opposite of what we did before. We need to lower the value of the investment, so our equity method investment is being decreased in this case because we had this loss of $40,000 and we have to take an investment loss just like we had an investment income previously. Well, this investment loss is decreasing our net income on our books. Right? So when we show our income statement as a big old company, the company will show this investment loss on its income statement of $40,000. Cool? This is very similar to when we had the net income in the previous example. Well, this is like having negative net income, right? So we have to flip the journal entry and reduce our investment and take the investment loss. We're going to see that the equity method investment decreased by $40,000 and we had this investment loss that goes to our income statement and reduces our equity by reducing our net income. So there we go. Nothing too crazy there. Let's move on to the next journal entry where we're going to receive dividends. Cool.

Dividends Received for Equity Method Investments

So remember we talked about 4 journal entries we were going to see in the equity method; we see the purchase, the net income of the investee, then the dividends received that we're going to deal with now, and finally the sale of the asset. So let's deal with the dividends received here. When we receive dividends, this is almost like a reduction of our retained earnings in our investment, okay? We have this investment account and we're receiving part of that investment back. They're saying, "Hey, here's some of the money that you have from your investment, from the earnings that we've made." So remember, we've been putting that net income from the investee, we've been putting it into the investment account. Now, we're receiving some of that money from the investee, so we're going to reduce that investment account. This is very different from the cost method where we did trading securities and available-for-sale securities, right? We were taking dividend revenue. Never do that with the equity method. That's going to be totally wrong. We don't have dividend revenue with the equity method; we just reduce the investment.

So it says January year 3, Small Boy Company declared and paid dividends of 420,000, so guess how much dividends we're going to receive? We're going to receive 40% of that, right? We receive 40% of the total dividends they pay. So if we do 420,000×0.4, it comes out to 168,000. Okay? So notice how often we're using that 40% ownership. It comes up in all our journal entries after our cost, right? We're using it to value the net income that we receive and the dividends are going to be at that 40 percent. Cool?

So you're going to really have to figure out that percentage and keep track of it. We're going to receive a 168,000 in dividends. So we're going to receive cash, right? This is going to be cash that we receive of 168,000. But what's going to be the credit? Remember, we reduce the investment. We don't take dividend revenue. We reduce the investment by the cash we receive, 168,000. This is almost like a payout of our investment that we've put in, okay? So 168,000 is going to be the reduction of the investment. We have cash received of 168,000 and the investment is decreasing by 168,000. So our assets stay the same there because we're decreasing the investment by the amount. Alright?

As you see these journal entries, as you do more and more examples of the equity method, you're going to see that it's always the same. You just gotta keep track of your percentage and these journal entries always look the same. Cool? Let's go ahead and move on to the next journal.

Calculating Book Value of Equity Method Investments

Alright, when it comes time to sell our equity method investment, it's important to know what the final value is in the investment account, because we have to calculate our gain or our loss based on the difference between the selling price and the book value. So it's always helpful to use a T account. So when we think about our equity method investments, we're going to have a T account that's going to have our beginning balance, which is usually what we purchased it for, right? We purchase it for some amount and then we increase it whenever there's net income, right? Whenever we have net income of the investee, we're going to have our percentage net income of the investee that's going to increase our investment just like we saw in our examples. And what's going to decrease our investment? Well, that's if we have a percentage net loss of the investee that'll decrease our investment account, our asset, and what else decreases it? Our percentage of the dividends, right? When we receive dividends from the investee, well, that's going to decrease our investment and it'll leave us with our ending balance in the account, right? So notice, doesn't this look very similar to another account we've dealt with when we deal with T accounts and the base formula? There's an account that we have a beginning balance. It increases by net income, it decreases by dividends, and then it ends up with an ending balance. It looks like retained earnings, doesn't it? Except this is our investment in another company. So you can almost think of this as almost our retained earnings in this other company. Okay? So it's like our equity in this other company and that's why it's called the equity method. We're keeping track of the equity that we have of their earnings and of their dividends paid, reducing our equity in them, right? So it looks very similar as far as the T account goes. So notice, we purchase the investment, we increase it by the net income or decrease it by the net loss and then we decrease it by the dividends to get to our ending balance.

In our example, if we plug in the numbers that we've had in our journal entries, well our purchase price was 1,250,000, right? And that's what we saw in the first entry. We debited the asset, the equity method investment. We debited it for the 1,250. Then we had the net income during year 1, right? The year 1, so this was the purchase. Let me do it in a different color. So this was the purchase right here, then we had the year 1 income, and in year 1, they earned, our percentage was 224,000 of their net income, right? Our 40% of their total net income came to 224,000 and that increased our value there. And in year 2, there was a loss which decreased our investment by 40,000. And then in year 3, they paid some dividends, right? We had the dividends that also decreased our investment by a 168,000, right? 168,000 was a decrease and that gets us to the ending balance in our investment. So what's going to be the ending balance after all of these transactions? Let's go ahead and calculate it. We're going to start with the 1,250,000, we're going to add 224,000, subtract 40,000, and subtract 168,000 and that gets us to our final balance of 1,266,000. So after all of these years of income and payment of dividends and the loss, right? Our ending balance in the account is 1,266,000.

So what you really want to be familiar with are those four entries that we dealt with, right? The purchase of the investment, the percentage of the net income or the loss, and then the percentage of dividends finally gets us to our ending balance that we're going to compare to our selling price, okay? So now, let's go ahead and let's look at the selling price of this investment. Actually, let's take a pause here with the now that we figured out the book value, let's take a pause and we'll do the gain and the sale. Gain on the sale and the loss on the sale in the next video.

Gain on Sale of Equity Method Investments

Alright. So now that we found the ending balance in our investment, which was right here, right? We found our ending balance to be $1,266,000. We can compare that to our selling price to see if we had a gain or a sale gain or a loss on the sale. So the company is going to report a gain on the sale if the selling price is greater than the book value of the investment. So if the selling price is greater than the book value, well, we have a gain, right? It was on our books for a certain amount and we sold it for more than that amount. So let's look at this. On January 2nd, year 3, Big Old Company sold its investment in Small Boy Company for $1,400,000. So there we go, $1,400,000 is the selling price. So, how much cash are we going to receive? $1,400,000. So we're going to debit cash for $1,400,000 and now we have to get the investment off of our books. It had a debit balance as we see from the T-account of $1,266,000, but we're going to use a credit to get rid of it, right? So we're going to credit our investment asset, asset, equity method investment for $1,266,000 and guess what the difference is? The difference is the gain on the sale, right? This gain on the sale is going to our income statement. Gain on a sale of investment is going to be on our income statement and what amount is that going to be? It's just the difference between these two numbers, right? 1,400,000-1,266,000=134,000. We had a $134,000 gain on the sale of this investment, right? Nothing too crazy. This is very similar to when we sell any sort of asset. We need to get the asset off of our books, we're going to receive some cash, and then we have to plug in the gain or the loss, depending on the difference between the numbers, okay? So, if we look on our balance sheet, how is this going to affect assets, liabilities, and equity? Well, cash is going to increase by $1,400,000. Our investment is now gone. The equity method investment is going to decrease by $1,266,000. So there was a net increase in our assets there by the same amount of the gain. The gain is $134,000. So our equity increased and our assets increased by that amount. Cool? Alright. Let's pause and we'll do the loss on the investment.

Loss on Sale of Equity Method Investments

So let's imagine instead of selling it at a gain, we had sold it at a loss. We'll still have that same book value that we had up above, the book value that we saw in our T account of 1,266,000. Well, let's compare that here in this example. So, we're going to report a loss if the selling price is below the book value, right? If the selling price is below the book value, well, we sold it at a loss. So on January 2nd year 3, Big Old Company sold its investment in Small Boy Company for 1,100,000. So again, how much cash did we receive? Well, we received 1,100,000 for this sale. So that's going to be our debit and we need to get the investment off of our books, right? So we need a credit to the investment, equity method investment, and that's going to be for the book value of 1,266,000 just like we saw in our T account, 1,266,000. So how do we make this balance? Well, we need the loss, right? We have a loss because we had it on our books for 1,266,000, but we sold it for less than that. So we're going to need another debit of 166,000 to make this balance out and that's going to be the loss on the sale of investment and that will go to our income statement, right? We saw that we got cash of 1,100,000 and that was an increase to our assets, but we had to decrease our assets by the amount of the investment, which is 1,266,000. We had a net decrease there in our assets and then the net decrease in the assets is matched by this loss on our income statement of 166,000 and everything stays balanced there, okay? So very similar to the gain except we sold it at a lower price than our book value. Cool? Alright. Let's try some practice problems related to the equity method.

On January 3, Johnson Corp acquired 35% of the outstanding common stock of Small Company for $350,000. For the year ended December 31, Small Company reported net income of $150,000 and paid cash dividends of $70,000 on its common stock. At December 31, the carrying value of Johnson Corp's investment in Small Company under the equity method is:

• A. $322,000
• B. $350,000
• C. $378,000
• D. $398,000

On January 4, The Jones Company purchased 35,000 out of the 87,500 outstanding shares of Miller Company for $400,000. During the year, the Miller Company reported net income of $240,000 and paid cash dividends of $60,000, while the Jones Company reported net income of $450,000 and paid cash dividends of $80,000. What is the carrying value of Jones Company's investment in Miller Company at the end of the year under the equity method?

• A. $400,000
• B. $472,000
• C. $496,000
• D. None of the above

GT Company owns 9,000 of the 48,000 shares of outstanding common stock of Bell Company. GT Company should account for this investment using the:

• A. Market method
• B. Equity method
• C. Lower-of-cost-or-market method
• D. Consolidation method

Here’s what students ask on this topic:

What is the equity method of accounting?

The equity method of accounting is used when a company acquires 20-50% of another company, indicating significant influence over the investee. Under this method, the investor recognizes its share of the investee's net income or loss proportional to its ownership percentage. Key journal entries include recording the purchase of the investment, recognizing investment income, adjusting for dividends received (which reduce the investment), and recording the sale of the investment. The gain or loss on sale is determined by comparing the selling price to the book value of the investment. This method ensures accurate financial reporting under GAAP.

When should a company use the equity method?

A company should use the equity method when it owns between 20% and 50% of another company's voting stock, indicating significant influence over the investee. Significant influence means the investor can affect the financial and operating policies of the investee, such as having representation on the board of directors or participating in policy-making processes. If ownership is less than 20%, the cost method is typically used, and if ownership exceeds 50%, consolidation accounting is required.

How are dividends treated under the equity method?

Under the equity method, dividends received from the investee are not recognized as dividend income. Instead, they reduce the carrying amount of the investment. This is because the investor's share of the investee's net income has already been recognized in the investment account. For example, if an investee declares and pays dividends, the investor will debit cash and credit the equity method investment account, thereby reducing the investment's book value.

How do you calculate investment income under the equity method?

Investment income under the equity method is calculated by multiplying the investee's net income by the investor's ownership percentage. For example, if the investee reports a net income of $560,000 and the investor owns 40% of the investee, the investment income would be calculated as follows:

$560000\times 0.4=224000$

This $224,000 would be recognized as investment income and would increase the carrying amount of the investment on the investor's balance sheet.

What are the key journal entries for the equity method?

The key journal entries for the equity method include:

• Purchase of Investment: Debit the equity method investment account and credit cash.
• Investment Income: Debit the equity method investment account and credit investment income.
• Dividends Received: Debit cash and credit the equity method investment account.
• Sale of Investment: Debit cash, credit the equity method investment account, and record any gain or loss on the sale by comparing the selling price to the book value.

These entries ensure accurate tracking of the investment's value and the investor's share of the investee's financial performance.