Equity Method: Videos & Practice Problems

When a company acquires a significant amount of another company, typically defined as owning between 20% and 50% of its shares, it must use the equity method of accounting to reflect this investment. This method is mandated by Generally Accepted Accounting Principles (GAAP) when the investor has significant influence over the investee's operations. In contrast, if ownership is less than 20%, the investor has no influence and would use the cost method, categorizing the investment as trading securities, available for sale, or held to maturity.

Significant influence allows the investor to participate in decision-making processes, such as voting for board members. However, if the investor holds more than 50% of the shares, it indicates a controlling interest, necessitating consolidation accounting instead of the equity method.

Under the equity method, there are four primary journal entries to manage:

1. Purchase of Investment: The initial investment is recorded at cost, reflecting the amount paid for the shares.
2. Net Income or Loss of the Investee: The investor recognizes investment income based on the investee's net income, proportional to the ownership percentage. For example, if an investor owns 30% of the investee, they would record 30% of the investee's net income as investment income.
3. Dividends Received: Unlike other investment methods, dividends received under the equity method do not count as income. Instead, they reduce the carrying value of the investment. This is a crucial distinction, as it reflects the return of capital rather than income.
4. Sale of Investment: When the investment is sold, any gain or loss is calculated based on the difference between the sale price and the book value of the investment at the time of sale.

Understanding these journal entries is essential for accurately applying the equity method. By mastering these concepts, one can effectively account for investments that provide significant influence over another company, ensuring compliance with accounting standards and accurate financial reporting.

On January 1st, Year 1, Big Old Company made a significant investment by purchasing 50,000 shares of Small Boy Company, which has a total of 125,000 outstanding shares of common stock, at a market price of $25 per share. This acquisition represents 40% ownership of Small Boy Company, calculated as follows:

Ownership Percentage = \(\frac{50,000 \text{ shares}}{125,000 \text{ shares}} = 0.4\) or 40%.

Since this ownership falls between the 20% and 50% threshold, Big Old Company must apply the equity method for accounting purposes. The total cost of the investment is determined by multiplying the number of shares purchased by the price per share:

Total Investment = \(50,000 \text{ shares} \times 25 \text{ dollars/share} = 1,250,000 \text{ dollars}.\)

In the journal entry, Big Old Company will record this investment as an asset under "Equity Method Investment" (abbreviated as EM Investment). The journal entry will reflect a debit to the EM Investment account and a credit to the cash account, as follows:

Debit: EM Investment = $1,250,000

Credit: Cash = $1,250,000

This entry indicates that the total assets remain unchanged, as the cash used to purchase the investment is offset by the increase in the investment asset. It is crucial to remember the ownership percentage, as it will influence future journal entries related to this investment.

When a company in which you own shares reports net income, your share of that income is determined by your ownership percentage. For instance, if you own 40% of a company, and that company reports a net income of $560,000, your share of the income would be calculated as follows:

Investment Income = Net Income × Ownership Percentage

In this case:

Investment Income = $560,000 × 0.4 = $224,000

This $224,000 represents your investment income, which is recorded using the equity method. Under this method, you will increase your investment account by this amount, reflecting it as a debit to the equity method investment account, which is classified as an asset. This increase signifies that the value of your investment has risen due to the company's earnings, similar to how retained earnings are reflected on a balance sheet.

Simultaneously, you will credit the investment income to your income statement, indicating that your company has earned $224,000. This income will appear in the non-operating section of the income statement, contributing to an increase in your overall net income and, consequently, your equity.

It's important to note that this approach differs significantly from the cost method used for trading securities or available-for-sale securities, where such adjustments to the investment account are not made. Understanding these distinctions is crucial for accurately reporting investment income and recognizing how it impacts your financial statements.

In the event of an investment loss, the accounting treatment would differ, and it is essential to familiarize yourself with the specific rules governing such scenarios to ensure accurate financial reporting.

In the context of the equity method of accounting, understanding how to record dividends received from an investee is crucial. When a company receives dividends, it is treated as a reduction of the investment account rather than as dividend revenue, which is a key distinction from the cost method. This approach reflects the fact that the dividends represent a return of capital from the investee's earnings.

For instance, if a company owns 40% of an investee and the investee declares and pays dividends totaling $420,000, the amount of dividends the company will receive is calculated as follows:

$$ \text{Dividends Received} = \text{Total Dividends} \times \text{Ownership Percentage} = 420,000 \times 0.4 = 168,000 $$

In this scenario, the company will receive $168,000 in cash. The journal entry to record this transaction involves debiting the cash account and crediting the investment account:

1. **Debit Cash**: $168,000

2. **Credit Investment in Investee**: $168,000

This entry reflects the cash inflow while simultaneously reducing the investment account by the same amount, indicating that the company is effectively reclaiming part of its investment. It is important to consistently apply the ownership percentage in all related journal entries, as this percentage will influence the recognition of net income and dividends throughout the investment period.

As you practice more examples of the equity method, you will notice that the structure of these journal entries remains consistent, reinforcing the importance of accurately tracking ownership percentages and their implications on financial reporting.

When selling an equity method investment, it's crucial to determine the final value in the investment account, as this will help calculate the gain or loss based on the difference between the selling price and the book value. A T account is a useful tool for visualizing this process. The T account for equity method investments starts with a beginning balance, typically the purchase price of the investment. This balance increases with the investee's net income, which is recorded as a percentage of the investee's total net income. Conversely, the investment account decreases due to the investee's net losses and any dividends received.

The structure of the T account resembles that of retained earnings, where the beginning balance is adjusted for income and dividends, ultimately leading to an ending balance. This reflects the investor's equity in the investee company. For example, if an investment is purchased for $1,250,000, and the investor's share of the net income in Year 1 is $224,000, this amount increases the investment account. In Year 2, if the investee incurs a loss of $40,000, this will decrease the investment account. Additionally, if dividends of $168,000 are paid in Year 3, this will further reduce the investment account.

To calculate the ending balance after these transactions, one would start with the initial investment of $1,250,000, add the net income of $224,000, subtract the loss of $40,000, and subtract the dividends of $168,000. This results in an ending balance of $1,266,000. Understanding these four key entries—purchase of the investment, net income or loss, and dividends—is essential for determining the final book value, which will be compared to the selling price when the investment is sold.

In evaluating the financial outcome of an investment sale, it is essential to compare the selling price with the book value of the investment. A gain is reported when the selling price exceeds the book value. For instance, if a company sold its investment for $1,400,000, and the book value was determined to be $1,266,000, the cash received from the sale would be recorded as a debit to cash for $1,400,000.

To remove the investment from the books, a credit entry is made to the investment asset account, specifically the equity method investment, for the book value of $1,266,000. The difference between the selling price and the book value represents the gain on the sale, calculated as:

$$ \text{Gain on Sale} = \text{Selling Price} - \text{Book Value} = 1,400,000 - 1,266,000 = 134,000 $$

This gain of $134,000 will be reported on the income statement as a gain on the sale of investment. The transaction impacts the balance sheet by increasing cash by $1,400,000 while decreasing the equity method investment by $1,266,000. Consequently, the net increase in assets is equal to the gain, which also results in an increase in equity by the same amount.

Understanding these transactions is crucial as they reflect the overall financial health of the company and its investment strategies. The process of recognizing gains or losses on asset sales is a fundamental aspect of financial accounting, ensuring accurate representation of a company's financial position.

When a company sells an investment at a loss, it is essential to understand how this transaction affects the financial statements. The book value of the investment represents the amount recorded on the balance sheet, which in this case is $1,266,000. If the selling price is below this book value, the company incurs a loss. For instance, if a company sells its investment for $1,100,000, it must recognize a loss of $166,000, calculated as:

Loss = Book Value - Selling Price = $1,266,000 - $1,100,000 = $166,000.

In accounting terms, the cash received from the sale is recorded as a debit to cash, reflecting an increase in assets. The investment account is credited to remove the investment from the books at its book value. To balance the accounting equation, a debit is also recorded for the loss on the sale of the investment, which impacts the income statement. This loss indicates a decrease in net income and is essential for accurately reflecting the company's financial performance.

In summary, the transaction results in an increase in cash assets by $1,100,000, a decrease in investment assets by $1,266,000, and a corresponding loss of $166,000 on the income statement. This process ensures that the accounting records remain balanced, illustrating the importance of accurately reporting gains and losses in investment transactions.