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Equity Method

Definition

The Equity Method is an accounting technique used by firms to evaluate the profits earned by their investments in other companies. It allows a company to record profits equal to its share of the invested company’s profit. The investment is initially recorded at cost and then adjusted based on the investing firm’s proportional share of the investee’s net income or loss.

Phonetic

The phonetic pronunciation of “Equity Method” is: ˈɛkwɪti ˈmɛθəd

Key Takeaways

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  1. Investor Influence: The equity method is used when the investor has significant influence over the investee, typically defined as owning 20-50% of the voting stock.
  2. Investment Earnings: Instead of recognizing dividends from the investee as income, the investment’s value is adjusted by the investor’s pro-rata share of the investee’s income or losses.
  3. Balance Sheet Presentation: The investment and its changes are recorded on the balance sheet, providing a more realistic picture of the investor’s financial health by showing their proportional interest in the investee’s net assets.

Importance

The Equity Method is a critical accounting technique used for investments in associate companies where significant influence can be exerted, but full control cannot be achieved by the investor. This method allows the investor to reflect its proportional share in the associate company’s income, losses, and dividends, but not its total assets and liabilities, hence displaying a more accurate financial picture. This method contrasts with the consolidation method where all assets, liabilities, revenues, and expenses are incorporated, regardless of the extent of control. Therefore, the Equity Method provides a balanced representation of the financial stake in an associate company and greatly impacts the investor’s balance sheet, income statement, and financial analysis. Its importance lies in its ability to present a realistic performance overview and investment value, aiding companies in efficient decision-making and strategic planning.

Explanation

The Equity Method serves as an accounting tool utilized by companies to manage investments in other enterprises where they have sizable but non-controlling ownership. It aids in the assessment of the value from a company’s investments, by providing insight into how these investments contribute to their financial health. Typically employed if a firm owns somewhere between 20-50% of another company’s stock, the method reflects the proportionate ownership of the investor in the investee company, allowing the investor to record profits that correlate to its share of the investment.The ultimate purpose of the Equity Method is to reflect the ongoing profits or losses of the invested company into the investor company’s own financial statements. This method promotes more accuracy in financial evaluation and promotes a true reflection of the company’s wealth, as it includes the returns from its investments. Essentially, it’s a way for companies to account for investments made in other entities and reflect how those investments impact their own financial standing. Without this method, the company’s income statements would not incorporate these indirect earnings or losses, which could deceive stakeholders about the firm’s genuine profitability.

Examples

1. Sony’s Ownership in Spotify: Sony has a major stake in Spotify but does not exercise complete control over the company. As a result, profits from Spotify are recognized and reported on Sony’s financial statements using the equity method. This means Sony reports its proportional share of Spotify’s net earnings, rather than its share of the streaming company’s revenue.2. Google’s Stake in Uber: In 2013, Google made a significant investment in Uber through its venture capital arm, Google Ventures. Because it did not acquire a controlling interest in Uber, this investment is accounted for using the equity method. This way, Google reported their share of Uber’s profits or losses in its own income statement. 3. Berkshire Hathaway’s Investment in Coca-Cola: Berkshire Hathaway, led by Warren Buffet, is a major shareholder of Coca-Cola. Because it does not have majority control but has significant influence, earnings from its investment in Coca-Cola are reported using the equity method. This allows Berkshire Hathaway to include its portion of Coca-Cola’s earnings in its own statements, reflecting the economic reality of its stake in the company.

Frequently Asked Questions(FAQ)

What is the Equity Method in finance and business?

The Equity Method is an accounting technique used by firms to assess the profits earned by their investments in other companies. The company operating under this method denotes its investment as an asset on its balance sheet.

How does the Equity Method work?

The Equity Method works by initially recording an investment in another company’s shares as an asset at cost and then adjusting this investment annually for the investing company’s proportionate share of the investee’s net income or loss.

In which scenarios is the Equity Method used?

The Equity Method is typically used when a company holds significant influence over another company but not full control, often reflected by owning 20% to 50% of the company’s stock.

When should a company not use the Equity Method?

If a company owns less than 20% of another company’s stock and doesn’t have significant influence over the company, the Equity Method should not be used. Instead, the cost method may be used.

Does the Equity Method affect the dividend received by the investing company?

Yes, under the Equity Method, when an investee company pays out dividends, the investment company reduces the carrying value of its investment.

What is the effect of using the Equity Method on the investing company’s net income?

The investing company’s net income will increase or decrease based on the investee company’s net income or loss. This is because the investing company must record its share of the investee company’s earnings as its own.

What happens under the Equity Method if the investee company incurs a loss?

The investing company reports its share of the loss by decreasing the carrying value of its investment. If the investment’s carrying value is reduced to zero and the investee continues to incur losses, the investing company may need to recognize these additional losses.

How is the initial investment recorded under the Equity Method?

The initial investment is recorded at cost and provides the basis for the equity method’s future accounting. Any additional costs associated with the investment increase its basis while distributions and losses decrease it.

What is an example of Equity Method used in real world business?

A common example of Equity Method would be a situation where Company A invests in 30% of the shares of Company B. Therefore, Company A would use the Equity Method to record this investment.

Can the Equity Method be used in consolidation financial statements?

No, the Equity Method and consolidated financial statements serve two different purposes. Consolidation is used when the investing company has control over the investee, typically more than 50% ownership. Instead, the Equity Method is applied when the investor has significant influence but not control, which is typically a 20% to 50% ownership stake.

Related Finance Terms

  • Investee: The company in which another company has equity interest.
  • Majority Shareholding: When an investor owns more than 50% of a company’s equity.
  • Joint Venture: A business partnership where two or more parties agree to share in the profits, losses, and control of a business entity.
  • Capital Stock: The combined value of a company’s shares of stock that have been issued.
  • Impairment Loss: A decrease in an investment’s value, often due to a sudden downturn in the investee’s profitability or overall economic conditions.

Sources for More Information

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