Equity Method

What Is the Equity Method?

The equity method is an accounting technique a company uses to report an investment in another company when it has significant influence over that company but does not control it. Instead of recording the investment at its market price, or adding the other company's full financial results to its own, the investor adjusts the investment's book value over time to reflect its share of the investee's profits and losses.

Under U.S. GAAP and IFRS, significant influence is generally presumed when an investor holds roughly 20% to 50% of a company's voting shares, although the facts of each case can change that conclusion. Investments without significant influence are typically reported under the cost method or at fair value.

How the Equity Method Works

The investment starts on the balance sheet at its original cost. Each reporting period, the investor increases the carrying amount by its share of the investee's net income and decreases it by its share of any net loss. Cash dividends the investor receives are treated as a return of investment rather than new income, so they reduce the carrying amount.

Carrying amount = Original cost + Share of net income − Share of net loss − Dividends received

The investor's income statement typically shows its share of the investee's earnings as a single line. The investee's individual assets, liabilities, and revenues are not added line by line, which distinguishes this approach from consolidation. The method is commonly used for joint ventures and other affiliated companies.

An Illustrative Example

Suppose an investor pays $300,000 for a 30% stake in a company. This is a hypothetical example. In the first year, the investee reports $100,000 of net income, so the investor records $30,000 of income and raises the investment balance to $330,000. If the investee then pays $10,000 in dividends, the investor's 30% share is $3,000, which reduces the balance to $327,000.

Why It Matters to Investors

Because the reported income reflects the investor's share of earnings rather than cash actually received, the equity method can show profit that has not yet been paid out. Readers of financial statements often compare reported net income with cash flow to understand that gap. The method also keeps large minority holdings off the consolidated balance sheet while still showing the economic relationship between the companies. A drawback is that the book value can differ substantially from the market value of the stake, and the figures depend on the investee's own reporting.