The Need to Apply the Equity Method

Question: Not all investments in capital stock are made solely for the possibility of gaining dividends and share price appreciation. As mentioned earlier, Starbucks holds 39.9 percent ownership of Starbucks Coffee Japan Ltd. The relationship between those two companies is different. The investor has real power; it can exert some amount of authority over the investee. Starbucks owns a large enough stake in Starbucks Coffee Japan Ltd. so that operating and financing decisions can be influenced. When one company holds a sizable portion of another company, is accounting for the investment as either an available-for-sale or trading security a reasonable approach?

Answer: The answer to this question depends on the size of ownership. As the percentage of shares being held grows, the investor gradually moves from having little or no authority over the investee to a position where significant influence can be exerted. At that point, for financial reporting purposes, the investment no longer qualifies as a trading security or an available-for-sale security. Instead, the shares are reported by means of the equity methodA method of reporting an investment in stock that is applied when the owner has the ability to exert significant influence on the decisions of an investee; in practice, it is used to report investments where 20 percent or more and less than or equal to 50 percent of the shares are held, unless evidence exists that significant influence does not exist.. The owner’s rationale for holding the investment has changed. The equity method views the connection between the two companies in an entirely different fashion. The accounting process applied by the investor is altered to more closely mirror this relationship.

The equity method is applied when the investor has the ability to apply significant influence to the operating and financing decisions of the investee. Unfortunately, the precise point at which one company gains that ability is impossible to ascertain. A bright line distinction simply does not exist. Although certain clues such as membership on the board of directors and the comparative size of other ownership interests can be helpful, the degree of influence is a nebulous criterion. When a question arises as to whether the ability to apply significant influence exists, the percentage of ownership can be used to provide an arbitrary standard.

According to U.S. GAAP, unless signs of significant influence are present, an investor owning less than 20 percent of the outstanding shares of another company reports the investment as either a trading security or available-for-sale security. In contrast, an investor holding 20 percent or more but less than or equal to 50 percent of the shares of another company is assumed to possess the ability to exert significant influence. Consequently, unless evidence is present that significant influence does not exist, the equity method is applied by the investor to report all investments in this 20–50 percent range of ownership.

The Reporting of Investments When Applying the Equity Method

Question: One company holds shares of another and has the ability to apply significant influence. Thus, the equity method of accounting is appropriate. What financial reporting is made of an investment when the equity method is used? What asset value is reported on the owner’s balance sheet and when is income recognized from the investment under this approach?

Answer: When applying the equity method, the investor does not wait until dividends are received to recognize profit from its investment. Because of the close relationship between the two companies, the investor reports income as it is earned by the investee. That is a key element of using the equity method. If, for example, a company reports net income of $100,000 in the current year, an investor holding a 40 percent ownership interest immediately records an increase in its own income of $40,000 ($100,000 × 40 percent). The appropriate percentage of the investee’s income is recognized by the investor. The investor also increases its investment account by $40,000 to reflect the growth in the size of the investee company.

Because income is recognized by the investor as earned by the investee, it cannot be reported again when a subsequent dividend is collected. That would double-count the impact. Income must be recognized either when earned by the investee or when later distributed to the investor in the form of a dividend, but not at both times. The equity method uses the earlier date rather than the latter.

Eventual payment of a dividend actually shrinks the size of the investee company because it has fewer assets. To reflect that change in size, the investor decreases the investment account when a dividend is received if the equity method is applied. No additional income is recorded because it was recorded by the investor when earned by the investee.

Because of the fair value option, companies are also allowed to report equity investments as if they were trading securities. However, few investors seem to have opted to make this election. If chosen, the investment is reported at fair value despite the degree of ownership with gains and losses in the change of fair value reported within net income.

Application of the Equity Method Illustrated

Question: In applying the equity method, income is recognized by the investor when earned by the investee. Subsequent dividend collections are not reported as revenue by the investor but rather as a reduction in the size of the investment account to avoid including the income twice.

To illustrate, assume that Big Company buys 40 percent of the outstanding stock of Little Company on January 1, Year One, for $900,000. No evidence is present to indicate that Big lacks the ability to exert significant influence over the financing and operating decisions of Little. Thus, application of the equity method is appropriate. During Year One, Little reports net income of $200,000 and distributes a total cash dividend to its stockholders of $30,000. What journal entries are appropriate for an investor when the equity method is applied to an investment?

Answer: The purchase of 40 percent of Little Company for cash is merely the exchange of one asset for another. Thus, the investment is recorded initially by Big at its historical cost, as shown in Figure 12.11 "Acquisition of Shares of Little to Be Reported Using the Equity Method".

Figure 12.11 Acquisition of Shares of Little to Be Reported Using the Equity Method

Ownership here is in the 20 to 50 percent range and no evidence is presented to indicate that the ability to apply significant influence is missing. Thus, according to U.S. GAAP, the equity method should be applied. That means Big recognizes its portion of Little’s $200,000 net income as soon as it is earned by the investee. As a 40 percent owner, Big accrues income of $80,000 ($200,000 × 40%). Because earning this income caused Little Company to grow, Big increases its investment account to reflect the change in the size of the investee. Big’s journal entry is shown in Figure 12.12 "Income of Investee Recognized by Investor Using the Equity Method".

Figure 12.12 Income of Investee Recognized by Investor Using the Equity Method

Big recognized its share of the income from this investee as it was earned. Consequently, any eventual dividend received from Little is a reduction in the investment rather than a new revenue. The investee company is smaller as a result of the cash payout. The balance in this investment account rises when the investee reports income but falls (by $12,000 or 40 percent of the dividend distribution of $30,000) when that income is later passed through to the stockholders.

Figure 12.13 Dividend Received from Investment Accounted for by the Equity Method

At the end of Year One, the investment account appearing on Big’s balance sheet reports a total of $968,000 ($900,000 + 80,000 − 12,000). This balance does not reflect fair value as was appropriate with investments in trading securities and available-for-sale securities. Unless impaired, fair value is ignored in reporting an equity method investment.

The reported amount also does not disclose historical cost. Rather, the asset figure determined under the equity method is an unusual mixture. It is the original cost of the shares plus the investor’s share of the investee’s subsequent income less any dividends received since the date of acquisition. Under the equity method, the investment balance is a conglomerate of amounts.

Selling an Investment Reported by Means of the Equity Method

Question: Assume, at the end of Year One, after the above journal entries have been made, Big sells all of its shares in Little Company for $950,000 in cash. When the equity method is applied to an investment, what is the appropriate recording of an eventual sale?

Answer: Any investment reported using the equity method quickly moves away from historical cost as income is earned and dividends received. After just one year in this illustration, the asset balance reported by Big has risen from $900,000 to $968,000 (income of $80,000 was added and $12,000 in dividends were subtracted). If these shares are then sold for $950,000, a loss of $18,000 is recognized, as shown in Figure 12.14 "Sale of Investment Reported Using the Equity Method".

Figure 12.14 Sale of Investment Reported Using the Equity Method

If the shares of Little had been sold for more than their $968,000 carrying value, a gain on the sale is recorded.

Summary. All investments in the stock of another company—where ownership is no more than 50 percent—must be accounted for in one of three ways depending on the degree of ownership and the intention of the investor: as trading securities, as available-for-sale securities, or according to the equity method. Figure 12.15 "Comparison of Three Methods to Account for Investments" provides an overview of the essential differences in these three accounting approaches. Note here that the available-for-sale securities and the investment using the equity method will have the same accounting as the trading securities if the fair value option is chosen.

Figure 12.15 Comparison of Three Methods to Account for Investments