Definition: The equity method of accounting is used to account for investments in securities with significant influence. In other words, when a company invests in the stock of another company and has enough stock to maintain a significant influence over the operations of the newly invested company, this investment should be accounted for using the equity method. It’s important to remember that significant influence does not always mean possessing controlling interest of the company. A stockholder with 30% of the outstanding shares can have significant influence if he is the single largest shareholder.
What Does Equity Method Mean?
The equity method treats an investment another company almost like an expansion or merger of the two companies. The investor becomes the parent company and the investee becomes the subsidiary company to the extent of the investment. This makes sense because if the investor has significant influence over the investee, they could be considered the same company. Let’s look at some examples.
When an investment with significant influence is purchased, the investment should be recorded at the purchase price. Let’s assume Bob’s Billiards buys 30% of Paul’s Pool Sticks outstanding stock for $50,000. Bob’s would debit the investment account and credit the cash account for the amount paid for the stock.
Since Bob is an investor with significant influence, he must use the equity method of accounting. At the end of the year, Paul’s Pool Sticks reports a $10,000 profit. The equity method requires that Bob recognize his share of this income. At the end of the year, Bob would record a debit to the investment account and a credit to a revenue from long-term investment account to record the income.
If Paul’s declares dividends for the year, Bob would have to reduce his investment account and increase his cash for the dividends received. Essentially, a dividend under the equity method is just a repayment of the investment.