Source: Textbook Ch. 12, pp. 683–686
Tags: equity method, significant influence, 20-50% ownership, investment in affiliate, equity in earnings, differential, amortisation of differential, investee net income, investee dividends, net assets, ACCTG 472, Chapter 12
Difficulty: Intermediate-Advanced | Prerequisites: Parts 1 and 2 of these notes; understanding of the accounting equation and how net income flows to retained earnings
Big picture: When an investor owns between 20% and 50% of an investee's outstanding common stock, the investor has significant influence. The cost method (TS/AFS) no longer applies. Instead, the equity method treats the investment as though the investor owns a proportional slice of the investee's net assets. The investment account on the investor's balance sheet rises with the investee's net income and falls with the investee's dividends. This section covers the concept, the journal entries, the amortisation of the differential between fair value and book value, and what happens when the investment is sold or when the ownership percentage changes.
Under the equity method, the investor's balance sheet carries the investment at cost plus its cumulative share of the investee's net income, minus its share of dividends received, minus amortisation of any fair-value-to-book-value differential on depreciable assets. Dividends from the investee reduce the investment account (they are not revenue). The investor's income statement includes its share of the investee's net income, adjusted for the differential amortisation.
Significant influence
The ability to participate in the financial and operating policy decisions of the investee, without having control. Presumed when the investor holds 20% to 50% of the investee's outstanding common stock.
Equity method
The accounting method used when the investor has significant influence. The investment account tracks the investor's proportional share of the investee's net assets over time. Think of it as: the investor's books mirror what is happening to the investee's equity.
Investment in equity affiliate / Investment in [Name]
The asset account on the investor's balance sheet that carries the equity-method investment. It increases with the investor's share of investee net income and decreases with the investor's share of investee dividends.
Equity in earnings of affiliate / Investment Revenue
The income-statement line item where the investor reports its share of the investee's net income. In simple terms, this is how the investee's profit shows up on the investor's income statement.
Net assets
Assets minus liabilities. Net assets equal shareholders' equity (A minus L = SE). When you buy into a company under the equity method, you are buying a share of its net assets at fair value.
Differential (FV-BV differential)
The difference between the fair value of the investee's net assets (what the investor paid for) and the book value of those net assets on the investee's books. This typically arises because depreciable assets like buildings carry a book value below their fair value due to accumulated depreciation.
Amortisation of the differential
The process of reducing the investor's share of investee net income to account for the extra depreciation the investor would take on the fair-value portion of depreciable assets. The investor depreciates at FV; the investee depreciates at BV. The difference must be amortised over the remaining life of the underlying assets.
Goodwill (in equity method context)
The excess of the purchase price over the investor's share of the fair value of the investee's identifiable net assets. Goodwill arising from an equity-method investment is not amortised and is not separately reported; it remains embedded in the investment account.
The equity method is grounded in the accounting equation rearranged:
ASSETS - LIABILITIES = SHAREHOLDERS' EQUITY = NET ASSETS
When an investor purchases a 30% stake in an investee, it is purchasing 30% of the investee's net assets at fair value. That amount is recorded as a single line item on the investor's balance sheet: "Investment in [Investee Name]."
The investee's shareholders' equity changes over time due to two main items:
Net income increases SE (and therefore net assets).
Dividends decrease SE (and therefore net assets).
Because the investor owns a proportional share of those net assets, its investment account mirrors these movements:
When the investee reports net income, the investor increases its investment account by its ownership percentage of that net income. This is also recognised as investment revenue on the investor's income statement.
When the investee pays dividends, the investor decreases its investment account by its share of those dividends. Dividends are not revenue under the equity method; they are a return of part of the investment.
This is the key conceptual difference from the cost method. Under the cost method (TS/AFS), dividends are revenue and the investee's net income has no effect on the investor's books. Under the equity method, the investor's books track the investee's equity in real time.
United purchased 30% of Arjent, Inc. for $1,500,000 (textbook pp. 683–686).
Debit | Credit | |
|---|---|---|
Investment in Arjent Stock | 1,500,000 | |
Cash | 1,500,000 |
The purchase price equals the investor's percentage of ownership times the fair value of the investee's net assets, plus any goodwill.
At year-end, Arjent reports $500,000 of net income. United's share is 30% of $500,000 = $150,000.
Debit | Credit | |
|---|---|---|
Investment in Arjent Stock | 150,000 | |
Investment Revenue | 150,000 |
The revenue is reported on the income statement, typically called "Equity in earnings of affiliate." The investee's NI increases the investor's assets and shareholders' equity, just as the investor's own NI does.
Note: under the cost method (TS/AFS), the investee's net income has no effect on the investor's books. This is a fundamental difference.
Arjent pays total dividends of $250,000. United's share is 30% of $250,000 = $75,000.
Debit | Credit | |
|---|---|---|
Cash | 75,000 | |
Investment in Arjent Stock | 75,000 |
Critical point: dividends are not revenue under the equity method. They reduce the investment account because the investee's SE (and net assets) decreased when it paid dividends. The investor already recognised income when the investee earned it.
The FV of Arjent's net assets was higher than book value at acquisition, partly because Arjent's buildings had a FV of $2 million against a BV of $1 million. United's 30% share of the differential is ($2M minus $1M) x 30% = $300,000. The buildings have a remaining useful life of 10 years, so annual amortisation is $300,000 / 10 = $30,000.
Debit | Credit | |
|---|---|---|
Investment Revenue | 30,000 | |
Investment in Arjent Stock | 30,000 |
This entry reduces both the investment revenue recognised and the investment account. It is made each year for 10 years.
Total investment revenue for the year: $150,000 minus $30,000 = $120,000.
Rules for the differential by asset type:
Depreciable assets (buildings, equipment): amortise the differential over the remaining useful life.
Inventory: recognise the differential in the period the inventory is sold (usually the following year). Do not amortise over time because inventory turns over quickly.
Land and goodwill: no adjustment. These assets are not depreciated or amortised.
At year-end, the investment account balance is:
$1,500,000 (purchase price)
Plus $150,000 (30% of Arjent's NI)
Minus $30,000 (amortisation of differential)
Minus $75,000 (30% of Arjent's dividends)
= $1,545,000
If the investee has a net loss instead of net income, the investor's investment account is decreased by its share of the loss. The investor also records its share in the income statement as an investment loss. This is the mirror image of the net income entry.
If the investment is purchased partway through the year, all amounts (share of NI, dividends, differential amortisation) are pro-rated for the number of months of ownership.
This happens when the investor's ownership drops below 20% (e.g. the investee issues new shares, diluting the investor's stake). The carrying amount (book value) of the investment at the date of the change becomes the new cost basis. Going forward, the cost method (TS or AFS classification) applies.
This happens when the investor's ownership rises to 20% or above. The treatment is retroactive: the investment account is adjusted as if the equity method had always been used. Retained earnings is adjusted for the cumulative difference in income, and all financial statements presented are restated.
The sale is treated like the sale of any other asset:
Record cash received.
Remove the investment account at its current book value (not original cost, since the equity method has adjusted the balance over time).
Recognise a gain or loss for the difference.
Example: United sells its investment in Arjent for $1,446,000. The book value of the investment is $1,545,000.
Debit | Credit | |
|---|---|---|
Cash | 1,446,000 | |
Loss on Sale of Investment | 99,000 | |
Investment in Arjent Stock | 1,545,000 |
Note that the loss is measured against the equity-method carrying value ($1,545,000), not the original purchase price ($1,500,000).
Students often think dividends received under the equity method are revenue. They are not. Dividends reduce the investment account because the investee's SE decreased when it paid them out. Revenue was already recognised when the investee earned net income.
Students sometimes confuse the equity method with the cost method by recording FV adjustments. The equity method does not use marking to market or an FV adjustment account. The investment account moves with the investee's equity, not with market prices.
A common error is forgetting to amortise the differential. If the investee's depreciable assets had a FV above BV at the acquisition date, the investor must reduce its share of investee NI by the extra depreciation each year. Without this adjustment, investment revenue is overstated.
Students sometimes apply the differential amortisation to land or goodwill. Land is not depreciated, and goodwill under the equity method is not amortised. Only depreciable assets (buildings, equipment) and inventory get differential adjustments.
The equity method investment account balance calculation (purchase price + share of NI - share of dividends - differential amortisation) is a near-certain exam question. Practise computing the year-end balance.
Expect true/false questions testing whether dividends are revenue under the equity method (false) and whether investee NI is revenue to the investor (true).
Differential amortisation questions are common. Know when to amortise (depreciable assets), when to recognise immediately (inventory), and when to make no adjustment (land, goodwill).
The sale-of-investment calculation uses the equity-method carrying value, not original cost. Students lose marks by plugging in the purchase price instead of the adjusted balance.
Method-change questions test whether you know the direction: dropping below 20% means switching to cost method (prospective, carrying value becomes the new cost); rising to 20% means switching to equity method (retroactive restatement).
True or false: Under the equity method, a portion of the investee's net income is revenue to the investor.
True or false: Under the equity method, a dividend received from the investee is revenue to the investor.
Fill in the blank: The investor would need to amortise the differential when the fair value of the investee's ____ assets is greater than their book value on the purchase date.
True or false: The equity method is used when the investor owns less than 20% of the investee.
Fill in the blank: Under the equity method, the investment account balance equals purchase price + share of ____ - share of ____ - amortisation of ____.
Answers: 1. True. 2. False (dividends reduce the investment account). 3. Depreciable. 4. False (it is used at 20–50% ownership). 5. Net income, dividends, differential.
Q: United owns 300,000 shares of Arjent, which has 1,000,000 common shares outstanding. What is United's ownership percentage, and which accounting method should it use?
A: 300,000 / 1,000,000 = 30%. Since this falls in the 20–50% range, United has significant influence and uses the equity method.
Q: Under the equity method, United purchased 30% of Arjent for $1,500,000. Arjent reports net income of $500,000 and pays total dividends of $250,000. There is no differential. What is the year-end balance of the investment account?
A: $1,500,000 + (30% x $500,000) - (30% x $250,000) = $1,500,000 + $150,000 - $75,000 = $1,575,000.
Q: Same facts, but the FV of Arjent's buildings exceeded BV by $1,000,000 at acquisition (remaining life 10 years). What is the year-end investment balance now?
A: Differential amortisation = 30% x $1,000,000 / 10 = $30,000 per year. Balance: $1,500,000 + $150,000 - $30,000 - $75,000 = $1,545,000.
Q: What is the total investment revenue United reports on its income statement for the year?
A: $150,000 (share of NI) minus $30,000 (differential amortisation) = $120,000.
Q: United sells its investment in Arjent for $1,446,000 when the carrying value is $1,545,000. What is the journal entry?
A: Dr. Cash $1,446,000, Dr. Loss on Sale of Investment $99,000, Cr. Investment in Arjent Stock $1,545,000. The loss is $1,545,000 minus $1,446,000 = $99,000.
Q: Under the equity method, when the investor's ownership drops below 20%, what happens?
A: The investor switches to the cost method. The carrying amount of the investment at the date of the change becomes the new cost basis, and the cost method (TS or AFS classification) is applied going forward.
The equity method connects directly to consolidation (above 50% ownership), which is covered in advanced accounting courses. Consolidation is the logical next step: if the equity method treats 30% of the investee's net assets as the investor's own, consolidation treats 100% by combining the financial statements entirely.
The differential amortisation concept parallels purchase-price allocation in business combinations. The same idea, that FV of assets at acquisition typically exceeds BV, drives goodwill calculations in M&A accounting.
The ownership thresholds (below 20%, 20–50%, above 50%) introduced in Part 1 of these notes are the gateway to this entire section. Understanding why the thresholds exist (voting influence) is essential context.
Equity method, significant influence, 20 to 50 percent ownership, investment in affiliate, equity in earnings of affiliate, investment revenue equity method, investee net income, investee dividends, differential, FV-BV differential, amortisation of differential, depreciable assets differential, inventory differential, goodwill equity method, mid-year acquisition pro-rata, change from equity to cost method, change from cost to equity method, sale of equity method investment, carrying value equity method, net assets, Chapter 12, ACCTG 472, intermediate financial accounting