Companies that are subject to generally accepted accounting principles (GAAP) for financial reporting purposes must use the equity method to account for the income from investments in companies it has significant influence over. This requires a higher level of detail of financial reporting in comparison to reporting the income from marketable securities.
1. Assess whether the investment accounts for 20 percent or more of the outstanding voting stock. The equity method of accounting is only appropriate when the reporting company holds at least 20 percent of the outstanding voting stock in the investee company. Under GAAP, owning 20 percent or more of the stock indicates that the investor has significant influence over its investee company. For example, this level of stock ownership generally allows the investor to influence the board of directors and general corporate policy decisions.
2. Record the stock investment. The initial entry to your company’s books is for the purchase price of the stock. You accomplish this by posting a debit entry to an investment account for the price of the shares and a credit entry for the same amount to the cash account to reflect the decrease in its balance. Both the investment and cash accounts are assets on the company’s balance sheet.
3. Report the earnings of the investee company. At the close of each reporting period, such as each fiscal quarter, you must obtain the income statement of the investee company and report a percentage of that income in proportion to your company’s percentage of ownership. For example, if your company owns 40 percent of all outstanding voting shares of the investee at the end of a fiscal period in which it reports $100,000 of net income, you must report $40,000 of investment income. The journal entry requires a debit to the investment account of $40,000 and a corresponding credit entry to an investment income account.
4. Reduce the balance of investment for the receipt of dividends. Whenever the investee company pays a dividend to your company, the equity method requires that you reduce the value of the company’s investment. This is because the issuance of a dividend reduces all shareholder equity in the investee company. Post a debit entry to the cash account for the amount of the dividend and reduce the investment account with a credit entry.
- The equity method of accounting is only applicable for investments that constitute 20 to 50 percent of the outstanding voting stock. Once a company’s level of investments exceeds 50 percent, its ownership interest is sufficient to warrant consolidated reporting under GAAP.
- An important distinction between marketable securities and equity method investments is that the equity method ignores the daily fluctuations in the stock’s market price.
Items you will need
- Financial results for the investee company
- Investee company’s outstanding shares of stock