9 - The Equity Method of Accounting LARRY WALTHER: Larry Walther. This is principlesofaccounting.com, Chapter 9. In this module, we will be looking at the equity method of accounting. A unique method of accounting for investments. Now the equity method is used when an investor may acquire enough ownership in the stock of another company to exercise significant influence over that over company known as the investee. The investor may have the ability to direct corporate policy, corporate governance, various decision making, fall short of control, but there is the ability to significantly influence these items. As a general benchmark, we look for 20% plus ownership for the presence of significant influence but the ultimate test is significant influence. That might occur with an investment of less than 20%, or it may fail to occur with an investment greater than 20%. Once significant influence is present, we opt for the equity method of accounting. And the equity method ignores market value for the investment. The accounting for the investment tracks the equity of the investee company as the investee makes money or has net income, the investor reports their proportionate share of that, and vice versa for a loss. So here we're going to have $50,000 investment, we're going to debit investment and credit cash $50,000. This is to record the purchase of 5,000 shares of Legg stock at $10 per share. Legg has a total of 20,000 shares outstanding and so its 5,000 share purchase represents a 25% ownership and we're going to deem that it is sufficient to exercise significant influence. We initially record this at its cost, the investment at cost. After a while, the investee reports income of $10,000. The investor's proportionate 25% share of that $10,000 is $2,500 and notice very uniquely what we're going to do. We're going to debit the investment account $2,500 and credit investment income, $2,500. That's the investor's proportionate share, 25%, of the total income of the investee. It causes the investment account to increase, and the credit causes income to be recognized on the investor's books. No dividends are being paid, it's just tracking. So if you think about the income of the investee, it causes equity to go up and we pick up our proportion share of that increase and equity as income as well, hence the 90 equity method. If Legg pays out $4,000 in dividends, we expect to collect our 25% share or $1,000 so we debit cash $1,000 and credit the investment account of $1,000. Now we're reducing the investment account but think about the effect of dividends. Dividends decrease the equity of the investee and we're decreasing our investment to account for out proportionate share. So in many ways, our investment account is tracking the equity of the investee both up and down for earnings and dividends.