The size of an investment in another company dictates your accounting treatment. Companies frequently buy equity method of accounting for investments journal entries stock of other companies.
The dividing line between the two motivations is 20 percent of outstanding shares, according to generally accepted accounting principles. If you own less than 20 percent of the investee shares, you use the cost method to record the investment. Cost Method You use the cost method when you make a passive but long-term investment in another company. You record the stock on a balance sheet account as a non-current asset at its historical purchase price. For example, if you purchase 10 percent of UVW Corp. 10 million, that amount would be the balance sheet value of the shares. You normally do not update this amount unless you purchase additional shares or sell shares.
Equity Method If you hold at least 20 percent of the investee’s shares, use the equity method unless you can prove you have no influence over the investee — for example, if the investee treats you hostilely or ignores your advice. Under the equity method, you book the stock purchase as you would under the cost method. However, you must adjust this balance to account for your share of the investee’s profits and losses. Tax Impact The dividends received under the cost method create taxable income. The equity method has a larger potential effect on income and thus on income taxes.
Suppose XYZ Corp routinely earns a 10 percent annual return on equity. Adjustments to Value Under the equity method, you update the carrying value of your investment by your share of the investee’s income or losses. In addition, you decrease carrying value by any dividends you receive on the shares. You do not otherwise adjust the carrying value to reflect changes to the fair market value of the investee. In the cost method, you never increase the book value of the shares because of an increase in fair market value. Examples include changes to foreign currency exchange rates, changes to the value of available-for-sale securities and gains or losses on pension plans. Under the equity method, you must record your share of the investee’s OCI as OCI on your own books.
About the Author Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. New York University and an M. You can see samples of his work at ericbank. Equity Method” accessed April 05, 2018. Copy Citation Note: Depending on which text editor you’re pasting into, you might have to add the italics to the site name.