Menu Close

Equity Method Definition

Definition

The word equity system identifies to a accounting procedure utilized once an investor has commanding interest or significant influence over the other firm. In training, the equity approach is utilized by organizations with a considerable financial interest in still another. This bookkeeping system requires businesses to occasionally correct their net resources as the worthiness with the financial interest varies with time.

Explanation

Unlike marketable securitiesthat can be short-term investments, an ownership interest in an alternative business represents a longterm investment. Broadly speaking, ownership falls in to three categories: restraining interest, significant sway, and also passive interestrates. Controlling interest happens once the investor holds over 50 percent of their voting stock issued with an organization, whereas significant leverage happens once the investor stays between 20% and 50 percent of their voting stock.

When an organization has commanding interest or significant change on the following, it’s crucial to make use of the equity method of accounting. This system takes the buyer (company) to list the first investment in cost. Following alterations are made occasionally to comprehend that a proportional share of their investee’s (associated company’s) earnings being a growth with their own investment, even though a loss and the payment of earnings could reduce the worth of their investment.

This profit or loss appears to be one line item to the invest or ‘s income statement. Extra detail is available at IAS 28 Investments in Associates and Joint Ventures and also IFRS 1-2 Disclosure of Interests in Other Entities.

Example

On January 1, Company A acquired 1,000,000 shares of Company XYZ’s common stock for about $20.00 each share. This acquisition represented 40 percent of their voting stock of Company XYZ. The journal entry to record that the first investment from Company XYZ will be:

Debit Credit
Long-Term Investment at Company XYZ $20,000,000
Cash $20,000,000

At year end, Company XYZ reported earnings of $4,000,000 and also paid a dividend of $0.50 per share. Employing the equity procedure, Company A will create the next journal entry to record its share of Company XYZ’s Net Gain ($4,000,000 x 40 percent, or 1,600,000):

Debit Credit
Long-Term Investment at Company XYZ $1,600,000
Revenue from Investment $1,600,000

While the next entry could be utilized to comprehend the fee of a dividend ($0.50 per share x 1,000,000, or $500,000):

Debit Credit
Cash $500,000
Long-Term Investment at Company XYZ $500,000