For tax purposes, dividends are the only revenue realized from the investee. Consequently, the investor must recognize deferred income tax expense on the investee’s undistributed earnings that will be taxed in the future. As investments in common stock accounted for under the equity method are generally shown in the balance sheet of the investor as a single amount, this is often referred to as a one-line consolidation.
| Equity Method of Accounting (Example) | ||||
| A firm acquired a 20% stake in Company XYZ for $40,000 on 1 January 2017 and applies the equity method to account for the investment. XYZ reports a profit of $10,000 at 31 December 2017 and distributes a dividend of $6,000 on 30 June 2018. | ||||
| 1 Jan 17 | Investment in XYZ | 40,000 | ||
| Cash | 40,000 | |||
| To record purchase of 20% interest in Company XYZ | ||||
| 31 Dec 17 | Investment in XYZ | 2,000 | ||
| Cash | 2,000 | |||
| To record 20% share of XYZ’s reported income of $10,000 | ||||
| 30 Jun 18 | Investment in XYZ | 1,200 | ||
| Investment in XYZ | 1,200 | |||
| To record 20% share of $6,0000 dividend distributed by XYZ | ||||
In the case of losses incurred by the investee, the investor is required to apply the equity method for an investment until losses reduce the investment to zero, where additional losses are not recognized unless the investor is committed to further support the investee. If the investee subsequently reports net income, the investor should start using the equity method again after its share of this net income equals the amount of net losses that were not recognized during the period the equity method was suspended.
Where an investee is controlled by an investor through the ownership of more than 50% of its voting rights, it is a subsidiary of the parent company and consolidated in the financial statements of the company group.
| Level of Influence – Investments | |||
| Interest | ≤ 20% | ≤ 50% | > 50% |
| Influence | Little | Significant | Control |
| Investment | Equity | Associate | Subsidiary |
| Accounting | Cost | Equity | Consolidation |