What is an Equity Method?

An equity method is a standard accounting technique that is used when a company holds a considerable amount of another company's stock and has significant influence over its operations. This method is used to assess and report the profits earned by a company or firm that has invested more than 20% stock in another company. Significant influence also means that the investor can participate in certain company processes such as sitting on the board of directors and being involved in policy making, management decisions and company transactions that may influence the financial workings of the company.

Simply put, when a company owns more than 20% of another company, the company that made the investment can record the other company’s earnings as income. The percentage of stock an investor holds is used as a measure of the amount of influence it has over the company. The higher the percentage of stock held, the greater the potential of return or loss on the initial investment. The principle of the equity method can only be applied when the investor can prove ownership of over 20% of stock and has significant influence over the company.

An equity method is used to financially account for an investor’s ownership in another company’s investments and revenue. A company that buys stock in another company is entitled to a percentage of the profits of the company that it invested in. The reported value of the investment is based on the firm’s share of the company assets. When the equity method is applied, the investor can report and reflect the earned income of the company up to the percentage of the investment. This amount is then reflected as a profit on the income statement.

The accountant working on behalf of the investor will record the cost of the initial investment of the stock, as well as any gains and losses and income earned. The investor will occasionally have to review the stock for change so that adjustments are made to the income record to reflect the loss or gain of the stock. The company’s resulting income gain will then be recorded on the investor’s income statement for the equivalent of the percentage that was invested. Just as income is reflected, so is loss.

The equity method is the practice that allows companies to get the maximum returns on the investments they have made in other companies. For example, if Company A invests 25% in Company B and Company B makes $1 million US Dollars (USD) that year; Company A can apply an equity method. By applying the equity method, the company can reflect an investment income of $250,000 USD, which is the equivalent percentage of what it owns.