What is the Equity Method and how can it be relevant and useful to you as a business owner? What are its advantages and drawbacks?
Understanding the concepts behind the Equity Method, how you can utilise it on your business and investing realities and opportunities, and taking note of its benefits and caveats will help you form a clearer picture on business earnings and liabilities, even future opportunities. To begin, we need to find—and establish—clear answers to the following questions:
- What is the Equity Method?
- How does the Equity Method work?
- What are the advantages and disadvantages of the Equity Method?
What is the Equity Method?
The Equity Method is an accounting technique utilised especially in investments. When an investor holds considerable influence on an investee—approximately around 20 to 25 per cent of a company’s stock, an indication of significant influence—but does not hold and exercise full control over the affiliate company, the investor will use the Equity Method to account for profits and losses on their investment on the said affiliate company.
Profits or losses recognised by the investor will then be included and will appear on the investor’s income statement. Recognised profits increase the said investment, while recognised losses decrease the same investment.
Note that the Equity Method can only be used when the investing business influences and holds considerable power over the investee’s decision-making process. When using the Equity Method, the investee isn’t treated as a subsidiary, but is usually termed “affiliate” or “associate”.
How does the Equity Method work?
To utilise the Equity Method, it must first be determined that the investor indeed does wield considerable power and influence over the affiliate or associate business—the investee. Several observable indications and circumstances can be accounted for to prove that indeed, an investor holds considerable power and influence over an investee. These indications and circumstances include:
- The investor’s participation or representation to the investee’s board of directors
- Intra-entity management professionals interchange and intra-entity material transactions
- Technological dependence between the investor and investee
- Proportion of the investor’s ownership—20 to 25 per cent—of the affiliate company, in comparison to other investors
Note, however, that in some cases, though an investor owns 20 to 25, even 50, per cent of the affiliate company’s stocks or shares, the investor may still not exercise significant power and influence over the investee. Although this doesn’t happen so often, the following indicates an investor may still not wield significant influence over an investee despite the considerable percentage of their ownership of the affiliate company:
- Evidence of lawsuits and complaints to regulatory authorities, signifying the affiliate company’s contention and opposition to the investor’s power and influence over it
- A shareholder or group of shareholders claim and control bigger ownership of the affiliate company, operating the associate business with very little regard—if at all—to the investor’s preferences and viewpoints
- Sufficient data and/or information isn’t available or made unavailable to the investor to effectively utilise the Equity Method
- The investor cannot or is made unable to have a seat or a representation at the affiliate business’ board of directors
Also, the investee can be considered an unconsolidated affiliate of the investor, but can also be a publicly traded, freestanding business.
Now, in utilising the Equity Method, the investor proceeds by recording the investee’s assets and liabilities on its own accounting balance sheet, or, having it proxied by investment in affiliate, or the equity investment, on the sheet as non-current asset account—all an indication of the investor’s established economic interest on the affiliating company’s assets and liabilities.
From this logic, we deduce that the investor is entitled a portion of the affiliate company’s earnings in proportion, of course, to the investor’s ownership of the investee’s stocks. The investor then proceeds by recording their proportionate share of the subsidiary’s profits and earnings and treats it as an increase to their own “investment in affiliate” account on their balance sheet. The said earnings may be, and are either distributed as dividends or simply retained by the investing company.
Further, cash taxes are paid by the investing company based only on the received cash dividends. The undistributed earnings result in a deferred tax liability (DTL) payable if the earnings have been finally distributed or the entire investment liquidated. Be advised that undistributed earnings rarely get dividends received deduction (DRD)-qualified, since their future distribution isn’t anticipated or expected.
What are the advantages and disadvantages of the Equity Method?
All methods have their own benefits and drawbacks. The same is true with the equity accounting technique. These advantages and disadvantages include:
- Accounting accuracy
- Ability to conceal critical figures when necessary
- Method complexity
- Dividends treated and shown as deductions
One of the most notable advantages of the Equity Method is its ability to enable the investor to record, show and prove a more truthful and realistic balance of income. The income on the sheet shows all earnings from all investments, not solely from the main company.
The equity accounting technique also makes it possible to carry together figures of the affiliate company’s and the investor’s statements without having to merge all figures, resulting in a clearer and more specific balance sheet, besides demonstrating that more earnings could be sourced not only from the main company but also from the affiliate business(es).
Ability to conceal critical figures when necessary
The Equity Method also allows the main company to hide critical figures from its own investors. This is most useful when the main company experiences low profits and/or earnings but still wants to encourage shareholders and the public to continue investing in its business. The main company works for and achieves this by including and focusing on the affiliate company’s earning figures and disclosing these to shareholders and the public, instead of its own. Since this is possible, it is also possible for the main company to avoid disclosing the affiliate company’s earning figures if they are lower than the figures of the main company.
Most accountants and relevant professionals would agree that, indeed, utilising the Equity Method involves a considerable level of difficulty. Bluntly, it is not especially easy to comprehend, much less apply. A considerable amount of time is also required to gather, compare and contrast, and then evaluate figures of the main company and then with its affiliate(s).
Note that it is of utmost importance to get specific, accurate, and if possible, precise fiscal data from the main company and its affiliate(s) to finally arrive at relevant and useful figures. A single data error, or error in interpretation or in the calculation process, could lead to serious effects and implications not only on the main company but also to its affiliate(s).
Dividends treated and shown as deductions
In employing the Equity Method, one must also remember that this accounting technique will not be able to show and treat dividends as revenue; instead, it will show them as deductions. Thus, in Equity Method, dividends are treated as a reduction to the investment amount, and not tagged as dividend income. The investor’s equity, then, will only be seen as being reflected by relevant net assets. Note, too, that in the employment of the Equity Method, the affiliate company’s dividends are never moved to the main company’s, or the investor’s.