Suppose a company owns 30% of another business. It does not control that business, so it would be wrong to report all of the business’s revenue and assets as its own. But it has a substantial say in how the business is run, and its fortunes are closely tied to the business’s results. Simply recording the investment at cost, or at market value, would miss much of the economic reality.
The equity method is the accounting answer to this middle ground. It is used when an investor has significant influence over an investee but not control: typically for holdings of roughly 20% to 50% of the voting rights, and for many joint ventures. Under Australian standards, such an investee is called an associate, and the method is set out in AASB 128 Investments in Associates and Joint Ventures, equivalent to the international standard IAS 28. US standards contain a similar method in ASC 323.
This article explains how the equity method works, step by step, with a worked example. It then covers the less obvious parts: other comprehensive income, losses, transactions between the investor and associate, impairment and what equity-accounted profits do and do not tell a reader. It is part of GoCore’s series on investments, groups and acquisitions, introduced in Accounting for investments in other companies.
The logic of the equity method
The equity method rests on a simple idea: an investor with significant influence should report its share of what the investee earns, as the investee earns it.
Under this view, the investor’s profit should include its share of the associate’s profit, whether or not the associate pays that profit out as dividends. The investor’s balance sheet should show an investment that grows as the associate earns profits and shrinks as it pays dividends or makes losses, broadly tracking the investor’s share of the associate’s net assets.
The equity method is sometimes called a one-line consolidation. Instead of adding the associate’s individual assets, liabilities, revenues and expenses to its own, as it would for a subsidiary, the investor captures its share in a single balance sheet line (the investment) and a single income statement line (its share of the associate’s profit or loss).
The basic mechanics
Three entries capture most of the equity method.
At acquisition: the investment is recorded at cost.
When the associate reports profit or loss: the investor increases the investment by its share of the profit, and recognises the same amount as income, often called share of profit of associates. A share of losses reduces both.
When the associate pays dividends: the investor records the cash received and reduces the investment by the same amount. Dividends are not income under the equity method, because the profit they come from has already been recognised. Paying a dividend simply converts part of the investor’s share of the associate’s net assets into cash.
A worked example
This is an illustration with round numbers.
On 1 July, Harbour Holdings buys 25% of the shares in Coastline Fabrication for $500,000, gaining two seats on a board of eight and a role in setting Coastline’s strategy. It has significant influence, so it uses the equity method.
During the year to 30 June, Coastline reports a profit of $240,000 and pays dividends totalling $80,000.
| Step | Calculation | Investment balance |
|---|---|---|
| Acquisition | Cost | $500,000 |
| Share of profit | 25% × $240,000 = $60,000 | $560,000 |
| Dividends received | 25% × $80,000 = $20,000 | $540,000 |
At year end:
- Harbour’s balance sheet shows an investment in associate of $540,000.
- Its income statement shows a share of profit of associates of $60,000.
- Its cash flow statement shows $20,000 of dividends received.
Notice the gap between profit and cash. Harbour reports $60,000 of income from Coastline but receives only $20,000 in cash. The other $40,000 remains inside Coastline, reflected in the higher carrying amount of the investment.
Other comprehensive income
Some gains and losses bypass the income statement and are recorded in other comprehensive income, such as certain revaluations of property or currency translation differences. If an associate records such items, the investor recognises its share in its own other comprehensive income, again adjusting the investment. The aim is for the investment to keep tracking the investor’s share of the associate’s net assets.
Paying more than book value
Investors rarely pay exactly their share of an associate’s recorded net assets. Often they pay more, because the associate’s assets are worth more than their book values, or because the associate has valuable intangible qualities such as reputation or customer relationships.
Under the equity method, the investor in effect identifies what its purchase price represents:
- its share of the associate’s net assets at book value
- its share of any differences between fair values and book values of identifiable assets and liabilities
- any remaining excess, which is effectively goodwill included in the carrying amount of the investment
Fair value differences on assets that are depreciated, such as equipment, cause adjustments to the investor’s share of later profits, because the associate’s own depreciation is based on the lower book values. These adjustments are made in the investor’s calculations, not in the associate’s records. Goodwill included in the investment is not amortised separately, but the investment as a whole is tested for impairment when there are signs of a decline in value.
If the investor pays less than its share of the fair value of the associate’s net identifiable assets, the difference is recognised as income in the period the investment is acquired.
Losses
When an associate makes losses, the investor’s share reduces the investment. If losses continue, the investment can be reduced to zero.
Under Australian standards, once the investor’s interest has been reduced to zero, it generally stops recognising further losses, unless it has legal or constructive obligations, or has made payments, on the associate’s behalf. The investor’s interest for this purpose includes long-term interests that are in substance part of the investment, such as certain long-term loans to the associate. If the associate later returns to profit, the investor resumes recognising its share only after its share of profits has made up for the losses not recognised.
This matters in practice. An investor that has guaranteed an associate’s debts may need to recognise losses beyond its investment, because it is exposed to them.
Transactions between investor and associate
Investors often trade with their associates: selling them goods, buying from them or providing services. Under the equity method, profits on such transactions are only partly recognised until the goods are sold on to outside parties.
The rule is that unrealised profits on transactions between the investor and its associate are eliminated to the extent of the investor’s interest. For example, if Harbour sells equipment to Coastline at a profit of $40,000 and Coastline still holds the equipment at year end, Harbour eliminates 25% of that profit, or $10,000, until the equipment is used up or sold.
The reasoning is that, to the extent Harbour owns Coastline, it has in effect sold the equipment partly to itself. Profit is not earned by selling to yourself.
Impairment
If there is evidence that the investment’s value has fallen below its carrying amount, for example because the associate is in financial difficulty, its market has deteriorated or its share price has fallen significantly, the investor tests the investment for impairment. If the recoverable amount is lower than the carrying amount, the investment is written down and the loss recognised in profit.
Practical requirements
Applying the equity method well depends on reliable information from the associate.
Reporting dates. The investor uses the associate’s most recent financial statements. If the associate’s reporting date differs from the investor’s, adjustments are made for significant transactions or events in between, and under Australian standards the difference should generally be no more than three months.
Consistent accounting policies. If the associate uses different accounting policies for similar transactions, the investor adjusts the associate’s figures so that they are consistent with its own policies before applying the equity method.
Access to information. Investors with significant influence usually have access to the associate’s financial information through board representation or agreements. Where information is hard to obtain, that itself may be a sign that the investor’s influence is weaker than its shareholding suggests.
When significant influence ends
If an investor loses significant influence, for example by selling part of its stake or because another party gains control, it stops using the equity method. Any interest it keeps is measured at fair value, and the difference between that fair value plus any sale proceeds and the carrying amount of the investment is recognised as a gain or loss in profit. Amounts previously recognised in other comprehensive income in relation to the associate are accounted for as if the associate had disposed of the related assets or liabilities.
Joint ventures
A joint venture is an arrangement in which two or more parties have joint control, meaning that decisions about the relevant activities require the unanimous consent of the parties sharing control, and the parties have rights to the net assets of the arrangement. Under Australian standards, investors in joint ventures generally use the equity method too.
Not every jointly controlled arrangement is a joint venture. A joint operation, in which the parties have direct rights to the assets and obligations for the liabilities, is accounted for differently: each party recognises its own share of the assets, liabilities, revenues and expenses. Classifying an arrangement correctly requires looking at its legal form, contractual terms and other facts.
Reading equity-accounted profits
For readers of financial statements, equity-accounted results deserve care.
They are not cash. The investor may receive only a fraction of its share of profit as dividends, or none at all.
The investor cannot simply take the cash. Without control, the investor cannot force the associate to pay dividends.
Debt is hidden. The associate’s borrowings do not appear in the investor’s balance sheet, even though they affect the associate’s value and risk. A business with large associates can appear less indebted than its economic position suggests.
Results depend on others’ accounts. The investor relies on the associate’s financial information, often prepared to a different timetable.
A useful check is to compare share of profits of associates with dividends received from associates over several years, using the cash flow statement. A persistent large gap may indicate profits that are being retained for reinvestment, or profits that are hard to turn into cash.
The equity method in business structures
The equity method appears often in Australian business:
- Joint ventures between companies in construction, mining, property development and technology.
- Strategic stakes in suppliers, customers or partners.
- Family and founder groups in which one entity holds a significant but non-controlling stake in another.
Whether the equity method applies depends on whether an entity prepares financial statements under Australian Accounting Standards in the first place, which depends on its size and type. For entities that do, the method can significantly affect reported results.
Common mistakes
Recording dividends from associates as income. Under the equity method they reduce the investment.
Ignoring fair value adjustments. Paying more than book value affects later shares of profit.
Continuing to recognise losses past zero without obligation. Recognition generally stops at zero unless the investor is exposed.
Forgetting to eliminate unrealised profits. Trading with an associate requires adjustment.
Treating equity-accounted profit as available cash. It may never be distributed.
Questions to ask
- Does the investor genuinely have significant influence, and what is the evidence?
- How does the share of profit compare with dividends actually received?
- What debts and risks does the associate carry that are not visible in the investor’s balance sheet?
- Are there transactions between the investor and associate that require elimination?
- For your own business: do any of your holdings or joint ventures require equity accounting?
Bringing it together
The equity method reports an investor’s share of an associate’s results as they are earned. The investment starts at cost, increases with the investor’s share of profits and other comprehensive income, and decreases with its share of losses and with dividends received. Adjustments arise for fair value differences at acquisition, unrealised profits on transactions with the associate, losses beyond the investment and impairment.
The method gives a more faithful picture than cost or market value for investments over which the investor has significant influence. But equity-accounted profits are not cash, and an associate’s debts and risks remain largely outside the investor’s balance sheet. Reading them well means looking at dividends, the associate’s own position and the substance of the relationship.
Sources: course materials from an advanced financial reporting course (Module 1, based on US GAAP), together with Australian Accounting Standards, including AASB 128. Figures are illustrations. This article is general information, not accounting, tax or financial advice; consult a qualified accountant about your circumstances.
