Equity Method Accounting BFC/GCR

Center of Excellence
edited January 12 in Best Practices

1. Abstract

The equity method is a crucial accounting approach used to reflect investments in associated entities accurately. This abstract provides a comprehensive overview of the equity method, elucidating its fundamental principles, application, and implications for financial reporting while focusing on its implementation within Board Financial Consolidation solutions (BFC/GCR).

In summary, this article serves as a quick reference for Board employees/partners or customers seeking to succinct understanding of the Equity Method in Accounting.

2. Context

In the corporate landscape, companies often invest in other entities to diversify their portfolios, gain strategic advantages, or foster collaborative ventures. These investments are not always in the form of a controlling interest, and herein lies the importance of the equity method.

When a company holds a significant but not majority ownership stake in another entity, typically ranging from 20% to 50%, the equity method is employed to account for this investment. Rather than consolidating the financial statements of the investee, the equity method allows the investor to recognize its share of the investee's profits or losses directly.

The equity method ensures transparency in financial reporting by reflecting the economic substance of the investment. It requires periodic adjustments based on changes in the investee's financial position, reinforcing the investor's commitment to accurately represent its equity in the associated entity.

As companies engage in complex networks of partnerships, joint ventures, and strategic alliances, the equity method stands as a valuable tool for maintaining fidelity in financial reporting.

3. Content

3.1 What is the equity method of accounting?

The term “equity method” describes the applicable accounting treatment when an organization holds an investment in a separate entity (reporting unit) in the form of common stock or capital and has the ability to influence the operating or financial decisions of the investee but does not exercise full control over it, as in the relationship between a parent company and its subsidiary.

3.2 How do you determine if the equity method is applicable?

There’s a presumption that an investor has the ability to exercise significant influence when it owns (directly or indirectly) 20% or more of the outstanding voting common stock or in-substance common stock of an investee. The FASB recognizes the determination of the ability to exercise significant control over reporting unit’s financial and operating policies will however require judgement.

3.3 Accounting for an equity method investment

Equity method investments are recorded as assets on the balance sheet at their initial cost and adjusted each reporting period by the investor through the income statement and/or other comprehensive income (OCI) in the equity section of the balance sheet.

3.3.1 Initial measurement

The investor should measure the initial value for an equity method investment in the common stock of an investee at cost.

3.3.2 Subsequent measurement

After initial measurement, the investee must recognize their share of net income/losses within current earnings with a corresponding adjustment to the recorded equity investment. Additionally, the entity adjusts their investment for received dividends, distributions, and other-than-temporary impairments.

The investor calculates their share of net income based on their proportionate share of common stock or capital. Adjustments to the equity investment from the investee’s net income or loss are recorded on the investor’s income statement in a single account. Income adjustments increase the balance of the equity investment and loss adjustments decrease the balance of the equity investment.

The investor’s share of the investee’s OCI is calculated and recorded similarly. The investor calculates their share of the investee’s OCI activity based on their proportionate share of common stock or capital. The investor records OCI activity directly to their equity method investment account, with the offset recorded to their OCI account.

From time to time, the investee may issue cash dividends or distributions to its owners. Dividends or distributions received from the investee decrease the value of the equity investment as a portion of the asset the investor owns is no longer outstanding.

In the case of an equity method investment, the investor’s investment asset is analyzed for impairment, not the underlying assets of the investee. Accounting in case of Disposal is not covered by this document.

3.4 Example of accounting for an investment using the equity method in BFC

3.4.1 Initial measurement

Suppose Reporting Unit X buys 30% of Reporting Unit Z’s voting common stock for $200,000. This is the entry that Reporting Unit X would record at initial investment:This will flow into BFC through trial balance data load. To identify the investment amount create a report with the following selection:

Screen selection: Month, Consolidation Node, Scenario and Investment Accounts (In BFC, this can be based on cube: S Investment Rule Account. In GCR, select member “Investment” from entity “Elimination Type”.),[AL5] Layer 8, and all Movements except for Closing.

Display by row: Reporting Unit and IC and Related Parties

Identify the investment amount of Reporting Unit “X” in IC and Related Parties “Z”

Note: Reporting Unit: Z will follow Equity Method and will not be consolidated.

3.4.2 Subsequent measurement

During the first year, Reporting Unit “Z” has net loss of $50,000. Total equity including profit for the period is -$300,000.

Reporting Unit “X” will apply its ownership interest, 30% , to Reporting Unit “Z”’s first year loss to determine its proportionate share of losses to record in current period earnings.

In BFC/GCR,[AL6] to identify the net income/loss of the period as well as the total equity of Reporting Unit “Z”, create the following report:

  1. Screen selection: Month, Consolidation Node, Scenario and Account Category: Equity, Layer 8, and all Movements except for Closing.
  2. Display by row: Reporting Unit and by column Tech Account for Select.
  3. Identify Profit/Loss for the period which will be recorded in tech account: 010 – Profit for the period (Company Level).[AL7] And the rest of the equity which will be the total minus the Profit/Loss for the period.

The automated journal for the equity method is generated on Layer 10-02 Investment Elimination. The following tech accounts are impacted:

  • 195 – Investment in Equity Subsidiaries Revaluation
  • 010 – Profit for the Period (Company Level)
  • 015 – Retained Earnings
  • 200 – Profit on Investment in Equity Subsidiaries Revaluation

First Year: Journal in Reporting Unit X:

Recognize Loss

  • Loss for the period: $50,000
  • Shares: 30%
  • Calculation: $50,000 *30% = $15,000

Investment Reevaluation

  • Total Equity: -$300,000
  • The Equity of Investee (profit excluded): -$350,000
  • Investment: $200,000
  • Calculation: $200,000 + (-$350,000*30%) = $95,000

3.5 Loss from equity method investments

As mentioned, the investors measure the initial value of an equity method investment at cost. The value of the investment is increased by the investor’s proportionate share of the investee’s current period net income.

On the other hand, the investment is decreased by the investor’s portion of the investee’s current period net loss, distributions, and dividends. The investment asset continues to be increased/decreased until the investment is disposed of or the investee’s portion of accumulated losses exceeds the investment balance.

When an investment balance is reduced to zero due to losses incurred over time, the investor generally pauses recognizing future losses to avoid recording a “negative” investment. 

If the investor pauses recognition of losses in the financial statements due to an investment balance that has been reduced to zero, the investor must continue to track cumulative losses and their impact to the investment balance outside of the general ledger.

The investor can only begin recording equity income again when their share of earnings reverses the total accumulated losses, they previously incurred. As such, it is important for an investor to properly track their share of income and loss even when they aren’t recording journal entries in their general ledger.