Two commonly used methods for consolidating financial statements are the equity method consolidation and the consolidation method. Choosing the correct method is essential for accurately presenting the financial position. However, small and medium businesses often need help deciding between the use of the equity method and consolidation when accounting for their investments.
This article aims to clarify the concept of equity method consolidation and ultimately assist you in determining the suitable method for consolidating your financial statements.
Equity method consolidation: Definition
The equity method consolidation is an accounting approach used to report the financial results when a company holds a significant influence over another company but not complete control.
Under this method, the investor records its share of the investee's profits or losses in its financial statements. The investor's initial investment is adjusted periodically to reflect its share of the investee's net assets. This method is typically employed when the investor holds between 20% and 50% of the voting rights in the investee company.
Equity method consolidation: Example
To illustrate the equity method, let's consider Company A and Company B.
Company A purchases a 30% stake in Company B for £1 million.
Company B reports a net income of £500,000 for the year.
Company A would initially record a £1 million investment on its balance sheet using the equity method. Subsequently, it would record its share of Company B's net income, amounting to £150,000 (£500,000 × 30%), as an increase in its investment and recognise it as income on its income statement.
See also: How leverage is used to improve a company's cash flow
Equity method consolidation: Balance Sheet
The balance sheet prepared using the equity method consolidation presents the investor's investment in the investee as a single line item, typically labelled as "Investment in Associate" or "Investment in Affiliate." This method allows for the initial recognition of the equity investment at cost.
The carrying value of the investment is adjusted periodically based on the investor's ownership percentage of the investee's net income or loss and any additional contributions or dividend distributions made by the investee.
Since the share is calculated based on ownership percentage as the recognition of income solely based on distributions received by the investor, it may not accurately reflect the actual earnings derived from an investment. This is because the distributions received may not be closely related to the investee’s performance.
When an investor has significant influence over an investee, it also carries a level of responsibility for the associate's performance and the return on its investment.
To account for this responsibility, the investor expands the scope of its consolidated financial statements to include its share of the investee’s results. Consequently, applying the equity method in consolidated financial statements provides informative reporting of the investor's net assets and net income.
Related article: Balance Sheet Forecast: How-To
Equity method consolidation: Income Statement
Under the equity method consolidation, the investor's income statement reflects its share of the investee's net income or loss. This share is calculated based on the investor's ownership percentage in the investee. The investor records its share of net income as revenue and its share of net loss as an expense, impacting its overall profitability.
In equity method consolidation, the cash flow statement summarises the cash inflows and outflows related to the investor's equity investment in the investee. It provides a snapshot of the investee's operating, investing, and financing activities while also reflecting the investor's share of net income or loss, dividends received, and adjustments to the investment value.
It is important to note that as per International Financial Reporting Standards, the financial statements of the investor and the equity method investee should have the same reporting period. However, when this is impracticable, the investee’s accounts may be reported on a different date, provided the difference between the reporting dates is no more than three months.
Equity method consolidation: Worksheet
To facilitate the application of the equity method, many investors maintain a worksheet to track the adjustments made to their investments. It serves as a step-by-step template for combining the financial statements of the investor and the investee to create a consolidated financial statement.
The results presented by a worksheet typically look like this:
| Account | Parent company (£) | Investment in subsidiary (£) | Equity income (£) |
|---|---|---|---|
| Sales revenue | 100,000 | ||
| Cost of goods sold | 60,000 | ||
| Gross profit | 40,000 | ||
| Operating expenses | 20,000 | ||
| Net income | 20,000 | ||
| Investment in subsidiary | 100,000 | ||
| Share of subsidiary's net income | 15,000 | ||
| Elimination of unrealised profit on intercompany sales | (5,000) | ||
| Consolidated net income | 20,000 | 10,000 |
Equity method consolidation: Profit and Loss Statement
The profit and loss statement prepared under the equity method consolidation primarily focuses on the investor's share of the investee's net income or loss. It allows the investor to accurately depict the financial performance of its investment while considering the financial results of the investee.
What are the differences between US GAAP and IFRS in the accounting for equity method investments?
The accounting for equity method investments involves certain differences under US GAAP and IFRS standards across recognition criteria, i.e., significant influence, voting rights, reporting gaps, use of fair value options, exemptions, and more. Here are some of the differences:
| Basis | US GAAP | IFRS |
|---|---|---|
| Significant influence | US GAAP presumes significant influence only when 20% or more of an investment is made in the corporation’s common stock or in-substance stock. This criterion changes to 3-5% for investments in limited partnerships, limited liability companies (LLCs), and unincorporated joint ventures. | IFRS presumes significant influence as long as 20% or more has been invested in any entity’s voting rights, without any different criterion for limited partnerships. |
| Potential voting rights | Voting rights are not factored in when determining significant influence. | IFRS factors in currently convertible and currently exercisable potential voting rights for ascertaining an investor’s significant influence on the investee firm. However, these rights do not impact the investor’s equity earnings. |
| Different reporting periods | When it is infeasible for the investor and investee to have the same reporting period, US GAAP directs that the material events during the gap period (not exceeding three months) should be recognised through disclosures or by making adjustments as per the investor’s policy. | IFRS encourages the same reporting period for both the investor and investee but allows the gap provided it doesn’t exceed three months, with the condition that adjustments must be made to the investor’s financial statements, resulting in early recognition of material events. |
| Exemptions and fair value option (FVO) | US GAAP affords exemption to a greater number of entities listed in ASC 323 from applying the equity method, including investment as per ASC 815-10, common stock investments by non-business entities/ investment companies/ per ASC 810, and debt investments in LLCs, compared to IFRS. Also, firms can opt for FVO to report their equity method investments, even for interest held in joint ventures and associates. | Under IFRS, the non-application of the equity method to joint venture or associate investments is restricted to two scenarios: Either the parent is exempted from reporting consolidated financial statements per IFRS 10.4(a) Or the investment fulfils three criteria: the investor is a wholly/partially-owned subsidiary with noncontrolling interests not objecting to the non-application of the equity method; its securities are not publicly traded; and its parent company issues IFRS-compliant consolidated statements as per IFRS 10. Also, FVO can be availed only for equity investments held by mutual funds, investment-linked insurance funds, unit trusts, and venture capital organisations. |
| Held for sale classification | Firms must maintain the equity accounting method even for investments meetings held for sale classification, unless they qualify as a discontinued operation. | Under IFRS, meeting discontinued operations criteria is not important for an equity method investment that meets the held for sale criteria, thus enabling its recording at the lower of fair market value less costs or its carrying amount. |
What is the difference between equity method and consolidation method in accounting?
The consolidation method is used when the parent company holds more than 50% ownership in its subsidiary. Some of the differences between the equity method and the consolidation method include the following:
| Aspect | Equity Method | Consolidation Method |
|---|---|---|
| Ownership | Generally between 20% and 50%. | More than 50% ownership. |
| Financial statement presentation | Investor's statements reflect its share of the investee's income or loss. | Financial statements of investors and investees combined into a consolidated set of financial statements, including minority stake. |
| Recognition of results | Proportionate share of profits/losses recognised. | Consolidation of all subsidiary's revenues, expenses, assets, and liabilities. |
| Control over decision-making | Limited influence on investee's operations and decisions. | Significant control over the investee's operations and decisions. |
| Intra-group transactions | Intra-group assets and liabilities are not eliminated. | Intra-group assets and liabilities must be eliminated. |
What is the difference between equity method and cost method of consolidation
Some of the differences between the equity method and the cost method include the following:
| Aspect | Equity Method | Cost Method |
|---|---|---|
| Ownership | Majority ownership is usually required. | Majority ownership is not required. |
| Reporting of investment | Investments are reported as an asset on the balance sheet, initially recorded at cost, and subsequently adjusted for the investor's share of the investee's net income or loss and changes in equity ownership. | Investments are reported at cost on the balance sheet. |
| Dividend income | Dividends received from the investee are recorded as income when declared by the investee. | Dividends received from the investee are recorded as income when received. |
| Recognition of investee's income | The investor recognises its share of the investee's income regardless of whether dividends are received. | The investor recognises its share of the investee's income only if dividends are received. |
| Financial statement presentation | The investor's financial statements usually include the investee's financial statements. | The investor's financial statements do not include the investee's financial statements. |
| Control over decision-making | The investor has significant influence on the investee's decision-making processes. | The investor has limited influence on the investee's decision-making processes. |
Key takeaways:
The equity method consolidation and the consolidation method are the two most common methods for consolidating an organisation’s financial statements. Based on the discussion above, choose the method that’s the most suited for your business to consolidate your firm’s financial statements.
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