Equity Method of Accounting for Investment
Overview
In accounting, when the company makes the stock investment and holds the shares from 20% to 50%, it needs to account for the stock investment with the equity method. Likewise, the journal entry for the stock investment in equity method is different from those under the cost method.
With the equity method, the company records the stock investment at cost on the acquisition date but it does not recognize the dividend revenue in the same way as those with the cost method of accounting. In this case, the cash dividend that the company receives from the investee will reduce the balance of the stock investments.
Also, under the equity method of accounting, the company’s stock investment will increase proportionately with the percentage of holding that the company has when the investee makes a net income. On the other hand, when the investee makes a loss, the company’s stock investment will decrease based on the percentage of shares it holds.
Equity method journal entry
At acquisition date
The company can make the journal entry for stock investment under the equity method of accounting on the acquisition date by debiting the stock investments account and crediting the cash account.
| Account | Debit | Credit |
|---|---|---|
| Stock investments | $$$ | |
| Cash | $$$ |
Net income from stock investment
The company can make the journal entry when the investee reports the net income as below:
| Account | Debit | Credit |
|---|---|---|
| Stock investments | $$$ | |
| Revenue from stock investments | $$$ |
In this journal entry, the balance of stock investments on the balance sheet will increase proportionately with the investee’s net income based on the percentage of shares that the company has with the investee.
Net loss from the stock investment
Alternatively, the company can make the journal entry when the investee reports the net loss as below:
| Account | Debit | Credit |
|---|---|---|
| Loss from stock investments | $$$ | |
| Stock investments | $$$ |
On the other hand, the balance of stock investments on the balance sheet in this journal entry will decrease instead as the investee makes a loss.
The journal entry for the net income or net loss from the stock investment is one of the points that make the equity method of accounting different from the cost method. This is due to the stock investment under the cost method will not have either of these journal entries and the cost of stock investment will stay the same.
Cash dividend
When the company receives the cash dividend from the investee, it can make the journal entry by debiting the cash account and crediting stock investments.
| Account | Debit | Credit |
|---|---|---|
| Cash | $$$ | |
| Stock investments | $$$ |
In this journal entry, stock investments on the balance sheet decrease in the amount of the cash dividend that the company receives. This is another part that makes the equity method of accounting different from the cost method.
Equity method of accounting example
For example, on January 1, 2020, the company ABC makes the investment by purchasing the common stock from XYZ Corporation for $800,000. After the purchase, the company ABC has 40% of shares in XYZ Corporation.
On December 31, 2020, XYZ Corporation reports a net income of $250,000. And on the same day, it also declares and pays the cash dividend of $50,000 to all of its stockholders.
What is the journal entry in the company ABC for the stock investment under the equity method of accounting on:
- On January 1, 2020, when it purchases stock investment from XYZ Corporation?
- On December 31, 2020, when XYZ Corporation reports the net income and pays the cash dividend?
Solution:
On January 1, 2020
As the company ABC holds 40% of shares in XYZ Corporation, it can make the journal entry for stock investment under the equity method of accounting on January 1, 2020, as below:
| Account | Debit | Credit |
|---|---|---|
| Stock investments | 800,000 | |
| Cash | 800,000 |
On December 31, 2020
When XYZ Corporation reports the net income of $250,000, the company ABC can make the journal entry for $100,000 (250,000 x 40%) of the increase in its stock investments as below:
| Account | Debit | Credit |
|---|---|---|
| Stock investments | 100,000 | |
| Revenue from stock investments | 100,000 |
When the company ABC receives the cash dividend of $20,000 (50,000 x 40%), it can make the journal entry to recognize the cash inflow as below:
| Account | Debit | Credit |
|---|---|---|
| Cash | 20,000 | |
| Stock investments | 20,000 |
After these two journal entries, the balance of stock investments that the company ABC has in XYZ Corporation will increase to $880,000 (800,000 + 100,000 – 20,000).
