Question

1. How should an investor, applying the “equity method” of accounting for an investment, recognize equity method earnings, losses, and dividends declared by an investee? Cite FASB codification to support your answer.

2. Please explain under what circumstances that an investor may not be able to use equity method to account for his investments even though the investor owns more than 20% interest in the investee? Cite FASB codification to support your answer. (Tips: significant influence over an investee).

Answer 1

1. An investor under the “equity method” of accounting for an investment, generally recognize equity method when an investment is with in the 20% to 50% of the total stake in Investee company unless it is confirmed that the Investor doesn’t possess an significant amount of influence or control in the Investee company. The investor uses the earnings in the Investee company to increase its investment in the Investee Company by portion of its invested share. Likewise, any loss in the Investee company would result in reduction in the investment in the Investee company and the same treatment is given in the case of any dividend is declared by the Investee company.

Say, you have acquired 40% stake in the Investee company for $20m and on board you possess significant influence, then you can use the equity method instead of cost method. In the coming year, the Investee made a earnings of $5m and declared total dividend of $1m, then you can appreciate the total investment in the Investee by $2m (40% share) and also reduce the investment by $0.4m towards receipt of dividend. The dividend is not treated as income.

2. The circumstances that an investor may not be able to use equity method to account for his investments even though the investor owns more than 20% interest in the investee are when the passive and long term investment in the Investee company doesn’t result in significant over the Investee Company. Here, the stone rule is that instead of percentage of investment is not important but the influence on the board of the Investee Company is more important. Here, the investment in the Investee company is recorded in the balance sheet at its historical purchase price. The dividend received from the Investee Company is treated as income and accordingly taxed.

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