Under U.S. generally accepted accounting principles (GAAP), the equity method initially records an investment at cost, then adjusts that balance for the investor's share of investee activity.
Significant influence is the ability to participate in an investee's operating and financial policy decisions without controlling those decisions. To identify when equity accounting applies, the investor evaluates control first, then influence, using substantive rights and the relationship's actual circumstances.
DECISION: Evaluate consolidation before selecting the equity method. These illustrations assume corporate common shares, no controlling financial interest, no fair-value-option election, and no private-company goodwill amortization election.
Influence depends on the investor's ability to participate, even when the investor chooses not to exercise that ability.
Relevant evidence includes:
- Board participation through a substantive voting seat.
- Involvement in budgets, financing, dividends, or other operating and financial policies.
- Material transactions between the investor and investee.
- Interchange of managers or other key personnel.
- Technological dependence, such as reliance on the investor's essential production technology.
- Voting ownership relative to the concentration and organization of other shareholders.
Common mistakes
- Wrong earnings period. Halving annual income produces $69,000 after the preferred claim, rather than Example 1's supported $72,000 before basis adjustments.
- Full-premium amortization. Example 1's acquisition premium is $90,000, but only $18,000 becomes a Year 1 basis expense.
- Dividend income duplicated. Crediting Example 1's $30,000 receipt to income would incorrectly increase equity-related income from $54,000 to $84,000.
Bottom line
- Significant influence depends on substantive participation rights; the 20% voting-ownership threshold is a rebuttable indicator.
- Acquisition cost includes the investor's share of book net assets, identifiable basis differences, and any residual embedded goodwill.
- Equity-method earnings use relevant postacquisition income available to the acquired interest, adjusted for basis differences and unrealized intercompany profit.
- Inventory differences follow sales, depreciable and finite-lived differences follow consumption, and land and goodwill receive no routine amortization under the general model.
Exam shortcut
Mark the acquisition and disposal dates before touching annual earnings. Circle any supplied interim income and determine whether preferred claims have already been deducted. Label every basis difference with its release event: inventory sale, remaining useful life, or eventual disposal. Calculate at the investor's percentage once, and check whether the schedule already supplies investor-level amounts. Build an income subtotal beside the investment rollforward.
The full lesson (about 5,187 words, 35 min read) adds 4 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- II.E3
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