A pharma company buys 30% of a generics maker for $500,000 when the target's net assets are worth $400,000 in book value. Three years later the investment line on the balance sheet reads $612,000, but the company never wrote a check for the $112,000 increase. That gap is the equity method at work.
When you own 30% of a company that earns $100, your economic share of those earnings is $30, regardless of whether the investee distributes any of it. If the investee pays out $20 and retains $80, your share of the retained earnings ($24) still belongs to you, it sits inside the investee growing the equity you partially own. Booking only the $6 dividend you received understates your true economic position by $24 every period.
The equity method captures this. You record your proportionate share of investee earnings as income and increase the carrying amount of the investment by that same share.
ASC 323 governs equity method accounting. The trigger is significant influence over operating and financial policies of the investee, not control, not just ownership.
Common mistakes
- Booking dividends as income. Dividends from an equity-method investee are NOT dividend income: they reduce the investment balance. A 30% holder receiving $30,000 in dividends credits Equity Method Investment for $30,000, not Dividend Income.
- Forgetting basis differential amortization. Reporting the full 25% x $200,000 = $50,000 share of investee NI without subtracting the $2,500 equipment amortization overstates equity in earnings by $2,500. Trap: $50,000 appears as a choice but the correct answer is $47,500.
- Amortizing equity-method goodwill. Equity-method goodwill is NOT separately amortized and NOT separately impairment-tested. It rides inside the investment and is evaluated only when the whole investment is tested for impairment under ASC 323. Trap: a candidate amortizes the $25,000 goodwill over 10 years and overstates expense by $2,500 per year.
Bottom line
- Significant influence (presumed 20-50% voting ownership) triggers the equity method under ASC 323. Below 20% with no other influence indicators is fair value through net income (ASC 321).
- Carrying amount rolls: cost + share of investee NI + share of OCI - dividends received - amortization of basis differential.
- Dividends are return of capital, not income. Booking dividend income double-counts the share of earnings already recognized.
- Basis differential (purchase price over share of book value) is allocated to identifiable assets (depreciate over remaining life) and goodwill (no amortization, but ASC 323 impairs the whole investment as one unit).
Exam shortcut
When a stem describes a 20-50% holding, default to the equity method, but scan the facts for rebutting indicators (loss of voting rights, bankruptcy of investee, contractual restrictions). The dividend trap is the highest-frequency wrong answer: any choice that records dividend income from an equity-method investee is wrong. Remember the rollforward in five layers: Cost + Share of NI + Share of OCI - Dividends - Basis Amortization.
The full lesson (about 3,667 words, 24 min read) adds 2 worked examples, all 7 common mistakes, a self-check, free in the app.
Learning objectives
- II.E3
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