In this tutorial, you’ll learn about the Equity Method of Accounting for recording minority stakes in other companies, and you’ll see how Net Income, Dividends, and changing ownership stakes flow through the financial statements.
Resources:
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Table of Contents:
0:00 Introduction
1:01 Basics of Equity Method Accounting
3:55 Equity Investments on the 3 Statements
9:24 Changing Ownership Percentages
16:40 Recap and Summary
Lesson Outline:
The Equity Method of Accounting is used when one company has “significant influence,” but not control, over another company (e.g., 20-50% ownership stake, or technically anything under a 50% stake).
The basic idea is that Parent Co. records its Ownership Percentage in Sub Co. * Sub Co.’s Net Income on its Income Statement under “Equity Investment Earnings” or a similar name, such as “Net Income from Equity Investments.”
Then, Parent Co. reverses that item on its Cash Flow Statement and records Ownership Percentage in Sub Co. * Sub Co.’s Dividends as a positive on its CFS; both items link into Equity Investments on the Balance Sheet.
As starting assumptions, we need Sub Co.’s Market Cap and the percentage we want to acquire, as well as both companies’ financial statements.
On the Cash Flow Statement, we record the initial acquisition as a cash outflow in Cash Flow from Investing, with Debt Issued to fund this acquisition below it in Cash Flow from Financing.
On the Balance Sheet, link the Equity Investment line item to all the Equity Investment-related items on the CFS (Gains/Losses, Purchases/Sales, Net Income, and Dividends).
Subtract each line item because you always subtract CFS line items when linking to them from the Assets side of the Balance Sheet.
On the Income Statement, record Ownership Percentage in Sub Co. * Sub Co. Net Income, and factor in the New Interest Expense if Debt was used to fund the deal.
On the Cash Flow Statement, record Ownership Percentage * Sub Co. Dividends as a positive cash inflow within Cash Flow from Operations.
Changing Ownership Percentages
We limit the ownership percentage to 49%, at most, because above that, the accounting gets much more complicated, and we need more than this simple model.
As starting assumptions, once again, we need the Sub Co.’s Market Cap and the new Ownership Percentage in each year (only end-of-year changes are allowed).
The Percentage Change in Equity Investments and the Change in the Equity Investment Dollar Amount (Market Cap * % Change) are both easy, and we have them from the previous part.
If Parent Co.’s stake in the Sub Co. decreases, it sold some of its stake, which means we need to calculate the Realized Gain or Loss on it (Unrealized Gains/Losses do not show up).
First, calculate the Cost Basis right before the change, i.e., Old Equity Investments - Equity Investment Earnings - Equity Investment Dividends.
Because of the signs on the CFS, this formula means that we add the Equity Investment Earnings and subtract the Dividends.
Then, the formula for the Realized Gain or Loss is:
=IF(Percentage Change is Negative, (Sub Co. Market Cap * Previous Ownership Percentage - Cost Basis) * -Percentage Change / Previous Ownership Percentage, 0)
We cannot possibly have a Gain or Loss if the Ownership Percentage has increased, so we check that part first; if the percentage change greater than or equal to 0, set the Gain/Loss to 0.
The next part, (Sub Co. Market Cap * Previous Ownership Percentage - Cost Basis), represents the Gain or Loss on the entire minority stake.
But the company may not have sold the entire stake - it could have sold only a percentage of it!
Therefore, the last part, -Percentage Change / Previous Ownership Percentage, adjusts for that and reduces the Gain or Loss proportionally based on the percentage sold.
To link the statements, record the Realized Gains and Losses on the Income Statement and reverse them on the Cash Flow Statement.
The Purchase / Sale of Equity Investments line item within Cash Flow from Investing handles the rest - that, plus the Gain or Loss, equals the change in Equity Investments when the ownership stake changes.