By Michael French, CPA, ABV, CFE, Managing Director

The equity method of accounting is an accounting method used to report activity from a minority investment or a joint venture that a company may have in another company. In the merger and acquisition environment, the equity method is sometimes referred to as the one line method of accounting for an investment.

The equity method is used to account for a company's investment when it is considered to have significant influence over the investee company. “Significant influence” is defined as holding at least 20% of the investee company, but less than 50%.

With the equity method of accounting, the investor company reports the revenue earned by the other company on its income statement in an amount that is proportional to the percentage of its equity investment in the other company. It may be called “income from joint venture” or “equity and earnings from investment.”

The investment is initially recorded at historical cost, and adjustments are made to the value based on the investor’s percentage ownership in net income, loss and dividend payouts. Net income of the investee company increases the investor’s asset value on their balance sheet, while the investee’s loss or dividend payout decreases it.

Role in Business Transactions

In a sale or potential merger transaction, an acquiring company may not be interested in buying the investment, especially if such investment is not related to the core business of the target company. Often, sellers will either divest themselves of such investments or not include the investment in the sale or merger.

Regardless of the decision, the income or loss from that investment must be identified separately in the financials to give the buyer an accurate financial picture of the company. A buyer who is not inclined to include the investment in the purchase will want to know whether the numbers included on the income statement will positively or negatively impact the overall company’s performance.

Key Issues to Consider

For both sellers and buyers, when there is an equity investment in another company some of the key issues to consider include:

• Figure out if including the investee company makes sense. Some buyers may want the investee if it is in a vertical business to the target.
• For the seller, any agreements with the investee company should be consulted first to determine if there are any restrictions or other adverse consequences in transferring the investment.
• If the investee company is to be included in the transaction, ensure that all disclosures for the investee company are included in the information provided to the buyer.

In summary, the equity method of accounting is a method to report investments in another company when certain criteria are met. Buyers and sellers need to understand how equity investments impact financial statements.

Contact

For more information or a discussion about how the equity method of accounting may impact a transaction you are considering, contact your PKF Advisory team member or:

Michael French, CPA, ABV, CFE
Managing Director
Tel: 949.860.9891
Email: mfrench@pkfadvisory.com