Understanding Equity Method Accounting: Net Income, Dividends, and Ownership Changes, Schemes and Mind Maps of Accounting

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The Equity Method of

Accounting: How

Minority Stakes in Other

Companies Work on the

Financial Statements

Net Income, Dividends, and Confusing Gains

and Losses

Equity Investments: Say What?! “Can you explain how the accounting for Equity Investments or Associate Companies works? Where do Net Income and Dividends go? What happens if a company changes its ownership percentage? What about Unrealized Gains and Losses?”

Part 1: Basic Minority-Stake Deal

• Assumptions: Need the Sub Co.’s Market Cap and the percentage we want to acquire, as well as both companies’ statements
• Cash Flow Statement: Record this acquisition as a cash outflow in Cash Flow from Investing, with Debt Issued below it in CFF
• 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)
• IS / CFS: Record Sub Co. Ownership Percentage in Period * Sub Co. Net Income on the IS, New Interest Expense, and Ownership Percentage * Sub Co. Dividends on the CFS

Part 2: Changing the Ownership Stake

• Constraint: We’re going to limit the ownership percentage to 49%, at most, because above that, the accounting changes and gets much more complicated
• Assumptions: Need the Sub Co.’s Market Cap and the new Ownership Percentage in each year (end-of-year changes only)
• Easy Part: Percentage Change in Equity Investments and the Change in the Equity Investment Dollar Amount (Market Cap * % Change)
• Harder: If the 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)

Part 2: Changing the Ownership Stake

• Logic, Continued: Next part is easiest to understand with a specific example… let’s say the Sub Co. Market Cap is $150, Previous Ownership % is 30%, Cost Basis is $30, and New Ownership % is 15%
• So: $150 * 30% = $45, and, therefore, the Total Gain or Loss is $45 – $30 = $
• BUT we don’t necessarily sell the entire investment!
• Last Part: Adjusts for this, so if we’re selling just 15%, 15% / 30% = 50%, so the Gain is $15 * 50% = $7.5 instead

Part 2: Changing the Ownership Stake

• Linking the Statements: Realized Gains and Losses always appear on the IS and are reversed on the CFS
• Cash Flow from Investing: The Purchase / Sale of Equity Investments line item handles the rest – that, plus the Gain or Loss, equals the change in the Equity Investment line item
• Testing: Try different Ownership Percentages, Market Caps, Debt/Cash splits, etc., to test this model

Recap and Summary

• Gain or Loss Formula: =IF(Percentage Change is Negative, (Sub Co. Market Cap * Previous Ownership Percentage – Cost Basis) * – Percentage Change / Previous Ownership Percentage, 0)
• Why: Adjusts for the fact that the company might sell only part of its stake, not the entire investment, and reduces the Gain or Loss proportionally