Equity Method of Accounting for Investment Journal Entries
When your small business buys a stake in another company, the method used to account for the investment depends on your level of ownership. Generally accepted accounting principles, or GAAP, require you to use the equity method when you have significant influence, but not control, over another company. The journal entries used to account for the investment in your records differ from those of other methods.
You usually must use the equity method when you own between 20 to 50 percent of another company’s voting stock. The equity method requires a journal entry when you buy the stock, when the other company reports a profit or loss, and when it pays a dividend. Because of the close relationship between you and the acquired company, your share of its profits and losses affect your financial statements similar to your own profits and losses.
The initial purchase of the other company’s stock increases your investment account and decreases your cash account on your balance sheet. To record this in a journal entry, debit your investment account by the purchase price and credit your cash account by the same amount. For example, if your small business buys a 40-percent stake in one of your suppliers for $400,000, you would debit the investment account and credit cash each by $400,000.
The accounting value of your investment and your profit on your income statement rise by your proportionate share of the other company’s profits. Your profit share equals your percentage stake times the other company’s profit. When the other company reports a profit, debit your investment account by the amount of your profit share and credit your “investment income” account by the same amount. Using the previous example, if the other company reports a $100,000 profit, debit your investment account and credit your investment income account each by $40,000.
If the other company reports a loss instead of a profit, the journal entry is the opposite of the profit entry. Debit your “investment loss” account by your share of the loss and credit your investment account by the same amount. Your share of the loss reduces your investment’s accounting value and decreases your profit on the income statement. In the previous example, if the company had instead reported a $50,000 net loss, you would debit the investment loss account and credit the investment account each by $20,000.
When the acquired company pays you a dividend, the equity method considers this a return of your investment rather than income. The dividend reduces your investment’s value but has no effect on your profit. In a journal entry, debit your cash account by the amount you receive and credit the investment account by the same amount. For example, if the acquired company pays your small business an $8,000 dividend, debit $8,000 to cash and credit $8,000 to your investment account.