Equity Method of Investments & Depreciation Adjustment
Companies use the equity method to account for purchases of 20 percent to 50 percent of the voting shares of another company, the investee. The equity method assumes that the investor has significant influence over the investee. Depreciation and amortization can affect the investor’s book value of the investee shares.
Under the equity method, the investor creates a noncurrent asset representing the purchase price of the investee’s shares. The investor subsequently recognizes its share of investee profits and losses by updates to its income account and to the noncurrent asset. For example, if an investor owns 25 percent of an investee’s voting shares, and the investee announces $2 million in profits for the quarter, the investor books $500,000 as income and as an increase to the noncurrent asset. The investor subtracts from the asset any dividends it receives on the investee shares, because these payments are a return of investment rather than income.
The price the investor pays for the investee shares might be higher than their book value -- the historical values of assets minus liabilities. The investor accounts for the excess over book value in two ways. The company first allocates the excess to undervalued assets and liabilities -- ones with a fair, or market, value higher than their book values. For instance, if a piece of equipment has a fair value of $100,000 but a book value of $60,000, the investor would create a memo assigning 25 percent of $40,000, or $10,000, of the excess to the equipment. After distributing the excess to all undervalued assets and liabilities, the investor assigns any remaining excess to the noncurrent asset "goodwill."
Depreciation is an accounting procedure to expense the cost of a long-lived asset over a number of years, called the recovery period. Different assets have different recovery periods, and the Internal Revenue Service publishes a set of standard recovery periods under the modified accelerated cost recovery system, or MACRS. A company uses these recovery periods for taxation purposes but may use different periods for financial reporting. Companies can choose from different methods of calculating the annual depreciation expense, such as the straight line or declining balance methods. Depreciation reduces the book value of assets.
Under the equity method, an investor amortizes, or expenses, the excess over book value paid for its share of the investee's tangible long-lived assets. For long-lived assets, book value is purchase price minus accumulated depreciation. The investor amortizes the amount above book value it allocates to investee assets. The investor amortizes the excess over a period equal to the recapture period of the asset. From our example, the depreciated book value of the equipment is $40,000 below its fair value. The investor amortizes its share, 25 percent, of the $40,000 over the recovery period for the equipment. If the recovery period is 10 years and the investor uses the straight-line method with no salvage value, the annual amortization adjustment is $1,000. This expense reduces the book value of the investee shares on the investor’s balance sheet.