When a company owns a substantial portion of another business -- but it isn't a majority owner, which would make it the parent -- generally accepted accounting principles, or GAAP, require that the investment be recorded under the equity method of accounting. Every investment is different, but the equity method journal entries follow the same typical format. Despite not being the parent company, minority owners who use the equity method can still exert “significant influence” over the businesses they invest in.

What Is Significant Influence

For many investors, the determining factor for assessing whether the equity method of accounting is appropriate for reporting an investment in a business is the ability of your company to exercise significant influence over how it operates. Pursuant to Accounting Standards Codification 323, or ASC 323, significant influence is presumed, and the equity method required, if you hold an ownership interest between 20 and 50 percent. This presumption isn't set in stone -- meaning your company may be able to exert significant influence as a 15 percent investor, or even have very little influence over business decisions as a 25 percent owner. In cases where ownership percentages don't reflect the true influential power of your company, ASC 323 notes other factors to consider, such as the level of authority your company has over the business's financial and operating policies, your company's presence on the business's board of directors and whether managerial employees are shared by the two companies.

Journal Entry to Record Investment

Suppose your company acquires 30 percent of the outstanding shares in ABC Inc. for $300,000. The initial journal entry under the equity method is to record the outflow of cash and to add the investment as a noncurrent asset on its balance sheet as follows:

Investment in ABC (debit) 300,000 Cash (credit) 300,000

Recording Equity Income and Losses

Under the equity method, an investor increases and decreases the book value of the investment to reflect the earnings and losses reported by the affiliate -- the business your company invests in -- in proportion to the percentage of ownership. For example, if ABC reports net income of $100,000, your company must book the following journal entry to increase the value of its investment by $30,000 for its 30 percent share of the affiliate's income.

Investment in ABC (debit) 30,000 Equity income in ABC (credit) 30,000

If ABC reports a $30,000 loss instead, the journal entry is reversed as follows:

Equity income in ABC (debit) 30,000 Investment in ABC (credit) 30,000

Dividends Decrease Investment's Book Value

When affiliates distribute earnings to owners, the distribution, such as a dividend payment, reduces the book value of your investment in the affiliate on the balance sheet. Therefore, if ABC issues a $10,000 dividend, your company will receive $3,000 of it. This requires a third journal entry to decrease the investment value by $3,000 and to reflect the inflow of cash.

Cash (debit) 3,000 Investment in ABC (credit) 3,000