What Is the Equity Method of Accounting? Definition and Examples
By Markets & Investing DeskUpdated Nov 10, 2026
Definition
The equity method is how a company accounts for an investment it significantly influences but does not control, adjusting the cost for its share of profits, losses and dividends.
Key takeaways
- Both ASC 323 and IAS 28 presume significant influence once an investor holds 20% or more of voting power.
- Dividends received reduce the investment's carrying amount because the underlying earnings were already recognized.
- Under U.S. GAAP an impairment write-down is not reversed, while IFRS allows a later recovery to reverse it.
- Equity income is non-cash until paid out, so it is subtracted in operating cash flow under the indirect method.
The equity method of accounting is the way a company reports an investment in another business over which it has significant influence but not control. The investor records the investment at cost. It then raises or lowers the carrying amount by its share of the investee’s profits or losses, and reduces it by dividends received. In practice, the equity method applies to stakes that usually fall between 20% and 50% of the investee’s voting shares. It is also the required treatment for joint ventures under international standards.
How the Equity Method Works
The equity method is built around significant influence: the power to take part in an investee’s financial and operating policy decisions without controlling them. In U.S. GAAP the governing standard is ASC 323. Under IFRS it is IAS 28, Investments in Associates and Joint Ventures. Both standards presume significant influence when an investor holds 20% or more of the voting power, directly or through subsidiaries.
Ownership percentage is a starting point, not the whole test. The standards list indicators that point to significant influence:
- Representation on the investee’s board of directors
- Participation in policy-making, including decisions about dividends
- Material transactions between the investor and the investee
- Interchange of managerial personnel
- Technological dependency, such as the investee relying on the investor’s essential technical information
When the 20% Presumption Does Not Hold
The presumption can be overcome in either direction. An investor with less than 20% may still apply the equity method if it can show significant influence, for example through a board seat and heavy intercompany trade. An investor with more than 20% may be unable to use it if evidence shows it lacks influence. Examples include an investee that opposes the investor’s attempts to exercise influence, or a situation where another shareholder controls the company outright.
Investors also disclose their equity method investments in the notes to the financial statements. These notes include the name of each significant investee and the percentage owned.
Recording Equity Method Changes on the Financial Statements
The investment is a single asset line on the investor’s balance sheet, usually labeled “investment in associates” or “investments accounted for using the equity method.” The following events change its carrying amount:
- Initial recognition. The investment is recorded at cost: the purchase price plus transaction costs.
- Share of profit or loss. Each period the investor multiplies the investee’s net income or loss by its ownership percentage. It recognizes that amount as a single line on its income statement, often labeled “equity in earnings of investees” or “share of profit of associates,” and adds it to (or subtracts it from) the investment account. This share of earnings, not the dividends received, is the investor’s investment income.
- Dividends. Cash dividends from the investee debit cash and credit the investment account. They are a return of part of the investment because the earnings behind them were already recognized. Recording them as income as well would count the same profit twice.
- Other comprehensive income. The investor records its share of changes in the investee’s other comprehensive income, such as foreign currency translation adjustments, in its own OCI rather than in net income.
- Basis differences. If the investor pays more than its share of the investee’s book value, the excess goes first to the gap between the fair value and book value of identifiable assets. Any remainder is equity method goodwill. Excess allocated to depreciable assets is amortized over their lives, which reduces equity income. Excess allocated to land affects income only if the land is sold or impaired. Equity method goodwill is not recorded separately or tested for impairment on its own.
- Intercompany profits. Unrealized profits on sales between the investor and the investee are eliminated to the extent of the investor’s interest until the goods are sold to an outside party.
- Impairment. Under U.S. GAAP, a decline in fair value below carrying amount that is other than temporary leads to a write-down that is not later reversed. Under IFRS, the net investment is tested under IAS 36, and a later recovery can reverse the loss.
Together, these rules give the formula:
Ending carrying amount = Beginning carrying amount + Share of net income (or − share of net loss) − Dividends received ± Share of OCI − Basis difference amortization − Impairment
The investor’s share of earnings is non-cash until paid out, so under the indirect method it is subtracted in the operating section of the cash flow statement. Dividends received are the cash actually collected. In free cash flow analysis, reported equity income can be much larger than the cash the investor receives.
Example of the Equity Method of Accounting
Hypothetical example. On January 1 of Year 1, Harbor Holdings buys 25% of Northline Logistics for $4,000,000, which equals its share of Northline’s book value (so there is no basis difference). Assume Harbor has significant influence, and that there are no intercompany sales or OCI items.
Year 1. Northline reports net income of $1,200,000 and pays total dividends of $400,000.
- Purchase: debit Investment in Northline $4,000,000; credit Cash $4,000,000.
- Share of income: $1,200,000 × 25% = $300,000. Debit Investment in Northline $300,000; credit Equity in Earnings of Northline $300,000.
- Dividends received: $400,000 × 25% = $100,000. Debit Cash $100,000; credit Investment in Northline $100,000.
Year-end carrying amount: $4,000,000 + $300,000 − $100,000 = $4,200,000.
Year 2. Northline reports a net loss of $800,000 and pays no dividend.
- Share of loss: $800,000 × 25% = $200,000. Debit Equity in Losses of Northline $200,000; credit Investment in Northline $200,000.
Year-end carrying amount: $4,200,000 − $200,000 = $4,000,000.
At the end of Year 2, Harbor concludes that Northline has lost major contracts and that the investment’s fair value has fallen to $3,600,000. Harbor judges the decline to be other than temporary (the U.S. GAAP test). It records an impairment loss of $400,000 ($4,000,000 − $3,600,000) and writes the investment down to $3,600,000.
Year 3. Assume Harbor sells its entire stake on January 1 for $3,900,000, before any Year 3 results are recorded. The gain on sale is proceeds minus carrying amount: $3,900,000 − $3,600,000 = $300,000, recognized in net income. Any amounts accumulated in OCI for this investment would also be reclassified on disposal. There are none here.
Equity Method vs. Cost, Fair Value and Consolidation
| Treatment | Typical relationship | Balance sheet | Income recognized |
|---|---|---|---|
| Fair value (or cost-based measurement) | No significant influence, usually under 20% | Fair value, or cost for certain investments without a readily determinable fair value | Dividends received, plus fair value changes where applicable |
| Equity method | Significant influence, usually 20% to 50%; joint ventures | Cost adjusted for share of results, dividends and other items | Share of investee’s net income or loss |
| Consolidation | Control, usually over 50% | Investee’s individual assets and liabilities combined with the parent’s | Investee’s full revenue and expenses, with a noncontrolling interest line |
Cost method vs. equity method. Under the cost method, an investment stays at historical cost and dividends are recorded as income when declared. A gain is recognized only on a sale above cost. Under the equity method, income comes from the investee’s earnings and dividends reduce the carrying amount. Current U.S. GAAP requires most equity investments without significant influence to be measured at fair value through net income. It allows a cost-based alternative only where fair value is not readily determinable. Under IFRS 9, an investor can elect fair value through other comprehensive income (FVOCI) for some equity investments. That election is a fair value measurement, not the equity method, and it does not apply to associates.
Equity method vs. consolidation. Consolidation brings the subsidiary’s entire revenue, expenses, assets and liabilities into the parent’s statements. The equity method shows a single line on each statement. An equity method investee is sometimes loosely called an “equity method subsidiary,” but it is not a subsidiary in accounting terms. A subsidiary is controlled and consolidated. An associate is influenced and accounted for with the equity method.
Limitations of the Equity Method of Accounting
- Judgment in classification. Whether significant influence exists can depend on facts beyond the ownership percentage, so two companies with similar stakes may account for them differently.
- One-line reporting hides detail. Readers see the net share of profit, not the investee’s revenue, debt or margins. An associate with heavy borrowings adds no liabilities to the investor’s balance sheet.
- Earnings are not cash. Equity income can far exceed dividends received, and companies differ on whether to include it in measures such as EBITDA.
- Carrying amount is not market value. Cost plus accumulated results may differ widely from what the stake would fetch in a sale until an impairment or disposal brings that difference into the accounts.
- Dependence on the investee’s reporting. The investor’s figures are only as timely and reliable as the investee’s statements, which may need adjustment to match the investor’s accounting policies.
FAQs
What happens when an investee's losses exceed the investment balance?
The investor generally stops recording its share of losses once the carrying amount reaches zero. The exception is when it has guaranteed the investee's obligations or committed to provide further financial support. Under IAS 28, long-term interests such as certain loans to the associate also absorb losses before recognition stops. If the investee later returns to profit, the investor resumes recognizing its share only after that share of profits equals the share of losses it did not recognize.
Are associates in separate financial statements recorded at cost or using the equity method?
Under IFRS, an investor that prepares separate (parent-only) financial statements can choose to carry associates at cost, at fair value under IFRS 9, or using the equity method, as permitted by IAS 27. In its main consolidated or investor-level statements, the equity method still applies.
The Bottom Line
Investors reading the statements of companies with stakes of roughly 20% to 50%, or with joint ventures, should treat equity method income carefully. The single reported line hides the investee's revenue and debt, and the earnings can far exceed the cash dividends actually collected. Comparing equity income with dividends received and checking the notes for significant investees gives a clearer view of what the stake contributes.
