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What are Equity Method Investments?

Companies use the equity method to report their profits earned through investments in other companies. The investor company will report the revenue earned by the investee company in its income statement, with the percentage of the equity investment in the investee company.

Investor companies will use the equity method to report their investments in the investee company when they have:

  • Significant influence but not control.
  • Usually, but not always, a stake between 20% and 50%.
    • Exception – if the investor company owns 55% but anti-trust issues prevent it from having control.
    • Exception – if you have a board veto and own 45%, then you would probably fully consolidate.

The investor company would report the investment as a one-line consolidation – one line on the income statement, balance sheet and cash flow statement. The investment on the balance sheet would reflect at the original cost, then retained earnings would be added over time. In most cases, the balance sheet does not reflect the fair value of the investment.

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Example

Nestle owns a 23.2% stake in L’Oreal, which is treated as an equity method investment:

On the income statement is a one-line called “Income from Associates and Joint Ventures”. The line is below tax and shown net of taxes. So Nestle’s share of income from equity method investments (which is largely L’Oreal) is 916MM.

On the balance sheet, a long-term asset shows the original purchase price plus any reinvested earnings to date:

The notes to the accounts provide more detail:

For L’Oreal, the 2018 year started with 8,184MM and Nestle then added it’s share of L’Oreal’s net income of 1,044MM (this number is different than the 919MM on the income statement as there were other associates and JVs, some of which were lossmaking so Nestle took their share of the other company’s losses). When Nestle receives dividends from L’Oreal these are deducted from the investment and added to the cash balance.

On the cash flow statement, the equity income of 1,044MM is subtracted in the cash flow from operations, and usually the dividends received are added to the cash flow from operations (there is scope under IFRS to add the dividends received to the cash flow from investing activities).

Accounting Entries

The initial purchase of the equity investment – 20% of the equity in Company B. for $100 million by Company A. Here are the impacts on Company A’s financial statements.
Assets (Company A)   L&E  
Cash

(100.0)

Equity investments

100.0

Company B records net income of $60 million after-tax.
Assets (Company A)   L&E  
Equity investments

12.0

 =60*20% RE equity income

12.0

Company B pays dividends of $30 million in total.
Assets (Company A)   L&E  
Equity investments

(6.0)

 =30*20%*-1

Cash

6.0

Points to Note

  • Company A reduces its cash with $100 million and shows its investment in Company B.
  • Although Company B earned $60 million net income, Company A only reports 20% of that in their books since that is their investment in Company B.
  • When Company B declared a dividend of $30 million, Company A reported only $6 million since they are entitled to 20% of that.
  • Company A increased their cash with the dividend amount ($6 million) but decreased their equity investment since they received the dividend from Company B. If they had increased their investment, they would be double-counting.

The dividend accounting is confusing as many people want to put the 6.0MM in dividends into the income statement. However, Goran has already taken 12.0MM to the income statement – its share of net income, taking the dividends as well, would be double counting.

Remember, when a public company pays a dividend its stock price drops. So, we reflect the decrease in Goran’s equity value by deducting the dividend from the equity method investment.

Summary of changes to the equity investment  
Beginning balance

0.0

Purchases

100.0

Share of income

12.0

Share of dividends

(6.0)

Ending balance

106.0

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