What are the conceptual and accounting implications of the Equity Method of Accounting?

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Equity refers to assets owned in the form of shares. The concept behind the equity method of accounting is that one firm reports its earnings in another company or affiliate. The first company is known as the investor, while the second firm is referred to as the investee or affiliate or unconsolidated subsidiary. The term “unconsolidated” means that both companies report their earnings in different statements. Normally, the investor owns at least twenty percent of the stock or more in the affiliate firm—the acceptable range is between twenty and fifty percent. The other assumption is that the investor has significant influence in the unconsolidated subsidiary. To exert such influence, the investor must have a seat at the investee’s board.

The accounting implications of the equity method of accounting are that the investor has to report the profits and losses of the affiliate firm in their income statement—they are usually recorded as equity income in affiliates. The investor’s equity is also included in their balance sheet. This share amount is inserted in the asset section of the balance sheet as an investment in affiliate. You should also note that the investor has to pay taxes on the dividends that they receive from the investee. Those taxes are deducted from the investor’s gross income.

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