Understanding the Equity Method in Accounting for Investments

The equity method of accounting is a crucial tool for businesses that hold significant influence over other companies. Unlike simple cost-based investment accounting, the equity method ensures that financial statements reflect an investor’s true economic interest in an associate or joint venture. For SMEs, startups, and growing firms entering strategic partnerships or acquiring substantial shares in other companies, understanding when and how to use the equity method is essential for transparent reporting and accurate financial analysis.

This article explains the purpose of the equity method, when it must be applied, how the bookkeeping entries are recorded, and the impact on your financial statements.

When Do We Use the Equity Method?

The equity method is applied when a company has **significant influence** over another entity—usually through ownership of **20% to 50%** of voting shares, or through other forms of influence such as board representation or participation in policy-making.

• Ownership between 20% and 50% typically indicates significant influence.

• Representation on the investee’s board strengthens the case for using the method.

• Material transactions and active involvement in policy decisions also qualify.

When significant influence exists, the equity method must be used under IFRS and most national GAAP standards, ensuring financial statements reflect the investor’s share of the investee’s performance.

Why We Use the Equity Method

The equity method aligns the investor’s financial results with the economic performance of the investee. Unlike fair value methods, which reflect market price changes, the equity method records the investor’s share of the investee’s **profits**, **losses**, and **dividends** directly into the investment account.

• It provides a realistic picture of long-term strategic investments.

• It prevents profit distortion that may occur with simple cost methods.

• It aligns bookkeeping with the true economic relationship between investor and investee.

This method is especially important for SMEs with partnerships, joint ventures, or partially owned subsidiaries where operational decisions are shared.

How Bookkeeping Entries Are Recorded Under the Equity Method

The equity method does not treat the investee as a traded financial instrument. Instead, the investment account is adjusted based on the investor’s proportional ownership of profits and losses.

1. Initial Recognition

The investment is recorded at cost when acquired:

• Debit: Investment in Associate

• Credit: Cash / Bank

2. Recording Share of Profit or Loss

The investor recognizes its share of the investee’s net profit or loss:

• Debit: Investment in Associate (for profits)

• Credit: Share of Profit from Associate (P&L)

For losses, the entry is reversed.

3. Recording Dividends Received

Dividends reduce the investment balance—not recognized as revenue:

• Debit: Cash / Bank

• Credit: Investment in Associate

This approach prevents double-counting of income.

Impact on Financial Statements

The equity method impacts both the balance sheet and the income statement, offering a more integrated representation of the investment.

• Balance Sheet: The “Investment in Associate” account increases with profits and decreases with losses and dividends.

• Income Statement: The investor’s share of the associate’s profit appears as a single line item: “Share of Profit from Associate.”

• Cash Flow: Only dividends affect cash flows; profits do not generate immediate cash movements.

This method results in smoother income recognition and prevents volatility from market price fluctuations.

Equity Method vs. Other Accounting Methods

The equity method sits between two other investment accounting treatments:

• Cost Method: Used for small investments without influence (usually < 20%).

• Consolidation: Used when the investor has control (usually > 50%).

The equity method is ideal for situations where involvement is meaningful but not controlling.

Conclusion

The equity method of accounting offers SMEs and growing companies an accurate way to reflect the economic value of their strategic investments. It provides clarity, ensures compliance with IFRS and GAAP, and gives investors and management a more reliable financial picture. Whether your business is partnering with another entity or expanding its investment footprint, applying the equity method correctly strengthens financial transparency and supports better decision-making.

Learn more about accounting services and how we support SMEs with IFRS, GAAP compliance, and investment reporting. Explore our resources on financial reporting and financial advisory or book a consultation with our team today for tailored guidance.

Book a Consultation