Facts

• The ability to exert significant influence is the determining factor in applying the equity method. Significant influence usually means an ownership level greater than 20 percent but less than 50 percent. To use the equity method and meet the "significant influence" test, the parent company -- which is the investing company -- must meet several other conditions, such as board representation in the subsidiary or the investee company, decision-making involvement and the presence of significant inter-company transactions.
  
  

Journal Entries

• In the equity method, the parent company recognizes the subsidiary's net income or loss on a prorated basis. For cash dividends, the parent company's journal entries are to debit (increase) the cash account and credit (decrease) the "investment in subsidiary" account when it receives the cash dividends. The investment in subsidiary account includes the acquisition cost of the subsidiary plus the prorated income or loss of the subsidiary. Dividends reduce this account because they come from after-tax income.
  
  For example, if a company owns 25 percent of a subsidiary that pays $1 million per quarter in dividends, the journal entries are to debit cash and credit investment in subsidiary by $250,000 each -- $1 million multiplied by 25 percent.
  
  

Changes

• If the ownership percentage and the influence level change, the parent company may have to use a different accounting method for the equity interest in the subsidiary. For example, if a company buys additional shares and owns a majority stake in the subsidiary, it must use the consolidated method and combine the financial statements. Similarly, if the company changes to the equity method from some other method, it must make the appropriate adjustments to the investment in subsidiary account on the balance sheet.
  
  

Issues

• Issues with the equity method include an overemphasis on ownership levels and using subjective assessments to determine the level of influence and control. The equity method could prevent income manipulation. For example, without the equity-method requirement, companies could decide to recognize income only when they receive cash dividends, thus potentially deferring taxes for a long time.