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Equity method of accounting for investment solutions

Written By: wwwcspwritescom

The equity accounting method is used to report ownership by a company of unconsolidated subsidiaries, where the purchasing company has significant board influence but never total control. The extent of ownership for controlling companies using this method ranges from 20% to 50%.

When using equity accounting, the company does not record the assets or liabilities of the subsidiary on its balance sheet. Instead, a reduction in cash equivalent to the acquisition cost will compensate the record of an investment in affiliate non-current assets at the equivalent purchase price.

Example: Company X buys 30% of Company Y’s stock (allowing voting rights) for $1000

Non-current assets: Investment in affiliate: $500 ↑

Current assets: Cash: $500 ↓

 

Earnings

The earnings reported in the subsidiary’s income statement will be taken into account to increase or decrease the investment in affiliate assets shown in the controlling company’s balance sheet. This amount will be the acquisition percentage applied to those earnings.

As a result of these profits, a new record named “equity income affiliate” will be added to the equity section of the investing company in order to reflect these gains. Matching the resulting increase in equity, investment in affiliate will move up the same quantity.

Example: Company Y reports a net profit of $100.

Equity income affiliate increase= $100*30% ownership= $30

Assets: Investment in affiliate: $30↑

Equity: Equity income affiliate: $30↑

 

Subsidiaries can also choose to distribute part of their earnings in the form of dividends. In doing so, the acquiring company will receive the percentage of dividends to which it holds the right. Subsequently, the cash reserves will increase, but the account detailing investment in affiliate entries will be reduced by the same amount because dividends are considered a return of capital.

Example: Company Y announces a $50 dividend.

Cash in dividends received by company X from company Y= $50*30%= $15

Non-current assets: Investment in affiliate: $15↑

Current assets: Cash: $15↓

 

Taxes on dividends

Taxes are paid only on cash dividends received from the controlled company. Dividend payments are entitled to the Dividends Received Deduction (DRD), which applies a tax percentage from which the receiving company is exempt. The exemption percentage increases as the equity interest in a particular company moves higher.

 

Companies displaying ownerships between 20% and 80% are entitled to an 80% tax deduction. DRD is used to reduce the effects of triple taxation on dividends.

Triple taxation occurs as a result of dividends transferred from the subsidiary to the controlling company originating from already taxed net income. After this, dividends are taxed as income to the controlling company. Finally, controlling company’s shareholders are taxed for their cash payments in dividends.

 

Taxes on undistributed earnings

Any increase in undistributed earnings resulting in an equity income in
affiliate increase will result in a Deferred Tax Liability. This quantity will be paid when these earnings are distributed in dividends or the controlled stock is liquidated.

Applying for DRD to reduce the Deferred Tax Liability expense is possible; however, as many times companies do not pay the expected dividends, this deduction will be used very rarely.

Taxes Example:

Using previous dividend and equity numbers under a 35% tax rate and 80% DRD tax exemption

Cash tax expenses: $15 (dividends)*(1-80%)*35%(tax applied)= $1.05

Deferred tax liability: [$30 (equity income)-$15(dividends)]*35%= $5.25

Total income tax expense= $6.3