The equity method and joint arrangements

On 1 January 2026 Larkspur pays $900,000 for 30 percent of the voting shares of Cedar Point Analytics, a private company that builds software for interpreting sensor data. Larkspur appoints two of Cedar Point's seven directors and licenses its sensor protocols to Cedar Point. Larkspur clearly has significant influence but not control. This lesson shows how Larkspur accounts for Cedar Point using the equity method, and then turns to joint arrangements, where two or more parties share control.

The logic of the equity method

Under the cost method, an investor recognizes income only when the investee declares dividends. If the investor can influence the dividend policy, it could time its income by deciding when the investee pays out. Fair value measurement, the alternative for passive holdings, ignores the investor's involvement in the investee's operations and can be hard to apply to private investees. The equity method answers both problems. It treats the investor's share of the investee's profit as the investor's own income as soon as the investee earns it, and treats dividends as a return of part of the investment rather than as income.

The basic entries are simple. The investment is recorded at cost. Each period, the investor increases the investment and recognizes income for its share of the investee's profit (or decreases both for a loss). It recognizes its share of the investee's other comprehensive income in its own OCI. When the investee pays a dividend, the investor debits cash and credits the investment, because the dividend converts part of the investment into cash.

ASC 323 requires the equity method for investments that give significant influence over common stock or in-substance common stock, unless the investor elects the fair value option under ASC 825. Investment companies measure such holdings at fair value. Unlike IFRS, US GAAP also uses the equity method for many investments in partnerships and LLCs that maintain specific ownership accounts when the investor's interest is more than minor, often interpreted as 3 to 5 percent.

The acquisition differential

An investor rarely pays exactly its share of the investee's carrying amounts. The difference between the cost of the investment and the investor's share of the carrying amount of the investee's net assets is called the acquisition differential (Canadian textbooks) or basis difference (US practice). It is allocated, in memorandum records only, to the investor's share of the differences between fair values and carrying amounts of the investee's identifiable assets and liabilities, with any remainder treated as goodwill. Amounts allocated to depreciable or amortizable assets are amortized over those assets' remaining lives, reducing the investor's share of profit; amounts allocated to inventory are expensed as the inventory is sold; goodwill is not amortized but is part of the carrying amount tested for impairment.

Unrealized profits on transactions with the investee

When an investor and an associate trade with each other, part of the profit on goods still held by the buyer has not been earned from the group's point of view. Under both IFRS and US GAAP, the investor eliminates its share of unrealized profits and losses on such transactions, whether the sale is downstream (investor to investee) or upstream (investee to investor). Only the investor's percentage is eliminated, because the other owners of the associate are outside parties. The elimination is reversed in the period the buyer sells the goods to an outside party, when the profit is realized.

The IASB is revising IAS 28. Its September 2024 exposure draft proposed recognizing the full gain or loss on transactions with associates and joint ventures instead of eliminating the investor's share; the IASB expects to issue the revised standard in the first half of 2027, effective 1 January 2029. US GAAP has no comparable project, so this difference may grow.

# Equity method schedule for Larkspur's 30% investment in Cedar Point (illustrative)
cost, share = 900_000, 0.30
building_diff, life = 0.30 * 300_000, 20
years = [  # (year, investee profit, dividends, unrealized downstream profit at year end)
    (2026, 500_000, 150_000, 40_000),
    (2027, 560_000, 180_000, 25_000),
]
inv, prior_unreal = cost, 0
print(f"{'Year':>4} {'Share':>9} {'Amort':>7} {'Unreal adj':>11} {'Income':>9} {'Dividends':>10} {'Investment':>11}")
for yr, profit, div, unreal in years:
    s = share * profit
    amort = building_diff / life
    unreal_adj = share * (prior_unreal - unreal)   # realize last year's, defer this year's
    income = s - amort + unreal_adj
    inv += income - share * div
    print(f"{yr:>4} {s:>9,.0f} {amort:>7,.0f} {unreal_adj:>11,.0f} {income:>9,.0f} {share*div:>10,.0f} {inv:>11,.0f}")
    prior_unreal = unreal

Year     Share   Amort  Unreal adj    Income  Dividends  Investment
2026   150,000   4,500     -12,000   133,500     45,000     988,500
2027   168,000   4,500       4,500   168,000     54,000   1,102,500

In 2027 the profit deferred at the end of 2026 is realized when Cedar Point sells the goods, so Larkspur adds back $12,000 and defers 30 percent of the new $25,000, a net adjustment of $4,500. Equity income for 2027 is $168,000 ($168,000 share, less $4,500 amortization, plus $4,500 net realization) and the investment rises to $1,102,500. The schedule shows how the equity method tracks the investee's growth year by year.

Losses, impairment and presentation

If an associate makes losses, the investor's share reduces the investment. When the investment reaches zero, the investor stops recognizing further losses unless it has guaranteed the investee's obligations or otherwise committed to provide further support. Under IFRS, the interest that absorbs losses includes long-term interests, such as loans to the associate that are in substance part of the net investment. If the associate later returns to profit, the investor resumes recognizing its share only after its share of profits equals the share of losses not recognized.

Under ASC 323, an equity method investment is impaired when a decline in value is other than temporary. The loss is measured as the difference between carrying amount and fair value and cannot be reversed. Equity method goodwill is not tested separately under ASC 350; the investment as a whole is evaluated. IFRS, by contrast, uses an IAS 36 recoverable amount test and permits reversals.

The investor presents its equity in earnings of investees as a separate line in the income statement, often after operating income, and the investment as a non-current asset. SEC registrants may need to provide summarized financial information, or even full financial statements, for significant equity method investees under Regulation S-X. Distributions received are classified in the cash flow statement as operating to the extent of cumulative equity in earnings and as investing beyond that, or using the nature of the distribution approach, as an accounting policy.

Joint arrangements

US GAAP uses the term corporate joint venture for an entity owned and operated by a small group of businesses as a separate business, with joint control. Investors account for corporate joint ventures using the equity method under ASC 323. Proportionate consolidation is permitted only in limited cases, chiefly unincorporated entities in construction and extractive industries where the investor owns an undivided interest in each asset and is proportionately liable for each liability. Since ASU 2023-05, effective for joint ventures formed on or after 1 January 2025, the joint venture itself measures its assets and liabilities at fair value at formation, establishing a new basis of accounting in its own financial statements.

IFRS 11 classifies joint arrangements differently: as joint operations, where the parties recognize their own share of the arrangement's assets, liabilities, revenues and expenses, or joint ventures, which are equity-accounted. Proportionate consolidation is not permitted for joint ventures under IFRS. A US company with an undivided interest in an oil and gas property, accounting proportionately under industry practice, reaches a result similar to an IFRS joint operator.