Equity Method

Lesson:

The more influence a stockholder has on another company, the more it can influence the decision to distribute dividends.

This would introduce the potential for misleading financial statements, if we used the fair value method. The stockholder could pressure the firm to release dividends, even if the company were losing money. This would make the investment look profitable.

For this reason, when the stockholder has significant influence (typically 20%-50% ownership), it should use the equity method.

investor may make a one-time change to elect to use irrevocably the fair value method.

Shady corp., the trusted hat exporter, has 650 shares outstanding. Your firm has purchased 215 of those shares for $178,000.00. The company reported a net income of $90,000.00 and issued $27,900.00 in dividends to its shareholders. You see that the current price of your shares is $149,520.00.
Under the equity method, what should you list as the company's carrying value?

Answer:

  • The carrying value is $198,540.77

Explanation:

    Calculating the carrying amount via the equity method is a four-step process:
    1. Figure out how much of the company was purchased: 215 purchased shares divided by 650 total shares outstanding is 0.3308
    2. Calculate the portion of net income corresponding to the purchased shares: 0.3308 * $90,000.00 = $29,769.23
    3. Figure out the portion of dividends that correspond to the purchased shares: 0.3308 * $27,900.00 = $9,228.46
    4. Add the purchase price to the portion of the net income and then remove the dividends received: $178,000.00 + $29,769.23 - $9,228.46 = $198,540.77
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