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A business uses the equity method as an accounting approach to record the earnings made by its investment in another business. The investor firm declares the revenue generated by the other company on its income statement using the equity method of accounting, in a proportional amount to the equity stake it has in the other company.
When a firm has significant control over the company it is investing in, the equity method is used to value the investment. The typical ownership requirement for “substantial influence” is 20–50%.The investment is initially recorded at historical cost under the equity method, and changes are made to the value based on the investor’s share of net income, loss, and dividend distributions.
The net income of the invested firm raises the asset worth of the investor on their balance sheet while the invested company’s net loss or dividend distribution lowers it. On their income statement, the investor also includes the percentage of the investee’s net profit or loss.
When one company, the investor, significantly influences another company, the investee, the equity method is the conventional strategy employed. A firm is seen to have significant influence when it owns 20% to 50% of the equity of that company. Companies that own less than 20% of another company’s stock may yet exercise significant influence, in which case they must also apply the equity method.
