Introduction
When companies invest in other entities, they must choose an appropriate method to account for these investments. The two primary methods used are the fair value method and the equity method. Each has different implications for financial reporting, profitability, and valuation. Understanding these methods is essential for investors, analysts, and corporate accountants.
In this article, I will explain both the fair value and equity methods, compare their applications, and illustrate their impact on financial statements using examples and calculations.
Fair Value Method
Definition
The fair value method is used when an investor has a passive interest in another company, typically owning less than 20% of its voting shares. Under this method, investments are recorded at their market value, with unrealized gains and losses recognized in the income statement or other comprehensive income.
Accounting Treatment
- Initial Recognition
- Investments are recorded at their acquisition cost.
- Subsequent Measurement
- The investment is adjusted to its fair value at each reporting period.
- Unrealized gains and losses are recognized in either:
- Net Income (for investments classified as fair value through profit or loss – FVTPL).
- Other Comprehensive Income (OCI) (for investments classified as fair value through other comprehensive income – FVOCI).
Example Calculation
Company A purchases 5% of Company B’s shares for $1 million. At year-end, the fair value of the investment increases to $1.2 million. The journal entries would be:
- At Acquisition:
At Year-End (Fair Value Adjustment):
\text{Unrealized Gain} = 1,200,000 - 1,000,000 = 200,000If classified as FVTPL:
\text{Cr. Unrealized Gain (Income Statement)} = 200,000If classified as FVOCI:
\text{Cr. Unrealized Gain (OCI)} = 200,000Advantages of Fair Value Method
- Provides real-time valuation of investments.
- Reflects the current market price of assets.
- Easy to apply for liquid investments (e.g., publicly traded stocks).
Disadvantages
- Can introduce volatility in financial statements due to market fluctuations.
- Not suitable for illiquid or privately held investments.
Equity Method
Definition
The equity method is used when an investor has significant influence over another company, typically owning 20-50% of its voting shares. Under this method, the investor recognizes its share of the investee’s net income in proportion to its ownership stake.
Accounting Treatment
- Initial Recognition
- Investments are recorded at cost.
- Subsequent Measurement
- The investment’s carrying amount is adjusted based on the investor’s share of the investee’s profits or losses.
- Dividends received from the investee reduce the carrying amount of the investment.
Example Calculation
Company X purchases 30% of Company Y for $5 million. Company Y reports net income of $2 million for the year and declares dividends of $500,000.
- Investor’s Share of Net Income:
Journal Entry:
\text{Cr. Investment Income} = 600,000Dividends Received:
\text{Investor’s Share} = 30\% \times 500,000 = 150,000Journal Entry:
\text{Cr. Investment Account} = 150,000Advantages of Equity Method
- Better reflects the underlying financial performance of the investee.
- Reduces volatility compared to the fair value method.
- Suitable for long-term strategic investments.
Disadvantages
- Requires more effort to track investee’s financials.
- Less transparency than the fair value method in terms of market valuation.
Comparison Table
| Feature | Fair Value Method | Equity Method |
|---|---|---|
| Ownership Stake | < 20% | 20-50% |
| Basis of Valuation | Market Value | Investee’s Financials |
| Income Recognition | Market Gains/Losses | Share of Investee’s Net Income |
| Dividend Treatment | Recognized as Income | Deducted from Investment Value |
| Volatility | High | Lower |
| Best for | Passive Investments | Strategic Investments |
When to Use Each Method
- Use the Fair Value Method when investing in publicly traded stocks without significant influence.
- Use the Equity Method when investing in an associate company where there is strategic involvement.
Conclusion
Both the fair value and equity methods serve distinct purposes. The fair value method provides real-time valuation but introduces volatility, while the equity method offers a more stable representation of an investment’s profitability. As an investor or accountant, choosing the right method depends on the level of influence over the investee and the intended financial reporting objectives.
