Equity Method Accounting

When Company A (the investor) has significant influence over Company B (the investee)—but not majority voting power—Company A accounts for its investment in Company B using the equity method of accounting. Company B is considered an unconsolidated subsidiary of Company A in such circumstances, from Company A’s perspective, but could be a freestanding, publicly traded corporation. A company is generally considered to have significant influence, but not control, when it owns 20% – 50% of the voting interest in the unconsolidated subsidiary. The company does not actually record the subsidiary’s assets and liabilities on its balance sheet. Rather, the Investment in Affiliate (or Equity Investment) non-current asset account on the balance sheet serves as a proxy for the Company A’s economic interest in Company B’s assets and liabilities.

Company A is entitled to a portion of Company B’s earnings in proportion to Company A’s economic ownership of Company B’s stock. Company A records its proportionate share of the subsidiary’s earnings as an increase to the Investment in Affiliate account on its balance sheet. These earnings may be distributed as cash dividends, or retained by Company B. To the extent Company A’s share of Company B’s earnings are distributed as cash dividends, the Investment in Affiliate account is reduced by the amount of the dividend because the dividend is considered a return of capital. The net effect is that the Investment in Affiliate account increases by Company A’s proportionate share of the undistributed earnings of Company B.

Cash taxes are paid by the investor only on cash dividends received. The undistributed earnings give rise to a deferred tax liability (“DTL”) payable when the earnings are ultimately distributed, or the investment is liquidated. Recall that taxes on dividend income may be offset by the Dividends Received Deduction (“DRD”). Whether you apply the DRD to deferred taxes on undistributed earnings is a judgment call. Accountants will generally advise you not to, since applying the DRD to undistributed earnings implies an expectation that those earnings will ultimately be distributed. However, companies rarely pay “catch-up” dividends. In other words, a company is unlikely to distribute earnings in the future that it declined to distribute in the past. So, undistributed earnings rarely qualify for the DRD because their future distribution is not expected. If you do expect undistributed earnings to be paid out in the future, then you could make a case for applying the DRD to the undistributed earnings in the current period.

In some cases, the deferred tax liability related to undistributed earnings from an equity investment can grow quite large over time. Monetizing the investment after the DTL has grown large can trigger a large tax bill that (i) must be weighed against the benefits of monetization, and (ii) may limit the investor’s strategic options with respect to the disposition of the stake. PNC Financial faced this dilemma in evaluating monetization options for its sizeable investment in BlackRock.

Now, let’s see how to actually model equity method investments. The concepts above are implemented in the following comprehensive example, where we assume a simplified P&L and balance sheet to focus on key takeaways, which are highlighted in yellow.