Equity Method vs Fair Value Method: Recording and Ownership Shifts

The equity method and the fair value method are two different ways of carrying a stock investment on your books, and which one you use depends on how much influence you have over the company you’ve invested in. The fair value method marks a passive investment to market each period and treats dividends as income. The equity method tracks your proportionate share of the investee’s actual profits and losses, adjusts the investment account for those earnings, and treats dividends as a return of capital rather than income. You don’t get to pick between them based on preference — the level of influence over the investee decides it.

Which Method Applies to Your Investment

Under GAAP, the trigger is whether you can exercise significant influence over the investee’s operating and financial decisions. Owning 20 percent or more of the voting stock creates a rebuttable presumption that you have that influence, which means the equity method applies. A stake below 20 percent creates the opposite presumption, and the fair value method applies instead.¹

Those percentages are guidelines, not bright lines. What matters is whether real influence exists, and several qualitative factors can push the answer either way regardless of the raw ownership number:

A seat on the investee’s board of directors.
Participation in the investee’s operating or financial policy decisions.
Significant transactions between the two companies.
Shared management personnel or dependence on the investor for technical expertise.
A concentrated ownership stake relative to otherwise dispersed shareholders, even if under 20 percent.

The factors can also work in reverse. An investor holding 25 percent of the voting stock might be able to demonstrate that another party effectively blocks any real influence, in which case the equity method is not appropriate.²

One boundary to keep in mind: if ownership crosses above 50 percent of the voting stock, neither method applies. A majority stake generally establishes control, and the investee’s financial statements have to be fully consolidated into the investor’s own reporting.³

How the Fair Value Method Records the Investment

Under ASC 321, a passive investment is initially recorded at cost, including the purchase price and any direct transaction costs. After that, the carrying value tracks whatever the market says the investment is worth.

For equity securities with a readily determinable fair value — essentially anything traded on a public exchange — changes in fair value are recognized directly in net income each reporting period.⁴ Dividends received are income when received. The practical result is earnings volatility: a rising market inflates the investor’s reported income; a downturn deflates it. Reported profitability swings with market sentiment rather than reflecting anything the investee did operationally.

For privately held securities without a readily determinable fair value, the investor can use a measurement alternative. The investment stays at cost, reduced for any impairment, and is adjusted up or down only when an observable transaction in the same or a similar security of that issuer provides a new data point.⁵ The carrying value stays stable between observable transactions, but the investor has to watch for pricing events and impairment indicators.

How the Equity Method Records the Investment

The equity method treats the investment account as a running scorecard of the investor’s proportionate claim on the investee’s net assets. It starts at cost. Everything after that works differently from the fair value method.

Earnings and Losses

When the investee reports net income, the investor increases the carrying value of the investment by its ownership percentage of that income and records the same amount as equity method income on its own income statement. When the investee reports a loss, the process reverses. Recognition happens when the investee reports results, not when dividends are declared.⁶

A 30 percent investor in a company reporting $100,000 of net income increases its investment account by $30,000 and reports $30,000 in equity method income. The investor’s reported profitability tracks the investee’s actual operating performance, not the market’s mood.

Dividends

This is one of the sharpest differences between the two methods. Under the fair value method, a dividend is income. Under the equity method, a dividend is a return of capital. The investee already increased the investor’s carrying value when it earned the money, so distributing cash simply converts part of that claim from retained earnings into cash in the investor’s pocket. The investor reduces the investment account by its share of the dividend, and no income is recognized from the distribution itself.⁶

Intercompany Profit

Because the equity method is sometimes described as a one-line consolidation, unrealized profits on transactions between the investor and investee have to be eliminated until a third party actually realizes them. If the investor sells inventory to the investee at a markup and that inventory is still sitting unsold at period end, the investor strips out its share of the unrealized profit from equity method income. The same rule applies to upstream sales from the investee to the investor. The percentage of profit eliminated matches the investor’s ownership percentage.⁷

Side-by-Side Financial Statement Impact

The balance sheet tells two different stories depending on which method applies. A fair value investment fluctuates with the market. It might double or halve based on investor sentiment, sector rotation, or macroeconomic news that has nothing to do with the investee’s actual business. An equity method investment moves with the investee’s retained earnings, creating a smoother trajectory tied to operational results rather than trading activity.

The income statement divergence is just as stark. Under the fair value method, reported income from the investment consists of dividends received and unrealized gains or losses from price movements. A company can report a large investment gain simply because the stock market rallied, even if the investee lost money. Under the equity method, income tracks the investee’s actual earnings. If the investee had a bad year, the investor’s income statement reflects that bad year regardless of what the stock price did.

The dividend treatment alone can create counterintuitive results. Consider an investee that reports $5 million in losses but still pays a dividend from prior-year cash. Under the fair value method, that dividend shows up as income on the investor’s books. Under the equity method, the investor first reduces its investment account for its share of the $5 million loss (which reduces reported income) and then reduces the account again for the dividend (with no income effect). The two methods produce opposite signals from identical underlying facts.

Impairment and Losses That Exceed the Investment

An equity method investment has to be written down when it suffers a decline in value that is more than temporary. Warning signs include a pattern of operating losses at the investee, an inability to recover the carrying amount, or a current fair value below the investment’s book value. No single indicator is conclusive; a bad quarter alone doesn’t necessarily mean the decline is permanent.⁸ When an impairment is judged to be other than temporary, the investor writes the investment down to fair value. That new figure becomes the cost basis going forward and cannot be written back up if the investment later recovers.

If the investor’s share of ongoing losses grinds the carrying value down to zero, the investor generally stops recognizing further losses. Equity method accounting is suspended, and additional investee losses are tracked off-balance-sheet. Two exceptions apply. First, if the investor has guaranteed the investee’s debts or committed to provide additional financial support, losses keep flowing through beyond zero. Second, if the investee’s return to profitability appears imminent — for example, an isolated, nonrecurring loss that doesn’t reflect ongoing earning power — the investor may continue recognizing losses temporarily.⁹

When Ownership Shifts and the Method Changes

If ownership crosses above the significant-influence threshold through additional purchases, the investee repurchasing its own stock, or another transaction, the investor moves to the equity method going forward. The previously held investment is first remeasured at fair value (or adjusted per the measurement alternative) immediately before the switch. The investor then adds the cost of the new shares to that remeasured basis and begins tracking its proportionate share of the investee’s income and losses from the transition date.¹⁰

The reverse happens when the investor sells shares, the investee issues new stock to others, or influence is otherwise diluted below the threshold. The investor stops accruing its share of the investee’s earnings and losses as of the date influence is lost. Previously recognized equity method adjustments stay embedded in the carrying value; the investment account is not restated retroactively. Going forward, the investment is accounted for under ASC 321.¹⁰

The Fair Value Option as an Override

An investor that would otherwise apply the equity method can elect the fair value option under ASC 825 at the time the investment first qualifies for equity method accounting. Under this election, the investment is recorded at fair value each reporting period with all changes flowing through earnings, which is effectively the same measurement as a passive investment without giving up the underlying relationship. The election is irrevocable once made and applies to the entire investment. This approach is common among venture capital funds and other entities that prefer mark-to-market reporting regardless of their influence over portfolio companies.¹¹ Anyone reading financial statements needs to know which method is in play before drawing conclusions about what investment income actually represents.

1
Deloitte Accounting Research Tool. Deloitte’s Roadmap: Equity Method Investments and Joint Ventures – 3.2 General Presumption
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Deloitte Accounting Research Tool. Deloitte’s Roadmap: Equity Method Investments and Joint Ventures – 3.3 Other Indicators of Significant Influence
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Deloitte Accounting Research Tool. Roadmap: Consolidation – D.1 General Consolidation Principles
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FASB. ASU 2020-01 Investments-Equity Securities (Topic 321)
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Deloitte Accounting Research Tool. Roadmap: Foreign Currency Transactions and Translations – 4.4 Investments in Debt and Equity Securities
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Deloitte Accounting Research Tool. Deloitte’s Roadmap: Equity Method Investments and Joint Ventures – 5.1 Equity Method Earnings and Losses
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PwC. Equity Method of Accounting – 4.2 Elimination of Intercompany Transactions
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Deloitte Accounting Research Tool. Deloitte’s Roadmap: Equity Method Investments and Joint Ventures – 5.5 Decrease in Investment Value and Impairment
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Deloitte Accounting Research Tool. Deloitte’s Roadmap: Equity Method Investments and Joint Ventures – 5.2 Equity Method Losses That Exceed the Investor’s Equity Method Investment
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Deloitte Accounting Research Tool. Deloitte’s Roadmap: Equity Method Investments and Joint Ventures – 5.6 Change in Level of Ownership or Degree of Influence
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Deloitte Accounting Research Tool. Roadmap: Equity Method Investees SEC Reporting – 1.7 Equity Method Investments Eligible for Fair Value Option