Why does the equity method record dividends from an investee as a reduction in the investment account not as dividend income?

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.

dr. Investment in affiliate (A ↑)

cr. Cash (A ↓)

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.

dr. Investment in affiliate (A ↑)

cr. Equity income in affiliate (SE ↑)

dr. Cash (A ↑)

cr. Investment in affiliate (A ↓)

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.

dr. Income tax expense (SE ↓)

cr. Cash (current tax expense) (A ↓)

cr. DTL (deferred tax expense) (L ↑)

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.

Suppose Company A buys 40% of Company B's voting common stock for $500. What journal entry does Company A make to record the purchase?

dr. Investment in affiliate	$500
cr. Cash		$500

The following quarter, Company B reports net income of $200 and announces a $40 dividend. What journal entries does Company A make to record its proportionate share of Company B's earnings and the cash dividend?

dr. Investment in affiliate	$80
cr. Equity income in affiliate [= 40% × $200]		$80

dr. Cash [= 40% × $40]	$16
cr. Investment in affiliate		$16

Assume Company A's tax rate is 35%, and that Company A can fully utilize the applicable DRD. What journal entry does Company A make to record its tax expense related to its investment in Company B?

dr. Income tax expense	$23.5
cr. Cash [= $16 × (1 − 80%) × 35%]		$1.1
cr. DTL [= ($80 − $16) × 35%]		$22.4

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.

Example B – Comprehensive Equity Method Example

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