The equity method is an accounting treatment used in recording equity investments to appropriately account for an investor company’s investment revenue and dividend. The use of the equity method depends on the investor company’s percentage equity holdings in the investee and its influence over the investee's business. The equity method of treating investment revenue and dividends often results in deferred taxes, because of the discrepancy with taxable income calculated based on the tax codes.
Relevant accounting rules prescribe that an investor company must choose an appropriate accounting method to account for its equity investment based on its level of equity holdings interest. An investment interest of less than 20 percent or more than 50 percent requires the use of the fair value method or the consolidated financial statement method, respectively. An investment interest of between 20 and 50 percent with significant influence over the business and financial decision-making process of the investee company demands the use of the equity method.
The equity method treats the investee’s reported business income as part of the investor company’s own income under investment revenue based on the proportion of its equity holdings. On the other hand, for example, the fair value method reports no investment revenue out of the investee’s business income to be part of the investor company’s income because of the relatively low level of equity holdings. The recording of investment revenue as income under the equity method has tax consequences.
When the investee company distributes dividends to the investor company, different accounting methods may or may not report the dividends received as a form of income. While the fair value method records dividends as the investor company’s investment revenue, the equity method treats dividends received as a reduction to the investor company’s investment holdings, unrelated to income and thus without tax implications for financial accounting purposes.
Deferred taxes are the result of the difference between financial income and taxable income. Under the equity method, the investor company reports investment revenue as its income while recording no income when receiving its investment dividends. Thus, related income tax expense is based on the reported investment revenue. On the other hand, the tax code requires that the investor company report the income tax payable based on the cash dividends received. The difference between the amount of investment revenue and investment dividend also causes the difference between total income tax expense and current income tax payable, expressed as deferred taxes. Such deferred taxes are a future tax liability due when the investor company receives more dividends out of its investment revenue.