Introduction
Microsoft owns a large stake in OpenAI, with total funding commitments of $13 billion, and accounts for it under the equity method. It does not consolidate OpenAI's revenue or costs. Instead, it records its share of OpenAI's results in a single line. In fiscal 2025, that line was a loss: the "other, net" component of Microsoft's other income and expense, which the company says primarily reflects net losses on equity method investments, including OpenAI, was minus $4.7 billion. Those losses reduced Microsoft's net income. They did not use any of Microsoft's cash.
The equity method separates profit from cash in a way that mirrors consolidation in miniature. The investor's income statement shows its share of the investee's earnings, the balance sheet carries an investment that grows and shrinks with those earnings, and cash moves only when the investor buys or sells shares in the investee or receives a dividend. Tracing both flows with the method from tracing a transaction through the statements shows where each one lands.
How the Equity Method Works
Under Accounting Standards Codification (ASC) 323, part of US generally accepted accounting principles (GAAP), an investor that has significant influence over an investee, usually presumed when it owns 20% to 50% of the voting stock, uses the equity method. It records the investment at cost, then increases it by its share of the investee's net income and decreases it by its share of losses and by dividends received. The investee's revenue, assets and debt never appear on the investor's statements. Where the equity method sits among the ways of accounting for an investment is covered in three ways to account for an investment.
- Equity method
A method of accounting for investments in which the investor has significant influence but not control, typically a 20% to 50% stake. The investor records its share of the investee's profit or loss in a single income statement line and carries the investment at cost adjusted for that share and for dividends received.
Share of Earnings: Income Without Cash
Suppose an investor owns 30% of an associate that earns $100 in a year. Ignoring taxes to isolate the mechanics:
Net income rises by $30, the investor's share. No cash has arrived, so the cash flow statement subtracts the $30 as a non-cash item in operating activities. On the balance sheet, the investment rises by $30, matched by retained earnings. A loss works the same way in reverse: Microsoft's equity method losses reduced its net income and its investment balance and were added back on its cash flow statement, with no cash effect.
In practice, the investor usually records deferred tax as well, because its share of undistributed earnings will be taxed when received as dividends or when the stake is sold. That deferred tax reduces net income without using cash, and appears as a deferred tax add-back on the cash flow statement.
Dividends Received: Cash Without Income
When the associate pays a dividend, the investor receives cash but records no income, because its share of the profit behind the dividend has already been recognized. Suppose the associate pays a $30 dividend in total, of which the investor receives $9:
Cash rises by $9 and the investment falls by $9; the income statement does not move. On many cash flow statements, the two steps are combined in a single operating line, equity in earnings net of dividends received, which would show $21 subtracted in this example: $30 of earnings less $9 received.
The classification of dividends received follows Accounting Standards Update (ASU) 2016-15. Investors choose one of two policies. Under the cumulative earnings approach, distributions up to the investor's cumulative share of earnings are a return on the investment, classified in operating activities, and any excess is a return of the investment, classified in investing activities. Under the nature of the distribution approach, the investor classifies each distribution by the activity that generated it, such as operating profits or the sale of an asset.
Paying More Than Book Value
Investors usually pay more for a stake than their share of the investee's book equity. Suppose the investor paid $400 for its 30% when the associate's book equity was $1,000, so its share of book equity was $300. The $100 difference is allocated, much as in an acquisition, to the investee's assets at fair value and to goodwill. If $50 relates to intangible assets with a ten-year life, the investor reduces its equity income by $5 a year to amortize that excess, while the other $50, equity method goodwill, is not amortized. The investor's reported share of earnings is therefore $5 lower than 30% of the investee's own net income. The rules are covered in the equity method.
Losses and the Floor at Zero
Losses reduce the investment until it reaches zero. At that point, the investor generally stops recording its share of further losses, unless it has guaranteed the investee's obligations or committed to fund it, and resumes recording income only after later profits have covered the losses not recognized. An investee that loses money, as many early-stage technology companies do, can therefore drag an investor's earnings down for years, then stop affecting them entirely once the investment reaches zero. Separately, if the investment's fair value falls below its carrying amount and the decline is other than temporary, the investor records a non-cash impairment write-down.
Under US GAAP, the full life of an equity method stake comes down to a handful of events, each with a fixed pattern on the statements:
| Event | Income statement | Cash flow statement | Investment balance |
|---|---|---|---|
| Buying the stake | No effect | Investing outflow | Up by the price |
| Share of investee profit | Equity income | Subtracted as non-cash | Up |
| Share of investee loss | Equity loss | Added back as non-cash | Down, to a floor of zero |
| Dividend received | No effect | Operating inflow, up to cumulative earnings | Down |
| Amortizing a basis difference | Lower equity income | Added back as non-cash | Down |
| Selling the stake | Gain or loss | Proceeds in investing | Removed |
What Bankers Do With Equity Method Investments
Because the investee's revenue, earnings before interest, taxes, depreciation and amortization (EBITDA) and debt are not consolidated, an investor's EBITDA excludes them, and equity method income should be left out of EBITDA too, so that EBITDA matches the operations that are actually consolidated. The investment is then valued separately and added to enterprise value in the bridge to equity value, at market value if the investee is listed or at an estimated value otherwise, rather than at its book carrying amount.
Microsoft's fiscal 2025 figures show why the separation matters. In its fiscal 2025 annual report, $4.7 billion of other, net losses, mostly equity method losses, sat below operating income of $128.5 billion and reduced net income, but said nothing about Microsoft's operating performance or cash generation. A banker valuing Microsoft would exclude them from operating metrics and value the OpenAI stake on its own.
In credit work, the dividends received are the cash that actually reaches the investor, and lenders count those, not equity income, when assessing coverage. The equity method thus gives the same answer as every other trace in this section: the income statement records an economic share of profit, the cash flow statement records the cash that arrives, and the balance sheet investment carries the difference between the two.
