Table of Contents
- What Is Equity Accounting?
- Key Takeaways
- Understanding Equity Accounting
- Important Note on Standards
- Equity Accounting and Investor Influence
- Presumptions on Ownership
- Equity Accounting vs. Cost Method
- When Is the Equity Accounting Method Used?
- What Are the Rules for the Equity Accounting Method?
- What Are the Problems With the Equity Accounting Method?
- The Bottom Line
What Is Equity Accounting?
Let me explain equity accounting to you directly: it's a financial reporting method I use to account for investments in associated companies. As a blog writer diving into technical finance, I'll tell you that equity accounting reports the portion of a company's income from its ownership in another company, treating that share of the affiliate's profits as returns on investment.
You should know that this method, often called the equity method, typically applies when a company owns 20–50% of the voting stock in the associate. I apply it only if the investing company can exert significant influence over the affiliated one. It's not for outright ownership.
Key Takeaways
Here's what you need to grasp: the equity method requires the investing company to record the affiliated company's profits or losses in proportion to its ownership percentage. I treat the ownership interest as an investment, with profits and losses as returns on that investment. Remember, this method demands periodic adjustments to the asset's value on the investing company's balance sheet.
Understanding Equity Accounting
Under the equity method, an investing company recognizes its share of profits or losses from another company in its income statement each period, reflecting the ownership percentage. The affiliated company still publishes its own income statement, so that's separate.
You record the initial investment as an asset on the balance sheet. Then, for each year, you add your share of profits to the income statement and increase the investment value on the balance sheet; losses do the opposite and decrease it.
Important Note on Standards
I must point out that the requirements for the equity method come from U.S. GAAP and IFRS rules. Some GAAP guidance isn't in IFRS, so check the specifics if you're dealing with international reporting.
Equity Accounting and Investor Influence
The core of equity accounting is the investor's influence over the investee's operating or financial decisions. If there's significant money invested, the investor can influence those decisions, affecting both companies' results.
No exact measure exists for influence, but indicators include board representation, policy-making participation, material transactions between entities, management personnel swaps, technology sharing, and the investor's ownership proportion compared to others.
Presumptions on Ownership
When an investor acquires 20% or more of voting stock, presume significant influence unless evidence shows otherwise. For less than 20%, presume no significant influence unless you can prove it. There are no strict rules; even large institutional investors might have more control than their stake suggests.
Equity Accounting vs. Cost Method
If there's no significant influence, use the cost method instead. This records the investment at historical cost as an asset and recognizes only dividend income, not the affiliate's earnings. The carrying amount stays at cost unless there's a permanent decline, then you write it down.
In contrast, the equity method adjusts the asset value periodically on the balance sheet due to the 20%-50% controlling interest.
When Is the Equity Accounting Method Used?
You use equity accounting if the reporting entity has significant interest but not outright ownership—practically, that's 20-50% stake. For 51% or more, it's a consolidated subsidiary. Smaller stakes follow the fair value method.
What Are the Rules for the Equity Accounting Method?
Under this method, record the stake as a balance sheet asset and the share of profits or losses on the income statement. That's the straightforward rule.
What Are the Problems With the Equity Accounting Method?
One issue is it doesn't give forward-looking insights to investors. It records assets and profits, but the investor doesn't fully control the investee's assets or receive profits unless dividends are paid.
The Bottom Line
To wrap this up, the equity method is a technique for reporting profits and losses from a significant ownership stake in another company. If you have that stake, report the investee's value and profits on your financial statements.
Other articles for you
A voucher is a backup document used in accounting to authorize and record payments to suppliers, and it also refers to redeemable coupons or government program benefits.
A warehouse receipt guarantees the quantity and quality of commodities stored in approved facilities for futures trading.
Financial intermediaries act as middlemen in financial transactions, enhancing market efficiency and providing benefits like safety and liquidity.
A real estate investment group (REIG) is a business entity focused on real estate investments, pooling capital from multiple investors to buy, manage, or sell properties without qualifying as a REIT.
Short-term debt refers to a company's financial obligations due within a year, listed as current liabilities on the balance sheet.
DuPont analysis breaks down return on equity into key components to evaluate a company's financial performance.
Hard dollars refer to direct cash payments made by investors to brokerage firms for services like research and account maintenance, contrasting with soft dollars paid through commissions.
A default occurs when a borrower fails to repay debt obligations, leading to severe financial and legal consequences for individuals, businesses, or countries.
Notional value represents the total value of the underlying asset in a derivatives contract, used to calculate payments and assess risks.
M3 is a broad measure of the money supply that includes M2 plus less liquid assets, though it's no longer officially tracked by the Federal Reserve.