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What Is Equity Accounting?
Equity accounting is a method of reporting the portion of a company’s income that is derived from its ownership interest in another company. Equity accounting treats the company’s share of the affiliate’s profits as returns on investment.
Typically, equity accounting–also called the equity method–is applied when a company owns 20–50% of the voting stock of the associate company. It is used only when the investing company can exert a significant influence over the affiliated company. It is not used if the company owns the affiliated company outright.
Key Takeaways
- The equity method of accounting requires the investing company to record the affiliated company’s profits or losses in proportion to the percentage of its ownership.
- The ownership interest is treated as an investment, and profits and losses are treated as returns on investment.
- The equity method demands periodic adjustments to the value of the asset on the investing company’s balance sheet.
Understanding Equity Accounting
Under the equity method of accounting, an investing company will recognize its share of the profits or losses in another company in its income statement for each period. The share it recognizes will reflect its percentage ownership.
The affiliated company will continue to publish its own income statement.
The initial investment amount in the company is recorded as an asset on the investing company’s balance sheet. It records its share of profit or loss in the income statement for the year. At the same time, the profits increase the investment value on the balance sheet while losses would decrease it.
Important
The requirements for the equity method are set out in both U.S. GAAP and the IFRS rules. Some of the guidance in GAAP does not appear in the IFRS.
Equity Accounting and Investor Influence
The biggest consideration in equity accounting is the level of investor influence over the operating or financial decisions of the investee. When there’s a significant amount of money invested in a company by another company, the investor can exert influence over financial and operating decisions, which ultimately impacts the financial results of both companies.
While no precise measure can gauge an exact level of influence, several indicators of operational and financial policy influences include:
- Board of directors representation, meaning a seat on the board of the owned company
- Policy-making participation
- Material intra-entity transactions
- Management personnel interchange
- Technology sharing
- The proportion of ownership by the investor in comparison to that of other investors
When an investor acquires 20% or more of the voting stock of an investee, it is presumed that, if there’s no evidence to the contrary, the investor will exercise significant influence over the investee.
If an ownership position is less than 20%, there is a presumption that the investor does not exert significant influence over the investee unless it can demonstrate otherwise.
There are no hard rules for establishing the level of influence that a company can exert. For instance, many large institutional investors enjoy more implicit control than their absolute ownership levels would ordinarily allow.
Equity Accounting vs. Cost Method
If a company does not exercise significant influence over a company that it has invested in, the cost method of accounting is used rather than the equity accounting method.
The cost method of accounting records the cost of the investment as an asset, using its historical cost. The company does not recognize the earnings of the affiliated company. Instead, it recognizes dividend income.
The carrying amount remains at historical cost unless the value of the investment declines permanently. In this case, this value is written down.
The equity method makes periodic adjustments to the value of the asset on the investor’s balance sheet because it is relevant to its 20%-50% controlling investment interest in the affiliated company.
When Is the Equity Accounting Method Used?
The equity accounting method is used if the reporting entity has a significant interest in another company but does not own it outright. In practice, this means an ownership stake of 20-50% in the other company.
If the reporting company has a controlling interest (51% or greater) it is reported as a consolidated subsidiary.
For smaller ownership stakes, the investment is reported according to the fair value method.
What Are the Rules for the Equity Accounting Method?
Under the equity accounting method, an investing company records its stake in another company as an asset on its balance sheet. It also records its share of the profits or losses of the invested company on its income statement.
What Are the Problems With the Equity Accounting Method?
One critique of the equity accounting method is that it does not provide usable insights to investors looking forward. Although it records the assets and profits of the investee in its financial statements, the investing company does not entirely control how the investee uses its assets, and it does not receive any profit unless the investee chooses to pay a dividend.
The Bottom Line
The equity method is an accounting technique for reporting profits and losses derived from a company’s ownership stake in another company. If the investing company has a significant stake, the company will report the value and profits of the investee on its own financial statements.
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