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There are many ways to record investment value, depending on the stakes involved. The equity method of accounting for investments offers companies a way to accurately reflect their ownership in another entity. Find out when and how these rules apply below.
Understanding the equity method of accounting
When one company owns part of another, the equity method of accounting tracks this interest. In other words, equity accounting is simply a method used to record investments in associated companies or other entities. However, it only applies when the investor owns a high percentage of the associate entity, typically between 20% and 50% of the stock. This high percentage of voting stock means that the investor exerts significant control over the owned company.
Purposes of the equity method of accounting for investments
The equity method of accounting GAAP rules allow investors to record profits or losses in proportion to their ownership percentage. It makes periodic adjustments to the asset’s value on the investor’s balance sheet to account for this ownership.
The purpose of equity accounting is to ensure that the investor’s accounts accurately reflect the investee’s profit and loss. A recognized profit increases the investment’s worth, while a recognized loss decreases its value accordingly.
What is investor influence?
For equity accounting to be applicable, the investor must have “significant” influence over the investee’s financial or operating decisions. This is usually determined by the percentage of voting stock ownership, which falls between 20% and 50%, as mentioned above. Other indicators of significant influence could include:
A seat on the board of directors
Material transactions between entities
Personnel exchanges between entities
Dependence on shared technology
How does the equity method of accounting work?
An investing company recognizes its share of the investee’s profits and losses using the equity method. These figures will be recorded in the following documents:
The initial investment is recorded as an asset on the investing company’s balance sheet. However, the value of this asset will change over time. When the investee’s profit increases, so does the investment value. When the investee records a loss, this is reflected in the investment value. These profits and losses must also be recorded on the income statement.
Here are two equity method of accounting for investment examples:
Example 1: Company A acquires a 25% stake in Company B. Company B records $1,000,000 of net income in the most recent accounting period. As a result, Company A must record $250,000 of this net income amount on its income statement as investment earnings, also increasing its investment value.
Example 2: Company B from above recorded a $400,000 loss during its latest accounting period. In this case, Company A would need to register $100,000 as an investment loss and adjust the investment value accordingly.
In both examples, these amounts would need to be adjusted after the next accounting period, as profit and loss fluctuates, to reflect Company A’s ownership in Company B.
Equity accounting vs. other accounting methods
To better understand the equity method of accounting for investment examples above, it’s also helpful to contrast equity with consolidation and cost methods.
According to the equity method of accounting GAAP regulations, investors report their proportionate share of the equity at cost. Any profit and loss should be recorded in a proportional amount to the percentage of shares, with dividends deducted from the account.
By contrast, consolidation accounting is used when the investor exerts full control over the company it’s investing in. This creates a parent-subsidiary relationship. With the consolidation method, investments in the subsidiary are recorded on the parent company’s balance sheet as an asset and on the subsidiary’s balance sheet under equity.
The cost method of accounting is used when an investor owns less than 20% of the investee, holding a minority interest. In this case, investments are recorded as an asset using their historical cost. While the equity method makes periodic value adjustments, these values won’t change over time with the cost method.
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