October 23, 2021

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What Is the Equity Method of Accounting?

What Is the Equity Method of Accounting?

Overview

One of the main advantages of accounting is that in many cases it has clear rules, guidelines, and requirements as to what a business has to do and how it should reflect its various activities on paper. If you are a business owner who wants to invest in another business, then you need to know about this accounting method.

An equity method of accounting is a way businesses keep a record of investments in their accounting books if they have a considerable influence in the organization they choose to buy shares from. In this case, the initial purchase of shares is entered into the books at cost, and then its carrying amount is changed up or down by recognizing the investor’s portion of the profit or loss the investee had recognized afterward.

The carrying amount of the investment is also adjusted to reflect changes arising from changes in the other comprehensive income of the investee. Such changes may include revaluation of PP&E, differences in translation of financial reports into another currency, etc. The investor records such changes in its books under other comprehensive income. As a result, such a bookkeeping approach allows presenting a more accurate picture of business activities and finances.

When using this method, you are not required to classify your investments into held for trading, available for sale, or held to maturity. The things you would focus on are slightly different than if you would have used other accounting methods. For instance, you will not be doing fair value adjustments, but instead adjusting your investments account. So, what do you do?

  • Well, first of all, you would need to record your initial investment in securities.
  • When the company you invested in does well and earns net income, which you will know it right away (before the general public), you need to make an adjustment to your investments account. Logically, if the business had a good year, it will increase, and if it suffered a loss, your investment account balance will go down.
  • When the company declares a dividend distribution, its retained earnings decrease. Thus, your investment account also goes down.
  • Other adjustments include depreciation and impairments. This is a required adjustment when using this accounting method.

In a nutshell, everything that is happening under the equity of the company you invested in will be reflected in your own accounts as a mirror image. The exception is that your amount will be equal to the proportion of the shares you own in that company. For instance, if you have 35% of shares of a particular company, then you would record 35% of its income or loss, 35% of the depreciation recorded in the investee’s books, and so on for other applicable items.

What Is the Equity Method of Accounting?

When is it used?

As said earlier, the equity method of accounting is adhered to when an organization invests in associates and joint ventures. These are business entities where the investor can take part in decision-making, but this is not control or even joint control over these policies.

If an investor owns 20 percent or more of shares with the ability to vote in the company they invested in, then they are considered to have significant influence. In the simplest case, the investor should have a 20-50% stake in such a company, i.e. more than 20%, but less than the controlling stake.

At the same time, it should be understood that the presence of such voting rights may indicate not only significant influence but also full control by the investor, which would mean that the equity method of accounting is not applicable. Moreover, it is important to note that if you purchased preferred stock, then in most cases you do not have any voting rights, which means that you cannot have any influence over what is happening in the company. Thus, the equity method of accounting assumes that you have acquired stock that gives you voting interest, which typically means you have shares of common stock.

This type of accounting provides more detailed information about the investor’s assets and profit (loss) in the financial documents than recognition of income as the amount of funds received as a result of the distribution of profits, since such funds may not show the actual results of activities of the investee.

One of the nice benefits of the equity method of accounting when compiling separate financial reports is that it also allows a reduction in the labor and resources required for those companies that prepare the consolidated accounting reports by applying this method to accounting for investments in subsidiaries, associates, and joint ventures.

Example

For better understanding, let’s review a simple sample example. You bought XYZ company 30% of shares for $10,000 on January 1st. During that year, XYZ company made a profit of $7,500. How would you reflect your investment in the shares of the XYZ company in your bookkeeping records and accounting reports on December 31st of the same year?

First, you need to record the amount of your initial investment. The equity investment is initially recognized at cost. Then, each reporting period, you would add your share (30%) of the XYZ company profits. For this example, the transaction of the initial purchase of shares would look like this:

Date

Jan. 1st

Account

Investments

DR

$10,000

CR

Cash $10,000

 

You know that the company made a profit of $7,500 and you are entitled to 30% of that profit. Accordingly, this would mean our Investments account goes up along with the Investment Income by $2,250 ($7,500 x 30%).

DateJan. 1st
AccountInvestments
DR$2,250
CRInvestment Income $2,250

The total balance under the Investments will be $12,250. This balance will fluctuate along with changes in the equity of the organization you decided to acquire the shares of. As you can see, although different than other accounting methods, the equity method of accounting is not that complicated.

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Author: Charles Lutwidge

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