Equity accounting is an accounting process for recording investments in associated companies or entities. Often, companies hold ownership interests in other businesses. Typically, this method—also known as the equity method—applies when an investor or parent entity owns 20-50% of the voting stock of the related company. The equity accounting method is utilized when the investor company can exercise substantial influence over the investee company’s operations.
Key Takeaways
- Equity accounting is a method to document investments in linked companies or entities.
- The approach applies when one company’s ownership interest in another company ranges between 20%-50% of its stock.
- Under this method, the investing company records a proportion of the investee company’s profits or losses based on ownership percentage.
- The value of the investment asset on the investor’s balance sheet is periodically adjusted.
Understanding Equity Accounting
Using the equity method, an investor acknowledges its share of the profits and losses of the investee. It records a proportion of profits relative to the ownership percentage. These profits and losses are reflected in the investee’s financial accounts. Any accrued profits or losses are exhibited on the investor’s income statement.
The initial investment amount in the investee is recorded as an asset on the investing company’s balance sheet. Fluctuations in the investment’s value are adjusted on the investor’s balance sheet. Increases in the investee’s profits elevate the investment’s value, whereas losses result in a corresponding decrease.
Equity Accounting and Investor Influence
Under equity accounting, a fundamental factor is the extent of the investor’s influence over operational or financial decisions of the investee. A significant financial stake often allows the investor to have a say in the financial and operational policy decisions, thereby affecting the investee’s financial outcomes.
Although precise measurement of influence is challenging, several indicators point to substantial influence, such as:
- Representation on the board of directors
- Participation in policy-making activities
- Significant intra-entity transactions
- Personnel exchanges between companies
- Technological dependence
- The proportion of ownership compared to other stakeholders
When an entity acquires 20% or more of an investee’s voting stock, it is typically presumed that the investor has significant influence. Conversely, ownership under 20% generally indicates lack of significant influence unless proven otherwise.
Even sizable ownership by another party doesn’t automatically negate an investor’s significant influence. Large institutional investors often maintain control that exceeds their basic ownership levels.
Equity Accounting vs. Cost Method
If no significant influence is exerted over the investee, the cost method is utilized. The cost method appraises the investment at its historical cost as an asset. Unlike the equity method, the value of this asset stays constant and isn’t adjusted based on the investee’s profits or losses. The equity method, however, periodically revises the asset’s value on the investor’s balance sheet due to a 20%-50% ownership interest in the investee.
By understanding and leveraging equity accounting, businesses can gain better insight into their financial influence and performance over associated entities.
Related Terms: income statement, balance sheet, asset, board of directors, voting stock.
