Equity accounting, also known as the equity method, is a way of recording investments that companies make in other companies or entities.
When a company owns a portion of another company, it needs a method to account for that investment on its financial statements.
This method is typically used when the investing company owns between 20% and 50% of the voting shares in the other company, known as the associate company.
The reason this range is significant is that it usually allows the investor to have a significant influence over the associate company’s decisions, even though they don’t have full control.
In simple terms, equity accounting allows the investing company to reflect its share of the associate company’s profits or losses on its financial records.
This way, the financial performance of the associate company directly affects the financial statements of the investing company, making equity accounting a crucial method when there is a meaningful level of influence.
Understanding Equity Accounting
When a company invests in another company, known as the investee, it needs to account for that investment in its financial statements.
Here’s how equity accounting, also called the equity method, works:
Recording the Investee’s Profits or Losses
The investee company will record its profits or losses for the period on its income statement.
Under equity accounting, the investing company will recognize its share of these profits or losses in its income statement.
The share recognized depends on the percentage of ownership the investing company holds in the investee.
For example, if the investing company owns 30% of the investee, it will recognize 30% of the investee’s profit or loss in its income statement.
Initial Investment as an Asset
The initial amount the investing company spends to acquire its stake in the investee is recorded as an asset on the investing company’s balance sheet.
This represents the value of its investment.
Adjusting the Investment Value
As the investee earns profits, the investing company’s share of these profits is added to the value of the investment on the balance sheet, effectively increasing the asset’s value.
Conversely, if the investee incurs losses, the investing company’s share of these losses is subtracted from the investment value, reducing the asset’s value on the balance sheet.
How Does Equity Accounting Work?
Equity accounting is a method used to reflect an investing company’s share of the profits and losses of the company it has invested in.
Proportionality
The investing company adjusts the value of its investment based on its ownership percentage in the invested company.
For example, if the investing company owns 30% of the invested company, it will adjust the value of the investment by 30% of the invested company’s financial results.
Recognition of Results
The investing company records its share of the profits or losses of the invested company in its financial statements.
This means if the invested company makes a profit, the investing company will recognize a proportionate share of that profit.
Similarly, if the invested company incurs a loss, the investing company will record its share of that loss.
Periodic Adjustments
The investment value on the investing company’s balance sheet is updated regularly.
These adjustments reflect changes in the invested company’s equity, such as profits, losses, or any other changes in financial position.
When is the Equity Method Used?
Equity accounting is used in various situations where a company has a notable investment in another company. Here’s how it is applied:
- Associated Companies: When a company owns between 20% and 50% of another company but doesn’t control it completely.
- Controlled Companies: When a company owns more than 50% of another company and has significant control over it.
- Joint Ventures: When two or more companies create a new entity together and share control of it.
- Participation Agreements: When there are specific agreements that give a company significant influence over another company’s financial and operational decisions.
Equity Accounting vs. Cost Method
Parameters |
Cost Method |
Equity Method |
Usage |
Applied when the investor does not have significant influence over the investee. | Applied when the investor has significant influence over the investee, typically owning 20% to 50% of the investee. |
Recording |
The investment is recorded at its historical cost as an asset.
|
The investment is initially recorded at cost but is adjusted periodically. |
Earnings |
The investor does not recognize the investee’s earnings. Instead, it records dividend income when the investee pays dividends.
|
The investor recognizes its share of the investee’s profits or losses on its financial statements.
|
Value Adjustments |
The investment’s value remains at historical cost unless the investee’s value permanently declines. If it does, the investment is written down to reflect the decrease. | The value of the investment is updated regularly based on the investee’s financial performance. |
What Are the Rules for the Equity Accounting Method?
- Recording the Investment: The investing company shows its stake in the investee company as an asset on its balance sheet.
- Recognizing Profits or Losses: The investing company includes its share of the investee’s profits or losses in its income statement, based on its ownership percentage.
What Are the Problems with the Equity Accounting Method?
- Limited Insight for Investors: The equity method might not provide useful insights for investors because it reflects only the investor’s share of the investee’s financial results.
- No Control Over Assets: The investing company doesn’t control how the investee uses its assets, nor does it directly benefit from the investee’s financial performance unless dividends are paid.
The Bottom Line
When a company owns a significant portion of another company—typically 20% or more—it must use the equity method of accounting to report this investment on its financial statements.
This is because owning a substantial share provides the investing company with some level of influence over the investee’s profits, performance, and decisions.
Therefore, any profit or loss from the investment is reflected in the investing company’s financial results.
