Companies use various accounting methods to track their losses and gains properly. If a business invests in another company, they most likely use the equity method of accounting to make sure the investment brings profit rather than losses.
Understanding how the method works may help you decide if it’s a proper accounting strategy for your business. Our article gives an explanation of what the equity method of accounting is, how does it work, and what the alternatives are. Keep reading to learn more about the topic.
What is the Equity Method
The equity method of accounting is a mechanism used by companies to record losses and profits generated through their investments into other businesses. According to this method, the investor company has to report the revenue generated by the investee on its income statement, in the amount that is proportional to the equity share invested in the investee.
This method is standard and used when the investor company has a considerable influence over the investee company. Considerable influence is when an investor owns from 20% to 50% of a company’s stock. But in some cases, less than 20% interest in another business may also guarantee a significant influence of an investor over the investee, and thus it’s crucial to apply the equity method of accounting.
Overall, the company has a significant influence if it can expand its power to influence other company’s decisions. This power includes being involved in the board of directors, developing policies, changing managerial staff.
You can easily determine if your business has a significant financial influence even without having 20% or more interest in another company. This is evidenced by:
- A seat on the board of directors.
- Material transactions with the investee.
- Influence over participating in policy-making decisions.
- Technological influence over the investee.
- The ability to exchange management personnel with the investee.
- Ownership over a similar investment share to other investors.
Businesses consider all equity or investment accounts as assets. In some cases, these businesses can sell these assets like stocks to use the capital to support business operations. The equity method is accepted by GAAP (Generally Accepted Accounting Principles) and ASC (Accounting Standards Codification).
How does Equity Method Work?
This accounting method works by determining the controlling interest percentage a business has in another organization, business, or entity. The company that invests has to record this percentage on their balance sheet and income statement to reflect their investment.
This percentage is used in a calculation of a profit or loss that is proportional to their investment. For instance, if a certain company owns 48% of another business’s voting stocks, then it can claim 48% of this company’s profits on its income statement.
If an investee reports the loss, then the investor company reports a loss on the balance sheet and income statement. The result of a loss affects the value of the investment on the investor company’s balance sheet.
Equity Method Examples
It’s easier to understand how the method works when looking at some examples. Below you may find examples of the equity method examples.
Let’s see a profit equity example by taking a look at two imaginary companies. ExampleCompany has purchased $400,000 worth of stock in an EquityBusiness company. This amount is equal to 43% of the voting stock in the EquityBusiness.
The EquityBusiness has reported annual profits of $500,000. ExampleCompany calculates their earnings by multiplying their controlling interest of 43% by the EquityBusiness’s profit of $500,000:
$500,000 x 0.43 = $215,000.
ExampleCompany may claim $215,000 in revenue from investing in EquityBusiness. ExampleCompany may also determine the value of their stock on the balance sheet.
ExampleCompany has to add the value of the investment that guaranteed the stock in EquityBusiness ($400,000) with the annual revenue ($215,000). The new value is $615,000, which determines how much ExampleCompany has invested in EquityBusiness.
ExampleHoldings bought $750,000 stock in a Lion Corp. The amount of stock is equal to 35% of the voting stock in Lion Corp.
Lion Corp has recorded and reported an annual loss of $475,000. ExampleHoldings has to calculate the loss from this investment by multiplying their controlling interest of 35% by Lion Corp’s loss of $475,000.
$475,000 x 0.35 = $166,250.
ExampleHoldings has to write off $166,250 as a loss from the investment. The next step is to calculate and record the new value of the investment on their balance sheet.
ExampleHoldings has to subtract the annual loss of $166,250 from the cost the company bought the stock for, which is $750,000, to calculate the new value of stock in Lion Corp:
$750,000 – $166,250 = $583,750.
This number reflects how much ExampleHoldings has invested in the Lion Corp business.
Alternative Accounting Methods
The equity method is used when a company has from 20% to 50% of a business’s stock, but what method to use if it has more than 50%? In that case, it means that an investor company exercises full control over the investee and must record investment in the subsidiary by applying a consolidation method of accounting.
According to the consolidation method of accounting, the company must record the investment in the subsidiary as an asset on the parent business’s balance sheet. Moreover, the investor must also record an equal transaction on the equity of the subsidiary’s balance sheet.
All expenses, revenue, liabilities, resources, and assets of the subsidiary are to be included in the parent company’s financial statement.
Suppose the investor company doesn’t have full control over another company or doesn’t have a significant influence over the company. In that case, the business may use the cost method to record their investments. According to the cost method, the investment by a company is recorded on the balance sheet at its historical value.