Reasons a Company Uses Equity Accounting Method



Companies often find it advantageous to invest in other companies without necessarily taking control of them. The accounting for investments hinges on the amount of sway the investor holds with the investee. Investors use the fairvalue method when the level of influence is insignificant and consolidationaccounting when investors control the investee. Companies use the equity method when they have substantial influence on the investee.

Equity Method
Under the equity method, the investor books the investment as a noncurrentasset at the price it pays for the investee stock. The investor then recognizes its share of investee income and adjusts the book value of the asset accordingly. For example, if the investor owns 30 percent of the investee’s voting shares and the investee earns $1 million in the quarter, the investor records $300,000 as income and as an increase to the investment’s book value. The investor treats any dividends it receives on the investee shares as a return of equity and subtracts them from the asset’s book value.

Compliance With GAAP
The primary reason that companies use the equity method is that it satisfies GAAP, or generally accepted accounting principles. By immediately recognizing investee income, the investor fulfills the GAAP requirement to record revenues and losses in the period earned. Furthermore, the Financial Accounting Standards Board states that the equity method is appropriate when the investor can influence the investee, because the investor must include the results of investee operations in its own income statement. In other words, because the investor has some control over investee results, it is rewarded or penalized accordingly.

Flexibility
Another reason that investors use the equity method is its flexibility. GAAP assumes you have significant influence over an investee if you own between 20 percent and 50 percent of voting shares. Yet a company can use the equity method if it owns less than 20 percent of investee stock if it can prove significant influence, such as having representatives on the investee board. The flexibility also works the other way: A company can avoid the equity method even with ownership of more than 20 percent investee shares. For instance, you may not be influential if the investee is hostile to your suggestions, sues you and denies you board representation.

Looking Good

A company might prefer the equity method over consolidated reporting to enhance its financial ratios. For example, suppose an investor purposely limits its investment to 50 percent of investee voting shares to use the equity method. The investor thus benefits from the assets and liabilities of the investee without needing to consolidate these items into its own balance sheet. This is desirable because the investor’s return on assets and return on debt are higher when the investee’s assets and liabilities are not consolidated with those of the investor. In effect, the investor benefits from off-balance-sheet financing when using the equity method.

Comments

Post a Comment

Popular posts from this blog

What is Double Entry ?

Double entry is the fundamental concept underlying present-day bookkeeping and accounting. Double-entry accounting is based on the fact that every financial transaction has equal and opposite effects in at least two different accounts. I t is used to satisfy the equation Assets = Liabilities + Equity, in which each entry is recorded to maintain the relationship. BREAKING DOWN 'Double Entry' In the double-entry system, transactions are recorded in terms of debits and credits . Since a debit in one account will be offset by a credit in another account, the sum of all debits must therefore be exactly equal to the sum of all credits. The double-entry system of bookkeeping or accounting makes it easier to prepare accurate financial statements directly from the books of account and detect errors. Types of Accounts Bookkeeping and accounting are a way of recording business transactions in monetary terms. A business transaction is an exchange of financial inter...
Read more

What is security?

A security is a tradable financial asset . The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some jurisdictions the term specifically excludes financialinstruments other than equities and fixed income instruments. In some jurisdictions it includes some instruments that are close to equities and fixedincome, e.g. equity warrants . In some countries and languages the term " security" is commonly used in day-to-day parlance to mean any form of financial instrument, even though the underlying legal and regulatory regime may not have such a broad definition. In the United Kingdom, the national competent authority for financial markets regulation is the Financial Conduct Authority ; the definition in its Handbook of the term "security"[1] applies only to equities, debentures, alternative debentures, government and public securities, warrants, certificates representing certain securities, units, st...
Read more

Do preferred stocks trade like common stocks?

The differences and similarities between common stocks and preferred stocks are numerous. Both represent a piece of ownership in a company, and both are tools investors can use to try to profit from the future successes of thebusiness. The main difference between the two types of stock is that holders of common stock typically have voting privileges , whereas holders of preferredstock do not. However, preferred stockholders receive a fixed dividend from the company, while common shareholders may or may not receive one, depending on the decisions of the board of directors. When valuing common and preferred stocks, an investor must consider the different properties of each type. Common stock may not offer the possibility of dividends, but generally investors will hold this type of stock because they are expecting to capture profit through a capital gain, or an increase in the stock price. Preferred stockholders, on the other hand, are generally interested in receiving a ...
Read more