- Equity Method of Accounting for Investments
- Equity Method Example
- Initial Equity Method Investment
- Equity Method Goodwill
- Share of Net Income
- Equity Method Dividend
- Share of Loss
- Accounting for Equity Investments
- Fair value method: 0 to 20% holding
- Example: fair value method
- Equity method: 20%-50% holding
- Example: equity method
- Equity accounting: where’s it at?
- Loss of influence
- Consolidation parallels
- Graham Holt is associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School
- Types of Equity Accounts
- Types of Equity Accounts – Explanation
- Partnership Equity Accounts
- Corporate Equity Accounts
- Equity Method Accounting — Definition, Explanation, Examples
- How does the equity method work?
- Practical example
- What are the other possible accounting methods?
- Additional Resources
- Equity Accounting Method (Definition, Examples) | How it Works?
- Example #1
- Example #2
- Advantages of Equity Accounting
- Disadvantages of Equity Accounting
- Limitations of Equity Accounting
- Recommended Articles
Equity Method of Accounting for Investments
When a business (investor) invests in the shares of another business (investee) and is in a position to exert significant influence over the investee but does not have a controlling interest, then it uses the equity method to account for the investment.
Significant influence refers to the ability of the investor to participate in the policy making decisions of the investee business. A major indicator of significant influence is an equity interest of more than 20% but less than 50%.
The investor records the initial cost of the shares in a balance sheet investment account. The equity accounting method seeks to reflect any subsequent changes in the value of the investee business in this investment account.
For example, if the investee makes a profit it increases in value and the investor reflects its share of the increase in the carrying value shown on its investment account. If the investee makes a loss it decreases in value and the investor reflects its share of the decrease in the carrying value shown on its investment account.
wise if the investee pays a dividend to shareholders its retained earnings, equity and net assets decrease in value and again the investor reflects its share of this decrease in the carrying value shown on the investment account.
In summary the carrying value shown on the investors equity method investment account is calculated as follows.
Cost + Share of net income — Share of net loss — Dividend received = Carrying value of investment
Equity Method Example
Suppose a business (the investor) buys 25% of the common stock of another business (the investee) for 220,000 in cash. The investor is deemed to exert significant influence over the investee and therefore accounts for its investment using the equity method of accounting.
Initial Equity Method Investment
The first of the equity method journal entries to be recorded is the initial cost of the investment of 220,000.
|Equity method investment||220,000|
The investment is recorded at its initial cost of 220,000.
Equity Method Goodwill
It should be noted that the initial cost might include equity method goodwill. Providing no other asset adjustments are required the goodwill is the difference between the value placed on the investee business and the book value of the underlying assets.
In this example, assuming the value of the underlying assets are 770,000, the goodwill is calculated as follows.
Value of investee business = 220,000 / 25% = 880,000 Book value of underlying assets = 770,000 Goodwill = 880,000 — 770,000 = 110,000 Investor share = 25% x 110,000 = 27,500
The investor share of the equity method goodwill of 27,500 is part of the initial cost of the investment of 220,000 and is included in the debit entry to the investment account. Equity method goodwill is not amortized.
Share of Net Income
Suppose in the first year the investee generates a net income of 140,000. The investors share of this net income is 35,000 (25% x 140,000).
Under the equity method the investee business has increased in value and the investor reflects its share of this increase in the investment account with the following journal entry.
|Equity method investment||35,000|
|Equity method income||35,000|
The debit entry increases the balance sheet carrying value of the investment by the share of net income. The credit entry reflects the income in the income statement of the investor.
The carrying value of the investment shown on the investment account is now as follows.
|Initial investment cost||220,000|
|+ Share of net income||35,000|
Equity Method Dividend
The investee subsequently declares and pays a dividend of 22,000 to its shareholders of which the investor is entitled 5,500 (25% x 22,000).
The investor records the receipt of its share of dividend with the following bookkeeping journal entry.
|Equity method investment||5,500|
The receipt of the dividend causes the cash balance of the investor to increase. The other side of the entry is not to dividend income but is a credit to the investment account in the balance sheet.
By using the equity method the investor has already reflected its share of income in its income statement in the previous journal. When the dividend is paid the value of the investee business decreases and the investor reflects its share of the decrease in the investment account.
The carrying value of the investment shown on the balance sheet is summarized as follows.
|Initial investment cost||220,000|
|+ Share of net income||35,000|
|– Dividend received||-5,500|
Share of Loss
In the next period the investee makes a loss of 60,000 of which the investors share is 15,000 (25% x 60,000). Under the equity method the investor records their share of loss using the following journal entry.
|Equity method investment||15,000|
|Equity method income||15,000|
The loss decreases the value of the investee business and the investor reflects their share of this decrease with the credit entry to the equity method investment account. The debit entry to the equity method income account reflects the share of the loss recognized by the investor.
At the end of the period the investment account equity method carrying value is as follows.
|Initial investment cost||220,000|
|+ Share of net income||35,000|
|– Dividend received||-5,500|
|– Share of net loss||-15,000|
The equity method of accounting is necessary to reflect the economic reality of the investment transaction.
If the investor was able to use the cost method and was in a position to exert significant influence over say the dividend distribution policy, then it could determine whether or not to declare a dividend from the investment and manipulate the amount of dividend income included in its earnings for the year. By using the equity method the investor reflects any earnings, dividends and changes in the value of the investee as they arise in the investment account.
Last modified December 13th, 2019 by Michael Brown December 13, 2019
Accounting for Equity Investments
Home Accounting Investments Accounting for Equity Investments
Accounting for equity investments, i.e.
investments in common stock, preferred stock or any associated derivative securities of a company, depends on the ownership stake.
Investment amounting to 0-20%, 20%-50% and more than 50% of the outstanding capital must be accounted for using fair value method, equity method and consolidation respectively.
Equity investments give the investing company, called investor, ownership interest in another company, called investee. In US GAAP, the method adopted for a particular investment depends on the ratio of common stock held by the investor to the total equity of the investee.
Fair value method: 0 to 20% holding
If an investor has 20% or less holding in a company, it means it has passive interest in the company, hence, it must be accounted for using the fair value method. The fair value method is also called cost method.
Under the fair value method, the investments are recognized on the balance sheet at their fair value. Any associated transaction costs are expensed. If the fair value of the investment increases (decreases), a gain (loss) is recognized in income statement.
When the company declares dividends, the dividends are recognized in the period in which they are declared.
When an equity investment held under the fair value method are sold, any gain or loss not already recognized in income statement is recognized in income statement
Example: fair value method
You purchased 1 million shares of Apple, Inc. (NYSE: AAPL) on 1 July 2017 at $144.02. Because Apple’s outstanding shares are 4.92 billion, you hold just 0.02% of the total stock, so you must use the fair value method. You will recognize the purchase as follows:
|Equity investments – fair value method||144,020,000|
Your financial year end is 31 December 2017 when the stock price is $172.26. You must adjust your investment for changes in fair value (i.e. $172.26 × 1,000,000 — $144,020,000) as follows:
|Equity investments – fair value adjustment||Balance Sheet||28,240,000|
|Unrealized gain on equity investment||Income Statement||28,240,000|
During the period, Apple declared two dividends of $0.63 per share each. This will be recorded in income as follows:
|Dividend income (2 × $0.63 × 1,000,000)||Income Statement||1,260,000|
On 8 February 2018, you sold the stock when the price per share was $155.15. This represents the loss on sales of $17,110,000 (=$144,020,000 + $28,240,000 — $155.15 × 1,000,000). This would be recorded as follows:
|Cash ($155.15 × 1,000,000)||Balance Sheet||$155,150,000|
|Loss on sale||Income Statement||$17,110,000|
|Equity investments ($144,020,000 + $28,240,000)||Income Statement||$172,260,000|
Equity method: 20%-50% holding
If an investor holds more than 20% but less than 50% of the outstanding stock of a company, it shows it has significant influence on the investee. Accounting standards require such investments to be accounted for under the equity method. The investor and investees with 20%-50% holding are called associates.
When an investor holds more than 20% but less than 50% of the voting rights, the investor has significant influence in determining the company’s dividend policies, etc. Hence, it’s appropriate to recognize the investor’s proportionate share in the net income of the investee as an increase in investment and the proportionate dividends declared as a reduction of investment carrying value.
The carrying value of an investment under the equity method is determined as follows:
|Add: proportionate share in income (i)||I × p|
|Less: proportionate share in dividends (d)||D × p|
|Equals: carrying value of investment||CV|
Where C is the cost of the investment i.e. purchase price, t represents the transaction costs, I is the total net income of the investee, D is the total dividends declared by the investee in the period, p is the percentage of holding and CV is the closing carrying value of the investment.
Example: equity method
Let’s continue the example above. Let’s say you purchased 1 billion shares of Apple instead of 1 million at $144.02 per share. Because total outstanding stocks are 4.
92 billion, your holding is 20.32% (=1B/4.92B), equity method must be applied. From 1 July 2017 to 31 December 2017, let’s say Apple earned net income of $30,779 million and declared dividends of $1.
26 (=$0.63 + $0.63) per share.
You will need to pass the following journal entries:
|01-Jul-17||Investment in associate — equity method||Balance Sheet||144,020|
Equity accounting: where’s it at?
In May 2011, the International Accounting Standards Board (IASB) issued a new version of IAS 28, Investments in Associates and Joint Ventures, that requires both joint ventures and associates to be equity-accounted. The standard is effective from 1 January 2013 and entities need to be aware of its implications, although the EU has endorsed IAS 28 from 1 January 2014.
An associate is an entity in which the investor has significant influence, but which is neither a subsidiary nor a joint venture of the investor. 'Significant influence' is the power to participate in the financial and operating policy decisions of the investee, but not to control those policy decisions.
It is presumed to exist when the investor holds at least 20 per cent of the investee's voting power. If the holding is less than 20 per cent, the entity will be presumed not to have significant influence unless such influence can be clearly demonstrated.
A substantial or majority ownership by another investor does not preclude an entity from having significant influence.
Loss of influence
An entity loses significant influence over an investee when it loses the power to participate in the financial and operating policy decisions of that investee. The loss of significant influence can occur with or without a change in absolute or relative ownership levels.
A joint venture is defined as a joint arrangement where the parties in joint control have rights to the net assets of the joint arrangement. Associates and joint ventures are accounted for using the equity method unless they meet the criteria to be classified as 'held for sale' under IFRS 5, Non-current Assets Held for Sale and Discontinued Operations.
On initial recognition, the investment in an associate or a joint venture is recognised at cost, and the carrying amount is increased or decreased to recognise the investor's share of the profit or loss of the investee after the date of acquisition.
IFRS 9, Financial Instruments, does not apply to interests in associates and joint ventures that are accounted for using the equity method.
Instruments containing potential voting rights in an associate or a joint venture are accounted for in accordance with IFRS 9 unless they currently give access to the returns associated with an ownership interest in an associate or a joint venture. An entity's interest in an associate or a joint venture is determined solely on the basis of existing ownership interests and, generally, does not reflect the possible exercise or conversion of potential voting rights.
Investments in associates or joint ventures are classified as non-current assets inclusive of goodwill on acquisition and presented as one-line items in the statement of financial position.
The investment is tested for impairment in accordance with IAS 36, Impairment of Assets, as single assets, if there are impairment indicators under IAS 39, Financial Instruments: Recognition and Measurement.
The entire carrying amount of the investment is tested for impairment as a single asset — that is, goodwill is not tested separately. The recoverable amount of an investment in an associate is assessed for each individual associate or joint venture, unless the associate or joint venture does not generate cashflows independently.
IFRS 5 applies to associates and joint ventures that meet the classification criteria. Any portion of the investment that has not been classified as held for sale is still equity-accounted until the disposal. After disposal, if the retained interest continues to be an associate or joint venture, it is equity-accounted.
Under the previous version of the standard, the cessation of significant interest or joint control triggered remeasurement of any retained investment even where significant influence was succeeded by joint control. IAS 28 now requires that any retained interest is not remeasured.
If an entity's interest in an associate or joint venture is reduced but the equity method continues to be applied, then the entity reclassifies to profit or loss the proportion of the gain or loss previously recognised in other comprehensive income relative to that reduction in ownership interest.
The IASB states that many of the procedures appropriate for equity accounting are similar to those for consolidation of entities and the concepts used in accounting for the acquisition of a subsidiary are also applicable to the acquisition of an associate or joint venture.
However, it is not always appropriate to apply IFRS 10, Consolidated Financial Statements, or IFRS 3, Business Combinations. There is disagreement over whether equity accounting is a one-line consolidation or a valuation approach. When an associate is impairment-tested, it is treated as a single asset and not as a collection of assets as would be the case under acquisition accounting.
Additionally as associates and joint ventures are not part of the group, not all of the consolidation principles will apply in the context of equity accounting.
There is no definition of the cost of an associate or joint venture in IAS 28. There is debate over whether costs should be defined as including the purchase price and other costs directly attributable to the acquisition such as professional fees and other transaction costs.
It might be appropriate to include transaction costs in the initial cost of an equity-accounted investment, but IFRS 3 would require these to be expensed if they relate to the acquisition of businesses.
IFRS 9 includes directly attributable transaction costs in the initial value of the investment.
IAS 28 states that profits and losses resulting from 'upstream' and 'downstream' transactions between an investor (including its consolidated subsidiaries) and an associate or joint venture are recognised only to the extent of the unrelated investors' interests in the associate or joint venture. Upstream transactions are sales of assets from an associate to the investor and downstream transactions are sales of assets by the investor to the associate.
There is no specific guidance on how the elimination should be carried out but generally in the case of downstream transactions any unrealised gains should be eliminated against the carrying value of the associate. In the case of upstream transactions any unrealised gains could be eliminated either against the carrying value of the associate or against the asset transferred.
The standards are currently unclear on whether this elimination also applies to unrealised gains and losses arising on transfer of subsidiaries, joint ventures and associates. An example would be where an investor sells its subsidiary to its associate and the question would be whether part of the gain on the transaction should be eliminated.
There is an inconsistency between guidance dealing with the loss of control of a subsidiary and the restrictions on recognising gains and losses arising from sales of non-monetary assets to an associate or a joint venture.
IFRS 10 requires recognition of both the realised gain on disposal and the unrealised holding gain on the retained interest.
In contrast, IAS 28 requires gains or losses on the sale of a non-monetary asset to an associate or a joint venture to be recognised only to the extent of the other party's interest.
The IASB accordingly issued an exposure draft in December 2012 stating that any gain or loss resulting from the sale of an asset that does not constitute a business between an investor and its associate or joint venture should be partially recognised. However, any gain or loss arising from the sale of an asset that does constitute a business between an investor and its associate or joint venture should be fully recognised.
IFRS 3 defines a business as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return directly to investors or other owners, members or participants.
Under the equity method, the investment is initially recognised at cost and adjusted to recognise the investor's share of the profit or loss and other comprehensive income (OCI) of the investee. Additionally, the investment is reduced by distributions received from the invest.
However, IAS 28 is silent on how to treat other changes in the net assets of the investee in the investor's accounts, which might include:
- issues of additional share capital to parties other than the investor;
- buybacks of equity instruments from shareholders other than the investor;
- writing of a put option over the investee's own equity instruments to other shareholders;
- purchase or sale of non-controlling interests in the investee's subsidiaries'
- equity-settled share-based payments.
The IASB proposed in an exposure draft issued in November 2012 that an investor's share of certain net asset changes in the investee should be recognised in the investor's equity.
The draft contains an alternative view by one board member who believes the amendment to be inconsistent with the concepts of IAS 1 and IFRS 10, and would cause serious conceptual confusion.
This board member believes this short-term solution would not improve financial reporting and would undermine a basic concept of consolidated financial statements.
The draft notes that an investor may discontinue the use of the equity method for various reasons including where the investment in the investee becomes a subsidiary or a financial asset.
The draft proposes that an investor should reclassify to profit or loss the cumulative amount of other net asset changes previously recognised in the investor's equity when an investor discontinues the use of the equity method for any reason.
Graham Holt is associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School
Types of Equity Accounts
Equity is defined as the owner’s interest in the company assets. In other words, upon liquidation after all the liabilities are paid off, the shareholders own the remaining assets. This is why equity is often referred to as net assets or assets minus liabilities.
Equity can be created by either owner contributions or by the company retaining its profits. When an owner contributes more money into the business to fund its operations, equity in the company increases. wise, if the company produces net income for the year and doesn’t distribute that money to its owner, equity increases.
Equity accounts, liabilities accounts, have credit balances. This means that entries created on the left side (debit entries) of an equity T-account decrease the equity account balance while journal entries created on the right side (credit entries) increase the account balance.
Types of Equity Accounts – Explanation
There are several types of equity accounts illustrated in the expanded accounting equation that all affect the overall equity balance differently. Here are the main types of equity accounts.
Capital – Capital consists of initial investments made by owners. Stock purchases or partnership buy-ins are considered capital because both are comprised of cash contributions made by the owners to the company. Capital accounts have a credit balance and increase the overall equity account.
Withdrawals – Owner withdrawals are the opposite of contributions. This is where the company distributes cash to its owners. Withdrawals have a debit balance and always reduce the equity account.
Revenues – Revenues are the monies received by a company or due to a company for providing goods and services. The most common examples of revenues are sales, commissions earned, and interest earned. Revenue has a credit balance and increases equity when it is earned.
Expenses – Expenses are essentially the costs incurred to produce revenue. Costs payroll, utilities, and rent are necessary for business to operate. Expenses are contra equity accounts with debit balances and reduce equity.
Un assets and liabilities, equity accounts vary depending on the type of entity. For example, partnerships and corporations use different equity accounts because they have different legal requirements to fulfill. Here are some examples of both sets of equity accounts.
Partnership Equity Accounts
Owner’s or Member’s Capital – The owner’s capital account is used by partnerships and sole proprietors that consists of contributed capital, invested capital, and profits left in the business. This account has a credit balance and increases equity.
Owner’s Distributions – Owner’s distributions or owner’s draw accounts show the amount of money the owner’s have taken the business. Distributions signify a reduction of company assets and company equity.
Corporate Equity Accounts
Common Stock – Common stock is an equity account that records the amount of money investors initially contributed to the corporation for their ownership in the company. This is usually recorded at the par value of the stock.
Paid-In Capital – Paid-in capital, also called paid-in capital in excess of par, is the excess dollar amount above par value that shareholders contribute to the company. For instance, if an investor paid $10 for a $5 par value stock, $5 would be recorded as common stock and $5 would be recorded as paid-in capital.
Treasury Stock – Sometimes corporations want to downsize or eliminate investors by purchasing company from shareholders. These shares that are purchased by the company are called treasury stock. This stock has a debit balance and reduces the equity of the company.
Dividends – Dividends are distributions of company profits to shareholders. Dividends are the corporate equivalent of partnership distributions. Both reduce the equity of the company.
Retained Earnings – Companies that make profits rarely distribute all of their profits to shareholders in the form of dividends. Most companies keep a significant share of their profits to reinvest and help run the company operations. These profits that are kept within the company are called retained earnings.
There is a basic overview of equity accounts and how their interact with the overall equity of the company.
Liability AccountsContra Accounts
Equity Method Accounting — Definition, Explanation, Examples
The equity method is a type of accounting used for intercorporate investmentsInvestment MethodsThis guide and overview of investment methods outlines they main ways investors try to make money and manage risk in capital markets.
An investment is any asset or instrument purchased with the intention of selling it for a price higher than the purchase price at some future point in time (capital gains), or with the hope that the asset will directly bring in income (such as rental income or dividends)..
This method is used when the investor holds significant influenceInvestor InfluenceThe level of investor influence a company holds in an investment transaction determines the method of accounting for said private investment. The accounting for the investment varies with the level of control the investor possesses.
over the investee but does not exercise full control over it, as in the relationship between a parent company and its subsidiary. In this case, the terminology of “parent” and “subsidiary” are not used, un in the consolidation method where the investor exerts full control over its investee.
Instead, in instances where it’s appropriate to use the equity method of accounting, the investee is often referred to as an “associate” or “affiliate”.
Although the following is only a general guideline, an investor is deemed to have significant influence over an investee if it owns between 20% to 50% of the investee’s shares or voting rights.
If, however, the investor has less than 20% of the investee’s shares but still has a significant influence in its operations, then the investor must still use the equity method and not the cost method.Cost MethodThe cost method is a type of accounting used for investments, where the investor holds little to no influence over the investee.
U the consolidation method, the terminology of “parent” and “subsidiary” are not used since the investor does not exert full control. Instead, the term “investment” is simply used
How does the equity method work?
Un with the consolidation methodConsolidation MethodThe consolidation method is a type of investment accounting used for consolidating the financial statements of majority ownership investments. This method can only be used when the investor possesses effective control of a subsidiary, which often assumes the investor owns at least 50.
1%, in using the equity method there is no consolidation and elimination process. Instead, the investor will report its proportionate share of the investee’s equity as an investment (at cost). Profit and loss from the investee increase the investment account by an amount proportionate to the investor’s shares in the investee. This is known as the “equity pick-up.
” Dividends paid out by the investee are deducted from this account.
Lion Inc. purchases 30% of Zombie Corp for $500,000.
At the end of the year, Zombie Corp reports a net incomeNet IncomeNet Income is a key line item, not only in the income statement, but in all three core financial statements.
While it is arrived at through the income statement, the net profit is also used in both the balance sheet and the cash flow statement. of $100,000 and a dividend of $50,000 to its shareholders.
When Lion makes the purchase, it records its investment under “Investments in Associates/Affiliates”, a long-term asset account. The transaction is recorded at cost.
|Dr.||Investments in Associates||500,000|
Lion receives dividends of $15,000, which is 30% of $50,000, and records a reduction in their investment account. The reason for this is that they have received money from their investee. In other words, there is an outflow of cash from the investee, as reflected in the reduced investment account.
|Cr.||Investments in Associates||15,000|
Finally, Lion records the net income from Zombie as an increase to its Investment account.
|Dr.||Investments in Associates||30,000|
The ending balance in their “Investments in Associates” account at year-end is $515,000. This represents a $15,000 increase from their investment cost.
This reconciles with their portion of Zombie’s retained earnings. Zombie has Net Income of $100,000, which is reduced by the $50,000 dividend. Thus, Zombie’s retained earnings for the year are $50,000. Lion’s portion of this $50,000 is $15,000.
What are the other possible accounting methods?
When an investor exercises full control over the company it invests in, the investing company may be known as a parent company to the investee. The latter is then known as a subsidiary of the parent company. In such a case, investments made by the parent company in the subsidiary are accounted for using the consolidation method.
The consolidation method records “investment in subsidiarySubsidiaryA subsidiary (sub) is a business entity or corporation that is fully owned or partially controlled by another company, termed as the parent, or holding, company.
Ownership is determined by the percentage of shares held by the parent company, and that ownership stake must be at least 51%.” as an asset on the parent company’s balance sheet, while recording an equal transaction on the equity side of the subsidiary’s balance sheet.
The subsidiary’s assets, liabilities, and all profit and loss items are reported in the consolidated financial statements of the parent company.
Alternatively, when an investor does not exercise full control over the investee, and has no influence over the investee, the investor possesses a passive minority interestMinority Interest in Enterprise Value CalculationEnterprise Value has to be adjusted by adding minority interest to account for consolidated reporting on the income statement. Example calculation, guide. When a company owns more than 50% (but less than 100%) of a subsidiary, they record all 100% of that company's revenue, costs, and other income statement items, even in the investee. In such a case, investments are accounted for using the cost method.
The cost method records the investment at cost and accounts for it depending on the investor’s historic transactions with the investee and other similar investees.
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- Investment methodsInvestment MethodsThis guide and overview of investment methods outlines they main ways investors try to make money and manage risk in capital markets. An investment is any asset or instrument purchased with the intention of selling it for a price higher than the purchase price at some future point in time (capital gains), or with the hope that the asset will directly bring in income (such as rental income or dividends).
- Public securitiesPublic SecuritiesPublic securities, or marketable securities, are investments that are openly or easily traded in a market. The securities are either equity or debt-based.
- Debt ScheduleDebt ScheduleA debt schedule lays out all of the debt a business has in a schedule its maturity and interest rate. In financial modeling, interest expense flows
Equity Accounting Method (Definition, Examples) | How it Works?
Equity Accounting refers to a form of accounting method that is used by various corporations to maintain and record the income and profits which it often accrues and earns through the investments and stake-holding that it buys in another entity.
Let us consider an example of Pacman co, which goes on to acquire 25% in company Target Co for a stake of 65000$. At the end of the year, Target co would report a dividend of $2500.
When Pacman co would record the purchase, it would do the same under the head ‘Investments in affiliates by debiting the same by $65000 and crediting the cash account by $65000, and the following journal entry would be passed –
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Pacman would only account for a dividend of $625 owing to its 25% stake. (25% of $65000). It would then be recorded as a reduction in an investment account, which is that they would have received some money from the investee. Hence, cash would be debited by $625, recording a credit in investment in associates.
Major co acquired Minor co for a 40% stake. Minor co declared a net income of $200000 for the year.
Hence the net income can be displayed as a certain amount of increase in the investment account in books of Major Co for an amount of $8000 ($20000*40%) by crediting the investment revenue account and debiting the investment in affiliates. The new balance in ‘Investment in minor Co’ will be $208000 ($200000+$8000).
Advantages of Equity Accounting
- Facilitates tracking: By having to understand the income or profits that are derived from the associate/affiliates or the subsidiary, the business can track such income accordingly by having to segregate or bifurcate such source of income into the various heads
- Provides the necessary bifurcation: By having to adopt the method of equity accounting, a firm can easily bifurcate and attribute the income to various other subheads or even subsidiaries which it happens to hold. The firm can now easily segregate the income which can be owed to profits/income that is earned by the target or the subsidiary company of which it happens to hold a certain stake.
- Facilitates attribution: The Company can now give a clear-cut view to all its stakeholders, be it investors, shareholders, creditors, customers. Government, etc., with regard to the profit that it attributes to its own and also the profits that tend to be derived from the subsidiaries. Such an attempt by the company will help it develop a certain amount of attribution practices with regard to the income/profit it can generate from its holdings.
- Boosts standalone earnings: When a company provides a standalone view rather than a consolidated view of its financial statements, the figures tend to be presented better for the division/unit owing to profits earned from that particular division. There may be times the parent company is performing poorly, yet it is the subsidiary company that tends to provide exceptional brilliant performance even at times of turmoil. Thus equity accounting tends to accurately reflect this by having to segregate the amount that can be attributed to the amount earned from the subsidiary.
- Simple procedure: The technique of having to make a simple adjustment by having to ascertain the value by arriving at each aspect of the value of the subsidiary is instead a simple task. One has to merely understand the percentage of stake involved and then do some amount of simple mathematics to arrive at the respective amounts for the value or the profits that can be attributed to the subsidiary.
Disadvantages of Equity Accounting
- Company may not be profitable on a standalone basis: There is an excellent possibility that the company may look good on a consolidated basis, but when an equity accounting method is undertaken to make efforts to understand the income that can be attributed to its subsidiaries, one may get to know that the company is not doing so well on a standalone basis, un the rosy picture that was painted by the parent company.
- Segregation requires additional time and effort: More often than not, when a company attempts to undertake equity accounting, it is often seen that the time undertaken for segregation to understand the value of equity in the subsidiary is often enormous. There are significant time and efforts involved in understanding the financials of the subsidiary on a standalone basis through the method of equity accounting.
Limitations of Equity Accounting
- Dependence on Subsidiary for Information: Without the relevant information which the subsidiary provides, be it details relating to income/profit for the year or even dividend for that matter, the equity accounting method cannot be undertaken.
Hence there is a significant dependence on the subsidiary company to gain the relevant information so that the necessary equity accounting can be undertaken by the parent company.
If such information is not provided, the method ceases to exist and thus goes on to be a significant limitation.
Equity accounting, no doubt, stands as an excellent method to gauge and understand the returns and also the income that can be attributed to the subsidiaries that the business owns or runs.
The income can be attributed to the different affiliates the business owns, manages, and runs.
Such a method facilitates tracking and segregating the various income heads among the subsidiaries, be it dividends or even revenue for the year.
However, owing to additional information required, the firm will have to rely on the income declared by a subsidiary, which otherwise will not be known if the affiliate tends to be a privately held company, where the parent has picked up the stake.
There tends to be significant reliance on the subsidiary in this regard. Moreover, there is time and effort required in doing additional steps that of equity accounting, and hence the firm needs to appropriate resources accordingly in this regard.
Nevertheless, equity accounting stands to be an excellent example of having to understand and segregate the income heads that can be attributed to the subsidiaries that the parent company has made an effort to acquire a significant stake.
This article has been a guide to Equity Accounting and its definition. Here we discuss an example of an equity accounting method with journal entries, advantages, disadvantages, and limitations. You can learn more from the following articles –