Equity Accounting
Equity accounting is an accounting process for recording investments in associated companies or entities. Companies sometimes have ownership interests in other companies. Typically, equity accounting–also called the equity method–is applied when an investor or holding entity owns 20–50% of the voting stock of the associate company. The equity method of accounting is used only when an investor or investing company can exert a significant influence over the investee or owned company.
Definition: Equity accounting is the process of recording investments in associated companies or entities. Typically, equity accounting, also known as the equity method, is used when an investor or holding company owns 20-50% of the voting shares of an associated company. This method is only used when the investor or investing company can exert significant influence over the investee company.
Origin: The concept of equity accounting originated in the mid-20th century as inter-company investments and collaborations increased. Traditional accounting methods could not accurately reflect the influence of investors on investee companies. To better represent this relationship, the equity accounting method was gradually introduced and adopted.
Categories and Characteristics: Equity accounting mainly falls into two categories: 1. Initial Investment Recording: The investor records the initial investment at the purchase cost when acquiring shares of the associated company. 2. Subsequent Adjustments: The book value of the investment is adjusted based on changes in the net assets of the investee company. Characteristics include: a. The investor has significant influence over the investee company; b. The book value of the investment is adjusted according to changes in the investee company's net assets; c. Investment income is recognized proportionally.
Specific Cases: Case 1: Company A purchases 30% of Company B's shares and has significant influence over Company B. The initial investment recorded by Company A is $1 million. Company B's net profit for the year is $500,000, and Company A recognizes $150,000 of investment income proportionally and adjusts the book value of the investment. Case 2: Company C holds 40% of Company D's shares, with an initial investment of $2 million. Company D incurs a loss of $200,000 for the year, and Company C recognizes $80,000 of investment loss proportionally and reduces the book value of the investment accordingly.
Common Questions: 1. How to determine if there is significant influence? This is usually determined by factors such as the percentage of shares held, board seats, and participation in policy-making. 2. What is the difference between equity accounting and the cost method? The cost method does not adjust based on changes in the investee company's net assets, whereas equity accounting adjusts according to changes in the investee company's net assets.
