Equity Method Investment Accounting: An Overview

Introduction

Investing in other companies is a popular way for businesses to diversify their portfolio and expand their operations. However, investing in another company requires an accounting method to be used to record the investment. One of these accounting methods is the equity method, which is used when an investor has significant influence over another company but does not have control over it.

What is the Equity Method?

The equity method is an accounting method used when an investor owns between 20% and 50% of another company’s outstanding shares. This method is used to record the investor’s share of the profits or losses generated by the investee company. The investor’s share of the investee’s profits or losses is recorded as a single line item on the investor’s income statement.

How Does the Equity Method Work?

When using the equity method, the investor first records the initial investment at cost. After the initial investment, the investor then records their share of the investee company’s profits or losses on their income statement. The investor also records their share of the investee’s dividends on their cash flow statement.

Benefits of Using the Equity Method

One of the main benefits of using the equity method is that it allows investors to recognize the profits or losses of their investee company as they occur. This method also provides investors with a more accurate representation of their investment in the investee company.

Limitations of Using the Equity Method

The equity method has some limitations, such as the fact that it does not allow investors to consolidate the investee’s financial statements with their own. Additionally, the equity method can be difficult to apply if the investor does not have significant influence over the investee company.

Example of Using the Equity Method

To better understand the equity method, consider the following example. Company A owns 30% of Company B’s outstanding shares. During the year, Company B generates a net income of $100,000. Using the equity method, Company A would record $30,000 ($100,000 x 30%) as income on their income statement.

Conclusion

In conclusion, the equity method is an accounting method used when an investor has significant influence over another company but does not have control over it. The equity method allows investors to recognize the profits or losses of their investee company as they occur, providing a more accurate representation of their investment in the investee company.

People Also Ask:

• What is the difference between the equity method and the consolidation method?
• When should the equity method be used?
• What is significant influence in accounting?
• How do you account for dividends received under the equity method?

Answers:

• The equity method is used when an investor owns between 20% and 50% of another company’s outstanding shares, while the consolidation method is used when an investor has control over another company.
• The equity method should be used when an investor has significant influence over another company but does not have control over it.
• Significant influence in accounting refers to the ability of an investor to affect the operating and financial decisions of another company.
• Dividends received under the equity method are recorded as a reduction in the investor’s investment in the investee company.