The principle of equity accounting requires an investing company to reflect its proportionate share of an investee's earnings (or losses) in its own financial statements. This method is used when an investor has significant influence over the investee, typically owning between 20% and 50% of its voting stock.
Understanding Equity Accounting
Equity accounting isn't just about recording an investment at its initial cost. It involves a dynamic process of recognizing ongoing financial performance.
Key Components:
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Proportional Profit/Loss Recognition:
- As the reference states, the investing company records the investee's profits or losses in proportion to the percentage of ownership. If an investing company owns 30% of another company, it will record 30% of the investee’s net income as its own income. Conversely, it will record 30% of the investee’s net loss as a loss.
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Balance Sheet Adjustments:
- The equity method periodically adjusts the value of the asset on the investor's balance sheet.
- The value of the investment on the investor's balance sheet increases when the investee makes a profit (because the investor's share of the earnings are added to the investment balance).
- Conversely, the value of the investment on the investor's balance sheet decreases when the investee experiences a loss (because the investor's share of the loss reduces the investment balance).
How Equity Accounting Works: A Simple Example
Let's say Company A owns 40% of Company B.
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Initial Investment: Company A buys a 40% stake in Company B for $1,000,000. This investment is recorded as an asset on Company A's balance sheet.
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Company B earns profit: If Company B makes a net profit of $500,000, Company A will recognize a 40% share, that is $200,000, as income on its income statement. Company A will increase its balance sheet asset by $200,000.
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Company B incurs loss: If Company B incurs a net loss of $300,000, Company A will recognize a 40% share, that is $120,000 as a loss on its income statement. Company A will decrease its balance sheet asset by $120,000.
Practical Insights:
- Significant Influence: Equity accounting is triggered by significant influence, which doesn't necessarily mean outright control. Key indicators of significant influence include representation on the board of directors, participation in policy-making, and material intercompany transactions.
- Not Control: It's crucial to understand that equity accounting is not used when the investor has control of the investee. In those cases, consolidation accounting would be more appropriate.
Equity Accounting: A Summary
In short, the principle of equity accounting is about recognizing the financial performance of a company’s investments over which it has significant influence, reflecting its proportionate share of the investee's earnings or losses in its own financial statements, and adjusting the carrying value of the investment accordingly.
