Companies use different accounting methods to accurately track their profits and losses. One method, called the equity method, is used by companies that invest in other businesses. This method helps them monitor the financial performance of these investments. Knowing how the equity method of accounting works can help you decide if it’s the right choice for your organization.
What is the Equity Method of Accounting?
The equity method of accounting involves the process of tracking financial records when a particular company decides to invest in other business. This equity method also helps to track profit as well as losses from the investments. Investment accounts are also considered as assets because sometimes many companies sell their stocks and invest those stocks into other businesses.
What do you mean by Investor Influence?
An investor usually influences if it owns 20% to 50% of the investor’s stock. This ownership gives the investor significant voting power in the investee’s decisions.
Other ways an investor can influence an investee include:
- Having a seat on the board of directors.
- Sharing staff and resources.
- Using the same technology.
Benefits of Using the Equity Method
There are several benefits to understanding the equity method of accounting for tracking company investments:
Improves Accounting Accuracy
Tracking investments along with company income gives a clearer picture of total earnings. This method captures income from the central business and its investments, showing them as short- or long-term investments on balance sheets. This helps clarify where the income is coming from and improves financial analysis.
Encourages More Investments
The equity method of accounting lets a company show better profits by including earnings from its investments. This is helpful during tough times or market downturns. By reporting higher profits thanks to their investments, companies can attract more shareholders and investors, showing positive results on their balance sheets.
Complies with Standard Accounting Rules
Businesses use the equity method of accounting because it follows standard accounting rules. This method allows investors to report income and losses when they occur, which accounting standards require. Additionally, if an investor can influence an investee, they must include their results in their financial statements, as the Financial Accounting Standards Board (FASB) recommends.
Determining Control in a Company
Companies gauge their control level by looking at how much voting stock they own. If it’s over 20%, they probably have control. Other signs include:
- Being on the board of directors.
- Influencing policy decisions.
- Engaging in significant transactions.
- Swapping management.
- Sharing technology.
- Having a similar stake as other investors.
How Does the Equity Method Work?
The equity method of accounting is more direct. Here is how it works;
The investor records its portion of the other company’s ownership as an investment, beginning with the initial purchase cost instead of combining the financial cost. When the other company earns profits, the investor adds its share to this investment — called “equity pick-up.” If the other company has losses, the investor subtracts its share.
If another company pays dividends, the investor may deduct a portion. The equity method allows investors to show the company’s profit and losses without merging anything.
This equity method of accounting helps businesses in various ways. If you’re interested in enhancing your equity method of accounting skills, consider exploring online courses offered by Finprov Learning. We provide accounting professional courses, including PG Diploma in Indian and Foreign Accounting (PGDIFA), PG Diploma in Business Accounting and Taxation (PGBAT), International Business Accounting Professional (IBAP) and more. Whether you’re a recent graduate or an experienced professional, Finprov’s accounting institute in Ernakulam offers a comprehensive learning experience.
At Finprov, the focus is on both theory and practical training to equip you with valuable skills. They also provide placement assistance to help you start your career after completing the courses. Contact Finprov today to explore accounting training and boost your career prospects for a bright future.
