Equity Accounting Method: Definition & Example | ORBITAL AFFAIRS

The equity method is an accounting technique that allows a company to record the profits earned through its investment in another company. This method is commonly used when a company has significant influence over the operations and financial decisions of the investee. In this article, we will delve deeper into how the equity method works and its implications for financial reporting.
Understanding the Equity Method
When a company acquires a significant ownership stake in another company, it may have the ability to exert significant influence over the investee’s operations and financial policies. In such cases, the equity method is used to account for this investment. The equity method requires the investor to recognize its share of the investee’s profits or losses in its own financial statements.
To apply the equity method, the investor initially records the investment at cost. Subsequently, the investor’s share of the investee’s profits or losses is recognized in the investor’s income statement. This recognition is based on the investor’s ownership percentage in the investee.
For example, if Company A owns 30% of Company B, Company A will record 30% of Company B’s profits or losses in its own financial statements. This allows for a more accurate representation of the investor’s financial position and performance.
Implications for Financial Reporting
The equity method has significant implications for financial reporting. By recognizing its share of the investee’s profits or losses, the investor provides a more comprehensive view of its financial performance. This is especially important when the investment represents a substantial portion of the investor’s overall business activities.
Under the equity method, the investor’s balance sheet will reflect the initial cost of the investment. However, as the investor recognizes its share of the investee’s profits or losses, these amounts will be reflected in the income statement. Consequently, the investor’s net income will be impacted by its investment activities.
Additionally, the equity method requires the investor to disclose certain information about its investments in the notes to the financial statements. This includes details about the investee’s financial statements, the investor’s share of the investee’s profits or losses, and any dividends received from the investee.
Comparison with Other Accounting Methods
The equity method differs from other accounting methods used for investments, such as the cost method and fair value method. Under the cost method, the investor records the investment at cost and does not recognize any share of the investee’s profits or losses. This method is typically used when the investor has little or no influence over the investee.
On the other hand, the fair value method requires the investor to record the investment at fair value and recognize any changes in fair value in its income statement. This method is commonly used for investments in publicly traded companies, where market prices are readily available.
The equity method strikes a balance between these two extremes. It allows the investor to recognize its share of the investee’s profits or losses, providing a more accurate representation of its financial performance. At the same time, it avoids the volatility associated with fair value accounting.
Conclusion
The equity method is an important accounting technique that allows a company to record the profits earned through its investment in another company. By recognizing its share of the investee’s profits or losses, the investor provides a more comprehensive view of its financial performance. This method is particularly relevant when the investment represents a significant portion of the investor’s overall business activities.
Financial reporting under the equity method involves recognizing the initial cost of the investment on the balance sheet and subsequently recognizing the investor’s share of the investee’s profits or losses in the income statement. The investor is also required to disclose relevant information about its investments in the notes to the financial statements.
Compared to other accounting methods, such as the cost method and fair value method, the equity method strikes a balance between recognizing investment income and avoiding excessive volatility. It is a valuable tool for companies with significant influence over their investees and provides a more accurate representation of their financial position and performance.