Definition
Equity accounting is a method used by firms to assess the profits earned by their investments in other companies. It involves recording the initial investment as an asset, then adjusting that value over time to maintain congruity with changes in the investee’s equity. The investor’s proportionate share of the investee’s profits or losses is reported in the income statement.
Key Takeaways
- Equity Accounting is a method for companies to account for investments in associates or subsidiaries. It allows the parent company to record profits and losses in line with its level of ownership in the associate or subsidiary.
- Under Equity Accounting, investments are initially recorded in the financial statements at cost and this cost is increased or decreased annually to take into account any profits or losses of the invested entity. The dividends received from an entity reduce the carrying value of the investment on the balance sheet.
- Equity Accounting provides a more accurate reflection of the investing company’s financial position and profitability. It can offer valuable information for investors and financial analysts about the origin of a company’s revenue, the range of its operations, and risk exposures.
Importance
Equity Accounting is a crucial financial term signifying the method of accounting used by an entity to record investments made in associate companies. The importance lies in its ability to present a realistic financial portrait of a company’s investment in an associate company.
Instead of considering the dividend received from the investment, Equity Accounting accounts for the company’s share of the associate’s profits and losses in the balance sheet. This is essential as it gives realistic, comprehensive, and clearer visibility into a company’s financial status, helping investors and stakeholders make informed decisions.
Moreover, it reflects economic reality since a company doesn’t just benefit from dividends by an associate but also from its performance in the market. Thus, Equity Accounting serves as a tool for better transparency and fair representation of a company’s financial health.
Explanation
Equity Accounting is a vital management tool used to accurately present a company’s financial health, particularly when it has significant investments in other entities. The primary purpose of equity accounting is to give an accurate picture of an organization’s investment income.
This method allows companies to account for investments in other companies that they have significant influence over, usually defined as owning 20-50% of voting stock. It reflects the economic reality that the investor company does not simply own a passive interest, but can actively influence the decisions of the associate entities.
Businesses use equity accounting not only to exhibit their own financial health but also to articulate the value they derive from their associate enterprises. By accounting for these investments at cost plus the investor’s share of post-acquisition changes, it ensures that the reported value of assets remains fair and close to their realisable value.
Hence, it presents a realistic picture of the investment’s worth and the profits or losses from it. This method also prevents the overstatement or understatement of asset values, thereby enhancing the accuracy of financial reporting.
Examples of Equity Accounting
Equity accounting is used when a parent company holds a significant, but not majority, stake in a smaller company. Rather than record the actual costs of this investment, the parent company records the income earned from their share of the smaller company. This is especially important for companies that hold a 20-50% stake, as this method better reflects their influence over the subsidiary company.Here are three real-world examples:Berkshire Hathaway & American Express: Berkshire Hathaway, the multinational conglomerate headed by Warren Buffet, uses the equity method in its accounting for its
8% stake in American Express as ofThe conglomerate records income from American Express onto its own books but does not control the company.
Google & Uber: In 2013, Google invested $258 million in Uber through Google Ventures, its venture-capital arm, obtaining about3% stake. Although Google didn’t have a controlling interest in Uber, it had significant influence hence it could use equity accounting method to report its share of Uber’s earnings or losses.
Microsoft & Comcast: Back in 1997, Microsoft invested $1 billion in Comcast, one of the largest broadcasting companies. Despite not having a majority stake, Microsoft would utilize the equity method of accounting to report the investment, showing earnings or losses corresponding to their stake in Comcast.
FAQs on Equity Accounting
1. What is Equity Accounting?
Equity accounting is a method of accounting where a company’s investment in a subsidiary is recorded on its balance sheet at cost and is adjusted based on the changes in the subsidiary’s equity. The investor company’s income statement will also reflect its share in the profits or losses of the subsidiary.
2. How is Equity Accounting applied?
Equity accounting is applied when a company owns 20% to 50% of another company’s shares. The company that owns the shares is the investor, and the company whose shares are being owned is the investee. The investor records initial investment as an asset and adjusts the values based on its share in the profits, losses, dividends and other comprehensive income of the investee.
3. What is the difference between Equity Accounting and Consolidation?
Both Equity Accounting and Consolidation are methods companies use to record investments in other companies. In Equity Accounting, the investment is recorded as a single line item on the balance sheet and adjusted based on earnings or losses. In Consolidation, the financial statements of the parent company and its subsidiaries are combined and presented as a single entity.
4. How does Equity Accounting impact the Financial Statements?
Equity Accounting impacts both the balance sheet and income statement of the investor. On the balance sheet, the investment appears as a non-current asset. On the income statement, the investor’s share of the investee’s net profit or loss is reported which directly affects the investor’s net earnings and thus its shareholders’ equity.
5. Are Dividends included in Equity Accounting?
Yes, dividends are included in equity accounting. Dividends received by the investor from the investee reduce the carrying amount of the investment on the balance sheet. They do not impact the income statement of the investor as they are seen as a return of investment rather than income.
Related Entrepreneurship Terms
- Investee
- Investor
- Ownership Interest
- Net Income
- Dividends
Sources for More Information
- Investopedia: A comprehensive online resource for understanding terms and concepts related to finance and investment, including equity accounting.
- AccountingTools: A website dedicated to providing clear insights and explanations for various accounting concepts such as equity accounting.
- Corporate Finance Institute (CFI): A professional financial education platform that provides articles and courses on a variety of topics including equity accounting.
- The Association of Chartered Certified Accountants (ACCA): As a global professional body for accountants, ACCA offers wide-ranging resources across many subjects such as equity accounting.
