Definition
Equity accounting is a method used in accounting where a company records profits and losses from its investments in other companies based on the ownership percentage. It shows the invested company’s income, losses, and dividends in the investing company’s financial statement. This method is typically used when an entity owns between 20% to 50% stakes in another company.
Phonetic
The phonetic pronunciation of “Equity Accounting” is: Equity: /ˈɛkwɪti/Accounting: /əˈkaʊntɪŋ/
Key Takeaways
- Understanding Equity Accounting: Equity accounting is a method of accounting where a company’s investment in another company is initially recorded at cost, but the investment balance is periodically adjusted to reflect the investor company’s share of the investee’s profit or loss.
- Significance of 20%-50% Ownership: Equity accounting is generally used when the investing company owns 20% to 50% of another company’s stock. This level of ownership indicates the investing company has significant influence over the investee, but not full control, which would instead necessitate the use of the consolidation method.
- Impacts on Financial Statements: The application of equity accounting influences the investing company’s balance sheet, income statement, and cash flow statement. The investor reports their share of the investee’s earnings as an increase to the investment account on the balance sheet and income from the investment on the income statement. Dividends received from the investee reduce the carrying amount of the investment but are recognized as cash inflows in the statement of cash flows.
Importance
Equity accounting is a crucial concept in the business and finance realm as it provides an invaluable measure of a company’s true net worth or value. It offers the ability to calculate the shareholders’ equity in a company, which is done by subtracting total liabilities from total assets. This method is important because it allows investors and stakeholders to assess the company’s financial health and profitability by providing insight into what portion of the company’s assets would remain if all the liabilities were paid off. Therefore, it plays a pivotal role in financial analysis, investment decisions, and business valuations. This is essential for investors to ascertain the return on their investment and for lenders or creditors to evaluate the company’s creditworthiness.
Explanation
Equity accounting, primarily known for its purpose in maintaining transparency, is used when an investor company holds significant influence over an investee company but does not possess full control. This method allows the investor company to reflect the changes in the investee’s income and other comprehensive income proportionate to its investment. The investor not only gets to track the profits earned but can also monitor the losses incurred by the investee company. Such transparency helps the investor assess its financial position and strategize for future investment decisions.The use of equity accounting helps in providing an accurate portrayal of an investor’s assets and equity on its balance sheet. Companies often invest in other businesses to diversify their business risk and to reap benefits from good investments. To capture these movements accurately in the financials, companies resort to equity accounting. Furthermore, it aids in avoiding overstatement or understatement of profits, thereby ensuring that an investor company’s financial statements show a true and fair view of its financial performance. This is particularly significant for shareholders and potential investors who base their investment decisions on financial statements provided by the company.
Examples
Equity Accounting is a method of accounting whereby a company records a share of undistributed earnings from its investments in equity securities. Here are three real-world examples of this:1. Google and Uber: Google Ventures invested $258 million in Uber in 2013, which at the time represented about 10% of the shares. Google accounted for this investment under the equity method, given the influence it had over Uber due to the large size of the investment. This meant that Google would include a proportion of Uber’s earnings or losses in its own financial statements.2. BMW’s Joint Venture with Brilliance China Automotive: BMW runs a joint venture (JV) with Brilliance China Automotive Holdings where they manufacture BMW cars for the Chinese market. BMW holds a 50% stake in this JV, and therefore, uses the equity method to account for this investment. The profits or losses from this venture are split equally and reflected in both companies’ financial statements.3. Softbank’s Investment in Alibaba: Softbank holds a significant stake in the Chinese conglomerate, Alibaba. Hence, it uses equity accounting to account for this investment. Resultant earnings or losses from Alibaba directly impact Softbank’s financial performance as they are reflected in their income statements.
Frequently Asked Questions(FAQ)
What is Equity Accounting?
Equity Accounting is a method of accounting whereby a company records a portion of the undistributed profits for an investment made in another company. This is generally correspondent to the ownership percentage held. It mainly applies when a company has significant influence, but not full control, over another company.
When is Equity Accounting used?
Equity Accounting is used when an investor company holds 20% to 50% shares in an investee company, creating significant influence but not control. It allows companies to count their share of the earnings (or losses) of the investee in their own books.
How does Equity Accounting work?
Equity accounting begins with an initial investment amount recorded on the balance sheet and this amount is subsequently adjusted to reflect the investor’s share in net profits or losses of the investee. Dividends received are recorded as a reduction from the investment on the balance sheet.
What is the difference between Equity Accounting and Consolidation Accounting?
While Equity Accounting covers situations where an investor has significant influence over, but not control of, an investee, Consolidation Accounting applies when an investor has control over an investee. Under Consolidation Accounting, the financial statements of the investor and the investee are combined as though they are a single entity.
Are dividends counted in Equity Accounting?
Any dividends that the investor receives from the investee are counted as a reduction in the value of the investment on the balance sheet, they are not treated as income.
Can losses be reported in Equity Accounting?
Yes, investors should report their share of losses in the investee company. These losses reduce the carrying amount of the investment.
How does Equity Accounting affect the Income Statement?
In Equity Accounting, the investor’s share of the post-acquisition profits or losses of the investee is reported in the investor’s profit and loss account, thereby affecting net profit or loss for the period.
Is Equity Accounting used in international business?
Yes, Equity Accounting is a widely accepted method of recording investments and is used internationally. The International Financial Reporting Standards (IFRS) provides guidelines for its implementation.
Is there any difference between Equity Accounting and the Equity Method?
No, Equity Accounting is often referred to as the Equity Method. Both terms describe the same accounting process.
: Why is Equity Accounting important?
: Equity Accounting provides a realistic and accurate picture of a company’s profits, financial health, and the value of its investments. It helps stakeholders to understand a company’s true financial state and its earnings from significant investments in other entities.
Related Finance Terms
- Investment Gain/Loss: This is the difference in the value of the investment from the time it was made to the present. It can be either positive (gain) or negative (loss).
- Book Value: The value of an asset as it appears on the company’s balance sheet, calculated by subtracting accumulated depreciation from the asset’s purchasing cost.
- Minority Interest: A significant but non-controlling ownership of less than 50% of a company’s voting shares by an investor or another company.
- Consolidated Financial Statements: These are financial statements that incorporate the assets, liabilities, equity, income, expenses and cash flows of the parent company and its subsidiaries.
- Cost Method: An accounting approach in which the investment is recorded at cost, without adjustment for changes in market value.
