Equity Method of Accounting

The equity method of accounting is a standard accounting technique used to account for or assess the profits that a company earns on all its equity investments made in other companies.

In fact, the perfect example can be when the parent company holds a significant (20 to 25 percent) stake of investments in another company, because under this method, the earnings confirm to be in proportion to the investment made.

In other words, when the parent is using this method, there is only one single item in the investor's balance sheet with the amount proportional to his share in the 'invested in' company's net income.

The following points showcase how the method works.

• This process is used when the owner owns about 20 percent and above of the 'invested in' company's stock with significant influence, but no control (or when a merger is not possible despite high stakeholder-ship because of parent subsidiary incompatibility, etc.).

• The investment acquisition is recorded in the balance sheet at historical cost and all the earnings since the time of acquisition and all the dividends received are added and deducted respectively from the amount.

• In other words, all the earnings of the subsidiary that are made after the acquisition increase both, the investment account as well as the income in the income statement, and vice versa. Dividends received from the company reduce the parent's investment account.

• If any of the subsidiaries assets show a significant deviation between their fair market value and the value listed in the books of accounts, the excess is amortized over the economic life of the asset in question. In the parent's books, this reduces the investment account and also the income earnings in the income statement.

This method for investments in a joint venture requires that the investments be recorded at the original cost and the asset be increased or decreased according to the investor's share in the profits and losses respectively.

All dividends received require the balance to be decreased, when the company is following this method of accounting. The highlight to note in this is that, as the incomes are recorded as single line items under the heading of investment income, they do not inflate revenues and thus leave the income from operations unaffected.

When using this method of accounting for investments in common stock, the following book entries are required.

• At the time of consolidation, a basic elimination entry for the book value of net assets at the time of acquisition is made.
• All excess cost elements are then accounted for with additional journal entries.

• The difference between the affected retained earnings of past periods and the current effect on the balance sheet and income statements is then obtained. This difference is amortized over a certain number of years.
• Elimination entries for the dividend incomes, accumulated depreciation, and inter-company transactions then follow.

The FASB (Financial Accounting Standards Board) recognizes many other methods for investments as well, one of them being the cost method of accounting. Neither this nor the equity method of accounting are suitable for investments under the following circumstances.

• If the company holds debt securities with the intent to hold them to maturity, they are accounted for as held-to-maturity investments. They are recorded in the Balance Sheet at amortized cost and the income statement records the amortization of premiums and discounts. Fair value notes must be provided with the financial statements for such investments.

• If the objective of the investment is to make profits on short term price differentials, they are classified as trading securities. Here, the Balance Sheet records the fair value of the investment while the income statement reports on the unrealized gains and losses for the period.

• All debt and equity securities that do not fall under any major investment categories are categorized as 'available-for-sale' securities. Similar to the trading securities, these investments are recorded at fair value on the Balance Sheet and a Statement of Comprehensive Income (SCI) reports the holding period gains and losses for the same.

Hope you are now equipped with adequate information on the subject of the 'equity method of accounting for investments in common stock'.