Equity Method (Accounting) - Explained
What is the Equity Method of Calculating Profits on Investments?
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Table of ContentsWhat is the Equity Method?How is the Equity Method Used?Equity Method Earnings AdjustmentEquity Method Loss AdjustmentEquity Method Dividend AdjustmentAcademic Research on the Equity Method
What is the Equity Method?
The equity method refers to an accounting tool that companies use to determine the amount of profits received on their investments made in other organizations. The income statement of the company includes the income that it earns on its investments, and this amount revolves around the share of the firm in other organizations assets. This reported value varies as per the level of the equity investment.
Back to: ACCOUNTING, TAX, & REPORTING
How is the Equity Method Used?
The equity method is a primary tool that a company uses when it has made a crucial investment in some other company. A company that holds at least 20% of the stock of another company, acquires prominent control on the other company's operations. They get the authority to be represented as the board of directors, make changes in policies, and switching managerial staff from one company to another. A company that has a net income of $1 million, and has an ownership of 25% of another organization, can use the equity method for reporting earnings of $250,000. When a company uses the equity method in order to account for ownership, the individual who makes investments, notes the original investment made in stock at cost. Further, this calculated amount or value keeps adjusting itself as per the organizational profits and losses.
Equity Method Earnings Adjustment
The equity method represents the economic relationship between the two companies: the one who invests, and the other one where the money is invested. When the investing firm holds a huge influence on the financial and day-to-day activities of another firm (the investee), it will have a direct impact on the investments made by the investor. A company holding 20% or more of the other company's stock records its portion of earnings made by the investee as investment revenue, that ultimately leads to an increase in the investments value.
Equity Method Loss Adjustment
In case, the investee company incurs a net loss on its income statement, the investor firm mentions that share of loss in its income statement as loss on investment, which ultimately declines the investments worth. With the help of the equity method, a firm can report the investments carrying value irrespective of any fair value market changes. As the investor firm can influence the financial and operating decisions of the investee, the investor can ascertain the value of investment based on changes related to the worth of net assets, and other performance measures such as profits and losses.
Equity Method Dividend Adjustment
There occurs a decline in the net assets value when the investee firm makes a cash payment of dividends. Considering the equity method, the investor firm, after receiving cash dividends, records an increase in its cash funds, but also, records a decline in the investments carrying value. The financial operations that have an effect on the net assets of the investee bear the similar effect on the extent of investments made by the investor firm. The primary aim of the equity method is to make sure that both the investor and investee are recording the value of investments ethically.
Academic Research on the Equity Method