What is Equity Accounting?
Equity accounting, also known as the equity method, is an accounting technique used to record investments in associate companies. This method is implemented when an investor company holds a significant influence over the investee company, typically represented by a 20% to 50% ownership stake in the investee’s voting shares. Under equity accounting, the investor recognizes its share of the investee’s net assets and undistributed profits as part of its financials.
How Equity Accounting Works
When using the equity method, the investor initially records the investment at cost. As the investee company earns profits, incurs losses, and pays dividends, the investor adjusts the carrying amount of the investment to reflect its share of the investee’s financial performance.
Examples
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Example 1: Investment in an Associate
- Company A invests in 30% of Company B’s equity. If Company B reports a profit of $1,000,000 at the end of the financial year, Company A will recognize 30% of that profit, i.e., $300,000 in its own financial statements.
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Example 2: Dividends Distribution
- Continuing the above example, if Company B decides to distribute dividends amounting to $200,000, then Company A will adjust its carrying amount of investment by reducing it with its share of dividends received, which is $60,000 (i.e., 30% of $200,000).
Frequently Asked Questions
What is significant influence in equity accounting?
- Answer: Significant influence refers to the power to participate in the financial and operating policy decisions of the investee but not having control or joint control over those policies.
Can equity accounting be applied to minority investments?
- Answer: No, equity accounting is typically applied when the investor holds significant influence, which is usually indicated by a 20%-50% ownership representation.
How do dividends impact the equity account?
- Answer: Dividends received reduce the carrying amount of the investment because they are considered a return on investment.
Where is the income from the equity method reflected in financial statements?
- Answer: The investor’s share of the investee’s profit or loss is reflected in the investor’s income statement under ‘equity in earnings of affiliates’.
Is equity accounting applicable to joint ventures?
- Answer: Yes, equity accounting is commonly used for joint ventures where joint control is shared among investing parties.
Related Terms
Equity Method
The accounting technique where the investor reports its share of the investee’s net assets and undistributed profits.
Gross Equity Method
A variation of the equity method where the reporting entity separates the profit-sharing and equity stakes in financial disclosures.
Consolidation
A method of accounting whereby the parent company combines its financial statements with its subsidiaries, reflecting total holdings.
Online References for Further Reading
- Investopedia on Equity Accounting: Read more
- IFRS (International Financial Reporting Standards) on Equity Method: Read more
Suggested Books for Further Studies
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield.
- “International Financial Statement Analysis” by Thomas R. Robinson, John D. Stowe, and Paul Munter.
- “Financial Accounting and Reporting” by Barry Elliott and Jamie Elliott.
Accounting Basics: “Equity Accounting” Fundamentals Quiz
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