Definition
The Gross Equity Method is an accounting technique used to record investments in associated undertakings — those in which the investor holds significant influence but not control. Unlike the more common equity method, which represents net assets and net income, the gross equity method requires the investor to show its share of the gross assets and liabilities of the investee on the balance sheet and account for its share of the turnover in the profit and loss account.
Examples
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Company A and Company B:
- Suppose Company A invests 30% in Company B. Using the gross equity method, Company A will report 30% of the gross assets and liabilities of Company B on its balance sheet. Additionally, it will record 30% of Company B’s revenue (turnover) on its profit and loss account.
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Investment in a Joint Venture:
- If Company X holds a 40% stake in a joint venture, applying the gross equity method, Company X shows 40% of the joint venture’s gross assets and liabilities on its balance sheet. It also records 40% of the venture’s turnover in its profit and loss statement.
Frequently Asked Questions
Q1: What differentiates the gross equity method from the net equity method?
A1: The gross equity method involves reporting the investor’s share of the gross assets and liabilities of the investee, whereas the net equity method records the net assets and net income only.
Q2: When is the gross equity method typically used?
A2: The gross equity method is less common and is primarily used in specific jurisdictions or under certain accounting frameworks which mandate its use.
Q3: How does the gross equity method affect financial ratios?
A3: The gross equity method can inflate total assets and liabilities compared to the net equity method, thereby potentially impacting financial ratios like the debt-to-equity ratio and return on assets.
Q4: What is an associated undertaking?
A4: An associated undertaking is an entity in which an investor holds significant influence, typically indicated by ownership of 20% to 50% of the voting shares, but not full control.
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Equity Method: An accounting method where the investment is initially recorded at cost and subsequently adjusted for the investor’s share of the net income or loss of the investee.
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Balance Sheet: A financial statement that presents the assets, liabilities, and equity of an entity at a specific point in time.
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Profit and Loss Account: Also known as an income statement, this financial document summarizes revenues, costs, and expenses incurred during a specific period.
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Turnover: Revenue generated from the normal business activities of a company, often used interchangeably with sales.
Online Resources
Suggested Books for Further Studies
- “Intermediate Accounting” by J. David Spiceland, Mark W. Nelson, Wayne Thomas
- “Financial Accounting: An Introduction to Concepts, Methods, and Uses” by Roman L. Weil, Katherine Schipper, Jennifer Francis
- “Accounting Principles” by Jerry J. Weygandt, Paul D. Kimmel, Donald E. Kieso
Accounting Basics: Gross Equity Method Fundamentals Quiz
### What does the gross equity method report on the balance sheet?
- [x] The investor’s share of the investee’s gross assets and liabilities.
- [ ] Only the investor’s share of net assets.
- [ ] Net income from the investee.
- [ ] Total control over the investee's operations.
> **Explanation:** The gross equity method involves reporting the investor’s share of the investee’s gross assets and liabilities, not just the net assets.
### Where is the investor’s share of the investee’s turnover recorded?
- [ ] Only in the investor’s cash flow statement.
- [ ] In the investee’s balance sheet.
- [x] In the investor’s profit and loss account.
- [ ] Nowhere, as turnover is irrelevant in this method.
> **Explanation:** The investor’s share of the investee’s turnover is recorded in the investor’s profit and loss account.
### In which circumstance is the gross equity method mainly applicable?
- [x] When the investor has significant influence but no control.
- [ ] When the investor has full control.
- [ ] Only in case of a minority interest.
- [ ] When no influence exists.
> **Explanation:** The gross equity method is used when the investor has significant influence over the investee but does not have control.
### How does the gross equity method affect the balance sheet?
- [ ] It reduces the total assets and liabilities.
- [ ] It only impacts net income.
- [x] It inflates both assets and liabilities.
- [ ] It does not affect the balance sheet.
> **Explanation:** The gross equity method inflates both assets and liabilities because it accounts for a share of the investee’s gross assets and gross liabilities.
### What signifies an associated undertaking?
- [ ] 100% ownership.
- [x] 20% to 50% ownership.
- [ ] Less than 5% ownership.
- [ ] Complete managerial control.
> **Explanation:** An associated undertaking is typically signified by ownership of 20% to 50% of the voting shares, indicating significant influence but not full control.
### What primary advantage does the gross equity method provide?
- [x] Detailed visibility of shared assets and liabilities.
- [ ] Simplified financial reporting.
- [ ] Higher earnings per share.
- [ ] Avoidance of taxation on joint ventures.
> **Explanation:** The gross equity method provides detailed visibility of shared assets and liabilities, beneficial for transparency and thoroughness in financial reports.
### Which document includes the sharing of turnover in the gross equity method?
- [ ] Cash flow statement.
- [ ] Balance sheet.
- [x] Profit and loss account.
- [ ] Statement of retained earnings.
> **Explanation:** The share of turnover is accounted for in the profit and loss account under the gross equity method.
### Why is the gross equity method less common than the equity method?
- [ ] It provides less accurate financial information.
- [ ] Regulatory restrictions limit its use.
- [x] It is required less frequently by accounting standards.
- [ ] Investors prefer consolidated statements.
> **Explanation:** The gross equity method is less common because it is required less frequently by accounting standards and is used in specific circumstances.
### How might the gross equity method impact financial analysis?
- [x] By altering key financial ratios.
- [ ] By simplifying calculations.
- [ ] By providing consistent results across different models.
- [ ] By ensuring minimal variance year to year.
> **Explanation:** The gross equity method can impact financial analysis by altering key financial ratios, such as the debt-to-equity ratio, due to the method's effects on reported assets and liabilities.
### Which of the following is NOT reported using the gross equity method?
- [ ] Share of gross assets
- [ ] Share of gross liabilities
- [x] Investor’s operating expenses
- [ ] Share of turnover
> **Explanation:** The gross equity method does not impact the investor’s operating expenses directly; it focuses on the share of the investee’s gross assets, liabilities, and turnover.
Thank you for delving into the concept of the Gross Equity Method in accounting, and for attempting our structured quiz. Through continuous learning and application, you can deepen your financial expertise!
