What is Equity Accounting
Equity accounting, or what is sometimes called the equity method, is an accounting process for recording investments in associated companies or entities. Generally, the equity accounting method is applied when an investor or holding entity owns 20–50% of the voting stock of an associate company.
This method of accounting is used only when an investor has significant influence over an investee. When using the equity method, an investor recognizes only its share of the profits and losses of the investee in the periods when these profits and losses are also reflected in the financial accounts of the investee (such as when calculating with the debt-to-capitalization ratio). If the investing entity records any profit or loss, it is reflected on its income statement. Also, any recognized profit increases the investment recorded by the investing entity, while a recognized loss decreases the investment.
BREAKING DOWN Equity Accounting
Under equity accounting, the biggest consideration is the level of investor influence over the operating or financial decisions of the investee. If there is no significant influence over the investee, the investor instead uses the cost method to account for its investment in an associated company.
While no precise measure can gauge an exact level of influence, several common indicators of operational and financial policies include:
- Board of directors representation
- Policy-making participation
- Intra-entity transactions that are material
- Intra-entity management personnel interchange
- Technological dependence
- The proportion of ownership by the investor in comparison to that of other investors
When an investor acquires 20% or more of the voting stock of an investee, it is presumed that, without evidence to the contrary, an investor maintains the ability to exercise significant influence over the investee. In contrast, when an ownership position is less than 20%, there is a presumption that the investor does not exert significant influence over the investee unless it can otherwise demonstrate such ability.
Interestingly, substantial or even majority ownership of an investee by another party does not necessarily prohibit the investor from also having significant influence with the investee. For instance, many sizable institutional investors may enjoy more implicit control than their absolute ownership level would ordinarily allow.