Equity investment accounting methods
Owning a share of stock in a company might earn you a few dollars, but you don’t get to do a whole lot of decision-making as such a small investor. Corporations, on the other hand, invest in equity securities on a much larger scale. In this article, we’ll look at three different methods of accounting for stock investments.
1. The concept of influence and control
The decision about which accounting method to use generally turns on percentage ownership, but specific circumstances should also be considered in each case. Keep that in mind as we describe these accounting procedures.
2. Cost method
This first accounting method should only be used when the investing company cannot significantly influence the investee. Percentage ownership will generally be less than 20%, but see the next section for additional considerations.
The cost method is conceptually governed by the historical cost principle. The amount paid for the securities is recorded with a debit to an investment account, and that amount might be adjusted periodically depending on how the security is classified. Dividends received are recorded as revenue.
3. Equity method
The equity method should be used when the investor can exert significant influence over the investee. An ownership percentage between 20% and 50% is generally sufficient, but representation on the board of directors or being the largest single owner could also be considered enough influence.
Under the equity method, the investment account is adjusted every year by the amount of investee net income attributed to the investor. Another major difference between the equity and cost methods is the treatment of dividends - if the investor is using the equity method, dividends paid reduce the investment account instead of providing revenue. In essence, dividends are treated as a return of capital.
As a quick example, if a corporation owns 40% of a business that reports $100,000 of net income and pays out $20,000 in common dividends, the corporation would increase its equity investment account by $32,000 ($40,000 from its share of net income minus $8,000 from its share of dividends).
4. Consolidation method
Finally, a corporation should use the consolidation method for investees it controls (generally more than 50% ownership). The investor adjusts the investment account using equity method transactions, but at the end of the year, an investor combines its financial statements with all companies it controls (now called subsidiaries).
Financial statement consolidation is an advanced topic that is beyond the scope of this article.
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