Equity Method of Accounting for Investments
Companies require funds for their setups and maintaining and running of their profit generating operations. The companies, in order to obtain funds, can either bring into financial obligations from other companies or procure the same by way of investment funds. Companies can get funds for their operations by selling part of their ownership to willing investors. Such investors may continue to have other businesses. However, rules are in place to tell how such investors should account for their investments in additional businesses. Equity method of accounting for investments stipulates that level of ownership of the investing company should be 20-50 percent.
The ownership of a shareholder to a company is calculated by the percentage of the total outstanding shares of the company held by that shareholder. For instance, let’s say that a company has one thousand outstanding shares. So, a shareholder possessing 200 shares of this company would have a twenty percent stake in that company. Equity method of accounting for investments is applied only when the shareholder holds“significance influence” in a company. The most common practice is to consider shareholders with ownership of twenty to fifty percent as having significant influence in a company, though investors exerting any indirect or direct influence in the affairs of the company are also classified in that category.
Investments in additional businesses can be accounted for, using three different categories, namely: no significant influence, significant influence and outright ownership. Investment with ‘no significance influence’ are taken into account in the same fashion as any other investment, whereas in case of outright ownership treats the investment as a part of investing business. In case of significance influence, the investment is accounted at cost. Additionally, a part of the income of the company that is invested needs to be documented in the income statement of the investor for each period of time.
Initial Investment and Dividend:
When using equity method of accounting for investments, investments in corporations are accounted for ‘at cost.’ Let’s say a company bought 1000 shares of another company, paying $2/share. So, the company would record an asset amounting to $2,000 and show a corresponding reduction in its reserved cash. Likewise, dividends paid to investors are treated as a reduction of its investment. For instance, if company where funds were invested declared $1,000 as dividend and the investing company is permitted to get twenty percent of that. In such case, cash reserves of the investor are credited by $200 and an equal amount is deducted from its investment assets.
Net Income and Loss:
In case of investor having a significant influence in the company wherein funds are invested, it is obligatory for the investor to record a part of net loss or profit of that company for all the time that the investor stayed invested in that company. Here’s an example. Say, an investor is in possession of thirty five percent of a company, which announced a loss of $100,000 for a particular period. So, the investor must show a loss of $35,000 in their income statement. How this finally affects the investor’s net income would depend on his own expenses and proceeds.