Whenever one company invests in another one, it can create some headaches for the legal department of the investing company. How do they account for the investment in that second company? Surely they have to note this on financial statements to provide transparency and clarity for the public. The good news is that there are multiple methods of accounting to choose from to make this happen. A company can choose either the cost method of accounting for investments in common stock or the equity method of accounting. The equity method of accounting is quite popular under many circumstances and can make accounting relatively simple.
When to use the equity method of accounting for investments in common stock
The first decision is on which method to use for accounting. The key question comes down to something very simple. Does the investing company exercise significant influence and control over the financial dealings of the investee? If your company is able to control what the second company does, then it is best to use the equity method of accounting. If you company cannot control the financial dealings of that second company, then the cost accounting method is a better choice.
There is no cutoff in equity that brings about the equity method of accounting. It is simply based on the perception of the investing company of how much control it has. The equity share does not need to be a controlling stake. As long as the company has some ability to exercise influence, then the equity method can be a great tool to use.
When to recognize the share of profits
When a company invests in another company, that investing company will realize some share of the profits, assuming the second company is profitable. From an accounting perspective, the big question is when the investing company recognizes its profits. The answer in the equity accounting method is that the investing company recognizes its share of the profits when the second company has the profits reflected in its accounts. This means that the investing company is basically following the second company. This is why it is important that the investing company has the ability to exercise control. Under this arrangement, it is still largely in charge of the timing of its reflected gains.
If the second company happens to post a loss, then the investing company must recognize this loss when the loss is realized by the second company. The investing company will have to put its losses or gains in its income statement in the quarter and year when the losses or gains took place. This allows investors to have a clear understanding of the company’s financial position.
Using the equity method of accounting, if there are profits, then this increases the amount of investment the first company has in the second. Any losses suffered decreases the amount of investment the first company must record. The equity method’s name suggests this sliding scale of equity that is impacted by the second company’s success or lack thereof.