EQUITY METHOD

 

EQUITY METHOD

Equity method is a type of accounting method used generally by companies to record and file its returns and profit from another companies. When a company invests in another company, the percentage of revenue realised through this company needs to be reported. With this method the investor company reports the revenue earned in that particular period by the invested company in its financial income statement. The invested amount is expressed as a percentage of total investment in the invested company.

Whenever a company has invested for 20%-50% of total investment in another company, the investing company is said to have a significant influence and can exercise power over the invested company. In such a case the invested company has to report the revenue earned in their income statement for that particular year. They have to use equity method while reporting such numbers. The decisions like choosing board of directors, making hierarchical changes in the organisation and making cultural changes can be exerted by the invested company in investing company. Whenever the holding crosses 50% usually the whole financial statements of invested company are consolidated with the parent company’s statements. It’s a type of accounting method in which investment in associate companies.

 

Significance of equity method and its methodology

·       For a company to have significant influence in the ownership, the minimum threshold always ranges from 20%-50%.

·       When a company has invested in a target company, its net income influences the target company’s book as assets. The values go up in the balance sheet but decreases the investee company’s dividend pay-out amount in case of company’s loss high dividend.

·       The above point works both the ways, investor also records the target company’s net income in its financial statement (income statement).

·       The probability of Investee Company making profit or losses will add volatility to Investor Company’s income statement. Then the target company becomes the associate (Subsidiary Company) firm of the investor.

·       Under the equity method the investment in Target Company is recorded at historical cost. This recorded amount is adjusted proportional to investor’s ownership by percentage.

Equity method vs cost method

·       Cost method of accounting when the invested amount doesn’t give the invested company any significant influence. The equity method of accounting is used when investment gives the investor a significant influence and ownership in the target company.

·       The cost method is used when the investment by the investor is passive and long-term. The investment doesn’t result in significant influence and this method is advised when ownership is less than 20%.

·       Cost method will have tax impact on the company’s taxable income, suppose the investment of 5 million in a company pays out 2 percent dividend. Then the dividend received will be 100000 USD. If the tax bracket if 20% then the deductions will be 20000 USD. This is recorded in investor company’s financials.

·       In equity method the company’s income is recorded as income in investor’s income statement. If a investment of 5 million is to be recorded using equity method, then the income from its subsidiary is recorded income statement and subjected to deductions later unlike in case of cost method earlier.

·       In general the income of a company is more volatile compared to the dividends of the same company thus equity method affects the taxes of the investor company more as compared to cost method.

Scenario of equity method with example

If the investor company A decides to make and investment of 1 Million in a target company B but investment doesn’t give any significant influence. This investment generates 10 grands as dividends every quarter, then this income is added to Investor Company’s net income. The method used here is cost method,

In the same scenario if the target company B was small and the investment gives investor company A, the significant influence then the income is supposed to be reported by equity method and the targeted firm will become the associate firm of the investor firm. The investor will now have the final say in making its subsidiary firm’s crucial decisions.

Consider below example on similar line

 

Example 2	Company A	Investment in USD	Effect on revenue	Impact	accounting method to be used by investor
Scenario 1	Rombus technologies	2000000	8% dividend	no significant influence	Cost method
Scenario 2	jatin Infra	2000000	15% of ownership	Significant influence	Equity method

 

Advantages of equity method

·       Equity method always records the income in a more balanced way.

·       Parent and subsidiary usually never share the consolidated statements, recording through equity method of accounting collates all these numbers and brings under one.

·       Equity method tracks all the income from all of Investor Company’s investment.

·       If parent company has numbers not to attractive from investor’s perspective, it can hide the detail from investors when recorded through equity method.

·       Hiding low profit numbers from investors will make the company look attractive from investor’s perspective.

·       Invested company when doesn’t report subsidiary’s numbers, the value of the company can also be brought down.

Disadvantages of equity method

·       The complex nature of the equity method (to use and to make understand) is the main drawback of the same.

·       Equity method of accounting also consumes a lot of time as it requires the company to gather data from subsidiary, verify and then reflect in its income statement.

·       The company has to double check the numbers from subsidiaries and make sure they are accurate and not forged or manipulated in any manner.

·       If unavailability of numbers from any of the subsidiary company can swing the valuation of invested company both ways significantly.

·       Dividends recorded through equity method makes entry in invested company’s income statements as deductions and not as income which another drawback of this method of accounting.

·       Even though the dividends from subsidiary companies makes entry in invested company’s book of account, the actual amount in never handed over to the parent company.

Conclusion

The equity method, to conclude is a type of accounting used when the investment made by an investor company has the “ Significant influence” and ends up giving it the ownership of the company. The method records the investment at the historical cost and is difficult to manipulate. Thus the method has weightage over another method of accounting, which is called as cost method. The equity method records the income generated by the subsidiary companies is captured accurately in invested company’s income statement. By equity method the value of investment is valued by the income or losses the subsidiary company has generated and doesn’t increase the book value of investment as in case of cost method. Thus investment is tracked to its actual invested amount. Even though this method is difficult to employ and understand, gives the most accurate picture for the investment amount on a whole.