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Equity Accounting

Updated on May 23, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Equity Accounting?

Equity Accounting refers to a form of accounting method used by various corporations to maintain and record the income and profits that it often accrues and earns through the investments and stake-holding that it buys in another entity. The Percentage of stake in the company would determine the voting rights and other authority-related factors.

Equity Accounting

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The equity accounting method reflects the investee’s profits and losses in the investors’ records. The asset values on the balance sheet are adjusted periodically to match the current market value post-depreciation and other reductions. These adjustments give all parties involved a clear picture of their profits or loses from such investments.

Key Takeaways

  • Equity accounting is a technique many corporations use to manage and record the income and profits generated from investments and stakes held in other entities.
  • Equity accounting requires relevant information the subsidiary provides, including information on income, profits, and dividends for the year. This enables a firm to allocate the gains to other subsidiaries or subheads.
  • Implementing equity accounting, like any other accounting technique, requires time and effort, so a firm needs to have adequate resources to manage it effectively.

Equity Accounting Explained

Equity accounting is a form of documenting the profits and losses from the investments made in an associate company. These documents allow all parties involved to understand their authority and voting rights in this intercorporate arrangement.

Depending on the stake of the investor, their authority and decision-making abilities would differ. It also allows both companies to function in accordance to their nature or style of working rather than being influenced by an individual outside the organization.

Private equity accounting, no doubt, stands as an excellent method to gauge and understand the returns and income that can be attributed to the subsidiaries that the business owns or runs. The income can be attributed to the different affiliates the business owns, manages, and runs. Such a method facilitates tracking and segregating the various income heads among the subsidiaries, be it dividends or revenue for the year.

However, owing to additional information required, the firm will have to rely on the income declared by a subsidiary, which otherwise will not be known if the affiliate tends to be a privately held company, where the parent has picked up the stake. There tends to be significant reliance on the subsidiary in this regard. Moreover, there is time and effort required in doing additional steps like that of equity accounting, and hence the firm needs to appropriate resources accordingly in this regard.

Nevertheless, equity accounting is an excellent example of understanding and segregating the income heads that can be attributed to the subsidiaries that the parent company has made an effort to acquire a significant stake.

Without the relevant information the subsidiary provides, be it details relating to income/profit for the year or even dividends, the equity accounting method cannot be undertaken. Hence, there is a significant dependence on the subsidiary company to gain the relevant information so that the parent company can undertake the necessary equity accounting. If such information is not provided, the method ceases to exist and thus is a significant limitation.

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Formula

Let us discuss the formula to calculate the equity accounting method which will make solving practical problems easier.

Equity = Assets – Liabilities

Examples

Let us understand the equity accounting method and its implications in depth with the help of a couple of examples.

Example #1

Let us consider an example of Pacman Co, which will acquire 25% in Target Co for a stake of 65000$. At the end of the year, Target co would report a dividend of $2500.

When Pacman co would record the purchase, it would do the same under the head ‘Investments in affiliates’ by debiting the same by $65000 and crediting the cash account by $65000, and the following journal entry would be passed –

ParticularsDebitCredit
Investment in Associate …….Dr65000
To Cash65000

Pacman would only account for a dividend of $625 owing to its 25% stake. (25% of $65000). It would then be recorded as a reduction in an investment account, which is that they would have received some money from the investee. Hence, cash would be debited by $625, recording a credit in investment in associates.

ParticularsDebitCredit
Cash A/c …….Dr625
To Investment in Associate625

Example #2

Major co acquired Minor co for a 40% stake. Minor co declared a net income of $200000 for the year. Hence the net income can be displayed as a certain amount of increase in the investment account in books of Major Co for an amount of $8000 ($20000*40%) by crediting the investment revenue account and debiting the investment in affiliates. The new balance in ‘Investment in minor Co’ will be $208000 ($200000+$8000).

ParticularsDebitCredit
Investment in Associate …….Dr8000
To Investment Revenue8000

Advantages

Let us understand the advantages of private equity accounting through the explanation below. It would help us grasp the intricate details of the concept.

  • Facilitates tracking: By understanding the income or profits derived from the associate/affiliates or the subsidiary, the business can track such income accordingly by segregating or bifurcating such source of income into the various heads.
  • Provides the necessary bifurcation: By adopting the method of equity accounting, a firm can easily bifurcate and attribute the income to various other subheads or even subsidiaries that it happens to hold. The firm can now easily segregate the income owed to profits/income earned by the target or the subsidiary company of which it happens to hold a certain stake.
  • Facilitates attribution: The Company can now give a clear-cut view to all its stakeholders, investors, shareholders, creditors, and customers. Government, etc., about the profit that it attributes to its own and the profits that tend to be derived from the subsidiaries. Such an attempt by the company will help it develop a certain amount of attribution practices about the income/profit it can generate from its holdings.
  • Boosts standalone earnings: When a company provides a standalone view rather than a consolidated view of its financial statements, the figures tend to be presented better for the division/unit owing to profits earned from that particular division. There may be times the parent company is performing poorly, yet the subsidiary company tends to provide exceptional brilliant performance even at times of turmoil. Thus equity accounting tends to accurately reflect this by segregating the amount that can be attributed to the amount earned from the subsidiary.
  • Simple procedure: The technique of having to make a simple adjustment by having to ascertain the value by arriving at each aspect of the value of the subsidiary is instead a simple task. One has to merely understand the percentage of stake involved and then do some simple mathematics to arrive at the respective amounts for the value of the profits that can be attributed to the subsidiary.

Disadvantages

Despite the significant number of advantages mentioned above, there are factors on the other extreme of the spectrum that prove to be hassled for the parties involved. Let us understand the disadvantages of the equity accounting method through the discussion below.

  • Company may not be profitable on a standalone basis: There is an excellent possibility that the company may look good on a consolidated basis, but when an equity accounting method is undertaken to make efforts to understand the income that can be attributed to its subsidiaries, one may get to know that the company is not doing so well on a standalone basis, unlike the rosy picture that the parent company painted.
  • Segregation requires additional time and effort: There is an excellent possibility that the company may look good on a consolidated basis, but when an equity accounting method is undertaken to make efforts to understand the income that can be attributed to its subsidiaries, one may get to know that the company is not doing so well on a standalone basis, unlike the rosy picture that the parent company painted.

Frequently Asked Questions (FAQs)

1. What is equity accounting vs. consolidation? 

Equity accounting and consolidation are both accounting methods for investments in other companies. Equity accounting is used when the investor has significant influence but no control over the investee. The investor records its share of the investee’s profits and losses as a single line item on its income statement. Consolidation, on the other hand, is used when the investor has control over the investee and combines the investee’s financial statements with its own.

2. What is converting debt to equity accounting? 

Converting debt to equity accounting involves exchanging outstanding debt obligations for equity ownership in a company. This can be a way for a company to reduce its debt load and improve its capital structure. It can also provide the company with more flexibility and a potentially lower cost of capital. 

3. What are the benefits of using equity accounting for a joint venture?

The benefits of using equity accounting for a joint venture include providing a more accurate reflection of the investor’s economic interest in the joint venture and allowing for more consistent and comparable financial reporting. 

This article has been a guide to what is Equity Accounting. Here we explain its formula, examples with journal entries, advantages, disadvantages. You can learn more from the following articles –

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