Equity Accounting Definition
Equity Accounting refers to a form of accounting method that is used by various corporations to maintain and record the income and profits which it often accrues and earns through the investments and stake-holding that it buys in another entity.
Examples of Equity Accounting
Let us consider an example of Pacman co, which goes on to acquire 25% in company 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 –
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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.
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).
Advantages of Equity Accounting
- Facilitates tracking: By having to understand the income or profits that are derived from the associate/affiliates or the subsidiary, the business can track such income accordingly by having to segregate or bifurcate such source of income into the various heads
- Provides the necessary bifurcation: By having to adopt the method of equity accounting, a firm can easily bifurcate and attribute the income to various other subheads or even subsidiaries which it happens to hold. The firm can now easily segregate the income which can be owed to profits/income that is 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, be it investors, shareholders, creditors, customers. Government, etc., with regard to the profit that it attributes to its own and also 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 with regard to 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 it is the subsidiary company that tends to provide exceptional brilliant performance even at times of turmoil. Thus equity accounting tends to accurately reflect this by having to segregate 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 amount of simple mathematics to arrive at the respective amounts for the value or the profits that can be attributed to the subsidiary.
Disadvantages of Equity Accounting
- 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 was painted by the parent company.
- Segregation requires additional time and effort: More often than not, when a company attempts to undertake equity accounting, it is often seen that the time undertaken for segregation to understand the value of equity in the subsidiary is often enormous. There are significant time and efforts involved in understanding the financials of the subsidiary on a standalone basis through the method of equity accounting.
Limitations of Equity Accounting
- Dependence on Subsidiary for Information: Without the relevant information which the subsidiary provides, be it details relating to income/profit for the year or even dividend for that matter, 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 necessary equity accounting can be undertaken by the parent company. If such information is not provided, the method ceases to exist and thus goes on to be a significant limitation.
Equity accounting, no doubt, stands as an excellent method to gauge and understand the returns and also the 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 even 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 stands to be an excellent example of having to understand and segregate the income heads that can be attributed to the subsidiaries that the parent company has made an effort to acquire a significant stake.
This article has been a guide to Equity Accounting and its definition. Here we discuss an example of an equity accounting method with journal entries, advantages, disadvantages, and limitations. You can learn more from the following articles –