What is equity method ?
The equity method is an technique used by the companies and firms to evaluate the profit gained by their investment in other companies .The report of income of the companies uses equity method and the profit earned by their investment is displayed in the income statement which is based on the firm or company assets
How Equity method is useful for the investors
Let us assume that you are an investor and you are investing in some companies but before that you will definitely analyze some of the companies .so by know equity method you will gain better understanding of this things work under the hood and you will able to read company balance sheet which is available in public . The Other benefits to it is
- Accurate accounting : – The Main advantage here is it allow the user who is using this method more accurate balance sheet and it also shows the income from all the source available and not just the parent company.Since parent company and subsidiaries do not share their financial statement
- Hiding number: – The another advantage of using equity method is that it enable us to hide unfavorable number from the investor . That is if company is in loss it can hide those number by sharing profit from its subsidies and show as if they are in profit to the investor so that they will invest in their companies .And the parent company can also hide the subsidies number if hiding would benefit the company
Example for explanation:-
Sam Inc. purchases 20% of orbs Corp for $800,000. At the end of the year, orbs Corp reports a net income of $100,000 and a dividend of $80,000 to its shareholders.
When Sam makes the purchase, it records its investment under “Investments in Associates/Affiliates”, a long-term asset account. The transaction is recorded at cost.
|Dr.||Investments in Associates||800,000|
Sam receives dividends of $16,000, which is 20% of 80,000, and records a reduction in their investment account. The reason for this is that they have received money from their investee. In other words, there is an outflow of cash from the investee, as reflected in the reduced investment account.
|Cr.||Investments in Associates||16,000|
Finally, Sam records the net income from orbs as an increase to its Investment account.
|Dr.||Investments in Associates||32,000|
The ending balance in their “Investments in Associates” account at year end is $816,000. This represents a $16,000 increase from their investment cost.
This reconciles with their portion of orbs’s retained earnings orbs has Net Income of $100,000, which is reduced by the $80,000 dividend. Thus, orbs’s retained earnings for the year are $80,000. Sam’s portion of this $80,000 is $16,000.
Other Methods of accounting which are used by investor:-
There are many method which are used by the investors to analyze the companies they want to invest in.We saw a method earlier which is equity method and another most used method is consolidation method.
Consolidation method involves “investment of parent companies in their subsidiaries” .The subsidiaries assets, profit ,loss and other financial activities are recorded in consolidation financial statement of the parent company . And when the investor does not have any influence over the investee, the investor gains a passive minority interest in the investee.In such case investment is accounted for using cost method.
Cost method records the investment at cost and it depends on the factors such as investor historic transaction with investee.