Companies often find it advantageous to invest in other companies without necessarily taking control of them. The accounting for investments hinges on the amount of sway the investor holds with the investee. Investors use the fair value method when the level of influence is insignificant and consolidation accounting when investors control the investee. Companies use the equity method when they have substantial influence on the investee.
Under the equity method, the investor books the investment as a noncurrent asset at the price it pays for the investee stock. The investor then recognizes its share of investee income and adjusts the book value of the asset accordingly. For example, if the investor owns 30 percent of the investee's voting shares and the investee earns $1 million in the quarter, the investor records $300,000 as income and as an increase to the investment's book value. The investor treats any dividends it receives on the investee shares as a return of equity and subtracts them from the asset's book value.
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Compliance With GAAP
The primary reason that companies use the equity method is that it satisfies GAAP, or generally accepted accounting principles. By immediately recognizing investee income, the investor fulfills the GAAP requirement to record revenues and losses in the period earned. Furthermore, the Financial Accounting Standards Board states that the equity method is appropriate when the investor can influence the investee, because the investor must include the results of investee operations in its own income statement. In other words, because the investor has some control over investee results, it is rewarded or penalized accordingly.
Another reason that investors use the equity method is its flexibility. GAAP assumes you have significant influence over an investee if you own between 20 percent and 50 percent of voting shares. Yet a company can use the equity method if it owns less than 20 percent of investee stock if it can prove significant influence, such as having representatives on the investee board. The flexibility also works the other way: A company can avoid the equity method even with ownership of more than 20 percent investee shares. For instance, you may not be influential if the investee is hostile to your suggestions, sues you and denies you board representation.
A company might prefer the equity method over consolidated reporting to enhance its financial ratios. For example, suppose an investor purposely limits its investment to 50 percent of investee voting shares to use the equity method. The investor thus benefits from the assets and liabilities of the investee without needing to consolidate these items into its own balance sheet. This is desirable because the investor's return on assets and return on debt are higher when the investee's assets and liabilities are not consolidated with those of the investor. In effect, the investor benefits from off-balance-sheet financing when using the equity method.