What is the Equity Method?
The Equity Method is a critical accounting technique employed for managing and reporting the financial engagements with associated undertakings. When a company invests in another entity (referred to as an associate) and exercises significant influence over it (generally holding 20% to 50% of voting shares), the equity method comes into play.
Key Processes of the Equity Method
Under the equity method:
- An investment is initially recorded at cost, directly capturing any goodwill generated during the acquisition phase.
- In subsequent accounting periods, the carrying amount of the investment is adjusted to reflect:
- The investor’s share in the periodic profits or losses of the associate post any goodwill amortization or immediate write-offs.
- The investor’s proportionate share in other comprehensive gains or losses affecting the investee’s net assets.
These recordings are meticulously noted immediately after the group’s operational profit in the consolidated profit and loss accounts.
Regulations and Standards
The equity method is governed by various standards, including the Financial Reporting Standard Applicable in the UK and Republic of Ireland and International Accounting Standard (IAS) 28, titled Investments in Associates. These documents provide a framework ensuring consistency and transparency in financial reports across borders.
Why the Equity Method?
The rationale behind using the equity method lies in its ability to provide a realistic picture of the investor’s financial health as influenced by their associative engagements. It prevents the overstatement of investor’s financial power by only recognizing the profit proportionate to their stake and not the total gains of the associate, creating a balanced financial declaration.
Related Terms
- Associated Undertakings: Typically involves entities where the investor has significant influence but not full control.
- Goodwill: A financial term for the premium paid over the fair market value during the acquisition of an associate.
- Amortization: The gradual write-off of intangible assets like goodwill over a specified period.
- Carrying Amount: This is the value at which an asset is recognized after deducting any accumulated depreciation and impairment.
- Net Assets: Total assets minus total liabilities, indicating the actual economic value of an entity.
- Gross Equity Method: A variant of the equity method, often requiring full consolidation before proportional adjustments.
Suggested Reading
To deepen your understanding of the equity method and its applications in accounting and finance, consider the following texts:
- “Accounting for Investments, Volume 2: Fixed Income and Interest Rate Derivatives. A Practitioner’s Handbook” by R. Venkata Subramani
- “Equity Valuation and Analysis” by Russell Lundholm and Richard Sloan
By grasping the intricacies of the Equity Method, businesses and stakeholders can preserve accuracy in financial reporting and ensure strategic investment decisions are made with a comprehensive understanding of their associative impacts.
