Simple Equity Method Accounting Defined

Simple equity method accounting is when a company looks at its investments in other companies and includes any profits into their income statement. The statement includes the price paid for shares plus the percentage equity of the reported net income of the affiliated company. This net income profit is figured based on the number of shares that are possessed.

Investing companies may only use this procedure when 20% to 50% of the other company's stock is owned. When this percentage range is achieved, it is accepted that the investing company has considerable impact within the other company. This power may include some representation on the board of directors and/or developing company policy.

Equity method accounting is widely common in the relationship between parent companies and subsidiary companies. When these two entities do not share consolidated statements, transactions between income statements are common for equity method accounting.

Dividends can be paid according to the increased value, but generally neither the dividends nor the net income profits are ever transferred to the investing company.

I know what you are thinking. The first thing that comes to mind is: Is it accurate to include profits from a rise in stock or investment? Is it even legal to pad the stats like that?

Firstly, it is legal and an accepted practice. In fact, it is even required of some parent/subsidiary company agreements. The accuracy depends on which way you look at the accounting.

On one side, personal finances are only calculated and taxed when a stock or investment is sold and the profit is physically obtained. On the other hand, the company does own the asset. And the company would normally include any transactions at the time of recording if it uses accrual accounting.

It may seem like counting your chickens before they hatch because the stock investment can easily drop in value as well. Profits that are only on paper will not physically buy more supplies or pay for the company expenses.

Conversely, companies want to include the additional profits because it looks much better when the board shows stockholders the income statement. This inflated income statement may help get a better loan for expansion or higher rankings when compared with competitors.

Even though the income taken into account is unrealized, there are several situations where companies must figure in the profits to accurately portray the status of the enterprise. This is where simple equity method accounting, figured into partial equity method accounting, calculates the included asset for the accounting statements.