by Michael Nnopu

Created on: August 14, 2010   Last Updated: August 16, 2010

Business entities at times may own investments either directly or indirectly in other corporations, either as subsidiaries, or affiliates. Accounting treatment of investments in common stocks of other companies vary depending on the percentage holding of such investments. If an investor has less than 20% of the issued common stocks of an investee, the investor’s influence on the investee is regarded as insignificant. In the investor’s books, this investment is treated using cost method accounting. For an investor with between 20 – 50% ownership interest in the investee’s common stock, the influence is regarded as significant and as such the equity method accounting is used. For investment of over 50%, a consolidated financial statement is prepared as the investor is deemed to have a controlling influence over the investee.

 Apart from holding between 20 – 50% common stocks of an investee, significant influence can also be demonstrated by having a position on the board of directors, participation in major decision making, interchange of managerial personnel, provision of essential technical information etc. Equity method accounting has several advantages over the cost method. First, it facilitates financial analysis of the investment; it is more useful for internal management purposes; it gives a good picture of the investing company as profits increases the balance sheet value and also makes good impression on the stock holders and investing public.

 The law of equity method accounting first appeared as Accounting Principles Board (APB) Opinion No. 18 dealing with Investments in Common Stock in 1971,  and much later again in 1986 as an exposure draft of International Accounting Standard 28 (commonly known as IAS 28) which deals in Investments in Associates. From then till date, it has undergone several reformations, amendments and revisions. All these with the intention of streamlining its application and ensuring its proper usage in the preparation of accounting information (iasplus.com).

How it works

Using the equity method accounting, investments in an investee is initially recorded at cost, and this amount is either increased or decreased to reflect the investor’s share of profit or loss of the investee’s operations after the acquisition date. While a profit will increase the investments, a loss will likewise cause a reduction in the total amount of the investment. Dividends paid out by the investee

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