Recording Equity Investments: A Comprehensive Guide

Recording an equity investment is a process that depends on the degree of control and influence the investor has over the company they are investing in. The two main methods for recording equity investments are the equity method and the cost method. The equity method is used when the investor holds significant influence over the company they are investing in, typically owning between 20% and 50% of the company's shares or voting rights. On the other hand, the cost method is used when the investor has no influence over the company's operations and holds less than 20% of the shares. Under the equity method, the initial investment is recorded at cost, and then the value is adjusted periodically to reflect changes in income and losses. Dividends paid by the company are not treated as income but as a return on investment. Conversely, under the cost method, the investment is recorded at the cost of acquisition, and income from dividends is recognised when received.

Owner's contributions

Owners' contributions are an essential aspect of equity investments, and understanding how to record them is crucial. When an owner invests in a business, it typically involves injecting personal funds or assets into the venture. This can take various forms, such as cash investments, gifts, inheritances, or other contributions. These contributions are considered capital injections, and they play a significant role in shaping the financial health and growth of the business.

In accounting terms, owners' contributions are recorded within the equity section of the balance sheet. This is because they represent the owners' claim on the assets of the business. The equity section of the balance sheet typically includes components such as retained earnings, outstanding shares, and additional paid-in capital. Owners' contributions add to the overall equity of the business and can be a critical indicator of the business's financial strength and stability.

When recording owners' contributions, it is essential to follow standard accounting practices and guidelines. One widely recognised method is the equity method of accounting, which is used when an investor holds significant influence over the investee but does not exercise full control. In this scenario, the investor records their proportionate share of the investee's earnings as an increase in the investment account on their balance sheet. This method is generally applied when an investor owns 20% or more of the investee's shares or voting rights.

To illustrate with an example, consider Company A, which purchases 30% of Company B's shares for $500,000. At the end of the year, Company B reports a net income of $100,000 and pays a dividend of $50,000 to its shareholders. Company A would record this transaction by increasing its investment account by 30% of Company B's net income and reducing it by 30% of the dividend paid. This adjustment reflects the "equity pickup" concept, where the investor's share of the investee's profits and losses directly impacts the value of their investment.

It is worth noting that the process of recording owners' contributions may vary depending on the business structure and accounting software used. For instance, when using QuickBooks, owners' contributions are typically recorded in equity accounts. The process involves selecting the "Chart of Accounts," choosing "Equity" as the account type, and then specifying the details of the contribution, such as the name and amount.

In summary, owners' contributions are a fundamental aspect of equity investments, and they are recorded within the equity section of the balance sheet. These contributions play a crucial role in assessing the financial health and growth of a business, and proper recording is essential for maintaining accurate financial records.

Equity method of accounting

The equity method of accounting is a technique used to record the profits earned by a company through its investment in another company. It is used when the investor company holds significant influence over the company it is investing in, usually when it owns 20% or more of the investee company's stock.

When using the equity method, the investor company reports the revenue earned by the investee company on its income statement. This amount is proportional to the percentage of its equity investment in the investee company. The investment is initially recorded at historical cost, and adjustments are made based on the investor's percentage ownership in net income, loss, and dividend payouts. Net income of the investee company increases the investor's asset value on their balance sheet, while the investee company's loss or dividend payout decreases it.

For example, if Company A buys 25% of Company B's voting common stock for $500, it records this as a debit to its "Investment in Affiliate" account. If Company B reports net income of $200 and announces a $40 dividend, Company A records its proportionate share of Company B's earnings as an increase to the "Investment in Affiliate" account. It also records a reduction in the investment account for the dividend received, as this is considered a return of capital.

The equity method acknowledges the substantive economic relationship between the investor and the investee. It allows for a more complete and accurate picture of the economic interest that one company has in another.

Fair value method

The fair value method is one of three methods that can be used to record an equity investment, the other two being the equity method and the consolidation method. The fair value method is used when ownership is less than 20% of the company's outstanding shares and the investor does not have significant influence over the company they are investing in. In this case, the company would classify the investment as "trading" or "available-for-sale".

When using the fair value method, an investment is initially accounted for at cost, and then adjusted to fair value at the balance sheet date each year. For example, if the fair value of the investment has dropped below cost, and the company considers this decline in value to be temporary, the security is classified as available-for-sale, and there would be a decrease in available-for-sale securities and a decrease in other comprehensive income.

The fair value method is also used when a company holds non-voting stock in another company, as significant influence cannot be exercised in this case.

Cost method

The cost method of accounting for investments is used when the investor has minimal influence over the business they are investing in. This generally means that the investor owns 20% or less of the shares of the company they are investing in.

The cost method is a conservative approach to recording investments. It requires the investor to account for the investment at its historical cost, or purchase price, which appears as an asset on the balance sheet. Once the initial transaction is recorded, there is no need to adjust it unless there is evidence that the fair market value of the investment has declined below the recorded historical cost. In this case, the investor writes down the recorded cost of the investment to its new fair market value.

If the company being invested in, or the 'investee', pays dividends, the investor records them as dividend income, and there is no impact on the balance in the investment account. Dividends are treated as taxable income. The investor may also periodically test for impairment of the investment. If it is found to be impaired, the asset is written down, affecting both net income and the investment balance on the balance sheet.

The cost method is considerably easier than the alternative equity method of accounting for investments. This is because the cost method only requires initial recordation and a periodic examination for impairment of the investment.

Consolidation method

The consolidation method is an accounting approach used to record an equity investment when the investor has majority control over the investee or subsidiary. This method can only be used when the investor possesses effective control of the investee, which often, but not always, assumes ownership of at least 50.1% of the subsidiary's shares or voting rights.

Under the consolidation method, the parent company combines its revenue with 100% of the subsidiary's revenue. The parent company's balance sheet will record 100% of the subsidiary's assets and liabilities, even if the parent company does not own 100% of the subsidiary's equity. The parent company's income statement will also include 100% of the subsidiary's revenue and expenses. If the parent company does not own 100% of the subsidiary, the parent company will allocate the percentage of the subsidiary's net income that it does not own to the non-controlling interest.

To ensure that values are not double-counted, an elimination adjustment is made to offset the intercompany transaction and the shareholders' equity. This is done by creating a consolidated statement that combines the balances of the parent company and the subsidiary.

For example, if a parent company invests $10 million in a new subsidiary, the parent company's books will show a decrease in cash of $10 million, while the subsidiary's books will show an increase in shareholder equity of $10 million. At the end of the year, a consolidated statement must be created for both companies, taking into account any elimination adjustments to avoid overstating the consolidated balance sheet.

The consolidation method is one of the three main methods used to record an equity investment, with the other two being the fair value method and the equity method. The fair value method is used when ownership is less than 20% of the company's outstanding shares, while the equity method is used when a company owns between 20% and 50% of the outstanding stock and has significant influence.

Frequently asked questions