Equity Investment Exclusions: What's Not Included?

Equity investments are a type of financial transaction where money is invested in a company by purchasing shares of that company on the stock market. These shares are typically traded on a stock exchange, and investors expect them to rise in value, resulting in capital gains and/or dividends. However, not all investments are considered equity investments. For instance, investments in partnerships, joint ventures, and limited liability companies (LLCs) are generally not considered equity investments. Additionally, certain types of investments, such as those in common stock held by non-business entities or investment companies, may not fall under the equity method of accounting. When determining if an investment is an equity investment, it's important to consider the level of influence and control the investor has over the company, as well as the specific accounting methods used.

Shares purchased in the stock market

Shares purchased on the stock market are a type of equity investment. Equity investments are made by purchasing shares of a company, which are then traded on a stock exchange.

Shares are units of ownership in a company. When a company issues shares, it is selling ownership stakes to investors. The terms "shares" and "stocks" are often used interchangeably, but they are technically different. "Stock" is the financial instrument a company issues, and a "share" is a single instance of that instrument.

There are two main types of shares: common stock shares and preferred stock shares. Common stock shares enable voting rights and possible returns through price appreciation and dividends. Preferred stock shares do not offer price appreciation but can be redeemed at an attractive price and offer regular dividends.

The price at which shares are sold or purchased on the stock market is called the Market Value (MV) of the share. This value can change frequently depending on the company's performance. If the company performs better than expected, the market value of its shares increases, and if the company is not doing well, the market value decreases.

When a company issues shares, it increases liquidity, makes it possible to give employee incentives, and diversifies ownership. Shares are also a way for companies to raise capital, which can then be used to fund operations, research and development, expansion, or other growth opportunities.

Shareholder equity is an important concept in finance, representing the value of an investor's stake in a company. It is calculated by subtracting a company's total liabilities from its total assets and can be found on a company's balance sheet. Equity can be either negative or positive, with positive equity indicating that a company has enough assets to cover its liabilities.

Overall, shares purchased on the stock market are a common form of equity investment, offering investors the potential for capital gains and dividends, as well as voting rights and other benefits.

Capital gains and dividends

Capital Gains

Capital gains are profits that occur when an investment is sold at a higher price than its original purchase price. In other words, a capital gain is an increase in the value of a capital asset, such as stocks or real estate, that gives it a higher value than the price paid for it. An investor realises a capital gain when they sell an investment for a profit. For example, if an investor bought a stock for $1,000 and sold it for $1,200, they would realise a capital gain of $200.

Dividends

Dividends are payouts to shareholders from the profits of a company that is authorised by its board of directors. They are usually distributed out of the profits of a corporation to the stockholders, although companies may also issue dividends from retained earnings. Dividends can be paid out at a scheduled frequency (e.g. monthly, quarterly, semi-annually, or annually) or as non-recurring special dividends. Dividends can be paid in cash or as stock or property. Dividends are the most common type of distribution from a corporation.

Tax Implications

The tax rates for capital gains differ depending on whether the asset was held for the short term or long term before being sold. Short-term capital gains, where the investor sells the asset after holding it for less than a year, are taxed as ordinary income for that year. Long-term capital gains, where assets are held for over a year before being sold, are usually taxed at the lowest rates available outside of tax-advantaged accounts.

Dividends are classified as either ordinary or qualified. Ordinary dividends are taxable as ordinary income, while qualified dividends that meet certain requirements are taxed at the lower capital gains rate. In the US, most stock dividends qualify to be taxed as capital gains.

Equity funds

There are several types of equity funds, categorised by investment style, portfolio focus and level of diversification. Actively managed and passive funds are the two primary categories. Actively managed funds tend to have higher fees. Some of the types of equity funds include:

• Large-cap funds: These invest in stocks of large companies, usually well-established businesses with stable growth and consistent dividends.
• Mid-cap funds: These invest in companies with a medium market capitalisation, often in the growth phase of their life cycle.
• Small-cap funds: These invest in smaller, younger companies with high growth potential but higher volatility and less liquidity.
• Growth funds: These invest in stocks of companies with rapid earnings growth potential, often reinvesting their earnings.
• Value funds: These invest in stocks that are considered undervalued and often have lower P/E ratios and higher dividends.
• Blend equity funds: These invest in a mix of both growth and value stocks, providing a balance for investors.
• Sector funds: These invest in stocks of companies within a particular industry or market sector, such as technology or healthcare.
• Geographically focused funds: These invest in stocks of companies based in certain areas of the world, such as domestic, international or global funds.
• Private equity funds: These are private, closed-end funds that invest in companies that are not publicly traded.
• Equity income funds: These funds own a portion of a business that pays dividends, providing income for the investor.
• Dividend growth funds: These invest in businesses that tend to increase their dividends per share at a faster rate than the market average.
• Index equity funds: These funds mimic the performance of a specific index, such as the FTSE 100, and are often passively managed.

Common stock

The first common stock was issued in 1602 by the Dutch East India Company and traded on the Amsterdam Stock Exchange. Today, common stocks are traded on major exchanges such as the New York Stock Exchange (NYSE) and Nasdaq.

Equity method accounting

The equity method acknowledges the substantive economic relationship between the two entities. The investor company initially records its investment in the second company's stock as an asset at historical cost. The investment's value is then periodically adjusted to reflect the changes in value due to the investor's share in the company's income or losses. The investor company reports the revenue earned by the other company on its income statement, proportional to the percentage of its equity investment.

For example, if a firm owns 25% of a company with a $1 million net income, the firm reports earnings from its investment of $250,000 under the equity method. The equity method ensures proper reporting on the business situations for both the investor and the company being invested in, given their economic relationship.

The equity method is one of several methods used to account for equity investments. If an investor can exercise control over the company being invested in, the investment is typically accounted for as a consolidated subsidiary. If the investor exercises neither control nor significant influence, the proper method of accounting is the fair value method.

Frequently asked questions