How to Use The Equity Method of Accounting For Investments in Common Stock

Valuing stock using the equity method

The "equity method" of accounting for investments in common stocks is one method used to determine the book value, from the investor's perspective, of common stocks. The alternative method, which will not be discussed here, is the "cost method." The equity method of stock valuation is generally used when the investor in a corporation is able to exert significant influence over the operation and policies of the corporation. Usually, this occurs when the investor owns at least 20 percent of the voting stock in the corporation. When using the equity method, the value of each stock share, for the investor's purposes, is counted based on the book value of the stock as reported by the investee corporation, rather than the purchase price of the stock (as in the cost method).

Instructions

1. Determine that the equity method is the appropriate method of accounting for your stock investment. Generally, if the total voting shares owned by the you (or your company) are 20 percent or more of the total voting shares, the equity method should be used. However, sometimes an accountant may advise you that the cost accounting method is more appropriate. Consulting a qualified accountant is always recommended before making accounting decisions that affect tax liability, or reporting of net worth or income.

   Example: You buy 2,000 shares of Acme Iron Inc. for $5 per share. These are voting shares. Acme has issued a total of 8,000 shares of voting stock. Because you have purchased 25 percent of the voting stock in Acme, and if no extenuating circumstances exist, you should use the equity method of accounting for investments in common stocks.

2. Record the purchase of the stock on your books at the time of purchase, for the actual purchase price.
   Example: You buy 2,000 shares of Acme Iron Inc. for $5 per share. The total purchase price of $10,000 for the 2,000 shares is recorded at the time of purchase. The entry on your books appears as a $10,000 debit to investments (an asset account), and a $10,000 credit to cash (an asset account).

3. Record on your books any increase in the value of your stock investment, according to the equity method of accounting for stock investments. Upon the close of the investee corporation's accounting period--annually or quarterly, for instance--determine if the corporation's stock value has increased. This information will be made available to you in the investee corporation's financial reports. Calculate the net increase in the value of your stock investment by multiplying the number of shares you own by the net increase in value per share.

   Example: Upon closing of the fiscal year, the value of Acme Iron Inc.'s common stock is determined to have increased in value from $5 per share to $5.50 per share. This means that the value of your investment has increased by 50 cents per share, or a total of $1,000 for the 2,000 shares that you own. The net gain is recorded on your books as a $1,000 debit to investments (an asset account), and a $1,000 credit to income from investments (a revenue account).

4. If your stock equity decreases instead increasing, record the loss on your books according to the equity method of accounting for stock investments.

   Example: If the value of Acme Iron Inc.'s common shares decreases to $4.75 per share, your investment decreases in value by $500. This is recorded as a $500 credit to investments and a $500 debit to loss from investments. The loss from investments will eventually be transferred onto your retained earnings account and in this way will offset revenue.

5. Record any dividends that are paid to you. When the investee corporation pays a dividend, its assets decrease, and likewise so does the value of the stock that you own. So, when you receive a cash dividend, your net investment decreases. Therefore the dividend is not recorded as revenue, but rather as a shift in assets.

   Example: Acme Iron Inc. decides to pay a dividend of 10 cents per share. Because you own 2,000 shares, you receive a cash dividend of $200 and your investment in Acme decreases by $200. This is recorded as a $200 debit to cash (an asset account) and a $200 credit to investments (an asset account).

Tips & Warnings

• A corporation can invest in another corporation. This is the most common instance calling for the use of the equity method of accounting for investments in common stocks.

• When a corporation owns more than 50 percent of another corpoartion, we say that it has "controlling interest" in the second corporation. The corporation with controlling interest is called the "parent corporation" and the owned corporation is called a "subsidiary corporation."

References

• Investopedia: Statement of Financial Accounting Concepts

Resources

• Accounting Coach: Basics of stockholders equity
• The Motley Fool: Investing Basics