When industry indicators slide on news that economic activity is contracting or that a major player is struggling to make ends meet, securities-exchange players are not the only group affected. Companies investing in other businesses — some of which may account for their investments under the equity method — also bear the consequences of a bad economy, especially with things like profitability and solvency.
An equity investment is money a company pours into another company’s activities. After the monetary injection, the investing company acquires an equity stake in the affiliate — which may go by names as diverse as investee, subsidiary, affiliate or associate, depending on applicable laws and the underlying equity stake. For example, Company A buys 1 million shares of Company B at $2 apiece at a moment when Company B has 5 million shares outstanding. As a result, Company A will pony up $2 million — or 1 million multiplied by $2 — and will acquire 20 percent — 1 million divided by 5 million multiplied by 100 — ownership in Company B.
Financial managers use the equity method to account for a corporate investment when it generates an equity stake ranging from 20 to 50 percent. Under these conditions, the business reduces the value of the investment when the affiliate declares dividends or post negative results. The opposite treatment happens when the associate heralds periodic profits because the investing company is entitled to part of the investee’s operating earnings. The corporate investor classifies the equity investment as a long-term asset in its balance sheet.
Reporting Other Investment Scenarios
When a business owns less than 20 percent of another organization’s equity, it uses the cost method. Under this method, the business reports the investment’s cost in its balance sheet and recognizes as income its share of cash dividends the investee periodically distributes. An equity stake exceeding 50 percent creates a parent company-subsidiary relationship, and the investing company uses the consolidation method to account for its investment. Consolidating financial statements means adding financial items in a parent company’s standalone performance data to a subsidiary’s operating results.
A flare-up in a company’s operating losses and the need for more income and greater market share often lie in the backdrop of equity investments. If the business can’t generate enough cash from its primary activities, it may need to seek cash from other sources, some of which include pouring money in other organizations. Beyond the obvious monetary benefit, equity investments also help a business wield operational influence over affiliates — a smart move, especially if the investing organization wants to expand market share and improve its economic standing.