The equity method of accounting is based on the assumption that if one corporation holds significant stock in another firm, it can control the other company. The investor must report the investee's income as if it were a subsidiary and acknowledge this relationship in its financial statements. The major shortcoming of this accounting treatment is that the underlying assumption of total control may not always be true.
When using the equity method of accounting, a corporation that holds a controlling stake in another treats the investee's financial transactions as its own. If, for instance, Company A holds owns 50 percent of company B, half of B's net income is reported as a line item in A's income statement. If A held a non-controlling stake in B, such income would be reported only if firm B distributed its earnings to shareholders in the form of dividends. The price paid for the shares of Company B over and above their book value are also recognized in A's balance sheet. In ordinary stock purchases, on the other hand, the book price of the shares would be largely irrelevant.
Definition of Controlling Stake
Perhaps the most important problem with this method of accounting is the difficulty in finding a universally accurate definition of controlling stake. Depending on the situation, a 20 percent ownership can be a controlling stake. In most major corporations traded on large stock exchanges, 20 percent can be enough to significantly influence the strategic decisions of the firm because most of the stocks are held by smaller investors which do not act in unison. In other situations, the number of directors of the investor company sitting on the board of directors of the other firm can be used a sign of control. No set of criteria, however, is perfect and what may look like a controlling stake may not enable the investor to control the key business decisions of the other firm. In other instances a below-threshold stake can be enough to exert significant control due to such factors as family ties and historic relationships.
Another major issue is that the income of the investee must be reported by the investor before any decision is to made to distribute such income. While this makes sense in many instances, it could also result in the declaration of excess profits by the investor. Especially when the smaller firm will use most reported income for reinvestment, with no plans for distribution to shareholders, the recognition of such income by the larger firm can create an illusion of healthy and sustainable profits. Such treatment also can result in an excess tax bill, based on declared profits.
The market price of most stocks is vastly above their book value. This is because most firms have intangible assets such as brand names, management expertise and know-how that is not recorded in accounting statements, but is reflected in the stock price. When a firm buys enough stock to warrant the use of equity method of accounting, the difference between the acquired shares market price and book value must be recorded, often as goodwill, and depreciated over time. Such depreciation will significantly reduce the reported income, leading to a smaller tax bill even though the shares held may still be as valuable as when they purchased, or even if they have appreciated since they were acquired.