What is Equity Accounting?
Companies may make investments in other companies. These are called intercorporate investments. Depending on the size of their ownership stake in those companies from those investments, the accounting is different. For example, a “minority” stake in a company — typically less than 20% — is different from an active minority stake (20%-50%) and a controlling stake (50% or more).
When a company creates its financial statements, it records its profits and losses on its income statement and accounts for its assets and liabilities on the company’s balance sheet. It must include in its accounting those investments and held securities the company owns.
Using the cost method of accounting, the company would simply include the value of those bonds and stocks it holds as part of its assets. Because the company’s ownership stake is less than 20% in those companies where it holds securities and has no ownership or voting rights, all those different investments can be consolidated into a line item on the balance sheet at the designated fair value.
However, when a company owns 20% or more of a company, the equity method of accounting must be used. The initial investment that the company makes must be recorded on the balance sheet. The value of that investment changes and an investor recognizes its portion of the profits and losses of the company or companies it invested in.