Understand the What is equity accounting and how is it applied?

If you've ever come across the term "equity" in a conversation about finance or accounting and felt lost, you're not alone. Equity may seem complex at first glance, but it's a fundamental concept for anyone who wants to better understand the financial health of companies and investments.

In this article, we'll demystify equity accounting in a simple and straightforward way. We'll explain what it is, how it works, and why it's important. We'll also present practical examples so you can see how this method is applied in practice, and we'll discuss its advantages and disadvantages. Get ready to understand this important financial and accounting term once and for all!

What is Equity Income?

Equity accounting is an accounting method used to value investments in affiliated and controlled companies. It allows the investing company to recognize its share of the invested company's profits and losses proportionally to its equity stake.

This method is crucial in the accounting and financial context, as it offers a more accurate view of investments, better reflecting the performance of subsidiaries and subsidiaries in the investing company's financial statements. This increases transparency and helps investors and analysts make more informed decisions.

How does equity accounting work?

Equity accounting allows an investing company to recognize its share of the invested company's profits and losses. The investment value is adjusted periodically based on the proportion of the invested company's financial results that belong to the investing company.

The basic principles include:

• Proportionality: The investing company must adjust the value of its investment according to its shareholding in the invested company.
• Recognition of results: Profits and losses of the invested company are recognized in the financial statements of the investing company in the same proportion as its equity interest.
• Periodic adjustments: The value of the investment is reviewed regularly to reflect changes in the equity of the invested company.

This adjustment allows Company A's financial statements to better reflect the performance of its holdings, providing a more accurate and transparent view of its financial situation.

When is Equity Method Used?

Equity accounting is applied in a variety of situations and contexts, particularly when a company has significant investments in other companies. Here are some examples of where and how it is used:

• Associated Companies:
  • Used when a company owns a significant stake (usually between 20% and 50%) in another company, but does not fully control it.
  • Example: A company holds 30% of the shares of another and must recognize its share of the profits and losses of that affiliate.
• Controlled Companies:
  • Applied when one company has significant control over another (more than 50% of the voting shares).
  • Example: A parent company controls a subsidiary and reflects the financial performance of that subsidiary in its own financial statements.
• Joint Ventures:
  • Used when two or more companies form a partnership and have joint control over a new entity.
  • Example: Two companies each hold 50% of a new company and must recognize their share of the profits and losses of that joint venture.
• Participation Agreements:
  • Applied in situations where there are specific agreements that guarantee significant influence over the financial and operational decisions of another company.
  • Example: One company owns 25% of the shares of another and, through a shareholding agreement, has significant influence over that company's operations.

Advantages and Disadvantages of Equity Methodology

Below, we present a table highlighting the main advantages and disadvantages of equity accounting. This method offers a more realistic and transparent view of investments, but it also presents challenges in its application and maintenance.

Difference Between Equity Methodology and Other Valuation Methods

Equity accounting is just one of the accounting methods used to value investments, and it's important to understand how it compares to other common methods:

• Historical Cost:
  • Description: Records the investment at its acquisition cost and is not subject to adjustments based on the performance of the invested company.
  • Difference: Unlike equity accounting, historical cost does not reflect changes in the performance of the invested company, offering a less dynamic view of the investment.
• Fair Value:
  • Description: Evaluates the investment based on its current market value, adjusted periodically to reflect market conditions.
  • Difference: Fair value is more sensitive to market fluctuations, while equity directly reflects the financial results of the invested company.
• Consolidation Method:
  • Description: Used when the investing company has full control over the invested company, combining the financial statements of both companies.
  • Difference: Full consolidation completely integrates the assets, liabilities, revenues and expenses of the investee, while equity accounting adjusts only the value of the investment and recognizes the proportion of profits and losses.

We hope this text has clarified the concept and application of equity accounting, making it more accessible to anyone who wants to better understand their finances and investments.