The equity method of accounting deals exclusively with reporting the investments made by one firm into another firm. In general, this method deals mostly with tax accounting, since the firm that is making the investment must treat the income made from these investments as normal income under corporate income tax rates.
The main advantage of the equity method centers around valuing the investments. The alternative accounting method is the enterprise value, which deals with market values of these assets rather than the dividends that derive from them. Equity methodology treats the book value of these investments as essential. The enterprise value method treats the market value of these assets as central. These are two very different methods of valuing a firm's investments and has tax repercussions.
If a firm takes a loss on its investments in another firm, the tax implications of equity methodology are far better than the market value. Debt is a marketable security. How much the debt is on paper is very different than the debt on the open market. If the firm making the investment is healthy, and yet takes a loss on bonds bought from another firm, the loss itself might be high. But it also might have a very good chance of being paid because the firm with the debt is healthy, and has a solid cash flow. Therefore, how these debts are valued determines how much tax the firm must pay. It will be higher if the market value is used, and lower if the book value is used.
Equity value deals almost exclusively with the firm's structure and its worth. Other methods care only about how much these are worth — both profits and debt — on the open market. Just as important, however, is the fact that the equity method only kicks in when the shares in another firm, represented by stocks or debt, is over 20 percent. This is considered to be a controlling influence. This means that the IRS is concerned with income coming from a firm in which the investor can control, at least in part. Only at 50 percent are the firms considered one in the same, as a parent to subsidiary. Equity value, therefore, means that the firms are not considered strictly separate. It is about control, not about money. The advantage here is that the firm that has the 20 percent controlling influence is considered connected to the other firm.
The equity method implies that the accounting for firm investments in other firms is more stable than any other method. This is an advantage of the book valuation method in general. The equity method stresses that market relations are very fluid. They can change drastically for reasons that have no direct economic value, such as lawsuits or fads. Therefore, using the equity method is a more honest sort of reporting. It ignores the extraneous details of short-term market fluctuations that — more often than not — have no real connection to the values of the investments.
- Jupiterimages/Photos.com/Getty Images