When companies purchase securities, they invest in the success of the company that issued the securities. Companies invest in these securities when they hold excess cash and want to increase the value of their money. The company hopes to sell the securities in the future for more than it paid. These securities include shares of stock or bonds. Companies use two different methods of recording these investments. These methods include the equity method and the available-for-sale method. Some advantages exist for companies that use the equity method.
The equity method requires the company to record the investment at the cost it pays. The company records a proportionate share of the investment’s income whenever it reports income. Dividends represent a return of the company’s investment and reduce the company’s total investment value. Companies that own between 20 percent and 50 percent of the investment’s outstanding stock must use the equity method to report changes in the investment’s value.
When the company uses the available-for-sale method it records the investment at its cost. The company recognizes income when it receives dividends from the investment. No entry is recorded for the company if the investment reports income. If the company still owns these investments at the end of the period, it estimates the fair market value of the investment and notes an adjustment to record this change in value.
One advantage of using the equity method involves the value of the investment reported in the financial records. Under the equity method, all transactions impact the value of the investment account, and the company always knows what the book value of the investment equals. If the company uses the available-for-sale, it only adjusts the book value of the investment at the end of the year.
Another advantage of using the equity method of accounting is its treatment of dividends received. Companies receive dividends from investments regardless of which accounting method they use. If the company uses the equity method, the company records dividends as a reduction in the investment. If the company uses the available-for-sale method, the company records the dividends as income. Dividend income increases the company’s net income and the income tax liability. Using the equity method avoids the tax liability for the company.
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