Question

Is the “equity method of accounting” a fair indicator of an investment of one company by another. Explain the reasons for your conclusion. How does this method compare to other forms of accounting, e.g., consolidations.

Answer 1

The equity method is an accounting technique used by a company to record the profits earned through its investment in another company. With the equity method of accounting, the investor company reports the revenue earned by the other company on its income statement, in an amount proportional to the percentage of its equity investment in the other company.

The equity method acknowledges the substantive economic relationship between two entities. The investor records its share of the investee's earnings as revenue from investment on the income statement.

When an investor company exercises full control, generally over 50% ownership, over the investee company, it must record its investment in the subsidiary using a consolidation method.

The proportional consolidation method provides a more accurate and detailed record because it breaks down how well a joint venture performs. This method allows each company to see the operational effectiveness of various steps in the joint venture process including production costs, shipping costs, and the profit margin.

There are proponents for the use of each of these accounting methods, and different accounting standards organizations are split as to which is the more appropriate practice. Companies generally use the method that fits best with their overall operations and existing accounting practices.