When an investor purchases stocks, he either plans to sell them to other investors at a higher price, or he is buying stock so he can control the company's management decisions. The investor's plans to trade the stock affect how the investor calculates the value of his investment because equity valuation involves assumptions about the period of time that the investor will keep the stock.
For example, a jeweler purchases shares of a diamond mine. When the jeweler only owns a few shares of the diamond mine, other shareholders can outvote the jeweler easily. The accounting assumption is that the jeweler intends to sell the diamond mine's stock after it increases in value, so the jeweler uses the fair value method, which uses the market price of the diamond mine's stock to determine the value of its holdings.
If the jeweler buys 20 percent of the diamond mine's shares, he has more power to influence the company's decisions, such as where to mine next. The accounting assumption is that the jeweler purchased a large number of shares because he plans to use this voting power to make long-term decisions about diamond mining, so he will hold onto the diamond mine's stock even if its price fluctuates. The jeweler uses the equity method, calculating the value of the diamond mine's assets to determine what his investment is worth.
Video of the Day
Brought to you by Sapling
The jeweler can override the votes of other investors if he owns most of the diamond mine's stock. If the jeweler owns more than 50 percent of the diamond mine, the financial statements of the two companies are combined, and the jeweler issues a consolidated statement.
Under the fair value method, if the jeweler receives a dividend from the diamond mine, he records this dividend as a profit. With the equity method, the jeweler owns a significant portion of the diamond mine. If the jeweler receives a dividend of $10,000, the jeweler subtracts $10,000 from the equity he holds in the diamond mine, according to Jacksonville State University.
The price of the diamond mine's stock will vary throughout the year. If the jeweler uses the equity method, these short-term stock price fluctuations aren't relevant. Under the fair value method, the jeweler plans to sell the diamond company's stock, so the day-to-day price changes affect the financial statements.