The equity method of accounting applies in situations that arise when a company invests enough money in another firm or company to influence the decision making process of that company. As a general rule, the purchase of 20 to 50 percent of another company’s stock requires the use of the equity method of accounting. Various types of equity methods exist, including complete equity method and adjusted equity method. Key differences exist between these two methods.
Complete Equity Method
The complete equity method calculates the value of a company’s investment in another company by subtracting dividends paid from the sum of the initial investment and the increase in stock value. For instance, if Company A invests $120,00 in Company B and earns $50,000 from that investment in a year, but Company B pays out dividends of 30 percent of invested stock, or $40,000 for Company A, Company A totals its investment as such: $120k + $50k - $40k = $130k. The complete equity method subtracts dividends from the total because dividends constitute money paid out to investors, or a partial buy back of total equity. In long-term equity investments, complete equity considers depreciable assets, or those that lose value over time, and also deduct this from total value.
Fully Adjusted Equity Method
The fully adjusted equity method of accounting provokes some confusion amongst sources, many of which describe it synonymously with the complete equity method. However, according to the textbook “Advanced Financial Accounting,” the fully adjusted equity method takes into account intercompany profits. Intercompany profits are comprised of those realized on services provided to related companies that do not necessarily result in an increase in the value of a company. Under the fully adjusted equity method of accounting, an investing company subtracts from the value of equity any unconfirmed intercompany profit. Or, to put it another way, fully adjusted equity method only considers intercompany profits confirmed in some way to impact the actual value of a company.
The only real difference between complete equity method and fully adjusted equity method arises from the question of intercompany profits. When accountants consider the value of an investment through complete equity, they only consider the value of an investment, the capital earned, the dividends paid and depreciable assets. When accountants consider the value of an investment through the fully adjusted equity method, they subtract from the capital earned any unrealized intercompany profits. Thus the fully adjusted equity method includes a slight tweaking of the profits earned on an investment, while the complete equity method calculates the value of an investment without considering the source of revenue of the company in which it invested.
Other Equity Methods
Two other common equity accounting methods exist beyond complete and fully adjusted, cost and partial. The cost equity method only considers the cost of an investment to a company by taking into account nothing but dividends paid. Dividends paid subtract from the overall value of an investment and thus cost the investing company a portion of the investment each year. If a company invests $100,000 in another company and receives 10 percent, or $10,000 in dividends in a year, cost equity method lists the value of the investment at $90,000, completely ignoring any increased stock value. The partial equity method bears similarity to the complete equity method. However, this method ignores depreciable assets but considers disparities between the market value and book value of a company, taking into account whether the public undervalues or overvalues the equity of an investment.
- “Accounting for M&A, Equity and Credit Analysis”; James E. Morris; 2004
- UC Berkeley; Advanced Financial Accounting Summary; C Chang
- Business Dictionary: Equity Method
- Wiley; Advanced Accounting Chapter 4; Joe Ben Hoyle et al; 2006
- Accounting Dictionary: Intercompany Profit
- Cliff Notes: Accounting for Equity Securities