Equity accounting is an accounting method used to record and report income from business investments. Business investments often represent the capital one company invests into another; these investments are made to generate passive income streams for companies outside of normal operational revenue streams. Businesses must report the size of the equity investment on their financial statements and the amount of any income they receive for this investment. Equity accounting must follow jurisdiction rules or standardized principles, such as the generally accepted accounting principles (GAAP) used in the United States.
Business investments are usually listed on the company’s balance sheet. Equity accounting methods usually record these amounts as the actual cost of capital invested into the organization. Companies may need to provide disclosures on the balance sheet indicating the terms or rules of the business investment. External users of the company’s financial statements may desire information regarding business investments, such as the number of shares of stock owned and if the shares of stock are preferred or common. Equity accounting does not usually require a specific number of disclosures for business investments.
The income generated from business investments is recorded on the investing company’s income statement. Equity accounting uses the business investment percentage to determine how much net income should be reported by the company owning the business investment. If a company owns 20 percent of another organization’s stock, the company owning the stock must report an equal percentage of net income from the investment on their income statement. For example, if the organization earns $100,000 U.S. Dollars (USD) in operational income, the company owning 20 percent of the organization’s stock must report $20,000 USD of investment income on published financial statements.
Under traditional equity accounting rules, companies that own 20 to 25 percent of another company’s stock are considered to have significant control over that companies business operations. An ownership percentage that is greater than 25 percent may result in a subsidiary relationship between two companies. The recording and reporting of financial information relating to subsidiary business organizations do not generally fall under equity accounting rules.
Companies owning significant portions of another organization's stock must accurately record the total value of ownership of the organization. Companies purchasing more or selling off large chunks of business stock investments in another organization must accurately report these changes on their balance sheet as well. Equity accounting rules require investments in other organizations to be recorded at the actual cost of the business investment.