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Accounting for Equity Securities

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Accounting for Equity Securities
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udgets (/study-guides/accounting/accounting-
An equity security is an investment in stock issued by another company. The accounting for an
investment in an equity security is determined by the amount of control of and inuence over operating
decisions the company purchasing the stock has over the company issuing the stock. If less than 20% of
the stock is acquired and no signicant inuence or control exists, the investment is accounted for using
the cost method. If 2050% of the stock is owned, the investor is usually able to signicantly inuence
the company it has invested in. Assuming the investor does not control the number of positions on the
Board of Directors or hold key ofcer positions, this investment would be accounted for using the equity
method. If the investor has 50% or more of a company's stock, signicant inuence and control are
deemed to exist and the investor reports its results using consolidated nancial statements. Although
percent of voting stock owned serves as a guideline, the amount of inuence and control is used to
determine the accounting for equity securities.

Cost method
 The cost method of accounting for
stock investments records the
acquisition costs in an asset account,
Equity Investments. As with debt
investments, acquisition costs include
commissions and fees paid to acquire
the stock. If 72 shares of PWC
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purchase is:

As dividends are received, dividend income is recorded. If PWC Corporation pays a $1 per share cash
dividend, the entry to record the receipt of the dividend increases (debits) cash and increases (credits)
dividend revenue.
Equity investments accounted for by using the cost method are classied as either trading securities or
availableforsale securities, and the value of the investment is adjusted to market value. When an
equity investment accounted for under the cost method is sold, a gain or loss is recognized for the
difference between its acquisition cost and the proceeds received from the sale. Assume 36 of the PWC
Corporation shares purchased were sold for $30 per share and a fee of $25 was paid. The entry to
record the sale would increase (debit) cash for the proceeds received of $1,055 (36 $30 = $1,080
$25 fee), decrease (credit) equity investments by $1,020.60 ($2,041 72 = $28.35 36 shares) and
record a gain on the sale for the $34.40 difference.

The equity method of accounting for stock investments is used when the investor is able to signicantly
inuence the operating and nancial policies or decisions of the company it has invested in. Given this
inuence, the investor adjusts the value of its equity investment for dividends received from, and the
earnings (or losses) of, the corporation whose stock has been purchased. The dividends received are
accounted for as a reduction of the investment value because dividends are a partial return of the
investor's investment. Assume The Sisters, Inc. acquired 30% of the stock of 2005 GROUP for $72,000
on Jan. 1. During the year, 2005 GROUP paid dividends totaling $30,000 and had net income of
$150,000. Under the equity method, the $9,000 in dividends ($30,000 30%) received by The Sisters,
Inc. would decrease the Investment in 2005 GROUP account rather than be reported as dividend
revenue. The same account would increase $45,000 for The Sisters, Inc. 30% share of net income
($150,000 30%) as they treat their share of net income as revenue. At the end of the year, the balance
in the Investment in 2005 GROUP account would be $108,000.
The entries by The Sisters, Inc. to record the acquisition of 2005 GROUP stock, receipt of dividends, and
share of net income are:

Consolidated nancial statements

A company that owns greater than 50% of another entity is called the parent company. The company
whose stock is owned is called the subsidiary company. A parent company uses the equity method to
account for its investment in its subsidiary. When nancial statements are prepared, the assets and
 liabilities (balance sheet), revenues and expenses (income statement), and cash ows (cash ow
statement) of both the parent company and subsidiary company are combined and shown in the same
statements. These statements are called consolidated balance sheets, consolidated income statements,
and consolidated cash ow statementstogether they are called consolidated nancial statements
and represent the nancial position, results of operations, and cash ows of the parent company and any
other companies it controls.

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