Equity accounted investments can be confusing for investors. They are a single line on a profit and loss statement and do not provide a full picture of the investment. Instead, investors should look at the company’s balance sheet to get the real picture of the investment. However, it is important to note that these investments are not necessarily illegal.
This method accounts for investments by recognizing income and loss as the investee earns it. Therefore, investors do not have to wait for dividends to recognize profit. Instead, they record income and expense as they accrue in the investee’s business. If an investor owns 40% of a company, he or she would record a profit of $40,000 and increase his or her investment account by that amount.
The equity method is generally applicable to investments where the investor has a stake of more than 20 percent of the voting stock. The ownership must be substantial enough to enable the investor to exercise significant influence over the investee. In the example below, the investor owns 25% of the shares of a start-up company, but also has some in-the-money options that he or she may exercise at a later date. Whether an investor owns more than twenty percent of the shares of a start-up company will depend on the particular investment.
When applying the equity method, investors may choose to use the most recent financial statements of the associate that is prepared on the investor’s reporting date. However, they must make adjustments for significant transactions or events between the two periods. Typically, the difference between reporting periods of the associate and investor is not more than three months.
The guidance from the Treasury Department provides best practice guidance. However, it should be read in conjunction with Treasury Direction – Equity investments, as well as applicable legislation and accounting standards. Although the guidance is not mandatory, it takes precedence over other legislative requirements. It also requires the agency to submit its audited financial statements to the DTF within two months after the end of the financial year.
A company must regularly evaluate its equity accounted investments to determine whether they have been impaired. Losses from these investments must be reflected in the financial statements. The entity must also consider the impact of impairment on estimated future cash flows. This should be done on an annual basis. Further, if there is objective evidence that an equity investment is impaired, further impairment write-downs may be necessary.
Operating cash flow is an important measurement of the performance of a firm. The management and auditors of the company should evaluate the distributions from equity accounted investments to assess their suitability.
