Corporations require capital in order to setup, maintain and run their revenue-producing operations. In order to acquire this capital, corporations must either incur economic obligations to other entities or receive it in the form of investment funds. Corporations solicit investments in their operations through selling shares in their ownership to interested investors. Such investors can include other businesses, and rules exist regarding how investing businesses account for their investment in other businesses. Ownership stakes of 20 to 50 percent must be accounted for using the equity method.
Ownership can be determined by the percentage of the corporation's total outstanding common shares that the shareholder in question holds. For example, if an shareholder holds 200 of a corporation's 1,000 outstanding common shares, that shareholder has a 20 percent ownership stake in the corporation. Equity method is used when the investor has "significant influence" in a corporation. Most often, this is defined as being 20 to 50 percent ownership, but it can also be based on the direct and indirect influence that the investor has on the corporation's decisions.
Accounting for investments in other businesses can be separated into no significant influence, significant influence and outright ownership. No significant influence calls for the investments to be accounted for in much the same manner as other investments, while outright ownership requires that the business being invested in be treated as a part of the investing business. Significant influence calls for the investment to be recorded at cost. Furthermore, a portion of the income of the corporation being invested must be recorded on the investor's income statement for each time period.
Dividends and Initial Investment
Investments in corporations under equity method are recorded "at cost." For example, if a corporation purchased 1,000 shares in another corporation at $2 per share, that corporation will record an investment asset of $2,000 and a corresponding decrease in its cash reserves. Dividends paid to the investor are considered decreases in its investment. For example, if the corporation invested in declared $1,000 in dividends and the investor was entitled to receive 20 percent of this, that would call for a $200 credit to the investor's cash reserves and a corresponding deduction to its investment asset.
Net Income and Loss
Since the investor is considered to possess significant influence in the corporation invested in, the investor is obligated to record a portion of that corporation's net income or loss in each time period in which it has ownership stake in the corporation. For example, if an investor owned 35 percent of a corporation and that corporation declared a $100,000 net loss in the current time period, the investor is required to record a $35,000 loss on its income statement. Depending on the investor's own revenues and expenses, it may or may not end up producing a net income for the period.