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Equity method of accounting for investment solutions

Written By: wwwcspwritescom

The equity accounting method is used to report ownership by a company of unconsolidated subsidiaries, where the purchasing company has significant board influence but never total control. The extent of ownership for controlling companies using this method ranges from 20% to 50%.

When using equity accounting, the company does not record the assets or liabilities of the subsidiary on its balance sheet. Instead, a reduction in cash equivalent to the acquisition cost will compensate the record of an investment in affiliate non-current assets at the equivalent purchase price.

Example: Company X buys 30% of Company Y’s stock (allowing voting rights) for $1000

Non-current assets: Investment in affiliate: $500 ↑

Current assets: Cash: $500 ↓

 

Earnings

The earnings reported in the subsidiary’s income statement will be taken into account to increase or decrease the investment in affiliate assets shown in the controlling company’s balance sheet. This amount will be the acquisition percentage applied to those earnings.

As a result of these profits, a new record named “equity income affiliate” will be added to the equity section of the investing company in order to reflect these gains. Matching the resulting increase in equity, investment in affiliate will move up the same quantity.

Example: Company Y reports a net profit of $100.

Equity income affiliate increase= $100*30% ownership= $30

Assets: Investment in affiliate: $30↑

Equity: Equity income affiliate: $30↑

 

Subsidiaries can also choose to distribute part of their earnings in the form of dividends. In doing so, the acquiring company will receive the percentage of dividends to which it holds the right. Subsequently, the cash reserves will increase, but the account detailing investment in affiliate entries will be reduced by the same amount because dividends are considered a return of capital.

Example: Company Y announces a $50 dividend.

Cash in dividends received by company X from company Y= $50*30%= $15

Non-current assets: Investment in affiliate: $15↑

Current assets: Cash: $15↓

 

Taxes on dividends

Taxes are paid only on cash dividends received from the controlled company. Dividend payments are entitled to the Dividends Received Deduction (DRD), which applies a tax percentage from which the receiving company is exempt. The exemption percentage increases as the equity interest in a particular company moves higher.

 

Companies displaying ownerships between 20% and 80% are entitled to an 80% tax deduction. DRD is used to reduce the effects of triple taxation on dividends.

Triple taxation occurs as a result of dividends transferred from the subsidiary to the controlling company originating from already taxed net income. After this, dividends are taxed as income to the controlling company. Finally, controlling company’s shareholders are taxed for their cash payments in dividends.

 

Taxes on undistributed earnings

Any increase in undistributed earnings resulting in an equity income in
affiliate increase will result in a Deferred Tax Liability. This quantity will be paid when these earnings are distributed in dividends or the controlled stock is liquidated.

Applying for DRD to reduce the Deferred Tax Liability expense is possible; however, as many times companies do not pay the expected dividends, this deduction will be used very rarely.

Taxes Example:

Using previous dividend and equity numbers under a 35% tax rate and 80% DRD tax exemption

Cash tax expenses: $15 (dividends)*(1-80%)*35%(tax applied)= $1.05

Deferred tax liability: [$30 (equity income)-$15(dividends)]*35%= $5.25

Total income tax expense= $6.3

 

 

 

 

 

 

The carrying amount

Written By: wwwcspwritescom

A straightforward definition of carrying amount would be the current value of a particular asset or liability that a company specifies in its books. Far from being simple task, indicating the right carrying value or amount for each financial entity must follow a certain set of rules, depending on its nature, and the reporting methods to be used may differ widely, which will be discussed below.

 

Property plant and equipment

Property plant and equipment refers to items such as machinery, property and manufacturing equipment owned by a company. With the aim of properly stating the current value of every asset, some vital information has to be borne in mind: useful life, initial value, any potential scrap value and the amortization technique to be used.

In the first year of acquisition, full value will be reported, with the following years seeing this number reduced by a percentage related to the chosen amortization technique. The straight line method will deduct even amounts from the original price before reaching the scrap value. Under the accelerated method, bigger amortization will be applied in the early years compared to that of the later stages of the asset’s life.

If applicable, a scrap value will be left as a permanent value should a potential disposal or sale be available.

 

Bonds

A bond’s current value suffers from depreciation, which is tightly related to its interest rate and the current one in the market. Bonds offering an interest rate lower than the market will have to be sold at a discount to their par value; on the other hand, those offering higher interest rates will be offered at premium prices.

This price difference to par value will generate a liability to be amortized for discount bonds and an asset to be sold at premium price. The current value will initially display the purchase price, and this quantity will increase or decrease heading towards the par value as the generated asset or liability does otherwise. The pace at which this amortization is realized usually follows the straight line method.

 

Intangible assets

Intangible assets with a finite life, such as patents, will be amortized using the straight line method at every accounting period. The decreasing carrying value will lead to a final amount which is their assessed residual value.

Intangible assets with an indefinite life are not amortized. Instead, an appraisal can be carried out to look for impairments in the asset’s price; therefore, a correction in the books may be required. An example of this would be goodwill.

 

Revaluations and impairments

Sometimes the carrying amount may largely differ from the current market value of an asset. To reflect these changes in price, revaluation and impairment models can be applied under certain circumstances.

Revaluation will aim to follow the changes in the market by updating the carrying amount upwards or downwards. Notice that this method will only be allowed under IFRS, not US GAAP accounting standards.

Revaluating upwards will generate and increase in equity under a revaluation reserve asset or, otherwise, a reversal of a previous loss on the income statement due to a downwards revaluation.

On the other hand, downward revaluation will reduce an already existing revaluation reserve or, alternatively, generate a loss displayed as an expense on the income statement.

Impairments are more targeted to writing down the historical asset value to reflect a fairer price following damages, becoming obsolete or changing market conditions. Book value will be reduced and an expense will be reflected in the income statement when the carrying amount exceeds the recoverable amount. The recoverable amount will vary depending on the required accounting standard.

Under IFRS, recoverable value will amount to the higher sum between the present value of the asset’s future discounted cash flows and the net realizable amount – or the value of the asset could be sold for less than selling or disposal costs.

Following US GAAP rules, the recoverable amount will be equal to the total value of the expected future undiscounted asset cash flows.

Accounting methods for small businesses

Written By: Martina James

All small business owners in the United States are required by the Internal Revenue Service (IRS) to choose an accounting method for their business when they file the first income tax return that includes Schedule C, Profit or Loss From Business. Once the choice of accounting method is set up, it can only be changed with approval of the IRS. An accounting method is a list of rules that dictate when and how income and expenses for a business are recorded. The cash accounting method and the accrual accounting method are two of the most popular choices for small businesses.

With the cash method, income and expenses are recorded when they are actually paid. That means that money only leaves or comes into the business account at the time of disbursement or receipt. For example, if a home improvement company installs a garage door for a customer on Dec. 30, 2014 but does not receive payment for the service until January 2, 2015 the income will be recorded for the 2015 tax year. The same rule applies to expenses. For example, if the same home improvement company writes a check for a recurring bill such as the phone bill on Dec. 30, 2014 but the amount of the check is not deducted from the business account until Jan. 3, 2015, this expense will also be recorded for the 2015 tax year.

With the accrual method, income and expenses are recorded when services are completed, not when payment is actually received or disbursed. For example, if the home improvement company from the earlier example installs a garage door for a customer on Dec. 30, 2014, it would record this income for the 2014 tax year, even if the customer did not pay until Jan. 2, 2015. Again, expenses are handled the same way. If the home improvement company writes a check for a phone bill on Dec. 30, 2014, it would record this expense for the 2014 tax year even if the amount of the check were not deducted from the business account until Jan. 3, 2015.

Most sole proprietors and small companies that are not incorporated chose to use the cash method simply because it is easier for them to keep records on their own without hiring an accounting firm. The cash method can only be used if no inventory is involved, which usually means a business provides services only. If a business is selling, purchasing or producing merchandise, an inventory must be kept and the accrual accounting method has to be used. However, there are exceptions to this rule. If a business produces $1 million or less in income in a year, the cash accounting method can be used regardless of the line of business they are in.

Both the cash and accrual accounting methods have pros and cons. There is no right or wrong accounting method. Which one a small business owner chooses or prefers for his company may depend on factors such as the size of the business or tax deductions. Small businesses often start out with the cash method and change to the accrual method after the business grows.

Do accountants prefer the equity method of accounting?

Written By: Doreen Martel

The method of cash accounting is most likely used by a small company such as a singly owned car repair shop. Accrual methods of accounting are typically used by larger companies such as Walmart, Rite Aid or other similar chains. With cash accounting, the business records their income and expenses as they occur. With accrual methods, income and expense owners are often projected outward meaning a company may offset some expenses in the future against cash taken in today.

When you start discussing companies that are publicly traded, or those companies where there are a number of shareholders, in most cases they will use the accounting method known as equity accounting. Equity accounting is typically considered the amount of undistributed profits. Using this method, the cost basis of the company or investors position is adjusted as retained earnings fluctuate. In nearly all cases, this is useful long-term investments especially when the investor owns 20% or more of the position allowing them to have some influence.

When equity accounting matters

One of the primary reasons for using equity accounting is to establish a value. The value may be established of an entire company, or of a single shareholder’s position within that company. In nearly all cases, equity accounting is used for reporting net asset value, for establishing value for annual reports or for establishing value when a business or a shareholders position is up for sale.

Nearly all larger firms that are in charge of business valuations will use equity methods of accounting. In large part, this is due to the fact that it is one of the few times where this method of accounting is critical. For example, mutual fund companies provide their shareholders with a valuation of the entire portfolio. This valuation is then further broken down to a price per share ratio. Once that ratio is established, the shareholders equity is based on the number of shares they own multiplied by the price per share.

There are of course some times when equity accounting is not appropriate. For example, a small sole proprietorship where one person has complete control over the company would not have any need for equity accounting. The exception to this may be if they were to decide to seek external financing, or decide to sell part of their ownership in the company. In these cases, equity accounting would be used to establish two things; first it would be used to establish the value of the overall company and secondarily it would be used to establish a “per share” value.

There is no simple answer to whether or not accountants prefer the equity method of accounting. In most cases, accountants will use the method that offers them the ability to provide a fair company valuation. When a company has shareholders, the most effective way to properly establish per-share value is by using equity accounting.

Balance sheets, income and expense sheets, as well as profit and loss statements are all important in determining the overall value of any company regardless of size. Using equity accounting, those numbers are then used to establish a per-share valuation.

Most Popular Accounting Methods in the US

Written By: Samuel

Accounting is the language of business; the success or failure of a business is recorded and reported using accounting. Accounting, generally speaking, involves the steps taken in making entries of financial transactions (economic exchanges between parties or businesses) for the preparation of financial reports. The practice of accounting ensures full and fair disclosure of the financial position and condition of business entities in compliance with principles, methods, rules, and regulations. There are two universal methods of accounting that determine how an entity records its business transactions: cash-based accounting and the accrual method of accounting.

Cash-based method of accounting

Cash-based accounting is a method of recognizing transactions as cash changes hands. Using this method, business entities record expenses when cash is actually paid out and record revenues when the cash is received. Expenses are not recognized until the money is actually paid, and previous revenues earned are not recognized until payment is received.

Say a company sold an item in December 2013 but received payment in March 2014, the transaction would be recorded in March despite the actual transaction having taken place in December of the previous year. Sole proprietors and partnerships use this accounting method because it is easier and more straightforward. The main drawback of using this method is that revenues and expenses are not properly matched to their actual period, hence, month-to-month records tend to be distorted.

Accrual method of accounting

The accrual method is a good method for matching revenues and expenses to the period to which they relate. Business entities record expenses when they are completed and not necessarily when the money is paid out or received.

Say a company sold an item in December 2013 but received payment in Match 2014. The transaction would be recorded in December 2013 despite payment not having been received then. In the United States, all companies that incorporated as limited companies, as directed by the Generally Accepted Accounting Principles (GAAPs), must use the accrual method of accounting. The accrual based accounting method is guided by two boards:

• General Accepted Accounting Principles (GAAPs), as promulgated by the US Financial Accounting Standard Board (FASB) 
• International Financial Reporting Standards, as promulgated by the International Financial Accounting Board (IASB)

The IFRS is grounded in the same principles as the GAAPs, and the two, more often than not, lead to the same results, though there are some differences. GAAP is the recognized set of standards used for financial reporting and is recognized as such by the Financial Accounting Standard Board (FASB), Government Accounting Standards Board (GASB), and American Institute of Certified Public Accountants (AICPA)

Under the accrual method, various reports are expected:
1. Statement of financial position
2. Statement of profit or loss
3. Statement of comprehensive income (single, continuous, or two consecutive statements)
4. Statement of cash flow
5. Accompanying notes to the financial statements

Business entities in the United Stated with gross revenues less than USD 5 million per annum may generally choose to use the cash-based method, while those with gross revenues exceeding this figure generally choose the accrual method of accounting. Secondly, private business that are not required to publicly disclose their financial results are free to use either method. For business entities that are incorporated as limited, they must comply with regulations and use only the accrual method of accounting. The key difference in the two methods is how the entity records cash coming in and cash going out.