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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.