Equity Method

• The equity method of accounting is a way of recording value for investments, especially when it comes to companies that have bought shares in another business. When a business is only a partial shareholder, it can choose whether or not to use the equity method, but the option becomes mandatory with more control over a company. The equity method starts off by assessing profits in an investment based on the initial funds used to buy the stock at cost. This value is then periodically adjusted to maintain accurate values based on the owned company's revenues and losses.
  
  

Investment Requirements for Control

• Control becomes important for the equity method because the IRS has decided that, after a certain point, the equity method is the most effective way to show investment value and return when companies invest in each other. As a general rule, companies are required to officially use the equity method when they control more than 20 percent of a subsidiary business.
  
  

Control of the Company

• Control of a company refers to the ability of a business to effect influence in the owned company. The reason 20 percent is the cutoff mark is because such ownership levels create an automatic assumption that the business has considerable influence, including room on the board of directors and a say in major strategic decisions. Because this ties the parent company's success to the operations of the subsidiary, the equity method becomes an effective way of charting progress.
  
  

Considerations

• When a company owns 20 percent or more of voting stock in a subsidiary, it does not always need to use the equity method, but this requires an exception. The company must present clear evidence that it does not have significant influence, such as opposition by the owned company, a private agreement between the two companies, or majority ownership by a third party with differing interests.