Advantages & Disadvantages of Using the Equity Method
The equity method of accounting is used by a parent company to include profits from its other companies in its income statement. The parent company must own more than 20 percent of the stock and be able to exercise significant influence to use this method. There are advantages and disadvantages to using this method of accounting. For example, the equity method enables companies to hide numbers from the public and it shows a more accurate profit margin. In contrast, this method can be difficult to understand and dividends are not listed as profit.
The first advantage to the equity method is that it provides a parent company with a more accurate income balance. It shows the investment income from all its sources and not just the parent company. Parent companies and subsidiaries do not share consoldiated statements so this method of accounting brings their numbers together. This can bolster a company's numbers to show a higher profit then could be seen from the parent company's numbers alone.
The second advantage is that a parent company can use the equity method to hide unfavorable numbers from investors. If a parent company has numbers showing a low profit, then adding the numbers from its subsidiaries can reflect a higher profit for the company. These higher numbers can encourage shareholders and the public to keep investing in the parent company and to see it as being of a higher value. The parent company can also fail to disclose subsidiary numbers if that would bring down the value of the parent company.
The first disadvantage to the equity method is that it is difficult to use and understand. This method takes a lot of time to obtain, compare and review numbers between the principal company and its subsidiaries. The financial information from all the companies needs to be accurate and comparable to reach a useful number. If one set of numbers are off, then the principal company could be greatly valued or greatly devalued.
The second disadvantage is that the equity method fails to show dividends as revenue and instead shows these as deductions. In this accounting method, dividends reduce the amount of the investment and are not reported as dividend income. This results in the investor's equity showing up as only being reflected by underlying net assets. It is also important to know that in this accounting method dividends from a subsidiary company are never transferred to the parenting company.