An investor's level of influence over an investee is the primary determinant of the method used to account for investments in common stock. The amount of influence refers to the degree of control exerted by the company that purchases the stock over operating decisions of the company issuing the stock.
Cost Method vs. Equity Method
An investor's level of influence over an investee determines how the investor reports the equity investment in financial statements. One guideline used to determine influence is the percentage of voting stock of the investee that is owned by the investor. Other indications of influence include representation on the Board of Directors, participation in policy-making processes, material inter-company transactions, interchange of managerial personnel or technical dependency.
According to "Renewable Energy Tax Credit Handbook," the acquisition of less than 20 percent of the stock of an investee is considered too small an investment to grant the investor a significant influence over the investee. As a result, this investment is accounted for using the cost method. In this instance, the acquisition costs are debited to the asset account "Equity Investments." Any dividends received are debited to the Cash account and credited to the Dividends Revenue account. Therefore, this income does not affect the carrying balance of the investment. When the equity investment is sold, a gain or loss is recognized in the amount of the difference between the acquisition cost and the sale price.
The "Renewable Energy Tax Credit Handbook" states that the acquisition of between 20 and 50 percent of an investee's stock is considered sufficiently large to grant a noncontrolling investor a significant influence over the investee. Such a noncontrolling interest implies the investor holds neither positions on the Board of Directors nor key officer positions in the investee. Such an investment is accounted for by the investor using the equity method. In this instance, the value of the stock is periodically adjusted to account for both dividends and earnings or losses of the investee. In this way, acquisition costs are debited to the asset account, "Equity Investments." In turn, dividends are credited to the Equity Investments account in that the dividends are treated as a partial return of the initial investment. As a result, the dividend income affects the carrying balance of the investment. In turn, the investor's share of the net income of the investee is debited to the Revenue from Investment account.
Differences Between Cost Method and Equity Method
Unlike the equity method, the cost method accounts for investments when the investor has no ability to exercise control over the investee's operations. Under the equity method, the initial investment is recorded at cost and this investment is increased or decreased periodically to account for dividends and the earnings or losses of the investee. In contrast, the cost method accounts for the initial investment as a debit to an investments account and the dividends as a credit to a revenues account. Unlike the equity method, cash distributions under the cost method do not affect the carrying balance of the investment.