Companies often purchase stocks of several other firms in what some people consider as investments while others at times deem it the desire of an organization to influence the investee. The difference between these two impetuses is 20% of the outstanding shares, consistent with the GAAP (Generally Accepted Accounting Principles).

How Companies Choose the Appropriate Method

If a company owns no more than 20% of the shares of the investee, it utilizes the cost method for recording the investment. However, when the company owns between 20%and 50% of the shares, then it would employ the equity method(Sargiacomo, 2018). For a majority of investors, the apt way of accounting for their investment losses and profits is using the cost method although it is never the only option. For an investment in which an investor takes the more substantial stake and bears legal influence over the business of the company, the equity method is considered suitable.

Comparing and Contrasting the Methods

By far, the cost accounting method is the most common methodology of reporting investment losses and gains. That is a fact for institutional and retail investors alike because, with this approach, the actual investment cost is employed as the baseline. Besides, the loss or profit is determined using the last stock’s sales price(Sargiacomo, 2018). For instance, when an individual purchases a stock at $15, and sells it at $25, netting a profit of $10. Between the period the stock is purchased and sold, the investment value is not altered to echo any income of investment, other than the dividends.

On the one side, when an investor owns 20 percent or more of all the stocks of a company, then the equity method becomes the best option. Ideally, as the primary owner, one would perhaps have a great seat or more significant control over the organizational decisions(Sargiacomo, 2018). With such an influence, the equity accounting method maintains that the performance of the investment is more closely linked to the operations of the firm than the stock price of the company.

Advantages and Disadvantages

For most investors, the cost accounting method is the most preferred as it is more effective, simpler, and applicable in nearly every case. However, it is considered expensive, dependent, and lacks uniformity. On the other hand, the equity method is advantageous in the sense that it offers a parent firm with more precise income balances. Additionally, the parent organization can utilize the equity method in hiding undesirable numbers from the investors (Sargiacomo, 2018). Nonetheless, this method is more intricate and, practically, it is nearly always applicable in cases where large investment firms are taking larger stakes in the other operating organizations. In short, the equity method is very challenging to understand and use.

References

Sargiacomo, M. (2018). The Routledge Companion to Qualitative Accounting Research Methods. Accounting in Europe, 15(1), 149-151. doi:10.1080/17449480.2018.1442581

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