The Fair Value or Equity Method

A company must use the proper accounting method when it buys shares of another company. The choice of method usually boils down to the amount of influence the buyer has over the investee. You use the fair value method if you do not exert significant influence over the investee. If you do have significant influence, you choose the equity method. However, if you actually control the investee, you must use consolidated reporting.

Generally accepted accounting principles assume that you don't have significant influence over an investee if you own less than 20 percent of its voting shares. Under the fair value method, you create a non-current asset at the purchase price of the shares. If possible, you periodically update the book value of the investment to reflect fair value -- the price the shares would sell for in the open market. If the shares are publicly traded, fair value is easy to determine -- it's the market price. Private shares may be harder to evaluate, and you should revalue them only if you have good reasons to do so.

Under the fair value method, you book as income unrealized gains and losses to shares you plan to trade within a year. If you classify the shares as available-for-sale -- meaning you will probably hold them for at least a year -- you can instead choose to book unrealized gains and losses to "other comprehensive income," a portion of owner's equity. In all cases, you update the book value of the investment to reflect the fair value and record any dividends you receive on your investment as income.

If you own between 20 percent and 50 percent of the investee's voting shares, you automatically qualify for equity method accounting. Under this method, you book your portion of the investee's income or losses on your income statement and update the asset's book value accordingly. Treat any dividends as a return of capital -- do not book them as income but rather subtract them from the carrying value of the investment. However, under the fair value option to the equity method, you recognize as income changes to the stocks' fair value rather than your share of investee income. You treat dividends as income under the fair value option.

The default percentages for determining your degree of influence over an investee may not match reality. For example, suppose you hold 35 percent of the investee's voting shares, but the investee refuses your repeated requests to install a board member and treats your suggestions with disdain. You might make the case that you lack significant influence despite the size of your investment. Under these circumstances, you might want to use the fair value method instead. Conversely, if your 35 percent investment allows you to install several board members and control investee actions, you might be justified in consolidating the investment into your own financial reporting.