What are the GAAP requirements for reporting an investment using the equity method of accounting?
GAAP stands for Generally Accepted Accounting Principles, and is a common standard in the United States that covers accounting practices and methods. GAAP allows accounting firms and cooperating businesses to have a reasonable amount of consistency in their reports, making it easier for all parties to understand the various financial dealings.
Under the Equity Method, reporting an investment would require several steps:
- Initial report of investment funds
- Report of Net Income (increases carrying amount)
- Report of Net Loss (decreased carrying amount)
- Report of Dividends received (decreases carrying amount)
Basically, the Equity Method requires that only income is treated as additional investment; both loss and dividends (which are paid out of company profits) are treated as loss in the carrying amount (the actual value of the assets). Therefore, if the stock rises in price, your investment rises as well; however, if the stock loses value, or if you are paid dividends from the company's profit, your investment shrinks by a corresponding number. This allows companies to control their stock voting by keeping minority shareholders from acquiring a huge amount of stock by reinvesting their dividends.