Equity Method Facilitates Off-Balance Sheet Financing
🔥 The Equity Method is a technique for recording the financial aspects of investments of one company in other companies. Any investments made by holding 20%-50% shares provide significant control over the investee company are recorded under the Equity Method.
Unlike the Consolidation Method, which is used if there is effective control with more than 50% shares in the investee company.
Although the Equity Method has been in use for many years, it also has been criticized by analysts and accountants due to its limitations.
The
Equity Method reports investments as a one-line amount in the financial statements of the investor company. This practice does not provide sufficient information about the businesses and affairs of the investee company and keeps the specific liabilities and debts
off the Balance Sheet.
The one-line consolidation only records the net (total) effect of the profits or losses of the investee. The investee company is still a separate entity; it can borrow funds or issue shares on its own, but of course the investor company does exercise influence over the decisions of Investee Company. Therefore, the investor company is liable for such debt but that remains unreported in the financial statements of the investor company. Consequently, the degree of risk to which the investor company is exposed thus does not reflect the actual creditworthiness of the investor company which shatters the wealth of shareholders.
Such loopholes and flaws in the application of the Equity Method provide an opportunity for accountants to manipulate the financial information and show companies more profitable than they are in actual. Companies exploit this opportunity and keep their debt off the balance sheet. The Equity method has been used as a technique of
creative accounting. Auditors and analysts should critically analyze and audit those companies which have investments with significant control over investee companies.
Sources:
Book: J. Edward Ketz, (2003)," Hidden Financial Risk: Understanding Off-Balance Sheet Accounting", 2003.
Book: Aileen Pierce, Niamh Brennan, (2003) "Principles and Practice of Group Accounts: A European Perspective ", 2003.
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