For most investors, the proper way to account for investing profits and losses is with the cost method of accounting. This method is not the only choice, however. For investments where the investor takes a very large stake and has legitimate influence over the company's business, the equity method could be more appropriate.
Let's compare and contrast so you're equipped with the right accounting for your stock investments.
The cost method of investment accounting
The cost method of accounting is by far the most common approach for reporting investment gains and losses. That's true for retail investors and institutional investors alike. With this method, the actual cost of the investment is used as the baseline, with the profit or loss determined by the final sales price of the stock. For example, you buy a stock at $10, sell it at $15, netting a $5 profit.
Between the time the stock is bought and sold, the value of the investment isn't changed to reflect any investment income, other than dividends. If the company issues any dividends, those dividends are immediately recorded as income.
The equity method of investment accounting
In general, when you own 20% or more of all a company's stock the equity method is the appropriate accounting choice.
The idea is that as a major owner, you will probably have a board seat or other significant influence over the decisions made at the company. With that control, the equity method of accounting states that the investment's performance is more closely tied to the company's operations than it is to the company's stock price.
For example, if an investment company owns 30% of another firm and that firm earned $10 million in profits in a given year, the equity method of accounting would include the firm's pro rata share of that net income as earnings on its income statement. In this case, that works out to $3 million.
Over time, the investment company will update the value of the firm on its balance sheet higher or lower from its initial cost based on the profits or losses the firm produces. Dividends actually reduce the investment's book value under this method, as the dividends reduce the company's book equity. Because the accounting method takes the view that the investment's return is driven by the company's operating performance, that reduction in book equity is therefore a reduction in the investor's interests.
The bottom line
For the vast, vast majority of investors, the cost method will be the accounting method in every case. From retail investors buying stock for retirement to large institutional investors buying for pension funds, the reality is the cost method is simpler, more effective, and applies in almost all cases.
The equity method is much more complex and in practice, it almost always applies to situations where large investment companies are taking very large stakes in other operating companies. Even the largest equity investors tend to keep their investments to less than 20% of a company's outstanding shares. In the grand scheme of things, that's a small universe of people with the need to dig into the details of equity method.
For the rest of us, thankfully, the cost method works just fine.
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