There are three possible ways to account for the investment by one company in the common stock of another, depending on the resulting degree of influence the investor has over the investee:
Cost or Market Method
Investor acquires < 20% of investee's voting stock (insignificant influence).
Investor acquires 20% – 50% of investee's voting stock (significant influence).
Investor acquires > 50% of investee's voting stock (legal control).
These percentages are merely guidelines; there are other factors that must be considered in evaluating the degree of influence. For example, exceptions to these guidelines might arise when:
- A corporate investor owns < 20% of voting stock, but still has considerable influence over the investee through veto power or business contracts (equity method could apply).
- Corporate investors in joint ventures share control (equity method could apply).
- A corporate investor owns > 50% of voting stock, but the investee is in bankruptcy proceedings and the court has control (equity method could apply).
This method, also known as the fair value method, applies when the investor does not have significant influence over the investee (as measured by voting power). Under this method, we treat the investment as a simple financial investment initially recorded at cost on the investor's balance sheet.
Classification of the investment depends on the intent of the investor. If the investor intends to profit from near-term (generally within than 12 months of initial investment) price movements, they are classified as either Trading Securities. If the investor does not intend to trade the securities in the near-term, they are considered Available for Sale. Alternatively, the investment might be called simply Investment in Affiliate(s), especially when no readily available market prices for the securities are available. Other possible names are Marketable Securities and Equity Investments.
Equity investments accounted for using the cost method must be periodically marked-to-market (fair value) if the securities have readily available market prices, creating unrealized gains and losses.
|Available for Sale
|Investment recorded at cost and periodically marked-to-market until sale||Investment recorded at cost and periodically marked-to-market until sale|
|Asset Type||Current||Current or long-term, depending on management intent|
|Unrealized gains/losses are recorded on the income statement||Unrealized gains/losses bypass the income statement and are recorded under Accumulated Other Comprehensive Income on the balance sheet|
|Dividends||Considered Other Income to the extent the investee has earnings (payment of dividends may reduce the FV of the investment)||Considered Other Income|
|Recognize realized gain/loss on the income statement equal to the difference between sale proceeds and book basis||Recognize realized gain/loss on the income statement equal to the difference between sale proceeds and book basis|
Some countries require the lower of cost or market ("LCM" or "LOCOM") method of periodically revaluing equity investments, rather than mark-to-market. One key implication of LCM is that unrealized losses are reported, while unrealized gains are not. The disadvantage to companies using LCM should be clear. The International Accounting Standards are similar to U.S. GAAP in the use of mark-to-market.
When an investor has significant influence over the investee—but not majority voting power—the investor accounts for its equity investment in the investee using the equity method. The equity method of accounting is sufficiently complex that we have dedicated a whole page to the topic. Give it a read to learn more about the equity method of accounting.
When a parent has legal control of a subsidiary, the parent consolidates the subsidiary's financial results with its own. Ownership of > 50% of the subsidiary's voting common stock generally implies legal control. However, the parent must own at least 80% of the vote and fair value of the subsidiary's common stock to consolidate for tax purposes. In preparing consolidated financial statements, intercompany balances and transactions are eliminated.
FAS 160, effective January 1, 2009, made significant changes to the accounting requirements for noncontrolling interest in consolidated financial statements. For now, let's just point out that FAS 160 drops the term minority interest in favor of noncontrolling interest. Other changes are reflected in all subsequent discussion and application of the consolidation method on this website unless otherwise stated.
Balance Sheet: The parent consolidates 100% of the subsidiary's assets and liabilities, regardless of the parent's actual percent equity ownership, and records any goodwill created in the acquisition of the controlling interest. The parent also records in the equity section of the consolidated balance sheet any noncontrolling interest representing the value of the subsidiary's equity (net assets) not owned by the parent. Any such noncontrolling interest is recorded separately from the parent's equity and labeled perhaps Noncontrolling Interest in Subsidiaries. Noncontrolling interests in more than one subsidiary may be presented in aggregate.
Income Statement: The acquirer consolidates 100% of the subsidiary's income and expenses. Any net income attributable to a noncontrolling interest is subtracted from the net income attributable to the consolidated entity to give the net income attributable to the parent on the consolidated income statement.
Suppose Alpha buys 80% of Tango's stock for $80. Tango's only asset is an office building fairly valued at $60. Alpha's pre-transaction balance sheet is shown below. What is Alpha's pro forma balance sheet?
Note that even though Alpha acquires just 80% of Tango, Alpha records all of Tango on its balance sheet as if it acquired the whole company. The excess of what Alpha "pays" for Tango over the FV of Tango's identifiable assets is allocated to goodwill ($40 = $100 - $60). The remaining 20% of Tango that Alpha does not own is reflected in minority interest ($20 = $100 - $80). All of Tango's income statement flows are recorded on Alpha's income statement, less minority investors' 20% interest in Tango's net earnings. We will cover the accounting specifics of the consolidation method in the lesson on Purchase Accounting.
You may be wondering how you find the FV of Tango's assets. The FV will ultimately be determined by appraisal shortly before the transaction is closed. For modeling purposes, however, you can simply make an assumption about the FV. When making a FV assumption, keep in mind that goodwill is often a large portion of the purchase price (40% in the example).
Most of our discussions on accounting for mergers will focus on the consolidation method.