Investments

Accounting for Equity Investments

Overview of Equity Investments

Three methods to recognize equity investments, such as stocks that provide ownership interest in another entity, are cost, equity, and consolidation.
Equity is ownership that represents an investment, such as stock ownership, in the performance of another entity. Equity investments are different than investments in bonds and notes because equity investments also provide the investor the ownership interest. Assessing ownership is key in determining the level of influence or control the investor has, or could have, over the target. Consequently, the level of ownership determines the appropriate accounting treatment necessary to recognize the investments. There are three methods to recognize equity investments—the cost method, the equity method, and the consolidation method. In accordance with the generally accepted accounting principles (GAAP), the differences between these three methods are based on the percentage of influence or control of ownership of the equity investments.

Accounting for Equity Securities

Investments below 20% of ownership are generally accounted for with the cost method. The equity method is appropriate for investments between 20% and 50%. For investments exceeding 50% of ownership, the consolidation method is best.
Common investment transactions include the initial purchase of the investment, the recognition of investee income (if allowed), the recognition of dividend income, and the sale or disposition of the investment. Each one of the three methods has different components.

Cost Method

The cost method for recognizing equity investments applies when a company owns less than 20% equity ownership in another company.

The cost method is used to recognize investments in the equity of another company for which no significant influence exists and where the investor owns less than 20% of the investee's outstanding stock. The investor can generate income or a return from such investments but does not influence or control the company's business decisions; thus, they are usually passive investments. Changes in the value of the stock can be recorded to adjust the asset account to its market value, which is using fair market value. The other side of the entry is to an offset account called unrealized gain or loss. An unrealized gain or loss is a gain or loss arising from the change in value of an investment that is still held by the investor. Because a change in value has occurred, the journal entry must reflect this change. Note that a change in value is considered only when the item is sold or when the fiscal reporting period ends.

For example, Lucky Corporation purchases 10% of Money Corporation for $1,000,000 on January 1, 2018. Also, at the end of the year, December 31, 2018, Money Corporation announces it will be paying out a dividend of $20,000 to its shareholders.

The initial purchase and subsequent dividend are recognized with a journal entry on the books of Lucky Corporation. This entry recognizes a current asset, called Trading Securities, recorded at cost and an outflow of cash.

Cost Method—Purchase and Dividend Recognition Journal Entry

Date Account Debit Credit
1/1/2018 Trading Securities $1,000,000
Cash $1,000,000

The year-end dividend would be recognized, as well. The $20,000 was paid to all investors. Because Lucky Corporation is a 10% investor, it is entitled to that percentage of the dividend, which is $2,000.

Cost Method—Year-End Dividend Journal Entry

Date Account Debit Credit
12/31/2018 Cash $2,000
Dividend Revenue* $2,000
*

Calculated as 10% of the total dividend of $20,000 = $2,000

The $1,000,000 stock investment has now appreciated by 5% at the end of 2019. This fluctuation of unrealized gain is recognized with a journal entry.

Cost Method—Gain or Loss Journal Entry

Date Account Debit Credit
12/31/2019 Trading Securities $50,000
Unrealized Gain or Loss—Trading Securities $50,000

Investors may dispose of their investment at any time. Suppose on January 31, 2020, Lucky Corporation sells its stock investment for $1,125,000 on the open market. Using the cost method, the transaction is recorded.

Cost Method—Realized Gain on Sale of Securities Journal Entry

Date Account Debit Credit
1/31/2020 Cash $1,125,000
Trading Securities $1,050,000
Gain on Sale—Trading Securities $75,000

The actual gain, or Gain on Sale, is $125,000. The investment is carried at $1,050,000 (the original $1,000,000 purchase plus the $50,000 increase in value) and is sold for $1,125,000. So there is a realized gain (a real economic gain) of $125,000 over the original investment purchase. The original investment account is reduced to zero.

Equity Method

Whenever a company holds between 20% and 50% ownership in another company, it must use the equity method to recognize the investment.

In accordance with GAAP, the equity method is used to recognize investments in the equity of another company when ownership is between 20% and 50%. In this method, it is presumed the company that is investing (the investor) may have significant influence on the operations decisions of the investee company. Profits or losses of the investee company are recorded in the investor company's income statement. The amount of profit or loss that is incorporated and recorded is based on the ownership percentage held.

For example, Ace Company buys 30% of Bay Company's common stock for $50,000 on January 1, 2018. This ownership percentage meets the threshold for the equity method. Ace Company makes a journal entry to record the purchase.

Equity Method—Purchase Recognition Journal Entry

Date Account Debit Credit
1/1/2018 Investment in Affiliate $50,000
Cash $50,000

On April 10, Bay Company declares first-quarter earnings of $10,000. Under the equity method, earnings of the investment company are considered to be owned, in part, by the investor. Thus, Ace Company would recognize its share—30% of the income in the affiliate, or $3,000. In contrast to the cost method, the investment asset is written up to reflect earnings but not changes in market value. A journal entry recognizes this income.

Equity Method—Earnings Journal Entry

Date Account Debit Credit
4/10/2018 Investment in Affiliate $3,000
Equity Income in Affiliate $3,000

Next, Bay Company declares a dividend of $5,000 on April 30. Under the equity method, dividends received are considered a return of invested capital and thus reduce the investment account. Ace Company would recognize its share, 30% of $5,000, or $1,500. This reduces the Investment in Affiliate account with a credit of $1,500.

Dividend Journal Entry

Date Account Debit Credit
4/10/2018 Cash $1,500
Investment in Affiliate $1,500

An investment may be sold at any time, and the equity method may be used to recognize the sale. For example, Ace Company sells its investment for $48,000 on June 1, 2018. A gain or loss is recognized, as appropriate. In the equity method, there is no unrealized loss as with the cost method.

Equity Method—Gain on Sale Journal Entry

Date Account Debit Credit
6/1/2018 Cash $48,000
Loss on Sale of Investment $3,500
Investment in Affiliate $51,500

Consolidation Method

When a company that is the investor owns or acquires more than 50% of an investee's stock, generally accepted accounting principles (GAAP) require the company to use the consolidation method to recognize the investment.

A consolidation is two or more independent businesses combining to be a business combination. Their results are reported together as a single set of financial statements. A business combination occurs with one business gaining control of another business entity or entities. The parent or parent company holds greater than 50% ownership of outstanding stock, and the subsidiary (or subsidiaries) holds the remainder. The consolidation method is used to recognize investments when control exists or where an investor owns more than 50% of the investee's outstanding stock.

Consolidated businesses may be required to prepare a single consolidated financial statement, a statement of combined reporting of a parent company and all its subsidiaries when the parent's control may exceed 50%. The companies combine their income statements, balance sheets, and statements of cash flow as one accounting entity reported in the consolidated financial statement.

The basic idea of consolidation is straightforward, but the accounting practice can be complicated. The acquisition of stock is not carried as an investment asset as it is carried in other methods, such as the cost method and equity method. Revenues and expenses (net income) are included together for the period of time after control is established. Prior to control, each entity still exists and maintains books of its own.

The balance sheets of the two companies are more difficult to combine. The date of control is the date of acquisition, and a market price is established for the entire purchase. Specific assets and liabilities are identified. If there is a difference, such as the acquisition price exceeding identifiable net assets, an intangible asset known as goodwill is created to fill in for this excess price. Regardless, reporting results of consolidation on the financial statements is required by generally accepted accounting principles (GAAP).