Accounting for Equity Investments

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.

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.

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).