Accounting for equity investments, i.e. investments in common stock, preferred stock or any associated derivative securities of a company, depends on the ownership stake. Investment amounting to 0-20%, 20%-50% and more than 50% of the outstanding capital must be accounted for using fair value method, equity method and consolidation respectively.
Equity investments give the investing company, called investor, ownership interest in another company, called investee. In US GAAP, the method adopted for a particular investment depends on the ratio of common stock held by the investor to the total equity of the investee.
If an investor has 20% or less holding in a company, it means it has passive interest in the company, hence, it must be accounted for using the fair value method. The fair value method is also called cost method.
Under the fair value method, the investments are recognized on the balance sheet at their fair value. Any associated transaction costs are expensed. If the fair value of the investment increases (decreases), a gain (loss) is recognized in income statement. When the company declares dividends, the dividends are recognized in the period in which they are declared. When an equity investment held under the fair value method are sold, any gain or loss not already recognized in income statement is recognized in income statement
You purchased 1 million shares of Apple, Inc. (NYSE: AAPL) on 1 July 2017 at $144.02. Because Apples outstanding shares are 4.92 billion, you hold just 0.02% of the total stock, so you must use the fair value method. You will recognize the purchase as follows:
Your financial year end is 31 December 2017 when the stock price is $172.26. You must adjust your investment for changes in fair value (i.e. $172.26 1,000,000 – $144,020,000) as follows:
During the period, Apple declared two dividends of $0.63 per share each. This will be recorded in income as follows:
On 8 February 2018, you sold the stock when the price per share was $155.15. This represents the loss on sales of $17,110,000 (=$144,020,000 + $28,240,000 – $155.15 1,000,000). This would be recorded as follows:
If an investor holds more than 20% but less than 50% of the outstanding stock of a company, it shows it has significant influence on the investee. Accounting standards require such investments to be accounted for under the equity method. The investor and investees with 20%-50% holding are called associates.
When an investor holds more than 20% but less than 50% of the voting rights, the investor has significant influence in determining the companys dividend policies, etc. Hence, its appropriate to recognize the investors proportionate share in the net income of the investee as an increase in investment and the proportionate dividends declared as a reduction of investment carrying value.
The carrying value of an investment under the equity method is determined as follows:
Where C is the cost of the investment i.e. purchase price, t represents the transaction costs, I is the total net income of the investee, D is the total dividends declared by the investee in the period, p is the percentage of holding and CV is the closing carrying value of the investment.
Lets continue the example above. Lets say you purchased 1 billion shares of Apple instead of 1 million at $144.02 per share. Because total outstanding stocks are 4.92 billion, your holding is 20.32% (=1B/4.92B), equity method must be applied. From 1 July 2017 to 31 December 2017, lets say Apple earned net income of $30,779 million and declared dividends of $1.26 (=$0.63 + $0.63) per share.
You will need to pass the following journal entries:
The carrying value of your investment in Apple, Inc. as at 31 December 2017 would be $149,016 million ($144,020 million + $6,256 million – $1,260 million).
Under the equity method, you do not need to adjust your investment carrying value based on change in stock price.
If an investor has more than 50% holding in a company, it is said to have control over the investee. The investor is called the parent and the investee is called the subsidiary.
Due to its majority holding, the parent decisively controls the business and financing decision of the investee, hence the investment is best accounted for by combing the financial performance and financial position of the parent and the subsidiary through the process of consolidation.
The consolidated financial statements combine the revenues and expenses of both the companies such that the combined net income is reported. A portion of the net income attributable to the other investors, called the minority interest is separately reported. Similarly, consolidated balance sheet combines assets and liabilities of the parent and the subsidiary and separately mentions the equity attributable to minority interest.
The following table compares the different method of equity investments accounting:
Proportionately recognized in income statement; increases carrying value of investment
Proportionately recognized to reduce the carrying value
Revenues, expenses, assets and liabilities are combined; minority interest is recognized when holding is less than 100%.
Written byObaidullah Jan, ACA, CFAand last revised onJun 9, 2018