Investment In Another Company Accounting

Investing in another company can take various forms, each with distinct accounting implications. Understanding these differences is crucial for accurate financial reporting.

Equity Method Investment: Significant Influence

If your company, the investor, holds between 20% and 50% ownership in the investee company, it’s generally presumed that you have “significant influence” but not control. In this scenario, the equity method of accounting is typically applied. Initially, the investment is recorded at cost. Subsequently, the investment account is increased by the investor’s proportionate share of the investee’s net income (and decreased by the proportionate share of any net loss). Dividends received from the investee reduce the investment account balance. This reflects the fact that the investor already recognized the investee’s income, and the dividend is essentially a distribution of that previously recognized income. The income recognized is reported on the investor’s income statement as “equity in earnings of [investee company].”

For example, if Company A owns 30% of Company B and Company B earns $100,000 in net income, Company A would increase its investment account by $30,000 (30% of $100,000) and recognize $30,000 as income. If Company B then pays dividends of $20,000, Company A would reduce its investment account by $6,000 (30% of $20,000).

Consolidated Financial Statements: Control

If the investor company has a controlling interest (typically more than 50% ownership) in the investee, the investee becomes a subsidiary. In this case, the investor prepares consolidated financial statements. This means combining the assets, liabilities, equity, revenues, and expenses of the parent (investor) and subsidiary companies as if they were a single economic entity. Intercompany transactions (e.g., sales between the parent and subsidiary) are eliminated to avoid double-counting.

A key element in consolidation is the accounting for noncontrolling interest (NCI). This represents the portion of the subsidiary’s equity that is not owned by the parent. NCI is presented separately in the consolidated balance sheet and income statement. The consolidated income statement shows the portion of the subsidiary’s income attributable to the NCI.

Fair Value Through Profit or Loss (FVTPL): Less Than Significant Influence

If the investor has less than 20% ownership and lacks significant influence, the investment is typically accounted for at fair value through profit or loss (FVTPL). The investment is initially recorded at cost. Subsequent changes in the fair value of the investment are recognized directly in the investor’s income statement each period. Dividends received are also recognized as income.

For example, if Company A owns 10% of Company B, initially purchased for $50,000, and the fair value of the investment increases to $60,000, Company A would recognize a gain of $10,000 in its income statement. This method reflects the short-term nature of the investment and its potential impact on the investor’s current period earnings.

Accounting Standards and Considerations

The specific accounting standards governing these investments (e.g., ASC 323 for the equity method, ASC 810 for consolidations, and ASC 321 for FVTPL) can be complex. Determining whether significant influence or control exists requires careful judgment and consideration of various factors beyond just ownership percentage. Furthermore, impairment testing may be required if the fair value of an investment declines significantly below its carrying amount. Consulting with qualified accounting professionals is crucial to ensure proper application of these standards.