5a-c) Pretend your client is the owner of a privately held manufacturing company

Question

5a-c) Pretend your client is the owner of a privately held manufacturing company with two operational subsidiaries.

Your client wants to consider expanding his investment in Subsidiary1, and he is willing to consider purchasing additional shares to expand his influence.

Your client is also considering reducing or eliminating his investment in Subsidiary 2.

Please respond to the following questions.

Your client has asked you to prepare a summary of the accounting issues he should consider in both the expansion of his investment in Subsidairy 1 and the reduction of his investment in Subsidairy 2.

Begin a discussion with you colleagues about the various accounting issues that must be considered.

-Rank the importance of each issue for your client and discuss whether the issues should be considered separately or as part of the larger conversation.

-Raise any timing issues that must be examined. Debate the most effective way to advise your client.

Explanation / Answer

Answer

Client is the owner of a privately held manufacturing company with two operational subsidiaries. Your client wants to consider expanding his investment in Subsidiary1, and he is willing to consider purchasing additional shares to expand his influence. Your client is also considering reducing or eliminating his investment in Subsidiary 2.

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).

Equity Method

Investor acquires 20% – 50% of investee's voting stock (significant influence).

Consolidation Method

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:

Cost/Market Method

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.

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 International Accounting Standards are similar to U.S. GAAP in the use of mark-to-market.

Equity Method

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.

When Company A (the investor) has significant influence over Company B (the investee)—but not majority voting power—Company A accounts for its investment in Company B using the equity method of accounting. Company B is considered an unconsolidated subsidiary of Company A in such circumstances, from Company A's perspective, but could be a freestanding, publicly traded corporation. A company is generally considered to have significant influence, but not control, when it owns 20% – 50% of the voting interest in the unconsolidated subsidiary. The company does not actually record the subsidiary's assets and liabilities on its balance sheet. Rather, the Investment in Affiliate (or Equity Investment) non-current asset account on the balance sheet serves as a proxy for the Company A's economic interest in Company B's assets and liabilities.

Company A is entitled to a portion of Company B's earnings in proportion to Company A's economic ownership of Company B's stock. Company A records its proportionate share of the subsidiary's earnings as an increase to the Investment in Affiliate account on its balance sheet. These earnings may be distributed as cash dividends, or retained by Company B. To the extent Company A's share of Company B's earnings are distributed as cash dividends, the Investment in Affiliate account is reduced by the amount of the dividend because the dividend is considered a return of capital. The net effect is that the Investment in Affiliate account increases by Company A's proportionate share of the undistributed earnings of Company B.

Consolidation Method

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.

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 labelled perhaps Noncontrolling Interest in Subsidiaries.

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.

Related Questions

Navigate

• Browse (All)
• Browse 5
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.