Explain the accounting for intercorporate investments in common stock

Answer 1

INTERCORPORATE INVESTMENTS IN COMMON STOCK

Firms sometimes invest in the common stock of other entities in order to exert significant influence or control over the other entity. U.S. GAAP and IFRS assume that firms owning between 20% and 50% of the voting stock of another entity can exert significant influence, and firms owning more than 50% can exert control, unless other information indicates the contrary.

A firm that can exert significant influence over another entity accounts for its intercorporate
investment using the equity method. The investor recognizes its share of the net income
or net loss of the investee, after eliminating any intercompany income items, and increases
(in the case of net income) or decreases (in the case of net loss) its investment account in
an equal amount. The investor decreases the investment account for dividends received. If
the acquisition cost of the investment exceeds the investor's interest in the net assets of the
investee at the time of the acquisition, the investor must decide if the excess relates to assets
or liabilities of the investee with a limited life. If so, the investor must amortize a portion of
the acquisition cost of the investment to reflect the decline in expected benefits. Firms can
apply the fair value option to equity method investments under certain conditions.

A firm that controls another entity prepares consolidated financial statements with that
entity. The consolidated financial statements reflect the results of the legally separate entities
as if they were a single entity. Thus, consolidated financial statements eliminate intercompany
balance sheet and income statement accounts and intercompany profit or loss on transactions
between the entities. If the parent company does not own 100% of the other entity, the
remaining shareholders hold a noncontrolling (formerly, minority) interest. Consolidated balance sheets consolidate all of the assets and liabilities of the controlled entity and then show
the claim of noncontrolling shareholders against consolidated net assets as part of shareholders' equity. Likewise, consolidated income statements consolidate all of the revenues and expenses of the controlled entity and then show the portions of the consolidated net income to which the noncontrolling shareholders and the controlling shareholders have a claim.

The usual criterion for preparing consolidated financial statements with another entity is
ownership of a majority of the voting stock. A firm might conduct business with or through
another entity, which it controls through contractual agreements and ownership of nonequity
instruments, not share ownership. In this case, the firm must apply criteria specified in U.S.
GAAP and IFRS to determine if the other entity qualifies as a variable interest entity (VIE)
under U.S. GAAP or a special purpose entity (SPE) under IFRS. If so, the firm must then
assess if it is the primary beneficiary of a VIE under U.S. GAAP or if it controls the SPE
under IFRS, in which case it would consolidate the financial statements of the VIE or SPE
with its own.

Standard-setting bodies are reconsidering the concept of an accounting entity, including
the use of majority equity ownership to gauge control of another entity. The evolving
concept of control involves both the capacity to direct the strategic, operating, investing, and
financing decisions of another entity and the ability to benefit from value increases and to
bear the loss from value decreases of the other entity.