There are lots of things a company can do to invest its money for the long haul. Long-term assets, including tangible assets like factories and intangible ones like patents and licenses, are something we’ve already covered in this course. They are reasonably straightforward because these assets don’t have minds of their own. The company has full control over them. (Yes, I know, AI is probably going to change all that.)
Things get more complicated when a company decides to invest its money in the shares of other companies. The idea of “control” become questionable because the other company is made up of human beings, and human behaviour is complicated. The degree of control is also questionable because the investing company’s influence over the investee will vary depending on the percentage of shares owned by the investor, and possibly on the terms of any contract between the companies.
Different levels of control give the investing company different opportunities to influence the other company’s financial results, which in turn will affect the investor’s financial returns from the investment. It’s possible, therefore, for an investor to use this influence to manipulate its own financial results. That’s the problem accounting has to wrestle with.
Degrees of Influence
Accounting divides the problem up into three situations. The first situation is where a company has a controlling interest. That's where the investing company owns between 50% and 100% of the shares of another company and so therefore has 100% control over the company. This is the case even if it owns less than 100% of the shares. Owning as little as 51% of the voting shares gives the investing company a majority on the board of directors, and therefore full control. Control can also be effected through the terms of a contract between the companies, which is why IFRS 10 talks about control in terms of the ability to affect return on investment, rather than how many shares are owned. Normally, though, the key factor is the percentage of voting shares that are owned.
The second situation is where a company has significant influence over another company. So less than 50% of the shares, but still a significant stake in the company and therefore a significant say in what the company does. CEOs tend to listen to their large minority shareholders because a large minority shareholder can become a majority shareholder and appoint a new CEO. A large minority shareholder might even have a seat on the board of directors, and be able to vote on decisions like whether and when to pay a dividend to shareholders. That would directly affect the minority investor’s own investment income.
The third and final situation is where a company is just making a passive investment in another company. For example, Microsoft might own, a million dollars worth of shares in Apple. That's a very, very small portion of the market capitalization of Apple. Microsoft, in that situation, would have no influence whatsoever on the business decisions made by Apple, at least not by voting at the annual general meeting.
So let's talk about these three levels in turn.
This scale from zero to 100 is represents the percentage of ownership that an investing company has in the voting shares of another company. That can range from 100%, where the investor has full control and feels the full impact of the investee’s financial performance. That’s great when the investee earns a profit, but not so great when it loses money.
If the investor owns somewhere between 100% and 50% of the voting shares, it’s got full control over the company through its control of the board of directors, but it only gets a portion of the financial returns. That’s because some of the financial returns from the investee go to it’s other shareholders, who hold a minority stake in the investee. (This is the situation we were talking about in another lesson when we discussed what “non-controlling interest” means on a company’s income statement and balance sheet.)
If the investor owns less than 50% of the investee’s voting shares, it has at least some influence over the investee because, we are told, every vote matters. However, there is a difference between owning a few shares and owning enough shares that you matter to the CEO. Accounting categories the latter situation as having “significant influence” over the investee.
Exactly how significant this is will depend entirely on how the rest of the investee’s voting shares are distributed. If all the remaining shares are owned by one person or one other company, your own influence will be quite minimal because even if you have a seat on the board of the investee, no matter how much you squawk at board meetings, the other shareholder has more than 50% of the voting shares and can simply outvote you.
If, however, the remaining shares of the investee company are widely distributed in the stock market and nobody else owns more than 1 or 2% of the shares, even with 10% of the shares you’d be the biggest shareholder and have a huge say at the board meeting. That would give you significant influence.
The lowest level of influence is where you own just a tiny portion of the company and you don't have any ability or intention to influence its strategic decisions. There is nothing you can do to influence your own financial returns, beyond buying more shares or selling the ones you have.
Let's look now at how the accounting is affected by these different ranges of influence, and how accounting regulators have decided we should account for them.
Accounting Methods
There are three accounting methods for a company’s investments in another company. These are the consolidation method, for subsidiaries; the equity method, for companies where the investee has significant influence; and the regular methods of accounting that are used for any other asset, where you either amortize the cost over time or assess the asset’s fair value, which apply when the investment in another company is entirely passive.
Consolidation Method
Consolidation combines the financial statements of the parent company and its subsidiaries into one set of financial statements that represent the overall economic entity. When a company owns a minority stake in another firm and does not control it, the investee is not considered a subsidiary. Only investee companies that are under the full control of the parent are consolidated. This is because the parent company controls not only the business decisions of the subsidiaries but also things like accounting policies and dividend payments. Legally, the subsidiaries are separate entities, but in economic terms, they are considered one entity, so the consolidation method accounts for this economic reality.
Consolidation Procedure
The procedure for consolidating financial statements is quite simple, conceptually, even though it is extremely complicated in practice. Conceptually, you must:
Combine all the line items on the balance sheets, income statements, and cash flow statements together, for the parent and all the subsidiaries. Cash gets added to cash, inventory to inventory, sales to sales, and so on.
Eliminate the all shares of subsidiaries that are recorded as financial assets on the parent company’s balance sheet, and also eliminate any portion of a subsidiary’s equity that is attributable to the parent company. This means that if a subsidiary is 100% owned by the parent company, everything in the equity section of its own balance sheet must go. The parent’s shares in the subsidiaries, and the subsidiaries equity that belongs to the parent, are a financial connection that is wholly within the boundary of the consolidated entity, and have no implication for the consolidated entity as far as outside observers are concerned.
Similarly, eliminate any assets, liabilities, equity, income, expenses, and cash flows that are entirely between the parent and the subsidiaries, or between subsidiaries. For instance, if one subsidiary owes money to another, those cancel each other out and should not appear on the consolidated financial statements. Or, for instance, if one subsidiary has sold something to another subsidiary or to the parent company, the revenue of the seller is the expense of the buyer, so those also cancel each other out and should not appear on the consolidated financial statements.
In practice, all kinds of microsteps need to be taken by the accountants to ensure that adjusting entries are completed properly and important details are accounted for properly, such as when a parent company charges overhead to its subsidiaries, or a parent company handles the payroll for a subsidiary’s employees. These detailed procedures are important to practicing accountants, but it is not necessary for you to be able to perform them if you just want to understand consolidation at a high level.
Goodwill
Consolidations are perhaps the most complicated thing that an accounting firm ever has to do. One of the things that makes it challenging is that often the price paid by the parent company to acquire the shares of the subsidiary is much greater than the net assets that the parent receives. The investing company might pay a million dollars for a company with only $500,000 of assets and $100,000 of liabilities. Why would it pay so much?
Well, there are all kinds of reasons. Perhaps the investee has developed a great new idea or product that the investor wants to own — an patented invention, a new computer game, or whatever. That idea or product would not appear on the balance sheet of the investee, because it was internally developed (remember the lesson on intangible assets?). The investor will have to pay a lot of money to get the shareholders of the investee to let go of their shares in the investee, but will not acquire net assets or net income that make the deal seem worthwhile. The investor is paying for potential, and has to negotiate the price of acquiring that potential from the investee’s shareholders. That price will bear virtually no relation to the assets and liabilities of the investee.
Perhaps the investee is acquiring a competitor in order to gain a monopoly position in the marketplace. The competitor on paper will only be worth what their current market share is in the competitive market. If the investee can take over that market and face no further competition, it can charge customers whatever it wants. That’s a lucrative position to be in, and it may be worth far more than the net assets of the investee to make the competition go away.
Perhaps the investee has a terrific reputation, or employees with rare skills, or domination in a market the investor has been trying unsuccessfully to penetrate, and the investor company feels they could use those qualities of the investee to generate much larger profits than the investee is currently generating with them. Maybe the assets of the investee fill a gap in the investor, and together, the assets of the investor and investee are worth much more than they are separately. You know what this is called: synergy, that much over-used business cliché. But clichés are sometimes true.
All of these are good reasons for one company to pay much more to acquire the shares of another company than the assets, liabilities, revenues, expenses, and cash flows of that company would suggest.
Whatever the reason may be, it is very common for companies to pay a premium to acquire another company. And by “premium,” I mean more than the fair value of the assets and liabilities that they gain control over when they buy the shares of the other company.
This phrase “fair value” is crucial in understanding consolidation. When the assets and liabilities of a subsidiary are added into the consolidated financial statements, the values shown on the balance sheet of the subsidiary are irrelevant. Instead, the assets and liabilities are recorded at their fair value. For instance, if the subsidiary has a truck that was purchased for $50,000 and has accumulated amortization of $10,000, it’s book value on the subsidiary’s balance sheet is $40,000. However, if the truck is worth only $30,000 on the used truck market, it has to be assigned a value of $30,000 on the consolidated statements. All the assets and liabilities of the subsidiary are assigned their fair value, for the purposes of consolidation.
The price paid for the shares of the subsidiary has to be compared to the net of those fair values. That’s the premium I’m talking about. That’s the extra amount that the investing company paid to acquire the shares. That extra amount is called goodwill.
Goodwill has nothing to do with reputation or customer satisfaction or anything else. It’s only the difference between the price paid for the acquisition of the subsidiary, and the fair value of the net assets of the subsidiary.
Here’s how a consolidation looks, conceptually, and how goodwill is determined:
You can see that the investment in the subsidiary is recorded at $1,000,000. That’s the price paid by the parent company to acquire the shares of the subsidiary. As discussed above, this investment needs to be removed from the equation in a consolidation. That’s by there is a negative $1,000,000 in the second column.
Then the fair value of the subsidiary’s assets and liabilities is added, like for like. The parent had $2,000 of cash and the subsidiary had $1,000 of cash, so together they have $3,000. And so on.
These two steps are going to throw the consolidated balance sheet out of balance, so a balancing entry needs to be made. That’s the $794,000 amount in the third column. That is the goodwill. Note that goodwill does not appear on the balance sheet of the parent company or the subsidiaries. It only appears on the consolidated balance sheet, to make everything balance. As you can see in the very last row of the spreadsheet, it’s the difference between the acquisition price, $1,000,000, and the fair value of the net assets, $206,000.
Goodwill is listed as an asset. Obviously, it is intangible, because it’s basically just a balancing entry. Goodwill is not amortized under IFRS, so it may never impact the income statement. However, goodwill must be evaluated annually to see if it is still worth what the consolidated statements say. This is called an impairment test. If the impairment test finds that the $794,000 of goodwill is now worth only $500,000, then the company would have to record a $294,000 credit to goodwill and a corresponding debit to an expense account. “Loss on impairment of investment” might be a good name for such an account. If the impairment test says the the goodwill is worthless, it needs to be written off entirely. However, if the impairment test says that the investment is still working out as expected, or even better than expected, then the goodwill just stays as it. It is never debited to increase its value beyond what it was at the time of acquisition, even if the investment is working out marvelously.
In some jurisdictions, privately-held companies can amortize goodwill over a fixed period of time, typically 10 years. This is not an option for companies whose shares trade publicly on the stock market.
There has been plenty of debate over the years by people who argue that goodwill should never be recognized in the first place. The investing company, they say, should simply record the difference between the acquisition price and the net assets as an expense. In other words, write off the goodwill immediately rather than listing it as an asset. It’s not an asset, they argue, it’s just the cost of doing business. So far, those arguments have not succeeded with accounting standards setters, but watch this space.
A quick note, in case this wasn’t clear: the acquisition has no effect on the financial statements of the subsidiary. The transaction is between the parent company and the subsidiary’s shareholders. The subsidiary itself is not involved.
Note also that there can never be goodwill if the subsidiary is a company created by — “spun off” from — the parent company. That’s because no money was paid to the subsidiary’s shareholders. The parent company is the original and only shareholder.
Minority or Non-Controlling Interest
Let me just remind you of something we discussed in a previous lesson. It’s when the words “non-controlling interest” (or “minority interest”) appear on consolidated financial statements. It simply means that when you did your consolidation, one or more of your subsidiaries was partly owned by someone else. When you included 100% of the net assets of the subsidiary on the consolidated balance sheet, and 100% of the net income of the subsidiary on the consolidated income statement, part of the net assets and net income has to be acknowledged as belonging to the minority shareholders of those subsidiaries.
You’ll see this line at the end of the equity section of the consolidated balance sheet, and at the end of the consolidated income statement. Just pay attention to that and be aware of what it means.
Equity Method
The second level of influence, where the company lacks full control over the investee but has a significant influence over it, requires companies to use the equity method.
The disclosure of this investment by the investor is quite straightforward. A single line on the investor’s balance sheet states the value of all the investments that are accounted for in this way. If this amount is not material on its own, it might be combined with other financial investments, but at the level of the accounts behind the balance sheet, there would be an asset account for equity investments.
So, rather than consolidating all of the assets and liabilities line by line, there is a single account showing the value of the investment. Same thing goes for the income statement: rather than consolidating the income statements on a line by line basis, there will be a single account for the profit you get from your equity investments. If the amount is material, it would be disclosed on its own line on the income statement, otherwise it would be lumped in with other income" or “investment income.”
Now here is where it gets interesting, perhaps even elegant. There are two ways in which the value of the investment will change on the investor’s balance sheet: when the investee earns a profit (or loss), and when the investee pays a dividend.
If the investee earns a profit, the equity on its own balance sheet goes up in the usual way, through retained earnings. The company has recorded a profit and is now more valuable. Since the investment of the investor represents a percentage ownership of the investee, a percentage of the investee’s profit is recognized by the investor as profit, and a percentage of the increase in the investee’s equity is added the value of the investment, because that investment is now more valuable. For example if the investor owns a 25% stake in the investee, and the investee earns a $10,000 profit, then the value of the investment goes up by one quarter of the $10,000, or $2,500, and the net income of the investor goes up by the same amount. Debit to the investment account, credit to investment income.
If the investee company pays a dividend, that means that it’s own net assets go down, because a dividend comes out of its retained earnings. Its cash and its retained earnings both go down. Suppose it declares a cash dividend of $1,000. The investing company, with its 25% stake, will receive 25% of the dividend, or $250. That’s a debit to cash. The credit goes to the asset account that records the value of the investment, because that investment is now less valuable (the investee has less cash). The beauty of this approach is that a dividend paid by the investee has no effect on the income of the investor. All that happens is that value is transferred from its equity investment account to its cash account, which are both asset accounts. This means that if the investor should ever attempt to use its significant influence to affect the timing or size of a dividend, it would not be able to manipulate its own net income. That is precisely why the equity method is used, to avoid manipulation of financial results.
Methods for Passive Investments
Piggy bank. (Photo by Andre Taissin, Unsplash)
Now let's look at accounting for passive investments. This is when one company owns a very small percentage of the shares of another company, giving the investor little or no influence over the decisions of the investee. There are three different methods for accounting for such investments, depending on whether the investment is in shares or debt instruments (such as bonds), and on how long the investor plans to hold onto the investment. In all three methods, the value of the investment is, of course, shown as an asset on the balance sheet. In all three methods, any dividend or interest payments received as a result of owning the investment are recorded as investment income (DR cash, CR investment income). Where the methods differ is in what to do with changes in the value of the investment asset.
The three possible methods are:
the default method, fair value through profit and loss (FVPL), where the change in the fair value of the investment from one period to another is recognized as a gain or loss on income statement,
the amortized cost method, which is used for bonds held to maturity,
and fair value through other comprehensive income (FVOCI), where the change in the fair value of the investment from one period to another bypasses the income statement and is disclosed as other comprehensive income.
Fair Value through Profit and Loss
As mentioned, this is the default method. If the company does not elect to treat an investment in one of the other two ways, it will use this method. The fair value of a financial investment is usually easy to determine: you just look it up on the stock market. Granted, for investments in private companies, this can be a more difficult proposition.
If the value has gone up, the investor will record a debit to its investment asset account and a credit to gain on investments, which is disclosed as investment income or other income on the income statement. If the value has gone down, it’s a credit to the investment account and a debit to an income statement account to record a loss on investments.
This is the default method because IFRS has a focus — almost an obsessive focus — on the balance sheet. IFRS wants the values on the balance sheet to be as useful and relevant as possible for people who are making investment decisions. The income statement is somewhat secondary, so the fact that the gain has not been realized yet is not considered important.
When a company has an investment where the fair value is not easily determined — such as an investment in real estate or some other not financial investment — it’s possible to use a combination of the fair value method and the amortized cost method. The company can reassess the investment at fair value every few years, and use amortized cost in between to save on revaluation costs.
Amortized Cost
A company uses the amortized cost method for an investment when two conditions are true:
The investment is in a financial security that pays the investor regular amounts and specifies a maturity date, and
The business model of the investor is to hold onto such investments until they mature.
The best example of such a security is a bond, which provides regular interest payments and a return of the principal at its maturity. Companies that buy and sell bonds as they go up and down in value on the stock market, selling them before their maturity date, do not use the amortized cost method. They use FVPL.
Bonds are usually purchased at a price that is different from the face value of the bond, due to differences between the interest rate on the bond and the market rate of interest. If the bond’s interest rate is higher, investors will pay more than face value (they pay a premium). If the bond’s interest rate is lower, investors will pay less than face value (they buy it at a discount).
The investment in the bond is recorded in two accounts: the investment itself, at the face value of the bond, and the premium or discount as a contra asset account. The net of the bond and the contra account will be equal to the price that was paid for the bond. It’s the premium or discount that is going to be amortized over the life of the bond, as interest payments are received. That’s where the name “amortized cost” comes from for this method.
The calculations are rather complicated to explain, so I’m going to defer all the details until a later lesson.
Fair Value through OCI
Fair value through other comprehensive income can be elected by a company when it does not want volatility in the value of the investment to impact the income statement until the asset is sold. The investment asset is updated each fiscal period to its fair value. The change is not recorded as a gain or loss on the income statement, the way it would be under FVPL. Instead, the change is recorded as other comprehensive income, bypassing the income statement.
The change is added to accumulated OCI in the equity section. It stays there until such time as the investment is sold. At that time, any overall change in the value of the investment since it was purchased is recognized in net income, as a gain or loss on the investment.
This is a very useful method for investments that are designed to hedge losses in other investments. For instance, if the investing company owns some sort of a derivative that it uses to offset the fluctuation in another asset, such as one denominated in a foreign currency, the fair value of the derivative will go wildly up and down depending on circumstances beyond the control of the company. The company doesn't want that fluctuation to affect its profit and loss, so it will accumulate those fluctuations in accumulated OCI rather than retained earnings. The fluctuations will affect the value of the asset on the balance sheet, but not the income statement.
When the company gets around to selling the derivative, the overall change in the derivative would be taken out of accumulated OCI, and put through the income statement as a gain or loss. That is, it is transferred from accumulated OCI to retained earnings, via the income statement.
Companies are not allowed to use FVOCI for assets that are held for trading. They are also not allowed to put an investments into this category and then take it back out whenever it wants. That, of course, would enable the company to park any losses in accumulated OCI, and take them back out when the asset goes back up in value. That would be income manipulation, so it’s not allowed. Investments that are put in this category must stay there.
Summary
Well, what have we learned about investments in other companies?
We started with the general question of how the accounting depends very much on the degree of influence that the investing company has over the other company. There are several ways in which the investment could be accounted for, and some of them lend themselves to manipulation if the investor can use their influence to change their own financial results.
We learned that when the investor has full control over the investee, the two companies need to be treated as a single economic entity. That’s what the consolidation method achieves. We looked at how the investment relationship between the two companies is factored out when combining the two companies’ financial statements. We saw how transactions between the two companies are also eliminated because as far as the single economic entity is concerned, they are not transactions with external parties. And we learned how, when an investor has full control over the investee but does not enjoy full financial returns because of the presence of a minority investor, that minority or non-controlling interest is signaled on the statements.
We learned how when an investor has significant influence over the investee, but not full control, the equity method is used to ensure that the investor is not able to benefit from manipulating things such as dividend payments.
And we learned the various methods of accounting for passive investments in other companies. These were the default method of fair value through profit and loss (FVPL), amortized cost, which applies mainly to bonds held to maturity, and fair value through other comprehensive income (FVOCI), which is used for investments that are subject to exogenous volatility, such as currency fluctuations.
There is a lot to chew on in this lesson. I hope you will explore it further using the spreadsheets I’ve provided below, and by looking carefully at the consolidated financial statements of any companies you happen to be interested in, so you can see how these accounting methods are used in practice.
When you are ready, move on to the next lesson. It’s rather important.
Downloadable Spreadsheets
Here is a comparison of some very, very simple consolidation calculations under different scenarios. It may help you work through what consolidations are intended to accomplish.
Here is a slightly extended version of the consolidation calculation shown above, for you to fill in. (Once you have tried your hand at that, here is the solution.)
Title photo: NY Stock Exchange, by TomasEE, CC BY 3.0, https://commons.wikimedia.org/w/index.php?curid=54505867