This week, you are learning about how the level of ownership involvement of an investing company influences the method of accounting used to record the transactions of an acquisition and those in subsequent reporting periods. Thus far in your study of advanced accounting, there are two methods for recording the ongoing transactions: the Cost method and the Equity method. These methods are used to record the transactions on the (separate) books of each company.
THE COST METHOD
If the investing company owns 20% or less of the common stock of the acquired company, the Cost method may be used. The rationale for this is that the Investor lacks the ability to influence the operations of the investee. The Cost method allows the acquiring company to record the value of the investment at the acquisition cost incurred, plus any expenses incurred in the process. The subsequent carrying amount is not adjusted and remains valued at the acquisition cost until sold. Income from the investment is recognized proportionately as dividends are declared by the acquired company.
THE EQUITY METHOD
If the investing company owns between 20% and 50% of the acquired company it is presumed that the investor will be able to exercise significant influence over the operations of the acquired company. In this case, the equity method must be used to account for the transactions between the two companies. Under this method, the investment is recorded at the acquisition price and is then adjusted each period to reflect the investor’s share of the acquired company’s income (or loss) and any dividends declared.
If the acquiring company owns more than 50%, then a parent-subsidiary relationship may exist. If the acquiring company has the ability to control the operations of the subsidiary, then the financial statements of the parent company must show the consolidated financial information of both companies. The parent company will use special entries, called elimination entries, to consolidate the financial information such that it is presented as if the economic activity of both companies were performed by one single corporation.
If a company is required to consolidate, they may choose to use the Cost Method to record the individual transactions between the two (or more) companies. This is because the choice of cost or equity method has no effect on the final consolidated statements. The process of recording the elimination entries ensures that there is no “double-counting” of the subsidiary’s income and the parent’s investment account balance.
Discussion instructions
read the scenario before beginning your discussion post:
The XYZ Company owns 37% of the outstanding stock of ABC Enterprises. According to ABC’s financial statements, over 85% of its total revenue came from distributing XYZ products. The agreements between ABC and XYZ, permit XYZ to establish pricing, terms of payment, and other conditions for the purchase of their trademarked formulations. Additionally, two members of the Board of Directors of XYZ Company are executive officers of ABC.
In your original post, answer the following:
What method of accounting would most fairly represent the relationship that exists between the two companies? Please explain.
PROFESSOR TWO CENTS
Hi Folks – This week when you are working on the discussion board, think about the percentage of ownership PLUS the other factors that affect the level of influence.
The percentages below 50% are only a guideline and are not fixed in stone.
Also – in addition to discussing whether or not the company should use the cost or equity method, be sure to consider whether or not Consolidation may be appropriatcixe. Be sure to explain your position.
