15 May WHAT OTHER METHODS MAY BE APPROPRIATE? WHY?
In this unit 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 relationships exists, and the financial statements of the parent company must show the consolidated financial information of both companies. This is because the parent company has control over the subsidiary. In this case, the two companies will most likely record the individual transactions during the period using the equity method. (Hoyle, 2011) Then 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. Consolidation is required when there is more than a 50% interest in a subsidiary.
However, 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.
- ***Scenario:The XYZ Company (Investor) accounts for its ownership of ABC Enterprises (Investee) using the equity method. Last year, XYZ held 33% interest in ABC’s outstanding stock. According to ABC’s financial statements, over 90% of the total revenue for ABC came from selling XYZ (Investor) products. Additionally, four members of the Board of Directors of XYZ Company are executive officers of ABC. ABC Enterprises conducts most of its business under contracts and agreements with XYZ to market, distribute and produce XYZ products in authorized containers in specific territories. These agreements permit XYZ to establish pricing, terms of payment, and other conditions for the purchase of trademarked formulations that are used in manufacturing the products.
- Discussthe following questions in your initial post:
- Does the equity method fairly represent the relationship that exists between the two companies? Please explain.
- What other methods may be appropriate? Why?
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