An investor should always use the equity method to account for an investment if:
In many instances, an investor possesses only a small percentage of an investee company’s outstanding stock, perhaps only a few shares. Because of the limited level of ownership, the investor cannot expect to significantly affect the investee’s operations or decision making. These shares are bought in anticipation of cash dividends or in appreciation of stock market values. Such investments are recorded at cost and periodically adjusted to fair value according to the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 321, “Investments—Equity Securities.”
Fair value is defined by the ASC (Master Glossary) as the “price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” For most investments in equity securities, quoted stock market prices represent fair values.
Because a full coverage of limited ownership investments in equity securities is presented in intermediate accounting textbooks, only the following basic principles are noted here:
Initial investments in equity securities are recorded at cost and subsequently adjusted to fair value if fair value is readily determinable (typically by reference to market value); otherwise, the investment remains at cost.
Changes in the fair values of equity securities during a reporting period are recognized as income.
Dividends declared on the equity securities are recognized as income.
Cost Method (Investments in Equity Securities without Readily Determinable Fair Values)
When the fair value of an investment in equity securities is not readily determinable, and the investment provides neither significant influence nor control, the investment may be measured at cost. Such investments sometimes can be found in ownership shares of firms that are not publicly traded or experience only infrequent trades.
Investments in equity securities that employ the cost method often continue to be reported at their original cost over time.3 Income from cost method equity investments usually consists of the investor’s share of dividends declared by the investee. However, despite its emphasis on cost measurements, GAAP allows for two fair value assessments that may affect cost method amounts reported on the balance sheet and the income statement.
Consolidation of Financial Statements
Many corporate investors acquire enough shares to gain actual control over an investee’s operations. In financial accounting, such control may be achieved when a stockholder accumulates more than 50 percent of an organization’s outstanding voting stock. At that point, rather than simply influencing the investee’s decisions, the investor often can direct the entire decision-making process. A review of the financial statements of America’s largest organizations indicates that legal control of one or more subsidiary companies is an almost universal practice. PepsiCo, Inc., as just one example, holds a majority interest in the voting stock of literally hundreds of corporations.
Investor control over an investee presents a special accounting challenge. Normally, when a majority of voting stock is held, the investor-investee relationship is so closely connected that the two corporations are viewed as a single entity for reporting purposes.5 Hence, an entirely different set of accounting procedures is applicable. Control generally requires the consolidation of the accounting information produced by the individual companies. Thus, a single set of financial statements is created for external reporting purposes with all assets, liabilities, revenues, and expenses brought together. The various procedures applied within this consolidation process are examined in subsequent chapters of this textbook.
Another investment relationship is appropriately accounted for using the equity method. In many investments, although control is not achieved, the degree of ownership indicates the ability of the investor to exercise significant influence over the investee.
To provide objective reporting for investments with significant influence, FASB ASC Topic 323, “Investments—Equity Method and Joint Ventures,” describes the use of the equity method. The equity method employs the accrual basis for recognizing the investor’s share of investee income. Accordingly, the investor recognizes income as it is earned by the investee. As noted in FASB ASC (para. 323-10-05-5), because of its significant influence over the investee, the investor
has a degree of responsibility for the return on its investment and it is appropriate to include in the results of operations of the investor its share of earnings or losses of the investee.
Furthermore, under the equity method, the investor records its share of investee dividends declared as a decrease in the investment account, not as income.