Business Combinations
Companies invest in other companies for a variety of reasons. The main one is an increase in profits. Another is the company being acquired offers something that can improve the acquiring company’s operations (vertical integration). Sometimes they are in totally unrelated businesses (horizontal integration). The first question our CPA should ask the client is why they want to invest in Company K.
When one company invests in another, they can account for the transaction in three ways. The cost method is used when the investment is less than 20% ownership and no influence on decision making. The equity method is used when ownership is between 20% - 50% with moderate influence. When ownership is greater than 50% and total control, the consolidation method is used. Since Company F is purchasing 40% of Company K, it will account for this investment under the equity method.
There are three considerations when using the equity method. They are recording the initial cost, accounting for the profits of the subsidiary, and the treatment of dividends. Under the equity method, the investment is recorded at cost as an asset (Investment in K) (Arizona State University, 2016). Company F will record its proportion of Company K’s income as revenue on its income statement (Equity earnings of affiliate) (Arizona State University, 2016) and increasing the Investment in K account on the balance sheet. Any dividend payments will be recorded as a return of capital (reduction in the investment in K account) (Arizona State University, 2016).
For example, let us say Company K is worth $1,000,000. IF Company F buys 40% on June, 30, 2016, the entry is: ($1,000,000*.40)
Next, Company K has $100,000 in earnings for 2016. The entry on December 31, 2016 is: ($100,000 *.40)
Finally, Company K pays a dividend of $70,000. The entry on December 31, 2016 is: ($70,000*.40)
Finally, here are the T accounts reflecting each transaction:
References
http://www.public.asu.edu/~bac524/long-terminvestments.pdf
