Minority, Active Investment
Firms often acquire shares of another corporation to exert significant influence over that company’s activities. This significant influence is usually at a broad policy-making level through representation on the other corporation’s board of directors. Because of wide dispersion of ownership of most publicly held corporations, and the fact that many shareholders do not vote their shares, firms can exert significant influence (but not outright control) over another corporation with ownership of less than a majority of the voting stock. In general, investments of between 20% and 50% of the voting stock of another company are generally deemed minority, active investments unless evidence indicates that the acquiring firm cannot exert significant influence, other circumstances give the investor firm control over the investee, or the investing firm is deemed the VIE’s primary beneficiary.
U.S. GAAP and IFRS require firms to account for minority, active investments, generally those for which ownership is between 20% and 50%, using the equity method.Under the equity method, the firm owning shares in another firm recognizes as income (loss) each period its share of the net income (loss) of the other firm. See, for example, the income statement of PepsiCo (Appendix A), which reports ‘‘Bottling equity income’’ of $734 million in 2010. At that time, this represented PepsiCo’s share of the earnings from 20–50%-owned bottling affiliates. The investor treats dividends received from the investee as a return of investment, not as income. Although PepsiCo acquired the remaining shares of its bottlers and now consolidates them, it still has equity method investments reported on the balance sheet as ‘‘Investments in Noncontrolled Affiliates’’ of $1,633 million at December 29, 2012. This balance sheet account represents PepsiCo’s original investment in the affiliates plus the accumulated amount of equity income it has recognized over time minus the dividends it has received from the affiliates.
Illustration of the Equity Method for Minority, Active Investments
On January 1, 2013, Lake Co. bought 40% of Pond Co. common stock at a cost of $500,000. Pond Co.’s net assets have a book value of $1,000,000. Assume that the individual fair values of identifiable net assets are equal to the book values of Pond’s assets except for a building that has a fair value that is $150,000 above book value. The building has an estimated remaining useful life of ten years. During 2013, Pond’s net income is $50,000 and it pays $30,000 in dividends. Lake Co. paid $500,000 to acquire 40% of Pond Co., which implies that $460,000 was paid for identifiable net assets and $40,000 for unidentifiable assets, as follows
Firms often acquire shares of another corporation to exert significant influence over that company’s activities. This significant influence is usually at a broad policy-making level through representation on the other corporation’s board of directors. Because of wide dispersion of ownership of most publicly held corporations, and the fact that many shareholders do not vote their shares, firms can exert significant influence (but not outright control) over another corporation with ownership of less than a majority of the voting stock. In general, investments of between 20% and 50% of the voting stock of another company are generally deemed minority, active investments unless evidence indicates that the acquiring firm cannot exert significant influence, other circumstances give the investor firm control over the investee, or the investing firm is deemed the VIE’s primary beneficiary.
U.S. GAAP and IFRS require firms to account for minority, active investments, generally those for which ownership is between 20% and 50%, using the equity method.Under the equity method, the firm owning shares in another firm recognizes as income (loss) each period its share of the net income (loss) of the other firm. See, for example, the income statement of PepsiCo (Appendix A), which reports ‘‘Bottling equity income’’ of $734 million in 2010. At that time, this represented PepsiCo’s share of the earnings from 20–50%-owned bottling affiliates. The investor treats dividends received from the investee as a return of investment, not as income. Although PepsiCo acquired the remaining shares of its bottlers and now consolidates them, it still has equity method investments reported on the balance sheet as ‘‘Investments in Noncontrolled Affiliates’’ of $1,633 million at December 29, 2012. This balance sheet account represents PepsiCo’s original investment in the affiliates plus the accumulated amount of equity income it has recognized over time minus the dividends it has received from the affiliates.
Illustration of the Equity Method for Minority, Active Investments
On January 1, 2013, Lake Co. bought 40% of Pond Co. common stock at a cost of $500,000. Pond Co.’s net assets have a book value of $1,000,000. Assume that the individual fair values of identifiable net assets are equal to the book values of Pond’s assets except for a building that has a fair value that is $150,000 above book value. The building has an estimated remaining useful life of ten years. During 2013, Pond’s net income is $50,000 and it pays $30,000 in dividends. Lake Co. paid $500,000 to acquire 40% of Pond Co., which implies that $460,000 was paid for identifiable net assets and $40,000 for unidentifiable assets, as follows
The investee (Pond Co.) calculated its $50,000 income by basing depreciation charges on the book values of its assets. Under the equity method, the investor (Lake) records its pro rata share of investee income of $20,000 ($50,000 3 40%). However, from Lake’s point of view, the resources committed to generating 40% of Pond’s revenues are greater than 40% of Pond’s costs because Lake paid $60,000 extra for the appreciated building when it purchased the 40% interest. Allocation of the cost of that extra investment also must be reflected in income measurement (hence, the $6,000 additional depreciation expense). The Investment in Pond Co. account is reported in the long-term investments section of the balance sheet at the original cost plus increases in the investment from the investee’s income less decreases in the investment from dividend distribution, as follows:
If Lake were to use the market method, the investment in Pond Co. would be marked to market at year-end. Further, $12,000 in dividend revenue ($30,000 3 40%) would be reported on the income statement. Under the equity method, however, the investee’s income, rather than the distribution of dividends, triggers the investor’s income recognition.Lake’s investment income is determined as follows:
Exhibit 8.8 summarizes the financial statement effects for Lake Company of its equity method investment in Pond. Although Lake’s net income includes an increment of $14,000 from investment revenue, it received only $12,000 of cash dividends. Therefore, the operating activities section of Lake’s statement of cash flows will report a $14,000 subtraction from net income for this non-cash component of income, as well as a $12,000 cash inflow from dividends (or alternately, a net $2,000 deduction for undistributed earnings of affiliates). Minority, active investments are related parties. Sales to and purchases from related parties, including any receivable and payable relationships, must be disclosed in the
notes to the financial statements. Related-party transactions with minority, active investments are not eliminated from the investor’s financial statements. However, profit lodged in inventory from intercompany sales or purchases must be eliminated by reducing both equity in net income of the affiliate and the Investment in Affiliate account. Assume that Lake sold inventory costing $75 to Pond for $100. Pond holds $10 of the inventory at year-end. Lake must eliminate $1 profit because, based on the gross margin percentage of 25% ($25 profit/$100 selling price), the $10 inventory contains $2.50 in profit and Lake owns 40% of Pond ($2.50 3 40% ¼ $1)
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