When a company owns less than 50% of the outstanding stock of another company as a long-term investment, the percentage of ownership determines whether to use the cost or equity method.

• A purchasing company owning less than 20% of the outstanding stock of the investee company, and does not exercise significant influence over it, uses the cost method.
• A purchasing company owning from 20% to 50% of the outstanding stock of the investee company or owns less than 20%, but still exercises significant influence over it, uses the equity method.

Thus, firms use the cost method for all short-term stock investments and almost all long-term stock investments of less than 20%. For investments of more than 50%, they use either the cost or equity method.

Available-for-sale securities

Assume the finance manager at YourCompany invested excess cash in 1,000 shares of stock in Ronco, Inc. for $32,000 three years ago. On December 31, the fair market value was $31,000.

The treatment of the loss depends on whether it results from a temporary decline in market value of the stock or a permanent decline in the value.

If the loss is related to a “temporary” decline in the market value of the stock, the unrealized loss on the available-for-sale securities would appear in the balance sheet as a separate negative component of stockholders’ equity rather than in the income statement (as it does for trading securities). An unrealized gain would be shown as a separate positive component of stockholders’ equity. An unrealized loss or gain on available-for-sale securities is not included in the determination of net income because it is not expected to be realized in the near future since these securities will probably not be sold soon.

The journal entry for a $1,000 temporary decline in market value would be:

Most publicly traded companies now have a fifth statement in addition to the balance sheet, income statement, statement of cash flows, and statement of owners’ equity.  This additional statement is called the statement of comprehensive income.  The bottom line, called “comprehensive income”, includes net income from the traditional income statement as well as some balance sheet adjustments, like foreign currency translations and unrealized gains and losses.  Comprehensive income then flows through to the statement of owners’ equity, either increasing or decreasing retained earnings.

See the statement long description here.

The sale of an available-for-sale security results in a realized gain or loss and is reported on the income statement for the period. Any unrealized gain or loss on the balance sheet must be recognized at that time. Assume the stock discussed above is sold on January 1 of the next year for $31,000 (assuming no change in market value from the previous day). The entries to record this sale are:

The account debited in the first entry shows the unrealized loss has been realized with the sale of the security; the amount is reported in the income statement. The second entry writes off the security and records the cash received and is similar to the entry for the sale of trading securities.

A loss on an individual available-for-sale security that is considered to be “permanent” is recorded as a realized loss and deducted in determining net income. The entry to record a permanent loss of  $1,400 reads:

No part of the $1,400 loss is subject to reversal if the market price of the stock recovers. The stock’s reduced value is now its “cost.” When this stock is later sold, the sale will be treated in the same manner as trading securities. The loss or gain has already been recognized on the income statement. Therefore, the entry would simply record the cash received and write off the security sold for its fair market value. If the market value of the security has fluctuated since the last time the account had been adjusted (end of the year), then an additional gain or loss may have to be recorded to account for this fluctuation.

The equity method for long-term investments of between 20 percent and 50 percent

When a company (the investor) purchases between 20% and 50% of the outstanding stock of another company (the investee) as a long-term investment, the purchasing company is said to have significant influence over the investee company. In certain cases, a company may have significant influence even when its investment is less than 20%. In either situation, the investor must account for the investment under the equity method.

When using the equity method in accounting for stock investments, the investor company must recognize its share of the investee company’s income, regardless of whether or not it receives dividends. The logic behind this treatment is that the investor company may exercise influence over the declaration of dividends and thereby manipulate its own income by influencing the investee’s decision to declare (or not declare) dividends.

Thus, when the investee reports income or losses, the investor company must recognize its share of the investee’s income or losses. For example, assume that Tone Company (the investor) owns 30% of Dutch Company (the investee) and Dutch reports $50,000 net income in the current year. Under the equity method, Tone makes the following entry as of the end of year:

The $15,000 income from Dutch would be reported on Tone’s income statement. The investment account is also increased by $15,000.

If the investee incurs a loss, the investor company debits a loss account and credits the investment account for the investor’s share of the loss. For example, assume Dutch incurs a loss of  $10,000 during the year. Since it still owns 30% of Dutch, Tone records its share of the loss as follows:

Tone would report the $3,000 loss on its income statement. The $3,000 credit reduces Tone’s equity in the investee. Furthermore, because dividends are a distribution of income to the owners of the corporation, if Dutch declares and pays $20,000 in dividends, this entry would also be required for Tone:

Under the equity method just illustrated, the investment in the Dutch Company account always reflects Tone’s 30% interest in the net assets of Dutch.

Here is a brief video explaining the equity method in a bit more detail:

Consolidation

If an investor has more than 50% holding in a company, it is said to have control over the investee. The investor is called the parent and the investee is called the subsidiary and the investment is accounted for by combining all the accounts of the parent and the subsidiary, eliminating any intercompany transactions.

These “consolidated” financial statements combine the revenues and expenses of all the companies, and a portion of the net income attributable to the other investors, called the minority interest, is separately reported. Similarly, the consolidated balance sheet combines assets and liabilities of the parent and the subsidiary and separately mentions the equity attributable to minority interest.

The following table compares the different methods of accounting for equity investments: