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The company you work for is considering acquiring stock in another company, and the CEO does not fully understand how the acquisition will be accounted for. He needs more information on whether or not the stock being acquired will require use of the equity method of accounting for investments or require consolidation.

Required

Prepare a memo to the CEO explaining when an investment is accounted for using the equity method and when consolidation is required. Make sure you fully cover how investments are classified and accounted for using both methods and that your post is in memo format.

Answer 1

XXX COMPANY

08/07/2018

To: CEO of XXX Company

From: Finance Executive of XXX Company

Subject: Regarding the classification of Investments.

   Basically the investments which a company purchases can be of marketable securities which are bought with a purpose to sell in the short run, or equity instruments which are bought with a purpose to influence the investee company or long term instruments to own the investee company.

   If we acquire 20% or more of the shareholding in other company and not more than 50%, we would follow equity method of accounting for investments. But this also means that we are having significant influence over the investee's company. For example, even though we own 21% of shareholding in XYZ company and another shareholder has 79% of shareholding, we cannot account for the investments as equity instruments because in this case we don't have significant influence because the shareholder with 79% rules the company.

If we acquire more than 50% of shareholding in the other company we would definitely follow consolidation of accounts. In this case, the company in which we invest becomes the subsidiary and we become its parent or holding company. All accounts are consolidated and some of the portion is diverted to the minority interest to show their stake int he subsidiary company.