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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

To: CEO of ABC Company

From: Accounts Manager

Date: 10^th August, 2018

Subject: Investment classification and accounting.

Due to complexity of subject matter, I, Mr.X, Accounts Manager of ABC Co. is drafting a report for the better understanding of investment classification and its accounting treatment.

Since our company is going to make investment in near future then it becomes my responsibility to throw some light on fundamentals of investment.

   Here I am elaborating two of them as per the current requirement.

Equity Method-This method would be accounted when investor holds significant control over investee but does not exercise full control over it. It involves two situations-

When investor owns-

1. Less than 20% of investee shares- In this situation, equity method would be of use only if investor has significant control over investee’s operations otherwise cost method would be applied.
2. More than 20% but less than 50%- In this situation investor is deemed to have significant control if it owns 20% to 50% of investee’s share or voting rights.

Under the equity method investee’s often referred to as associate or affiliate.

Equity Method Accounting-Under the equity method, the investor begins as a baseline with the cost of its original investment in the investee, and then in subsequent periods recognizes its share of the earnings or losses of the investee, both as adjustments to its original investment as noted on its balance sheet, and also in the investor’s income statement.

The share of the investee’s earnings that the investor recognizes is calculated based on the investor’s ownership percentage of the investee’s common stock. When calculating its share of the investee’s earnings, the investor must also eliminate intra-entity profits and losses. Further, if the investee issues dividends to the investor, the investor should deduct the amount of these dividends from the carrying amount, of its investment in the investee.

Consolidation Method-When an investor exercises full control over the company it invests in, the investing company may be known as a parent company to the investee. The latter is then known as a subsidiary of the parent company. In such a case, investments made by the parent company in the subsidiary are accounted for using the consolidation method.

It involves one situation when investor made an investment of 50% or more in investee’s assets. This relationship is called Parent and subsidiary relationship. Under this method parent company combines its own revenue with 100% revenue of subsidiary company.

Consolidation method Accounting-

The parent company will report the “investment in subsidiary” as an asset, with the subsidiary reporting the equivalent equity owned by the parent as equity on its own accounts. At the consolidated level, an elimination adjustment must be added so that the consolidated statement is not overstated by the amount of equity held by the parent. The elimination adjustment is made with the intent of offsetting the intercompany transaction, such that the values are not double counted at the consolidated level.

These are the basic concepts and accounting treatment of two investment methods. Further I will update members of our company on timely basis as per the requirement. For any further clarification feel free to connect or mail me.

Best

Mr.X

Accounts Manager.