Consolidation, equity method accounting and cost accounting for investments
November 10, 2014
Accounting for investments may be challenging and complex. In this article, we will provide an overview of methods of accounting for investments.
Depending on the level of influence obtained and the size of the investment, the following accounting approaches can be used:
- Consolidation of financial statements;
- Equity method;
- Fair value and cost method.
Consolidation takes place when a company includes financial information of the company’s investee. Typically, consolidation should take place when the company exercises control over the investee.
US GAAP has a two-tier consolidation model. All entities are classified into VIEs (variable interest entities) and non-VIEs.
For VIEs, a qualitative model is applied that focuses on the assessment of possession of controlling financial interest. According to the model, control is considered to exist if an entity has power to direct activities of a VIE that most significantly impact the VIE’s economic performance (power criterion) and receives benefits or suffers losses from the VIE (losses/benefits criterion). Consequently, the concept of VIEs requires consolidation of entities that are financially controlled through special contractual arrangements rather than through voting stock interests.
For non-VIEs, the voting interest model is used that considers the actual share of voting rights.
The relative size of ownership (generally, more than 50 percent of shares) is the key factor in assessing existence of control. However, in certain circumstances, under effective control concept control may exist with less than 50 percent of ownership. For instance, if one party owns 30 percent of common stock and the remaining shares of the company are spread out among a large number of small investors, then that party would be considered to have an effective control over the company even though the party has less than 50 percent of voting shares.
Moreover, in practice investors may possess an equal number of shares (50-50 percent or near). In such a case, any other variable interest determines consolidation decisions. In making this judgment, consideration is given to the legal form of the arrangement, the contractual terms and conditions as well as other facts and circumstances. For example, in 2013 financial statements Coca-Cola Hellenic Bottling Company S.A. states that it has a joint arrangement with Brewinvest S.A. Group in Greece with 50% share and consolidates its results.
A consolidated income statement includes both financial results of a parent company and its subsidiaries. In a consolidated balance sheet, all assets and liabilities are added up. Necessary adjustments are made to the assets and liabilities for the purpose of consolidation, such as excluding account(s) “Investment in subsidiary” from the parent’s financial statement, elimination of intergroup accounts, representation of equity and reserves only of a parent company. A detailed consolidation model of financial statements is a complex accounting topic and is out of scope in this article.