Some companies grow through internal sales and marketing initiatives. Other companies make whole or partial acquisitions of businesses they believe will help them achieve their revenue or market share objectives. When a company purchases more than a 50 percent stake in another business, the entity’s financials get consolidated into the purchaser’s overall financials. When a company purchases 20 to 25 percent but less than 50 percent of a company and exercises significant control, the purchaser uses the equity method of accounting.
When one company purchases a majority stake in another firm, the purchasing company is called the acquirer, parent or controlling entity. The acquired firm is a division, subsidiary or controlled entity. Consolidated financial statements reflect the combination of the parent company's financials with that of its subsidiary in one set of financials, presenting financial results as though they were one. Generally accepted accounting principles, or GAAP, require consolidation to provide a clear, accurate picture of overall company performance. Solely reviewing parent company financials can provide management, lenders and investors with a distorted view.
The first step in consolidating financial statements is to prepare financial statements for both the parent and its subsidiary. According to GAAP, a business cannot transfer or sell cash or assets or make loans to itself. Therefore, accountants eliminate the double counting associated with inter-company sales or transfers through the use of a separate worksheet for each statement. Accountants then add each statement with the applicable adjustments. For example, accountants add the parent's income statement, the subsidiary's income statement and the associated adjustments. The final product is a set of consolidated financial statements.
Equity Method Defined
When one company purchases a minority stake in another, the purchasing firm is called the investor, and the company it buys into is called the investee. Companies that own minority stakes in other businesses use the equity method as their standard accounting technique to account for those holdings in which their stake is significant but below 50 percent. These minority stakes lie between 20 to 25 percent at a minimum and 50 percent stake at a maximum. With such sizable interests, investor companies exert considerable influence over the strategy and operations of the investees.
Equity Method Process – Income
With the equity method, the investor documents its proportionate share of the investee's profits or losses on one line of the income statement. This amount captures what the investor earned on its investment. For example, if the investor had a 30 percent stake in the investee and the investee generated $200,000 in net income, the investor would attribute $60,000 of net income on its income statement to the investee.
Equity Method Process – Equity
In addition, the investor documents the value of its equity stake in the investee on one line on the balance sheet under owner’s equity. When the investor makes the initial investment, it documents the equity investment at cost. The investor subsequently reflects changes in value at the end of each accounting period.
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