Page 559 - Accounting Principles (A Business Perspective)

14. Stock investments

Business acquisitions are commonplace in every industry. The role of accounting professionals in business
valuation is essential to the success of the company and represents one of the fastest growing areas in accounting.
Often a large company attempts to take over a smaller company by acquiring a controlling interest (more than

50 per cent of the outstanding shares) in that target company. Some of these takeover attempts are friendly (not
resisted by the target company), and some are unfriendly (resisted by the target company). If the attempt is
successful, the two companies become one business entity for accounting purposes, and consolidated financial
statements are prepared. The company that takes over another company is the parent company; the company
acquired is the subsidiary company. This chapter discusses accounting for parent and subsidiary companies.
When a corporation purchases the stock of another corporation, the method of accounting for the stock
investment depends on the corporation's motivation for making the investment and the relative size of the

investment. A corporation's motivation for purchasing the stock of another company may be as: (1) a short-term
investment of excess cash; (2) a long-term investment in a substantial percentage of another company's stock to
ensure a supply of a required raw material (for example, when large oil companies invest heavily in, or purchase
outright, wildcat oil drilling companies); or (3) a long-term investment for expansion (when a company purchases
another profitable company rather than starting a new business operation). On the balance sheet, the first type of
investment is a current asset, and the last two types are long-term (noncurrent) investments. As explained in the
chapter, the purchaser's level of ownership of the investee company determines whether the investment is
accounted for by the cost method or the equity method.

Cost and equity methods
Investors in common stock can use two methods to account for their investments the cost method or the equity

method. Under both methods, they initially record the investment at cost (price paid at acquisition). Under the
cost method, the investor company does not adjust the investment account balance subsequently for its share of
the investee's reported income, losses, and dividends. Instead, the investor company receives dividends and credits
them to a Dividends Revenue account. Under the equity method, the investor company adjusts the investment
account for its share of the investee's reported income, losses, and dividends.
The Accounting Principles Board (the predecessor of the Financial Accounting Standards Board) has identified
the circumstances under which each method must be used. This chapter illustrates each of those circumstances.
The general rules for determining the appropriate method of accounting follow:
Types of Common
Stock Investment Method of accounting
required
By accounting principles
board
in most cases
All short-term Cost
investments
Long-term investments
of:
Less than 20%:
If no significant Cost
influence
If significant influence Equity
20% - 50% Equity
More than 50% Cost or equity

560