Companies buy and sell stock in other companies for both short-term profit and long-term strategic reasons. Corporate accounting rules categorize these investments as either passive, influencing or controlling. In general, an influencing stake is one in which your corporation owns between 20 percent and 50 percent of the other company's outstanding stock. If your corporation owns less stock, the investment is passive. If it owns more than 50 percent of the stock, the investment is a controlling stake. When you buy an influencing stake in another company, you report these investments in your financial statements using the equity method of accounting.
Accounting for Initial Purchase
1. Buy an influencing stake in the target company. For example, assume you bought 100,000 of a company's 350,000 available shares for $10 apiece, or a total of $1 million.
2. Reduce the cash account in the current assets section of your balance sheet by the purchase price of the stock you bought. Continuing with the example from the previous step, you'd reduce it by $1 million.
3. List the investment under long-term assets on the balance sheet at the purchase price. Note that your total assets have not changed; you've just shifted $1 million from cash to long-term assets.
Determining Size of Stake
1. Look up the precise number of shares you bought -- not the percentage, but the actual number. This number should appear in your transaction records from the purchase, or the company itself should be able to tell you.
2. Find the number of shares the target company has "outstanding" -- that is, the number issued to the public and available to be bought and sold. This number will appear in its most recent annual report.
3. Divide the number of shares you own by the total number the company has outstanding. The result is your exact percentage of ownership, which will matter later when adjusting the value of the investment. For example, if you own 100,000 shares, and the company has 350,000 shares outstanding, your stake is 0.2857, or 28.57 percent.
1. Adjust the investment for dividends received. When the company pays you a dividend, add the total amount you receive to the cash account on your balance sheet. Then reduce the value of the investment by the amount of the dividend you received. Total assets have not changed, they have only shifted.
2. Adjust the value of the investment for profit or loss. When the company reports an annual profit, increase or decrease the value of the investment on your balance sheet by the percentage of the profit or loss. If you own 28.57 percent of the stock, and the company reports a $2 million profit, then you'd increase the value of the investment by $571,400. If it lost $1 million, you'd decrease the value by $285,700.
3. Report your share of the target company's profit or loss on your income statement as an investment gain or loss.
4. Adjust the retained earnings account in the stockholders' equity section of the balance sheet by the amount of the profit or loss you reported on the income statement. If you had a $571,400 gain, for example, retained earnings would rise by $571,400. If you had a $285,700 loss, retained earnings would decline by $285,700. Since assets and equity are on opposite sides of the balance sheet, the sheet is now balanced.
- Ownership of less than 20 percent of a company's stock might still qualify as an influencing stake if it gives the investing company significant influence over the direction of the company, such as a seat on the board of directors. It's up to the company's accountants to use their best judgment.
- Do not report dividends received from the company as revenue on your income statement. Dividends are a distribution of capital, meaning they reduce the value of the investment. On the balance sheet, value simply transfers from the investment to the cash account. Your total assets haven't changed, so there is no income to report.
Items you will need
- Transaction record of stock purchase
- Annual report of target company
- "Financial Accounting for MBAs," Fourth Edition; Peter Easton, et al; 2010
- "Encyclopedia of Banking & Finance," reprinted by Eagle Traders; Equity Method of Accounting; Charles J. Woelfel
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