Key Takeaways
- Intercorporate investments occur when a company invests in another company.
- Ownership percentages determine the accounting method: minority passive, minority active, or controlling interest.
- The cost method is used for ownership stakes of less than 20%.
- The equity method applies to 20%-50% ownership stakes and adjusts for profits or losses.
- Consolidation combines financials for ownership stakes of 50% or more.
What Is Intercorporate Investment?
Intercorporate investment can occur when a company makes an investment in another company. These types of investments can be accounted for in a few different ways, depending on the investment.
Generally, the broadest and most comprehensive way to account for these types of investments is by the percentage of ownership stake.
Exploring the Types and Importance of Intercorporate Investments
Intercorporate investment occurs when a company makes an investment in another company. Broadly, there can be three categories for classifying an intercorporate investment, which can help to guide and dictate the accounting treatment used. The three categories generally include: minority passive (less than 20% ownership), minority active (20%-50% ownership), and controlling interest (over 50% ownership). These classifications are general divisions, but companies should also consult the Accounting Standards Codification (ASC), specifically ASC 805, which details the Generally Accepted Accounting Principles for business combinations. Companies may be able to deviate from the three major classifications depending on participation controls.
There can be a variety of ways a company can choose to make an intercorporate investment. It could be through the purchase of shares of a publicly traded company on a public exchange or a privately negotiated deal for a share of a company that is not publicly traded. The investment may also involve buying the debt of another company, publicly traded or otherwise. The controlling interest of a company will commonly come from a merger or acquisition.
Classifying Intercorporate Investments: Minority and Controlling Interests
Intercorporate investments can fall into three broad categories: minority passive, minority active, and controlling interests. Below are some additional details on each of the three classifications for intercorporate investments:
Minority Passive
Minority passive includes investments that lead to less than 20% ownership in a company. This can cover a broad range of investments, including debt, because ownership and voting rights are not typically offered with debt investments. When a minority passive interest is taken, the investment is basically treated the same as other securities owned by the company for investment purposes.
Minority Active
Minority active encompasses investments that lead to 20%-50% of ownership. In this segment, companies usually use the equity method. This is an important segment because many companies make a significant ownership investment in another company, but may not necessarily want to consolidate the business with consolidated financial statements, as is required with a controlling interest. Taking an ownership stake of 20%-50% offers many opportunities for things like joint ventures as well as off-balance sheet reporting.
Controlling Interest
Companies that have a 50% or more ownership stake in another company are generally required to use the consolidation method. The consolidation method requires companies to combine their financial reporting and report consolidated financial statements. At the top level, this requires a comprehensive balance sheet, income statement, and cash flow statement with integrated results.
Key Accounting Methods for Intercorporate Investments
The ownership stake of an intercorporate investment helps to provide general guidance for the methodology used in accounting for the investment on a company’s financials. Overall, there are three main methodologies that correspond with the three broad investment classifications. Keep in mind that debt investments usually don’t come with an ownership stake or voting rights.
Understanding the Cost Method in Investment Accounting
The cost method can be widely used because it encompasses a vast array of investments that are tied to an ownership stake of less than 20%. Intercorporate debt investments are typically accounted for using the cost method because debt does not often come with ownership rights or voting power.
Within the cost method, there can also be some further delineation of investments. Generally, these investments will be treated the same as other securities owned by the company for investment purposes. The securities may be designated as held to maturity (bonds), held for trading (bonds and stocks), available for sale (bonds and stocks), or strictly held on the balance sheet at the designated fair value.
The Equity Method Explained for Investors
In the equity method of accounting, the initial investment in the target company is recorded on the balance sheet. The value of the investment is adjusted based on the percentage of profit or loss for the owner. Dividends are not recorded as income. Rather, dividends increase cash and reduce the value of the investment for the investor.
Goodwill may also be associated with investments when the equity method is used. If the investor pays more than the carrying value of the investment, the target company may recognize goodwill for the difference.
How Consolidation Works in Accounting for Majority Stakes
Holding a 50% or more ownership stake in another company generally requires the consolidation method. With the consolidation method, companies must combine their financials into consolidated financial statements. The consolidation method is common after a merger or acquisition.