Stock Investments

Summary :

This chapter explains how to report stock investments and distinguishes the cost method from the equity method of accounting for them. It covers journal entries for short-term stock investments and for long-term investments of 20 to 50 percent, parent and subsidiary corporations, and preparing consolidated financial statements.

Cost method versus equity method

A short-term or a long-term investment of less than 20 percent in another company's stock, where the investor cannot exert significant influence, is generally accounted for under the cost method, recording dividends received as income. Once an investment reaches 20 to 50 percent, significant influence is presumed and the equity method applies instead, under which the investor recognizes its proportionate share of the investee's income as it is earned, not merely when a dividend is declared, and adjusts the investment account accordingly.

Parent and subsidiary corporations

When one corporation, the parent, acquires a controlling interest, typically more than 50 percent, in another corporation, the subsidiary, the two remain separate legal entities but are combined for financial reporting purposes as a single economic unit. This combination is necessary because the parent's own financial statements alone would not reflect the full scope of resources and operations it actually controls through its subsidiaries.

Consolidated statements and analyzing returns

Consolidated financial statements are prepared using a consolidated statement work sheet that combines the parent's and subsidiary's individual statements and eliminates transactions between them, such as intercompany receivables and payables, so the group is reported as though it were one company; they carry the limitation of obscuring the results of any single subsidiary. Dividend yield, dividends per share divided by market price, and the payout ratio, dividends divided by earnings, help analysts assess a stock's return to shareholders relative to its price and profits.