Corporations often invest in other companies or government securities for various strategic and financial reasons.
Understanding how these investments are recorded and analyzed is crucial for accurate financial reporting.
This chapter covers:
- Why corporations invest
- How debt and equity investments are accounted for
- Cost and equity methods
- Income recognition from investments
- Consolidation of financial statements when control exists
Why Corporations Invest
Companies invest for three main reasons:
- Excess Cash – Instead of holding idle funds, firms invest to earn returns.
- Investment Income – To generate interest, dividends, or capital gains.
- Strategic Influence – To gain significant or controlling interest in another firm (e.g., partnerships, mergers).
Investments can be broadly classified into debt investments and stock (equity) investments.
Accounting for Debt Investments
Debt investments include bonds issued by corporations or governments.
The accounting process involves three stages:
1. Acquisition
When a company purchases bonds, it records them at cost — which includes the purchase price and any brokerage fees.
Example:
Corporation K acquires 8%, 10-year, $1,000 bonds of Corporation H at a cost of $50,000.
Journal Entry:
2. Interest Revenue
Each year, the company records interest income based on the bond’s stated rate.
Example:
Annual interest = 8% × $50,000 = $4,000
Journal Entry:
Sale of Bonds
If the company sells bonds before maturity, it records a gain or loss depending on the sale proceeds versus the book value.
Example:
Corporation K sells the bonds for $53,000.
Journal Entry:
Gains appear under “Other Revenues and Gains”, and losses under “Other Expenses and Losses” in the income statement.
Accounting for Stock Investments
When a company purchases stock in another corporation, the accounting treatment depends on the percentage of ownership — because that determines influence or control over the investee.
Holdings of Less than 20% (No Significant Influence) – Cost Method
The cost method is used when the investor has minor influence over the investee’s operations.
Investments are recorded at cost, and income is recognized only when cash dividends are received.
a) Acquisition
Example:
Corporation F buys 1,000 shares (10% ownership) of Corporation M at $40 per share.
Journal Entry:
b) Dividend Income
Example:
Corporation F receives a $2 per share dividend.
Journal Entry:
c) Sale of Stock
If the investment is sold, any gain or loss is recorded based on the sale price.
Example:
Corporation F sells the stock for $39,500.
Journal Entry:
Holdings Between 20% and 50% (Significant Influence) – Equity Method
The equity method applies when the investor can exert significant influence (e.g., through board representation).
- The investor records its share of the investee’s profits or losses.
- Dividends received reduce the carrying amount of the investment.
a) Acquisition
Example:
Corporation C acquires 30% of the common stock of Corporation L for $120,000.
Journal Entry:
b) Dividend Receipt
Dividends reduce the investment account.
Example:
Corporation L declares a $40,000 cash dividend.
Investor’s share = 30% × $40,000 = $12,000.
Journal Entry:
c) Income Recognition
The investor increases (debits) its investment for its share of the investee’s net income.
Example:
Corporation L reports $100,000 net income.
Investor’s share = 30% × $100,000 = $30,000.
Journal Entry:
This entry increases both the investment value and recognized income.
Holdings of More than 50% (Controlling Interest) – Consolidated Financial Statements
When one company owns more than 50% of another’s voting stock, it becomes a parent company, and the other is a subsidiary.
The parent must prepare consolidated financial statements that:
- Combine assets, liabilities, and equity of both firms.
- Report total revenues and expenses as if the group were a single entity.
Consolidation eliminates inter-company transactions to prevent duplication.
Comparison of Investment Accounting Methods
| Ownership Level | Influence | Method Used | Key Treatment |
|---|---|---|---|
| Less than 20% | No significant influence | Cost Method | Record dividends as income |
| 20–50% | Significant influence | Equity Method | Record share of income/losses; reduce for dividends |
| More than 50% | Control | Consolidation | Combine financial statements |
Real-World Context
- Debt Investments: Common among corporations seeking stable returns (e.g., bonds issued by governments or blue-chip companies).
- Stock Investments: Strategic when firms want influence, collaboration, or control (e.g., parent-subsidiary relationships like Alphabet and YouTube).
These investments also diversify income streams, manage excess liquidity, and enhance long-term competitiveness.
Summary
1. Corporations invest excess funds to generate returns or gain influence.2. Debt investments are recorded at cost, and interest is recognized as income.
3. Stock investments are classified based on ownership percentage:
- Cost method (<20%)
- Equity method (20–50%)
- Consolidation (>50%)
6. Understanding these accounting methods ensures accurate reporting of financial relationships between firms.
FAQs About Reporting and Analyzing Investments
1. Why do corporations invest in other companies?
To earn income, manage surplus cash, or gain strategic control over operations.
2. What’s the difference between debt and equity investments?
Debt investments (like bonds) generate interest, while equity investments (stocks) generate dividends and ownership influence.
3. When is the cost method used?
When ownership is less than 20% and the investor has no significant influence.
4. What is the equity method?
Used for ownership between 20–50%, recording proportional income and reducing investment for dividends.
5. How are consolidated statements different?
They combine financial data from the parent and subsidiary as one company.
6. What happens when a company sells its investment?
The difference between sale proceeds and cost is recorded as a gain or loss.
7. Why are dividends not considered income under the equity method?
Because they represent a return of investment, not new earnings.
8. What is significant influence?
The ability to affect policy or operations of another firm, typically with 20–50% ownership.
