Intercorporate investments refer to investments made by a company into another company. There are several key factors that can affect the balance sheet treatment and reporting of these investments. Specifically, whether the investment allows significant influence, joint control, or outright control over the investee company will determine if and how the investment appears on the balance sheet.
For example, investments that allow control lead to full consolidation of the subsidiaries assets, liabilities, revenues and expenses. Meanwhile, significant influence investments are accounted for using the equity method, where only a single investment line appears on the balance sheet. On the other hand, investments without significant influence are simply held as financial assets at fair value. Understanding these key factors is crucial for properly accounting for intercorporate investments on the balance sheet.
Consolidation method leads to full inclusion of subsidiary balances
One key factor is the level of control the parent company exerts over the subsidiary. If there is outright control, such as owning over 50% of the voting shares, then the subsidiary must be fully consolidated under the acquisition method. This means that 100% of the subsidiary’s assets, liabilities, revenues and expenses appear line-by-line on the consolidated financial statements with the parent company. There are no special investment accounts under this full consolidation method.
Essentially, the parent and subsidiary’s financial statements are combined as if they are a single economic entity. This provides investors and creditors with a more complete picture of the overall operations and financial position when one company fully controls another.
Equity method leads to single investment account on balance sheet
Alternatively, when an investor can exert significant influence over the investee, but does not fully control it, then the equity method is used. This applies the company owns 20% to 50% of the voting shares. Under the equity method, the investment is initially recorded at cost. Then the carrying value is adjusted each period by the investor’s proportional share of the investee’s net income or loss. Any dividends received reduce the carrying amount. Ultimately, this results in a single investment account on the balance sheet reflecting the investor’s share of the underlying equity of the investee.
Fair value option simplifies accounting for certain holdings
For minority stake investments without significant influence, such as less than 20% ownership, companies can elect to use the fair value option. This values the investee shares at current fair market values rather than based on the investee’s operating performance. Fair value adjustments are then recognized either in net income or other comprehensive income, depending on the classification. This method greatly simplifies accounting and reporting compared to the equity method, as no proportional share calculations are necessary. As such, corporate investors often prefer the fair value option for smaller financial investments where significant influence does not exist.
Consolidate SPEs and VIEs expected to hold majority risks/benefits
Special rules apply for consolidation involving special purpose entities (SPEs) and variable interest entities (VIEs). These structures are created to fulfill specific objectives, often for financing or risk management. Rather than relying on percentage ownership, account standards look at which investor is expected to receive the majority of expected losses/benefits. This investor must consolidate the SPE/VIE regardless of actual equity owned. So SPEs/VIEs end up fully on the balance sheet of the entity holding the predominant economic risks and rewards.
In summary, the key factors affecting the balance sheet treatment of intercorporate investments are: 1) level of control over subsidiary leading to either full consolidation or equity method, and 2) special rules requiring SPE/VIE consolidation for majority risk/benefit holders.