Reporting intercorporate interest—investments in common stock[edit]

20% ownership or less—investment[edit]

When a company purchases 20% or less of the outstanding common stock, the purchasing

company's influence over the acquired company is not significant. (APB 18 specifies conditions

where ownership is less than 20% but there is significant influence).

The purchasing company uses the cost method to account for this type of investment. Under

the cost method, the investment is recorded at cost at the time of purchase. The company does

not need any entries to adjust this account balance unless the investment is considered

impaired or there are liquidating dividends, both of which reduce the investment account.

Liquidating dividends : Liquidating dividends occur when there is an excess of dividends

declared over earnings of the acquired company since the date of acquisition. Regular dividends

are recorded as dividend income whenever they are declared.

Impairment loss : An impairment loss occurs when there is a decline in the value of the

investment other than temporary.

20% to 50% ownership—associate company[edit]

When the amount of stock purchased is between 20% and 50% of the common stock

outstanding, the purchasing company's influence over the acquired company is often

significant. The deciding factor, however, is significant influence. If other factors exist that

reduce the influence or if significant influence is gained at an ownership of less than 20%, the
equity method may be appropriate (FASB interpretation 35 (FIN 35) underlines the

circumstances where the investor is unable to exercise significant influence).

To account for this type of investment, the purchasing company uses the equity method. Under

the equity method, the purchaser records its investment at original cost. This balance increases

with income and decreases for dividends from the subsidiary that accrue to the purchaser.

Treatment of Purchase Differentials: At the time of purchase, purchase differentials arise from

the difference between the cost of the investment and the book value of the underlying assets.

Purchase differentials have two components:

 The difference between the fair market value of the underlying assets and their book

value.

 Goodwill: the difference between the cost of the investment and the fair market value

of the underlying assets.

Purchase differentials need to be amortized over their useful life; however, new accounting

guidance states that goodwill is not amortized or reduced until it is permanently impaired, or

the underlying asset is sold.

More than 50% ownership—subsidiary[edit]

When the amount of stock purchased is more than 50% of the outstanding common stock, the

purchasing company has control over the acquired company. Control in this context is defined

as ability to direct policies and management. In this type of relationship the controlling

company is the parent and the controlled company is the subsidiary. The parent company
needs to issue consolidated financial statements at the end of the year to reflect this

relationship.

Consolidated financial statements show the parent and the subsidiary as one single entity.

During the year, the parent company can use the equity or the cost method to account for its

investment in the subsidiary. Each company keeps separate books. However, at the end of the

year, a consolidation working paper is prepared to combine the separate balances and to

eliminate[5][6] the intercompany transactions, the subsidiary's stockholder equity and the

parent's investment account. The result is one set of financial statements that reflect the

financial results of the consolidated entity. There are three forms of combination: 1. horizontal

integration: is the combination of firms in the same business lines and markets. 2. vertical

integration: is the combination of firms with operations in different but successive stages of

production or distribution or both. 3. Conglomeration: is the combination of firms with

unrelated and diverse products or services functions, or both.