If your business reaches the point where you can buy or spin off another company, that's pretty impressive. Unfortunately, your taxes get a lot more complicated. On top of your own business taxes, you have to account for investment income in the subsidiary with the equity method.
TL;DR (Too Long; Didn't Read)
Equity income accounting is straightforward. If you own, say, 30% of another company, you claim 30% of its net income as an increase to your investment account. If it uses some of that income to issue dividends, your investment account shrinks.
Equity Method vs. Cost Method
You use the equity method if your investment in company B gives you significant influence over its operations and decisions. Otherwise, you use an alternative accounting approach called the cost method. If you buy 20% of company B's stock or more, it's assumed you have enough influence and should use equity income accounting. There are other tests:
- You have a representative on the board of directors.
- You participate in setting policy for company B.
- Management migrates between your company and company B.
- Company B is dependent on your proprietary tech.
- You own a larger chunk of stock than any of the other investors.
If you're debating the equity method vs. the cost method, some factors argue for the cost method even if you have a 20% or more investment.
- The investee opposes your influence — for example, company B sues you or complains about you to regulators.
- You've signed an agreement to give up some of your shareholder rights.
- The majority shareholder isn't you and runs the company without caring what you think.
- You don't have any board representation.
- You can't gather sufficient information to use equity income accounting.
Equity Income Accounting
Equity income accounting is fairly simple and is based on your ownership percentage. For example, suppose you spend $1 million investing in company B, which gives you a 25 % ownership claim. The following year, company B makes $600,000 in net income and issues a $100,000 dividend.
As a one-quarter owner in company B, you get $25,000 of the dividend. Your investment has increased by $150,000, 25% of the net income. Now, you have to record it.
- For your original investment, you credit cash for $1 million and debit your investment account.
- You debit the investment account for $150,000 and credit investment revenue for the same amount.
- Your dividend comes out of your share of the net income. You credit your investment account for $25,000 and debit cash for the same amount.
- You report your equity income on the income statement. Increases in the investment account show up in the assets section of your balance sheet.
Cost Method of Accounting
The cost method is much simpler. Once you credit your investment account for $1 million, nothing changes unless you buy or sell more of the company or the market value of your investment drops significantly. Otherwise:
- You treat dividends as dividend income. They have no effect on your investment account.
- If company B retains some of the earnings instead of issuing them as dividends, they have zero effect on your financing. You don't have to report or record them.
The Consolidation Method
If you own 50% or more of company B or companies B, C and D, you'll probably need to use the consolidation method. Along with tracking your investment account and dividends, you'll have a lot more work. For example:
- If your subsidiary makes you an intercompany loan, you need to record it.
- If your company allocates some of its overhead to subsidiaries, you need to record that too.
- If your company handles accounts payable for the subsidiaries, every account and payment has to be charged to the right company. The same is true if you use a consolidated payroll system.
- If company C sells to you or company D buys from E, you have to avoid double counting the transactions in your consolidated financial statements.
- If an overseas subsidiary uses foreign currency figures in its financial statements, the consolidated statements will have to convert them to dollars.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com