Rules for Consolidating Financial Statements vs. Equity Method
If your company's financial statements are prepared in accordance with generally accepted accounting principles, or GAAP, the rules provide alternative ways of reporting the ownership interests you have in other businesses. Whether these interests require consolidating financial statements or reporting under the equity method generally comes down to the level of control your company has over the businesses in which it invests. Consolidation of financial statements and equity method accounting, however, don't apply to the typical or casual stocks you acquire.
A consolidated financial statement, such as an income statement, combines the revenue, expenses and other items that companies typically report, of two or more businesses that are interrelated through a common equity investor. For example, if your company owns 100 percent of the outstanding stock in another corporation, your consolidated income statement will report the revenue of both businesses as a single figure after elimination of the transactions between the two companies. When consolidation isn't necessary, both companies report their own operating activities on separate financial statements without any reduction for inter-company transactions or equity investments held by one company in the other.
The general rule requires consolidation of financial statements when one company's ownership interest in a business provides it with a majority of the voting power -- meaning it controls more than 50 percent of the voting shares. But even if your company's equity or voting interest is 50 percent or less, consolidation may still be required. In the absence of owning a majority of the equity, extensive contractual agreements or other business arrangements between two enterprises may be sufficient to establish the requisite control that warrants consolidating financial statements.
If your business holds between 20 and 50 percent of the equity in a company, GAAP recognizes that you likely exert “significant influence” over the business and may require that you report the investment on your company's financial statements under the equity method rules. Some of the factors that indicate your ability to exert significant influence include the presence of substantial transactions between the two companies, sharing of employees and your ability to choose some or all of the people who serve on the board of directors.
Under the equity method of accounting, your company's investments in other businesses are reported on financial statements with more detail than is required for the stocks you hold that don't give you the ability to exert significant influence. Initially, your equity investment is reported on the balance sheet at cost. Each dividend payment you receive reduces the reported value of the investment, whereas it increases for your share of the net income reported by the company. To illustrate, suppose your company acquires a 30-percent ownership interest in a business for $100,000 cash. If you receive a $10,000 dividend payment during a year the business reports net income of $50,000, the amount reported on the balance sheet decreases to $90,000 for the dividend payment, but increases by $15,000 for your 30-percent share of its reported net income.