Firms buy stock in other companies as either an investment or to fulfill a strategic positioning. For example, a computer manufacturing firm may buy ownership in a hard drive manufacturer for strategic positioning. To account for the purchase of stock in another company, the firm must use either the cost method, the equity method or consolidation. The method used depends on the percent of stock ownership and the amount of control a firm has in the subsidiary.
Internal reporting of financial statements does not need to be consolidated. If a firm owns more than 50 percent of another company, the firm must consolidate externally, but internally may choose between the equity method or the cost method.
When choosing between the equity method and consolidation look at the control a company can influence over another company. Generally speaking if a firm owns between 20 percent and 50 percent of another company then the firm should use the equity method to account for the subsidiary. If a firm owns more than 50 percent of a company, the firm should consolidate the financial statements.
Stock ownership is a general rule of thumb. An accountant must also consider other influences the firm currently has. For example, a firm may own 40 percent of stock, but not exert influence. In situations like an impending bankruptcy, the firm only intends to keep the stock for a short time, or only one person owns the other 60 percent of the company are situations where the firm meets the general rule of thumb of stock ownership, but cannot exert control.
Consolidating the financial statements involves combining the firms' income statements and balance sheets together to form one statement. The equity method does not combine the accounts in the statement, but it accounts for the investment as an asset and accounts for income received from the subsidiary.
