Chapter 15
Active Investments In Corporations
Mark Higgins
Nature of Investments in Corporations
Passive Investment in Corporation – The
acquisition of another entity’s stock with the
intent earn a return on the investment (i.e.,
Chapter 10 – Marketable Securities).
Active Investment in Corporation – The
acquisition of another entity’s stock with the
intent to obtain influence or control the
operations of that company.
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Investments in Corporations
Terminology
The entity purchasing the stock is termed
the investor.
The company whose stock is purchased,
the investee.
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Investments in Corporations
A corporation becomes an active investor with the
intent to:
 Increase efficiency of its present operations (e.g.,
through the purchase of a company in the same line of
business).
 Gain access to raw materials, distribution services, or
markets (e.g., through a vertical integration).
 Exploit its expertise by improving operations of the
inefficiently run investee.
Transparency 15-4
Economic Rationale for
Investing in Another Corporations
The economic rationale for a corporation
becoming an active investor is that it
believes the combined value through
efficiencies, vertical integration etc. of the
two entities will exceed the sum value of the
separate entities.
Transparency 15-5
Economic Rationale Example
The fair market value of Rhody is 18 million.
Rhody decides to acquire the Minuteman
Company which has a fair market value of
$8 million. Rhody believes that through
operating efficiencies the combined entity is
worth $32 million. How much would Rhody
be willing to pay for the Minuteman
Company?
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Economic Rationale Example
Since the combined value of the two entities
is $6 million more than the sum value of the
entities, Rhody would be willing to pay $14
million ( a $6 million dollar premium) for
Minuteman.
$18 million + $ 8 million = $26 million
$32 million - $26 million = $ 6 million
Transparency 15-7
Accounting for Investments
in Corporations
GAAP requires a corporation that owns all or parts
of other corporations to report on the relevant
economic entity regardless of the legal ownership
structure. This is usually accomplished in one of
two ways:
Consolidation – If ownership interest exceeds 50%
the operations of the investee company are
included in the financial statements (e.g., income
statement, balance sheet etc.) of the entity.
Minority interest – An ownership interest of 50% or
less in the investee’s total stock outstanding.
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Accounting for Minority Interests
A minority interest is accounted for depending on
the size of the minority interest.
Small Minority Interest - are generally defined as
less than 20% ownership. These are accounted
for as available-for-sale securities as discussed in
Chapter 10.
Large Minority Interest – are between 20% and
50% employ the equity method to account for
holdings. This method summarizes the ownership
of the subsidiary as an asset line item and is not
adjusted to reflect changes in the market value of
the investment.
Transparency 15-9
Equity Method Example
On January 1, 2002, Rhody Corporation
acquires a 30% interest (45,000 shares) in
Huskie Corporation for $540,000. What is
the entry Rhody would make to record the
purchase of Huskie stock?
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Equity Method Example
The journal entry to record the investment
is:
Investment unconsolidated affiliate
Cash
540,000
540,000
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Equity Method Example
On December 31, 2002, the calendar year
Huskie Corporation reports net income of
$130,000. What impact does this have on
Rhody’s investment in Huskie?
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Equity Method Example
Rhody will increase its investment in Huskie
by its pro rata share $39,000 ($130,000 x
30%) of Huskies net income.
Investment in Unconsolidated Affiliate 39,000
Equity in net earnings unconsolidated affiliate
39,000
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Equity Method Example
On January 15, 2003, Huskie Corporation
declares a dividend of $20,000 payable on
January 31, 2003. What impact does this
have on Rhody’s investment in Huskie?
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Equity Method Example
Rhody will decrease its investment in Huskie
by its pro rata share $6,000 ($20,000 x
30%) of the dividend.
Declaration Date:
Dividend receivable
6,000
Investment in Unconsolidated Affiliate
6,000
Payment Date:
Cash
Dividend receivable
6,000
6,000
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Consolidated Financial Statements
When a corporation’s ownership interest
exceeds 50% the consolidated financial
statements (e.g., income statement, balance
sheet, cash flow of the statement) reflect the
combined active for the year of all the
entities minus any related party transactions
(e.g., sales between the entities).
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Consolidation Example
Rhody owns 100% of Minuteman
Corporation. During the year Rhody had
sales of $100 million and Minuteman had
sales of $40 million of which $6 million were
sales to Rhody. What will Rhody report as
total sales for the year?
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Consolidation Example
Since $6 million of Minuteman’s sales are to
Rhody, the consolidated entity must reduce
its combined sales of $140 ($100 + $40) by
the $6 million of related party sales. Thus
Rhody will report total sales of $134 million
($100 + $40 - $6).
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Treatment of Minority Interest on
Consolidated Financial Statements
Balance Sheet:
If a corporation holds more than a 50%
interest but less than a 100% interest in
another entity this minority interest
represents the minority owners’ claims
against the net assets of the subsidiary. This
account will usually appear after the
liabilities, but before the shareholders’ equity
section, in the consolidated balance sheet.
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Treatment of Minority Interest on
Consolidated Financial Statements
Income Statement:
The consolidated income statement lists all
revenue and expenses for the combined
entities. The pro rata amount of income not
belonging to the parent is captured in a line
item called “minority interest”.
Cash Flow Statement:
Minority interest is added back to the cash
flow statement because it reduced net
income but does not require the use of cash.
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