What are the two methods available to account for interim acquisitions of a subsidiary's stock at the end of the first year?
Equity Method:
Under the equity method, the acquiring company recognizes its share of the subsidiary's earnings and losses in its own financial statements. This method is used when the acquiring company has significant influence over the subsidiary, typically defined as owning between 20% and 50% of the subsidiary's voting stock. For example, if Company A acquires 30% of the voting stock of Company B and Company B reports a net income of $100,000 at the end of the first year, Company A would recognize 30% of this net income, or $30,000, as its share of the subsidiary's earnings.
Cost Method:
Under the cost method, the acquiring company initially records the investment in the subsidiary at its cost and does not adjust the investment account for the subsidiary's earnings or losses. This method is used when the acquiring company does not have significant influence over the subsidiary, typically defined as owning less than 20% of the subsidiary's voting stock. For example, if Company X acquires 15% of the voting stock of Company Y and Company Y reports a net income of $50,000 at the end of the first year, Company X would not recognize any portion of the net income in its financial statements.
In summary, the equity method is used when there is significant influence over the subsidiary and involves recognizing a share of the subsidiary's earnings or losses, while the cost method is used when there is no significant influence and does not involve recognizing any portion of the subsidiary's earnings or losses.
Understanding the Equity Method and Cost Method
The Equity Method: When an acquiring company has significant influence over a subsidiary, the equity method is used to account for interim acquisitions. This method allows the acquiring company to reflect its share of the subsidiary's financial performance in its own financial statements. By recognizing a portion of the subsidiary's earnings or losses, the acquiring company can accurately represent its investment in the subsidiary.
The Cost Method: On the other hand, the cost method is employed when the acquiring company lacks significant influence over the subsidiary. In this case, the investment in the subsidiary is initially recorded at its cost and not adjusted for the subsidiary's earnings or losses. This method is more conservative and does not reflect the acquiring company's share of the subsidiary's financial results.
Key Differences: The key difference between the equity method and the cost method lies in the treatment of the subsidiary's earnings and losses. With the equity method, the acquiring company recognizes its share of the subsidiary's performance, indicating a higher level of influence. In contrast, the cost method does not involve recognizing any portion of the subsidiary's financial results, reflecting a lack of influence.
Decision Factors: When deciding between the equity method and the cost method, companies must consider the degree of control and influence they have over the subsidiary. If significant influence is present, the equity method is appropriate for a more accurate representation of the investment. Conversely, if no significant influence exists, the cost method may be more suitable for a conservative approach to accounting for interim acquisitions.
Conclusion: The choice between the equity method and the cost method depends on the level of influence the acquiring company has over the subsidiary. By understanding the characteristics and implications of each method, companies can effectively account for interim acquisitions and accurately reflect their investment in a subsidiary.