Companies account for their investments in other corporations based on the size and nature of their stake. When one company has a controlling interest in another, it generally must include all of that company's information in its own financial statements, as if they were a single company -- a process called consolidation. Nonconsolidated subsidiaries and affiliates are companies in which a corporation has a significant stake, but not a controlling stake that would require consolidated statements.
Levels of Control
The rules that govern corporate financial reporting define two levels of noncontrolling inter-company investments: passive and influential. In a passive investment, the investing company is just another shareholder. It doesn't hold a large enough stake in the "target company" to affect its corporate policies or strategies. An influential investment, on the other hand, is large enough to give the investing company a say in the way the target company does business, such as with a seat on the board of directors.
In the footnotes to its financial statements, a company may or may not divulge the nature of its relationship with its nonconsolidated subsidiaries and affiliate companies, but it usually describes how it treats them for accounting purposes. Typically, they'll be treated like influential investments. Nonconsolidated subsidiaries are often created by the investing corporation itself -- such as joint ventures set up to share costs with another company, or "special purpose entities," temporary companies set up to keep the revenue and expenses from particular projects separate from the investing company's own finances. Affiliates are usually independent companies in which the investing corporation has purchased an influential stake.
Accounting rules generally describe a passive investment as one that includes up to 20 percent of a company's outstanding stock, while an influential stake is one with more than 20 percent but less than 50 percent. These are just guidelines, though; it's possible to control a company with less than 50 percent of the stock, and an investor could gain significant influence even with less than 20 percent. It's usually up to the investing company's management to decide whether its stake is passive or influential, though the company's external auditors have to sign off on it. In their financial statements, companies account for their passive investments simply by reporting the market value of the shares they own. But they account for influential investments using the equity method of accounting.
In the equity method, a company reports its investment as an asset on its own balance sheet, with a value equal to the amount the company paid for its shares in the target company. When the target company reports a profit, the value of the investment rises by the investing company's share of the profit, as determined by its percentage of ownership. By the same token, if the target company loses money, the investing company decreases the value of the investment by its share of that loss. Unlike with passive investments, the market price of the stock doesn't factor in -- because an influential stake, by definition, might allow the company to manipulate that price.
- Financial Accounting for MBAs, Fourth Edition; Peter Easton, et al.
- Center for Financial Research and Analysis at Babson College: Transferring Risks Off of the Balance Sheet and the Income Statement
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.