How to Account for Control Equity Investments

An equity investment becomes a “control” investment when it provides an investor with the power to direct the most important activities of another company, the investee. This level of influence initiates specific accounting procedures under U.S. Generally Accepted Accounting Principles (GAAP). These rules are designed to portray the two separate companies, the parent and its subsidiary, as a single, unified economic entity in financial reports.

This consolidated approach provides a comprehensive view of the financial position and performance of the combined enterprise. It ensures that users of financial statements can see the full scope of the resources controlled by the parent and the total obligations for which it is responsible.

Establishing Control Over an Investee

Under U.S. GAAP, determining if an investor has a controlling financial interest requires a two-model approach guided by Accounting Standards Codification (ASC) 810. The first step is to evaluate the investee to determine which model applies: the voting interest entity (VOE) model or the variable interest entity (VIE) model.

The VOE model is the more common framework, where control is determined by ownership of voting rights. An investor that owns more than 50% of an investee’s outstanding voting shares is presumed to have control.

The VIE model applies to entities that lack sufficient equity to finance their activities or where the equity holders lack the typical characteristics of a controlling financial interest. In these cases, a simple majority ownership test is insufficient, and control is instead established by identifying the “primary beneficiary.” An investor is the primary beneficiary of a VIE if it has the power to direct the activities that most significantly impact the entity’s economic performance and the obligation to absorb losses or the right to receive benefits that could be significant.

Accounting for the Business Combination

Once control is established, the acquirer must account for the transaction as a business combination using the acquisition method governed by ASC 805. This is a one-time event that occurs on the acquisition date. The first step is to measure the consideration transferred, calculated as the fair value of all assets transferred, liabilities incurred, and equity interests issued by the acquirer.

Next, the acquirer must identify and measure all of the subsidiary’s identifiable assets acquired and liabilities assumed. These items are recorded at their fair values on the acquisition date, not their previous book values. This “step-up” in basis provides a new accounting foundation for the subsidiary’s assets and liabilities.

After valuing the consideration and the net assets, the acquirer calculates either goodwill or a bargain purchase gain. Goodwill arises when the consideration transferred is greater than the fair value of the identifiable net assets acquired and represents intangible assets that are not individually identifiable, such as a strong brand reputation. If the consideration is less than the fair value of the net assets, a bargain purchase gain is recognized in the acquirer’s income statement.

If the acquirer purchases less than 100% of the subsidiary, a noncontrolling interest (NCI) must be recognized. The NCI represents the portion of the subsidiary’s equity owned by other shareholders. The NCI is also measured at its fair value on the acquisition date, which reflects the price that would be paid for the shares not acquired by the parent company.

Preparing Consolidated Financial Statements

Following the acquisition, the parent company must prepare consolidated financial statements for each reporting period. The starting point is to sum the assets, liabilities, equity, income, and expenses of the parent and subsidiary on a line-by-line basis. For example, the cash balance on the consolidated balance sheet would be the sum of the parent’s cash and the subsidiary’s cash.

A required step in consolidation is creating elimination entries to remove the effects of transactions between the parent and the subsidiary. If the parent sold inventory to the subsidiary at a profit, that profit must be eliminated until the inventory is sold to an outside party. Similarly, intercompany loans must be eliminated to avoid overstating the consolidated entity’s assets and liabilities.

The consolidated financial statements must also properly account for the noncontrolling interest. The portion of the subsidiary’s net income belonging to the NCI shareholders is reported as an allocation of the consolidated net income. On the consolidated balance sheet, the NCI’s claim on the subsidiary’s net assets is presented as a separate component of stockholders’ equity.

Subsequent Changes in Ownership Interest

After the initial business combination, the parent company may change its ownership percentage in the subsidiary, and the accounting depends on whether the parent retains control. When a parent acquires additional shares in a subsidiary while still maintaining control, the transaction is accounted for as an equity transaction. No additional goodwill is recorded, and no gain or loss is recognized in the income statement.

If a parent sells a portion of its shares in a subsidiary but retains control, the transaction is also treated as an equity transaction. The parent recognizes the cash received and adjusts the carrying amounts of the noncontrolling interest and additional paid-in capital. No gain or loss is recognized in the income statement.

When a parent sells shares and loses control of the subsidiary, an event known as deconsolidation, the parent company must recognize a gain or loss on the sale of its investment. Any investment retained in the former subsidiary must be remeasured to its fair value on the date control is lost, with any resulting gain or loss also recognized in income. From that point forward, the investor will account for the retained investment using a different method, depending on the level of influence it retains.