When a corporation purchases the stock of another corporation, the method of accounting for the stock investment depends on the corporation’s motivation for making the investment and the relative size of the investment. A corporation’s motivation for purchasing the stock of another company may be as: (1) a short-term investment of excess cash; (2) a long-term investment in a substantial percentage of another company’s stock to ensure a supply of a required raw material (for example, when large oil companies invest heavily in, or purchase outright, wildcat oil drilling companies); or (3) a long-term investment for expansion (when a company purchases another profitable company rather than starting a new business operation). On the balance sheet, the first type of investment is a current asset, and the last two types are long-term (noncurrent) investments. As explained in the chapter, the purchaser’s level of ownership of the investee company determines whether the investment is accounted for by the cost method or the equity method. The video explains the different classifications for accounting based on the company’s intent with the investment.
Cost and equity methods
Investors in common stock can use two methods to account for their investments the cost method or the equity method. Under both methods, they initially record the investment at cost (price paid at acquisition). Under the cost method, the investor company does not adjust the investment account balance subsequently for its share of the investee’s reported income, losses, and dividends. Instead, the investor company receives dividends and credits them to a Dividends Revenue account. Under the equity method, the investor company adjusts the investment account for its share of the investee’s reported income, losses, and dividends.
The Accounting Principles Board (the predecessor of the Financial Accounting Standards Board) has identified the circ*mstances under which each method must be used. This chapter illustrates each of those circ*mstances.
