There are various methods to account for corporate investments, and often management has some discretion in selecting a method. When one company (a parent company) controls more than 50% of the shares of another company (a subsidiary), the subsidiary’s accounts are consolidated into the parent’s. When the control is less than 50%, there are three basic methods for carrying the value of an investment: these are the cost, market, and equity methods. We show each method below. But first, keep in mind there are three sorts of investment returns:

1. The investment can appreciate (or depreciate) in market value: we call these holding gains or losses.
2. The investment can generate earnings that are not currently distributed to the parent (they are instead retained): we call this investment income.
3. The investment can distribute some of its income as cash dividends to the parent.

When an investment pays cash dividends, the rules are straightforward: they will be recognized on the parent company’s income statement. But the rules are not straightforward for (i) undistributed earnings and (ii) gains/losses in the investment’s holding value. In both cases, the parent may or may not recognize the earnings/gains/losses.

We have at least three goals when examining the investment accounts. First, we want to see if the accounting treatment has hidden some underlying economic gain or loss. For example, if a company uses the cost method on a superior investment that doesn’t pay dividends, the investment gains will eventually pay off in a future period. Our second goal is to ask whether investment gains/losses are recurring. Because they are usually not operating assets of the business, we may want to consider them separately from a valuation of the business. The third goal is to gain valuable clues about the company’s business strategy by looking at its investments. More often than not, such investments are not solely motivated by financial returns. They are often strategic investments made in current/future business partners. Interesting examples include investments essentially made to outsource research and development or to tap into different markets.

Taken From : Advanced Financial Statements Analysis

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