Businesses often own shares in other businesses. A company might hold a small parcel of shares in a listed supplier, a 30% stake in a joint venture with a partner, or the whole of a subsidiary it set up or bought. Families and founders frequently build groups of companies and trusts that own pieces of each other.
It would be convenient if all these holdings were reported the same way. They are not. Depending on how much influence the owner has over the business it has invested in, the same shareholding can appear in the financial statements as a single line measured at market value, as a share of the other company’s profits, or as a full combination of every asset, liability, revenue and expense of both companies.
This article explains the three main approaches, the ownership levels that usually trigger each, and why the choice matters for anyone reading financial statements or building a group of businesses. It draws on course material from an advanced financial reporting course that uses US accounting standards, and sets those ideas alongside the Australian Accounting Standards that apply here. It is the first article in GoCore’s series on investments, groups and acquisitions.
The key idea: influence
The accounting for an investment in another company’s shares depends on the influence the investor has over the company it has invested in, called the investee. Influence is about the investor’s ability to affect the investee’s decisions: its strategy, its operations, its dividends, its financing.
Because influence can be hard to judge directly, accounting standards use the percentage of voting shares held as a starting presumption. The presumption can be overturned by other evidence, but it provides a practical guide.
| Voting interest | Presumed influence | Usual accounting |
|---|---|---|
| Less than 20% | Little or none | Fair value |
| 20% to 50% | Significant influence, but not control | Equity method |
| More than 50% | Control | Consolidation |
These thresholds are presumptions, not rules. A 15% holder with seats on the board and a say in policy may have significant influence. A 25% holder whose votes are routinely ignored by a majority owner may not. And as the article What control means explains, control can exist with less than half the votes, or be absent with more.
Little or no influence: fair value
When an investor has little or no influence, the investment is treated much like any other financial asset. The investor cannot shape the investee’s results, so it simply reports what the shares are worth.
Under Australian standards (AASB 9 Financial Instruments, equivalent to the international standard IFRS 9), equity investments of this kind are generally measured at fair value, with changes in value recognised in profit or loss. Dividends received are recognised as income.
There is one important choice. For an equity investment that is not held for trading, an investor can make an irrevocable election, when the investment is first recognised, to present changes in fair value in other comprehensive income instead of profit. This keeps market swings out of reported profit, but the gains and losses are never transferred into profit later, even when the shares are sold.
Under US standards (ASC 321), the approach is similar: fair value through net income, with dividends as income. Where fair value is not readily determinable, such as shares in a private company, US standards allow a measurement alternative: cost, less any impairment, adjusted for observable prices in orderly transactions for identical or similar shares of the same company.
The details are covered in Small shareholdings: fair value accounting.
Significant influence: the equity method
When an investor has significant influence, the power to participate in the investee’s financial and operating policy decisions without controlling them, the investee is usually called an associate in Australia, and the investor normally uses the equity method.
Under the equity method:
- the investment starts at cost
- each year, the investor adds its share of the associate’s profit (or subtracts its share of losses), recognising the same amount in its own income statement
- dividends received reduce the carrying amount of the investment rather than being recorded as income
- the investor also recognises its share of the associate’s other comprehensive income
The result is that the investment’s carrying amount tracks the investor’s share of the associate’s net assets, and the investor’s profit includes its share of the associate’s profit, whether or not that profit is paid out as dividends.
Under Australian standards (AASB 128 Investments in Associates and Joint Ventures), the equity method is generally required for associates and joint ventures. Venture capital organisations, mutual funds, unit trusts and similar entities may instead measure such investments at fair value through profit or loss. Under US standards, investors with significant influence may choose either the equity method or a fair value option.
The mechanics, with a worked example, are covered in The equity method explained.
Evidence of significant influence
Beyond the percentage held, standards point to evidence such as:
- representation on the investee’s board
- participation in policy-making, including decisions about dividends
- material transactions between the investor and the investee
- exchange of managerial personnel
- provision of essential technical information
Control: consolidation
When an investor controls an investee, it is called the parent and the investee its subsidiary. The parent prepares consolidated financial statements, which present the parent and all its subsidiaries as a single economic entity.
In consolidated statements, the investment in the subsidiary disappears. In its place, every asset, liability, revenue and expense of the subsidiary is added line by line to the parent’s, with transactions between group members removed. If the parent owns less than 100%, the share belonging to other owners is shown separately as a non-controlling interest.
The acquisition that first gives control is accounted for as a business combination (AASB 3 in Australia, ASC 805 in the US), if what was acquired is a business. The ongoing preparation of group accounts follows consolidation standards (AASB 10 in Australia, ASC 810 in the US).
These topics are covered in Consolidated financial statements explained and Buying a business or buying assets?.
Why the method matters
The three methods can produce very different pictures of the same investment.
An illustration
This is an illustration with round numbers. An investor buys shares in another company for $300,000. During the year, the investee earns a profit of $200,000 and pays dividends of $50,000. The investor’s shares rise in market value to $360,000.
Suppose the investor’s stake is either 10% (little influence) or 30% (significant influence). To keep the comparison clear, assume the $300,000 bought whichever stake applies.
| 10% stake at fair value | 30% stake, equity method | |
|---|---|---|
| Income recognised | Dividends $5,000 plus fair value gain $60,000 | Share of profit $60,000 |
| Dividends received | $5,000, recorded as income | $15,000, reducing the investment |
| Investment at year end | $360,000 | $345,000 |
Under fair value, the investor’s profit depends heavily on market movements. Under the equity method, it depends on the investee’s earnings, regardless of what happens to the share price. Under consolidation, which would apply above 50%, the investor would report the investee’s entire revenue, expenses, assets and liabilities, a far larger footprint in the financial statements.
What this means for readers of financial statements
- Profit can include results the company cannot access. Equity-accounted profit is a share of another company’s earnings, which may never be paid out.
- Market swings can drive profit. Fair value accounting brings share price movements into the income statement, unless the other comprehensive income election is used.
- Consolidation changes scale. A group’s revenue and debt include those of subsidiaries that may have their own lenders and minority shareholders.
- Thresholds can shape behaviour. Holdings just below 20% or 50% sometimes reflect a deliberate choice about how an investment will be reported.
When holdings change over time
Investments rarely stay fixed. An investor may build up a stake gradually, sell part of it, or gain or lose rights that change its influence. When a holding crosses from one category to another, the accounting changes too, sometimes with significant effects on profit.
Gaining significant influence. An investor that increases a small holding until it has significant influence starts applying the equity method from that point.
Gaining control. If an investor that already holds an interest in a company obtains control, for example by increasing a 40% stake to 60%, Australian and US standards treat the earlier interest as if it had been sold and repurchased at fair value on the date control is obtained. Any difference between its carrying amount and fair value is recognised as a gain or loss in profit. The business combination is then accounted for as a whole.
Losing control or influence. When a parent loses control of a subsidiary, or an investor loses significant influence over an associate, any interest it keeps is generally remeasured to fair value, again with a gain or loss in profit.
These remeasurements can produce large accounting gains or losses with no cash changing hands. Readers of financial statements should look out for them, and business owners planning changes to their holdings should understand the reporting consequences in advance.
What this means for business owners
Many Australian business owners hold interests in other entities: a stake in a supplier, a joint venture with a partner, a property-holding company or trust, or several operating companies. Some practical points follow.
Know how each holding will be reported. The method affects reported profit, the balance sheet and sometimes borrowing covenants, which are often calculated from financial statements.
Influence matters, not just percentages. Board seats, management roles and contractual rights can change the accounting.
Group structures affect reporting obligations. Whether a company must prepare financial statements, and whether they must be consolidated, depends on its size and type under the Corporations Act and accounting standards. Large proprietary companies, public companies and listed entities generally have reporting obligations that small proprietary companies may not.
Accounting and tax are different. The accounting treatment of an investment does not determine its tax treatment. Australia’s income tax consolidation regime, for example, applies to wholly owned groups that choose to consolidate for tax, which is separate from consolidation for financial reporting.
Common mistakes
Treating the 20% and 50% thresholds as absolute. They are presumptions; the facts can override them.
Reading equity-accounted profit as cash. It is a share of profit, not a cash flow.
Ignoring the other comprehensive income election. It changes how fair value gains and losses affect profit.
Assuming US and Australian rules are the same. They are similar in outline but differ in important details.
Confusing accounting and tax consolidation. They follow different rules for different purposes.
Questions to ask
- What percentage of voting rights does each holding represent?
- What other rights, roles or relationships might create influence or control?
- Which accounting method applies to each, and why?
- How would reported profit change if a holding crossed a threshold?
- For your own business: which entities in your structure would need to be consolidated, and who prepares those accounts?
Bringing it together
The accounting for an investment in another company depends on influence. Little or no influence usually means fair value accounting; significant influence usually means the equity method; control means consolidation, with the initial acquisition accounted for as a business combination if a business was acquired. Ownership thresholds of 20% and 50% are useful presumptions, but the substance of the relationship decides.
The method chosen can change reported profit, assets and liabilities substantially. Understanding it helps investors read financial statements accurately and helps business owners structure and report their holdings sensibly.
The series continues with:
- The equity method explained
- Small shareholdings: fair value accounting
- What control means
- Consolidated financial statements explained
- Buying a business or buying assets? The business test
- Asset acquisition or business combination: why the accounting differs
- Goodwill in acquisitions
- Buying a business in Australia: what the accounting means for buyers
- US GAAP and Australian standards: key differences for investments and groups
Sources: course materials from an advanced financial reporting course (Module 1, based on US GAAP), together with Australian Accounting Standards. Figures are illustrations. This article is general information, not accounting, tax or financial advice; consult a qualified accountant about your circumstances.
