A parent company may select either the equity method or the cost method of accounting for the operating results of consolidated subsidiaries.
In the equity method of accounting for a subsidiary's operating results, the parent company enters in its accounting records its share of the subsidiary's net income or net loss, as well as its share of dividends declared by the subsidiary.
Proponents of the equity method of accounting claim that the method is consistent with the accrual basis of accounting, and that it stresses the economic substance of the parent company—subsidiary relationship.
In the cost method of accounting for a subsidiary's operating results, the parent company accounts for the subsidiary's operations only to the extent that dividends are declared to the parent by the subsidiary.
Supporters of the cost method of accounting claim that the method appropriately recognizes the legal form of the parent company—subsidiary relationship.
A parent company that uses the equity method of accounting for a subsidiary's operations prepares the following journal entries (explanations omitted) to account for its share of a subsidiary's dividend declarations and net income, respectively (disregarding income tax effects).
Intercompany Dividends Receivable
XXX
Investment in Subsidiary Common Stock
XXX
Investment in Subsidiary Common Stock
XXX
Intercompany Investment Income
XXX
In addition to the equity method journal entries for a subsidiary described in paragraph 6, a parent company that accounts for a subsidiary by the equity method must prepare a journal entry to record its share of the depreciation and amortization of differences between current fair values and carrying amounts of the subsidiary's net assets on the date of the business combination.
To illustrate the accounting described in paragraph 7, assume that on March 1, 2005, Prague Corporation paid $1,600,000 for 80% of the outstanding common stock of Slovak Company. On that date, the current fair values of Slovak's identifiable net assets totaled $1,900,000—the same as their carrying amounts. Thus, goodwill of $80,000 was recognized in the Prague-Slovak business combination [$1,600,000 — ($1,900,000 x 0.80) = $80,000]. In addition to journal entries recording its share of Slovak's net income or loss, Prague would prepare the following journal entry on February 28, 2006, the end of the fiscal year (assuming that goodwill was partially impaired on that date).
Loss on Impairment of Goodwill
2,000
Investment in Slovak Company Common Stock
2,000
To recognize 2½% impairment loss on goodwill attributable to Slovak Company for year ended February 28, 2006, as follows (disregarding income taxes):
Goodwill, Mar. 1, 2005
$80,000
Impairment loss for year ended Feb. 28, 2006: ($80,000 x 0.025)
$ 2,000
If a parent company accounts for a subsidiary's operations by the equity method of accounting, the parent company's closing entries include a credit to the Retained Earnings of Subsidiary ledger account for the parent's share of the subsidiary's adjusted net income not distributed as dividends during the accounting period. For example, if the adjusted net income of a 95%-owned subsidiary for a fiscal year was $100,000 and the subsidiary declared dividends in the amount of $40,000, the parent company's closing entries at the end of the fiscal year would include a credit of $57,000 to the Retained Earnings of Subsidiary ledger account [($100,000 — $40,000) x 0.95 = $57,000].
In the cost method of accounting for a subsidiary's operating results, the parent company prepares no journal entries to record its share of the subsidiary's net income or losses. Dividends declared by a subsidiary from net income subsequent to the business combination are recorded by the parent company under the cost method of accounting with a debit to Intercompany Dividends Receivable and a credit to Intercompany Dividend Revenue in the amount of the parent company's share of the subsidiary's dividends.
Use of the cost method of accounting for a subsidiary's operating results requires more working paper eliminations than the equity method. However, the consolidated amounts are identical, regardless of whether the equity method or the cost method of accounting is used to account for a subsidiary's operating results.
The equity method of accounting for a subsidiary's operations is preferable to the cost method for a number of reasons, chief of which is the equity method's emphasis on economic substance, rather than legal form, of the parent company-subsidiary relationship.
