Equity method - Education

How to read from financial statements when a company has investments in other companies?

When reading an annual report of a company with intercorporate investments, this is investments of a company in other companies, it is common to disregard whether the classification of this financial asset in the financial statements reported is the most adequate or if it is the same used by their peers. The impact of this, at first sight, an irrelevant account, can be tremendous on the firm´s top and bottom line, balance sheet, and as a consequence on their ratios. The accounting treatment of this intercorporate investment can significantly distort the financial statements of a company. 

Throughout this article, we will explain what are the different methods of accounting for a company’s investment in another company (focusing on equity investment) and will illustrate with examples (Coca-Cola) why we should pay attention to this topic. 

Intercorporate investments are usually classified into three categories, mainly depending on the percentage of ownership or voting control that the investor has from the investee (this is a simplifying assumption because more factors affect this decision):

  1. Investments in financial assets (ownership <20%)
  2. Investment in associates (ownership between 20% and 50%)
  3. Business combinations (>50% ownership)

1. Investments in financial assets

With an ownership interest of less than 20%, this investment is considered not significantly influential. The recording of this investment depends on whether it is a debt or equity investment and when it is intended to be held. A deepening of this classification could be a topic for another day. Today, we will exemplify all the theory, we will use Coca-Cola’s 2022 financial statements.

Depending on the classification of financial assets, the impact on the income statement would be different. But for equity securities, it is mandatory to record our investments in the Balance Sheet at fair value. Coca-Cola does not do this because they consider they have a significant influence on the investees. Although for some of the companies in the table below, they have less than 20% of ownership.

Fair and carrying value of invested companies (all the data in this article is in millions except for percentages):

Investment in financial assets

With a net income of $9,542 (we will see this in more detail later), if we accounted for the investments as financial assets, there would be an increase of $11,341 in assets in the balance sheet. Then, we would have to adjust all the factors affected by non-current assets, for example, ROA (return on assets) would go down from 10.3% to 9.2%. This is just an example but the consequences of this would also be translated into a lower asset turnover or a lower debt-to-asset- ratio. But this is a minimum effect compared to what will see in the profitability ratios in the next section.

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