Accounting for Cross Holdings
In
the category of investments and marketable securities, accountants consider
investments made by firms in the securities or assets of other firms, and other
marketable securities including treasury bills or bonds. The way in which these
assets are valued depends upon the way the investment is categorized and the
motive behind the investment. In general, an investment in the securities of
another firm can be categorized as a minority, passive investment; a minority, active investment; or a majority, active investment. The accounting rules vary depending upon the
categorization.
If
the securities or assets owned in another firm represent less than 20% of the
overall ownership of that firm, an investment is treated as a minority, passive
investment. These investments have an acquisition value, which represents what
the firm originally paid for the securities and often a market value. Accounting
principles require that these assets be sub-categorized into one of three
groups: investments that will be held to maturity, investments that are
available for sale and trading investments. The valuation principles vary for
each.
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For investments that will be held to maturity, the
valuation is at historical cost or book value, and interest or dividends from
this investment are shown in the income statement under net interest expenses
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For investments that are available for sale, the
valuation is at market value, but the unrealized gains or losses are shown as
part of the equity in the balance sheet and not in the income statement. Thus,
unrealized losses reduce the book value of the equity in the firm, and
unrealized gains increase the book value of equity.
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For trading investments, the valuation is at market
value and the unrealized gains and losses are shown in the income
statement.
Firms are allowed an element of
discretion in the way they classify investments and, subsequently, in the way
they value these assets. This classification ensures that firms such as
investment banks, whose assets are primarily securities held in other firms for
purposes of trading, revalue the bulk of these assets at market levels each
period. This is called marking-to-market
and provides one of the few instances in which market value trumps book value
in accounting statements.
If
the securities or assets owned in another firm represent between 20% and 50% of
the overall ownership of that firm, an investment is treated as a minority,
active investment. While these investments
have an initial acquisition value, a proportional share (based upon ownership
proportion) of the net income and losses made by the firm in which the
investment was made, is used to adjust the acquisition cost. In addition, the
dividends received from the investment reduce the acquisition cost. This
approach to valuing investments is called the equity approach.
The
market value of these investments is not considered until the investment is
liquidated, at which point the gain or loss from the sale, relative to the
adjusted acquisition cost is shown as part of the earnings under extraordinary
items in that period.
If
the securities or assets owned in another firm represent more than 50% of the
overall ownership of that firm, an investment is treated as a majority
active investment[1].
In this case, the investment is no longer shown as a financial investment but
is instead replaced by the assets and liabilities of the firm in which the
investment was made. This approach leads to a consolidation of the balance sheets of the two firms, where the
assets and liabilities of the two firms are merged and presented as one balance
sheet. The share of the firm that is owned by other investors is shown as a minority
interest on the liability side of the
balance sheet. A similar consolidation occurs in the financial statements of
the other firm as well. The statement of cash flows reflects the cumulated cash
inflows and outflows of the combined firm. This is in contrast to the equity
approach, used for minority active investments, in which only the dividends
received on the investment are shown as a cash inflow in the cash flow
statement.
Here again, the market value of this investment is not considered until the ownership stake is liquidated. At that point, the difference between the market price and the net value of the equity stake in the firm is treated as a gain or loss for the period.
[1] Firms have evaded the requirements of consolidation by keeping their share of ownership in other firms below 50%.