Question

HOW DOES A COMPANY REALLY DECIDE WHICH INVESTMENT METHOD TO APPLY?

Pilgrim Products, Inc., buys a controlling interest in the common stock of Crestwood Corporation. Shortly after the acquisition, a meeting of Pilgrim's accounting department is convened to discuss the internal reporting procedures required by the ownership of this subsidiary. Each member of the staff has a definite opinion as to whether the equity method, initial value method, or partial equity method should be adopted. To resolve this issue, Pilgrim's chief financial officer outlines several of her concerns about the decision.

I already understand how each method works. I know the general advantages and disadvantages of all three. I realize, for example, that the equity method provides more detailed information whereas the initial value method is much easier to apply. What I need to know are the factors specific to our situation that should be considered in deciding which method to adopt. I must make a recommendation to the president on this matter, and he will want firm reasons for my favoring a particular approach. I don't want us to select a method and then find out in six months that the information is not adequate for our needs or that the cost of adapting our system to monitor Crestwood outweighs the benefits derived from the data.

What are the factors that Pilgrim's officials should evaluate when making this decision?

Answer 1

Decision regarding the selection of Investment Method will depend upon several internal as well as external factors affecting the business environment. Most appropriate investment Method will highly vary according to the nature of the business, scale of business operations and vision,mission & future goals of the organization. There are 3 investment methods to decide

• Equity Method
• Fair Value Method
• Consolidation

All the Investment Method are correct, however the way it interpret information and approach adopted will be different. Therefore the final results by using various investment method will vary due to certain assumptions considered while following approach and doing calculation.

As I stated earlier, both Internal as well as External factors are crucial to analyse while making the final selection of the appropriate and best-suitable investment method that will go hand- in hand with the company's internal policies, regulation and create & maximize value for their shareholders and all other stakeholders of the business

Major Factors that will determine whether to use Equity Method or Cost Method while making Investment decision during acquisition are mentioned below.

• Amount of Control- In general Equity method is used when the amount of control or influence in the company being acquired is large and significant. Whereas if the amount of influence or control is relatively small in the invested company then cost method is ideal and appropriate method of selection.
• General Rule adopted by company while making selection about the investment method i.e. If the amount of control or ownership stake is less than 20% then cost method is preferred. If the ownership stake in the acquired company is between 20% to 50% (amount of control or influence) then Equity Method is desirable and most appropriate while making investments decision. If one firm buys the controlling stake of the other firm i.e. if the ownership/controlling stake is more than 50% in the acquired company then consolidation method is used.
• Dividend Recordings - In the Equity method dividends reduce the investment account whereas dividends are recognized as income in the fair value method. All the investment methods have their own assumptions and approach for calculation purpose.

Example- If the company previously own 15% ownership stake of the another company, then Cost method is appropriate. However later if the company buys 25% additional ownership stake in the same company then it is advisable for the company to change from Cost method to Equity Method as now company owns 40% of ownership stake ( 15% +25% additional stake of investee)

In the above question Pilgrim Products, Inc buys a controlling stake in the common stock of Crestwood Corporation. Therefore as per general guidelines Pilgrim Products, Inc should use Consolidation Method since they are buying more than 50% ownership stakes of Crestwood Corporation. In the Consolidation method financial statements of both the companies (investor as well as investee) are consolidated and reported as combined entity.