The level of investor influence a company holds in an investment transaction determines the method of accounting for said private investment. The accounting for the investment varies with the level of control the investor possesses.
What are the Varying Levels of Control?
An investor can hold majority ownership or minority interest in a company they own or have invested in. If they hold a minority interest, this control can be further divided into two levels – the investor either has minority active or minority passive control.
#1 Majority ownership
Majority ownership exists when an investor holds more than 50% of a company’s shares. This gives the investor effective control of the company. Investments in this company are then accounted for using the consolidation method. Note that having exactly 50% of a company’s shares does not necessarily mean effective control for an investor, as another investor holding the other 50% would result in a split.
#2 Minority – active
A minority active interest exists when the investor holds 20-50% of the company’s shares. This gives the investor the ability to influence management decisions, but not to control them entirely. Investments of this type are accounted for using the equity method.
#3 Minority – passive
Finally, a minority passive ownership interest exists when the investor holds less than 20% of the company’s shares. This gives them no significant influence over the company. Investments in this company are accounted for using the cost method or the market method and may be classified as public or marketable securities.
It is important to note that the classifications above are simply guidelines to classify the degree of influence an investor possesses over a company.
In reality, there may be circumstances where these guidelines don’t apply. For example, if an investor owns less than 20% of a company but holds significant influence in it, then they may use the equity method to account for their investments in said company.
In another example, if an investor owns a 51% share in a company, but does not exercise effective control over it, then they may not use the consolidation method to account for their investments.
See the following resources from CFI to learn more about equity investing and accounting.
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