Anyone understand why the equity investment is carried on the balance sheet as cost plus share of income less dividends? I’m confused to why the dividends are subtracted and why the income from the subsidiary is even included in the carrying value.
I believe the dividends are considered a return of capital.
Ok think of it this way. Say your purchase a stake in the company for $100. So from your point of view that’s an asset which you carry on your balance sheet. Now your investment value is not static, it changes overtime. How does that happen? Well if the company in which you have the stake does well (Income goes up) then your investment increase in value by your share of ownership; same logic applies if the income goes down. This is like interest on a loan that you receive. How about Dividends? Well Dividends are like principal on a loan being paid down. Everytime the company pays you a dividend, they are essentially “reimboursing” your investment, that you “lent” them when you purchase a stake in the company. This is similar to an ownership of a stock (See Reading 29 in Corporate finance). Say you bought one share for $60. When the company does well (say unexpected increase in Earnings), then the value of the stock goes up say to $80 (this is a capital gain). When the company pays a Dividends say of $10. The value of the stocks falls to $70 ($80 - $10). So the total effect is Initial Invest. + share * ( NI - DIV) I hope this makes sense
Just adding to Intelo’s already detailed explanation. When you invest in a company, you get 2 types of gains. 1) Capital Gain: That would be any Retained Earnings, they did not pay out as dividend. That makes your reported asset investment increase by RE, which is (NI - Div) 2) Cash Gain: That would be any cash dividends they pay out to you. This will be reported in your Assets under ‘Cash’. So, if you dont minus dividends in step 1, you will be counting it twice. Once in Step 1 and then again in Step 2.
Thanks guys, as soon as I read that explanation it was like a sudden epiphany. It makes complete sense, I was just thinking about it entirely wrong.