So I hold 40% significant control stake in a small cap company. The stock is only a few dollars worth
Suddenly the company (due to change in market or their performance or whatever) decides to pay a large dividend.
That large dividend considerably shrinks my reporting of the investment account (as it’s treated as return under equity method).
This continues for the next 2-3 years…Wouldn’t we end up with a situation where we have received more dividends on a small cap stock than the investment account says it’s worth? Because on BS, the investment account was reported at cost.
So, how do we account for income from a 40% stake in a small cap company which has paid back my (original) cost of investment in divs (i.e. the investment account is almost shrunk to zero now)?
Will this dividend be higher that the reported income of the small company? No matter how big is the investment in your BS under equity method you will increase it with % of (NI - dividends). I can’t think of an example where dividends are higher than NI for several years. Ok, let’s say the small company is taking new debt to pay dividends and dividends are enough higher that NI (quite unlikely scenario). At some point you will end with 0 investment in associate. If this happens I think you’ll start to recognize income in IS = % dividends. Usually when investment in associate decline to 0 the equity method is discontinued (i.e. you don’t start to have negative investment). If subsequently situation change (your investment becomes positive again) the equity method is used again.
I can’t think of an example where dividends are higher than NI for several years.
yes you’re right , this is the key, I overlooked it.
company is taking new debt to pay dividends and dividends are enough higher that NI
This I think is quite frankly impossible and not just unlikely. Why would any bank lend to a company that’s taking on debt to pass it on to shareholders and not in operational activities. i can’t see how a banker will be able to even value that transaction.
You have dividend safety ratios that have to be respected (such as NI / (Div + Repurchases) or FCFE / (Div + Repurchases)). I don’t think a company can in the mid-term distribute more dividends than their NI.
^Yeh, I know, I just wanted to point out the fact that equity method can be discontinued and then after some time restored again. This works with impairments.