Book of Wise Investors

For fundamental investors, as opposed to technical investors, reading and interpreting financial statements are some of the standard things to do. But sometimes, when we look at the figures for accounting profits, it looks impressive. However, what is stated on a so called audited financial statement may not be as real as it seems. If you plan to manage own portfolio through direct stock ownerships, then understanding accounting rules is something that must be done.

There are a total of three ways in which a listed company can list its investment in another listed company, and this will affect the numbers you see as earnings and profits in the company you invest or intend to invest in.

How the company is classified depends on percentage of ownership in that company.

1. Less than 20% – An investment

Income to parent company is simply dividends, interest if it is a debt instrument like bond and capital gains as increase in value of investments.

2. Between 20% to 50% – an associated company

Equity accounting is used in this case. The income of the company own by parent company is treated as income to parent company according to the percentage of shares own. Take note that it is income, not dividends payments in the form of cash yet.

3. More than 50% – a subsidiary

Everything is lumped together under the parent’s company balance sheet. These include all revenues, expenses, assets and liabilities.

This is where caveat emptor came in,

In general, when a listed company holds many associated and subsidiaries, its share in the profits these associated and subsidiaries does sum to a significant amount in the parent group earnings.

The problem is whether parent company can live to see the accounting profits contributed by the many associated and subsidiaries held by it transformed into actual dividends in cash is another issue.

In particular, two types of scenarios warrants extra mention,

a. Parent company uses debt to acquire 20% to 50% shares in many companies, i.e. getting many associated companies so that can use equity accounting to boast earnings numbers. This is a bit different from using debt to expand rapidly like ABC learning in Australia.

b. The many associated companies are incorporated in places like China that is well known for poor corporate governance.

Perhaps you need to pay attention to the associated and subsidiaries’ companies’ cashflows and not impressive net profits numbers. Or even better don’t ever invest in this company who use associated companies to artificially inflate profits.

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