Looked at a company earlier today which sparked what I thought would be a good learning point to those of you learning your way around financial statements:

Assuming Company A and Company B are both publicly traded, accounting rules say the following:

If Company A owns 20% or less of the shares of Company B, Company A will indicate the value of its stake on its balance sheet, not the income statement. That value will be “the lower of cost or market“, meaning it is the more conservative of either (1) the price Company A originally paid for its shares in Company B, or (2) the market price of B shares on the balance sheet date.

If Company A owns between 21% and 49% of Company B, Company A will include a proportionate share of Company B’s earnings in a single line item on its income statement. Keep in mind this is an accounting convention, not cash.

If Company A owns 50% or more of Company B, then Company A adds all of Company B’s financial statements to its own, and then, near the bottom of the income statement, deducts the percentage of earnings it does not own. You’ll see a “Minority interest” deduction below the operating earnings section. And this may go without saying, but to be clear – if A owns 100% of B, there will simply be nothing to deduct.

You may see the above referred to as the cost/equity/consolidated methods of accounting when reading through a company’s filings. There are some fine-print rules around each related to control versus actual percentages owned, treatment of dividends, etc., but don’t sweat that stuff…or perhaps the better advice is simply to not consider investing in a company where those things might actually sway your decision.

The important part is to figure out what the above means in the real-world for a potential investment. For instance, a company might see a spike in revenues after acquiring majority interest in another company, but if it buys only 51%, those higher revenues won’t filter through to earnings (or cash flow) nearly as quickly as might otherwise be thought. That can be important to realize when evaluating earnings power.

Here’s Warren Buffett on the subject in the 1980 Berkshire Hathaway letter.