Part 1, Lesson 11
While minority interest is not a significant item for many companies, there are a number of companies that have significant minority interests or equity investments, so let’s run through the basics of what each of these items represent.
You will notice on many large company financial statements that the statements included the word “Consolidated” at the top of the financial statement. For example, in the Verizon income statement pasted below, the title reads, “Consolidated Statements of Income.”
The word, “Consolidated,” is used in the income statement because a large company like Verizon is not comprised of a single legal entity. While only Verizon knows the exact number, it is probably reasonable to assume that Verizon Communications Inc as a corporation owns hundreds of underlying entities. In constructing their legal structure, Verizon has likely established a “parent entity” that owns a variety of subsidiaries that have all been formed as separate legal entities.
There are numerous reasons for why this type of structure is used. One reason could be financing. Companies may often set up a separate legal entity for a specific line of business that could be easier to finance than another line of business. Another reason could be for reporting purposes. A company may want separate subsidiaries / entities for different lines of business in order to track them more efficiently. Another reason could be for legal purposes. Verizon may be required by state laws to operate a locally formed entity in that particular state, or it may be to separate liability from one entity to another.
But whatever the reasons are, a very high percentage of public companies operate using multiple subsidiaries under a common parent entity.
This creates an accounting issue regarding how to account for the various subsidiaries vs the parent company. Let’s use a simple example.
Parent A is the parent company. Subsidiary B is the subsidiary company, which is 100% owned by Parent A. When the accountants prepare the financial statements, Subsidiary B will have its own set of financial statements that incorporate all the income, expenses, etc of Subsidiary B. Also, Parent A will have its own set of financials that incorporate all the activity of Parent A.
But, the question then becomes – if Parent A owns 100% of Subsidiary B, then, shouldn’t the Parent A financials reflect its ownership of Subsidiary B? The answer is yes. If a parent company owns more than 50% of a subsidiary entity, then, the parent company must fully consolidate the subsidiary financials into the parent company financials.
Let’s consolidate a simple Parent A and Subsidiary B income statement:
Parent A Subsidiary B Consolidated Statement Revenue $100,000 $50,000 $150,000 COGS $50,000 $20,000 $70,000 Gross Profit $50,000 $30,000 $80,000 SG&A $10,000 $15,000 $25,000 EBITDA $40,000 $15,000 $55,000 D&A $10,000 $5,000 $15,000 EBIT $30,000 $10,000 $40,000 Interest $5,000 $2,000 $7,000 Earnings Before Taxes $25,000 $8,000 $33,000 Taxes (at 40%) $10,000 $3,200 $13,200 Net Income $15,000 $4,800 $19,800
When we consolidate the income statement of a 100% owned subsidiary, all we have to do is simply add together the corresponding line items into one fully consolidated statement.
But what happens if Parent A only owns 90% of Subsidiary B?
This is where minority interest comes into play. We know that as the parent, we must consolidate the subsidiary financial statement if the Parent owns more than 50% of the subsidiary. But if Parent A owns 90% of Subsidiary B, how do we account for this in the consolidated financial statements.
You may think that we simply take 90% of the value of each line item from Subsidiary B and add it into Parent A, but current accounting rules do not allow for this. Instead, the Parent company must consolidate 100% of Subsidiary B financials into Parent A but then subtract out the 10% it doesn’t own from Net Income.
Let’s look at how this works:
Parent A Subsidiary B: 90% owned by Parent A Consolidated Statement Revenue $100,000 $50,000 $150,000 COGS $50,000 $20,000 $70,000 Gross Profit $50,000 $30,000 $80,000 SG&A $10,000 $15,000 $25,000 EBITDA $40,000 $15,000 $55,000 D&A $10,000 $5,000 $15,000 EBIT $30,000 $10,000 $40,000 Interest $5,000 $2,000 $7,000 Earnings Before Taxes $25,000 $8,000 $33,000 Taxes (at 40%) $10,000 $3,200 $13,200 Net Income Before Minority Interest $15,000 $4,800 $19,800 Minority Interest $480 Net Income After Minority Interest $19,320
You will notice that the majority of the consolidated income statement preparation remains the same. We add up 100% of each line item together until we get to net income. Once we get to net income, we then make the minority interest adjustment by subtracting out the 10% of Subsidiary B net income that is not owned by Parent A.
Subsidiary B is owned 10% by someone else, so $480 of the $4,800 net income belongs to another party. Therefore, in the consolidated statement, we will subtract out $480 of minority interest from the net income to arrive at our final net income after minority interest of $19,320. It is this amount that is available to the shareholders of Parent A.
Example – Verizon Income Statement
Let’s look at Verizon’s income statement to get a sense for how public companies show minority interests in their income statement.
Highlighted in red is where minority interests come into play. Verizon shows the total net income for 2017 of $30.550 billion. Verizon then identifies $449 million of net income that is owed to minority interests. Verizon labels this as “Net income attributable to noncontrolling interests.” This nomenclature is frequently used to identify minority interests.
Netting $449 million from $30.550 billion leaves $30.101 billion which is attributable to Verizon shareholders. When Verizon calculates their earnings per share, they will use the net income of $30.101 billion since Verizon has no claim over the $449 million of minority interest.
When a parent company owns more than 50% of a subsidiary entity, the financials are consolidated and a minority interest is subtracted from the income statement. But how do we treat a subsidiary where the parent company owns less than 50% of a subsidiary entity.
An ownership in a subsidiary entity of less than 50% is referred to as an “equity investment.” In fact, it would be a misnomer to call this entity a “subsidiary.” Ownership of less than 50% typically indicates that the owner does not have control of the entity.
For example, if Company A owns 20% of Company B, then, Company A likely does not exert any control over Company B. There is no parent-subsidiary relationship, so the 20% ownership in Company B is simply referred to as an equity investment.
Accounting for equity investments in other companies is essentially the converse of accounting for minority investments in a parent companies’ subsidiaries.
Let’s look at an example, where Company A owns 20% of Company B:
Company A Company B: 20% owned by Company A Revenue $100,000 $50,000 COGS $50,000 $20,000 Gross Profit $50,000 $30,000 SG&A $10,000 $15,000 EBITDA $40,000 $15,000 D&A $10,000 $5,000 EBIT $30,000 $10,000 Interest $5,000 $2,000 Earnings Before Taxes $25,000 $8,000 Taxes (at 40%) $10,000 $3,200 Net Income $15,000 $4,800 Net Income from Equity Investments $960 Total Net Income $15,960
You will see that when Company A owns less than 50% of another company (Company B), the income statement items are not consolidated into the Company A financials. Instead, once we get down to the net income line, we add in the 20% of Company B net income that is attributable to Company A. Company B earned $4,800 of net income, so we take 20% of $960 of net income and include this amount in the Company A income statement.
The net result is that Company A has earned $15,960 in net income available to its own shareholders. $15,000 of this came from their own operations and $960 came from its equity investment in Company B.