2. By only a controlling ownership.
3. Through the agency of advances, particularly when, because of poor credit, the usual money markets may be closed to the borrowing company.
Valuation of Permanent Investments
The problem of the valuation of investments under the three forms mentioned presents some interesting features. It might seem that, inasmuch as the investment is in the nature of a fixed asset, valuation should always be at full cost; that market fluctuations should have no effect. The last half of this statement is correct but the first part needs modification. It is to be expected that a concern in purchasing the stock of another will not pay more than it considers the stock to be worth. The price may be more or less than the face value of the stock, depending upon the existence of an element of good-will or the overstatement of the assets on the books of the vendee company; or again, where the stock is bought on the open market many other factors may cause a variance of purchase price from par value of the stocks.
Were the investment simply an inanimate asset to be used, cost, perhaps less depreciation, would be the proper basis for valuation. Since, however, a corporation cannot remain stationary—it must usually record a gain or a loss from year to year—ownership in that corporation must accordingly suffer change from year to year. So many things can happen to an operating corporation that cannot befall an inanimate asset held for use that the proposal to value both on the same basis is hardly tenable. Furthermore, if proper principles of valuation are applied to the subsidiary concern, its true value can be determined with fair accuracy. Accordingly, a true basis is secured for valuing it as an investment on the books of the holding company. Any increase in value over cost is due to the profits made by the subsidiary enterprise, and in the case of its complete ownership by the holding company these profits belong in full to the holding corporation. If all the profits are disbursed as dividends to the holding company, the subsidiary enterprise suffers no change in condition and therefore no change in value. If, however, some of the profits are retained, this would result in an increased value which should be reflected in the valuation of the subsidiary enterprise on the books of the holding company. How this may best be shown also requires consideration.
Holding Company and Subsidiary Enterprises
A holding company may have but few assets aside from its holdings in subsidiary concerns. A balance sheet showing only these few assets and its investments in the other concerns does not usually give much useful information. Therefore, as the assets of the subsidiaries belong to the holding company and really comprise its operating plant, a more intelligent way of showing the investments of the holding company is to combine or consolidate the balance sheets of the subsidiaries and incorporate them in the balance sheet of the holding company in place of the item of investments. This method is known as the “consolidated balance sheet” and is given fuller treatment in a subsequent chapter. Here attention is called to it merely as a device for showing the valuation of permanent investments represented by substantially full ownership of the subsidiary companies.
Controlling Investments
Where ownership is not complete but still controlling, the method of the consolidated balance sheet is not so fully applicable and often is not used. In this case the investment will appear as such on the balance sheet with whatever adjustments in value may be necessary due to the success or failure of the subsidiary’s operation for the past period. Whatever profits are made enhance its value and in the enhanced value the controlling company has a pro rata share, the effect of which should be taken up in the valuation of its investment therein. The net amount of the enhancement in value is the difference between the net profit made by the subsidiary concern and that portion paid out in dividends—in other words, the portion reinvested in the business.
This portion, i.e., such part of it as belongs to the controlling company, may be taken up directly by charging the investment account and crediting a proper income account; or the share of the entire net profit belonging to the controlling company may be charged to the investment and credited to an income account. In the event of dividends being paid by the subsidiary company, these would be credited to the investment account of the controlling company, which account would then show, as in the first method, the new value due to the profits reinvested in the business. That this policy of increasing the value of the investment is conservative and sound is apparent when one considers that the holding company’s ownership of the subsidiary concern controls the latter’s policies, including the dividend policy. The profit taken onto the books of the holding company by the above method is a real, not a book, profit.