Also called indirect,
unreported, or undisclosed earnings, that part of the surplus earnings
of a subsidiary company,
over and above dividend payments, not reported by the parent company.
Most of the large corporations hold or control through full, majority,
joint (half, third, quarter, etc.) or minority stock ownership in subsidiary
is or affiliated companies. Unless
the ownership of such subsidiary is a majority interest, the parent company
cannot under proper accounting principles consolidate the earnings of
a subsidiary or subsidiaries in the income account of the parent company,
but only such part of such earnings as may be actually paid to the parent
organization as dividends. When
earnings of subsidiaries are consolidated in the income account of the
parent organization, the proportion of earnings applicable to the minority
interest must be deducted.
Principles Board Opinion No. 18, "The Equity Method of Accounting for
Investments in Common Stock," the investor company owning a block of voting
stock in an investee corporation other than a subsidiary should carry
the investment on its books on the equity method (cost basis or market
value basis should not be used) if the percentage of ownership is a majority
interest or if the percentage of ownership held is not a majority interest
but is sufficient in fact to influence the operating or financial decisions
of the investee corporation. Under the equity method, the investor corporation records the
initial investment in the investee stock at cost, and then adjusts such
carrying value, increasing or decreasing it, by the percentage of ownership
applied to undistributed earnings of the investee (dividends received
from the investee reduce the carrying amount of the investment).
Under the Internal
Revenue Code, and subject to regulations, an affiliated group of corporations
has the privilege of choosing to be taxed as a single unit by filing a
consolidated return rather than separate returns.
The code specifically defines an affiliated group to exist when
(1) at least 80% of all classes of voting power stock and at least 80%
of each class of nonvoting stock of each affiliated corporation (except
the common parent corporation) is owned directly by one or more of the
other affiliated corporations which may be included; and (2) the common
parent corporation owns directly 80% of all classes of the voting stock
and at least 80% of each class of nonvoting stock of at least one of the
other corporations which may be included.
(Stock does not include nonvoting preferred stock.)
Consolidated returns are advantageous if some of the affiliated
corporations which may be included have losses, which in consolidation
will offset profits of the other affiliated corporations.
But once a consolidated return is filed, the affiliated group must
continue to file consolidated returns unless the IRS concurs in discontinuing
Even where the parent
corporation does not report earnings on a consolidated basis, the security
analyst will be interested in total earnings, including equity of the
parent in undistributed earnings of subsidiaries.
To illustrate the nature of equity earnings, the following example
A parent company
owns 800,000 shares of a subsidiary having 1,000,000 shares (its sole
capitalization) outstanding. The
subsidiary earns $5 million in a given year and pays $3 in dividends,
or $3 million. The parent
company thereby receives $2,4 million from its subsidiary which is taken
up in the parent company's income account and reported accordingly.
Such report, however, does not disclose full earnings, since the
surplus earnings in excess of the subsidiary's parent company for the
year in question are equal to its proportionate ownership in the $2 million
earned but not disbursed. This
proportionate interest or equity earnings is 80% of $2 million, or $1.6
million. Such equity earnings must be added to the actually reported
earnings of the parent company to measure its full earning power.