Financial Statements

The company's business cycle is reflected in its financial statements; the main ones are the company's balance sheet, income statement, and cash flow statement. The company's financial statements provide information about its financial condition: The main purpose of the balance sheet is to describe the assets and liabilities of the company on a given date; the main purpose of the income statement is to describe the transactions and changes in the assets and liabilities of the company over a period of time; and the cash flow statement describes the changes in the company's cash flow over a period of time.

The company's financial statements are usually prepared in accordance with generally accepted accounting principles (GAAP). In most cases, the company prepares two sets of statements: One is used for reporting to the company's shareholders and debt holders, and the other, which is based on the tax rules governing the recording of transactions, is used for reporting to the tax authorities. Obviously, the statements report the same business results, but different rules used for different needs create differences between the reported results. The reason for the differences in most cases is the existence of specific directives for tax reporting, as opposed to other financial reporting principles that attempt to reflect the company's business condition in general.

In order to understand the company's financial condition and prepare financial and business plans accordingly, entrepreneurs need to understand the meaning of the different statements and the logic behind the reflection of the company's business cycle. The following explanation of the statements and their components is consistent with the customary reporting rules, but is based on the economic principles underlying them, rather than on the precise reporting rules.

Balance Sheet

The company's balance sheet reflects the company's overall assets and liabilities or, in other words, its financial condition at a given point of time. The balance sheet may be likened to a snapshot of the company's financial condition. It distinguishes among various types of assets and liabilities, such as cash held by the company or in its bank accounts, as opposed to inventories. The balance sheet also reflects the shareholders' equity, namely, the investment in the company made by the shareholders and the profits accumulated in the company (retained earnings). The company's total recorded assets are always equal to the sum of its liabilities plus the shareholders' equity (see Figure 3-2).

Figure 3-2. The balance sheet


According to the reporting principles, the company is required to distinguish between current assets and liabilities which may be liquidated or are due within one year or less, and other assets and liabilities, referred to as long-term assets and liabilities, whose life span is longer than one year. Assets are presented in a declining order of liquidity, i.e., the most liquid assets appear before the less liquid assets. The first assets presented (namely, the most liquid) include cash and traded securities, and the assets presented last are the company's fixed assets, such as industrial equipment and real estate.

It is important to note that the presentation of assets and liabilities in financial statements is guided by the principle of conservativeness: Assets are recorded according to their lowest reasonable value (in other words, they are not likely to be liquidated for less), whereas liabilities are recorded according to their highest reasonable value.

The main assets and liabilities appearing on the balance sheet (see Figure 3-2), are the following:


  • Cash, cash-equivalents and securities These are the first among the company's current assets. Cash, cash-equivalents, and securities include, except for the cash in the company's bank account, all short-term deposits owned by the company and traded securities, including treasury bills. The guiding principle underlying the classification of these assets is that they entail a relatively low risk in proportion to their value at the time of liquidation, and can be liquidated quickly (usually, within less than three months).

  • Accounts Receivable Since most companies do not receive payment in cash for all of their sales, almost every company that has reached the stage of sales has an Accounts Receivable (or Receivables) item. These are short-term customer debts that the company records on its balance sheet after offsetting allowance for doubtful debts which it does not expect to collect. For example: a company by the name of Speed is owed $1,000 by its customers, but predicts that only $800 will be paid. The company will present in its balance sheet a net amount of $800 under this item, representing the portion of the debts that the company expects to collect. This amount is produced by deducting an allowance of $200 for doubtful debts from the gross debt of $1,000.

  • Inventory Inventories are assets in various stages of production that the company expects to sell as products. Inventories are divided into several types in accordance with their stage along the production process. Companies usually specify the types of inventories they have, since investors attribute a different value to different types of inventories. For instance, in most cases, an inventory of raw materials is easier to liquidate than an inventory of products in progress. A manufacturing company will generally have three types of inventories: an inventory of raw materials, an inventory of goods in process, and an inventory of finished goods. Inventories are estimated according to their cost, not according to the revenue they are expected to produce, unless such revenue is lower than the cost of production (in which case, the principle of conservativeness directs that they be recorded according to their net realizable value). The reporting of inventories in progress, as well as inventories of finished products, usually includes also allocated labor and overhead costs (such as electricity and some of the depreciation of the equipment used to manufacture them).

    When analyzing inventories, it is important to pay attention to the method of recording of the inventories, since a company selling products uses inventories of raw materials and finished products which might be recorded according to different prices. For instance, let us assume that Speed manufactures instruments that it combines with tractors that it purchases. In one month, the company purchased three identical tractors at different prices (according to the order of acquisition): $100,000, $120,000 and $115,000. At the end of the month, the company sold one set of equipment (a tractor on which the company's equipment was assembled) for $200,000. Obviously, the reported financial results reported by Speed will be affected by the choice of the tractor that constitutes a material part of the sold equipment. If the company uses an inventory method called FIFO (First In, First Out), then, assuming that Speed had no prior inventories, it will report an inventory of $235,000. $100,000 (the cost of the first tractor) will be reported as part of the cost of the equipment sold (see the next subsection for a further discussion of revenues and expenses). If the company uses the method of LIFO (Last In, First Out), then the company will report an inventory of $220,000. According to yet another method, the inventory (and the components of the cost of the goods sold) is calculated according to the average cost of the components of the sale. In our case, the inventory at the end of the period will be reported at: (100,000 + 120,000 + 115,000)*(2/3) = 223,333.33.

  • Advance payments Although companies usually try to defer payments, in many cases they pay in advance for services they will receive after the date of the balance sheet. For instance, companies often pay rent for several months in advance. The principle in the statements is to report expenses and revenues at the time of the economic occurrence of their underlying events. In other words, since the services will be received after the date of the statements, the expenses will be recorded concurrently with the receipt of the service. Therefore, the balance sheet will reflect an asset incorporating the cost for which the services or product was not yet received.

  • Long-term assets Assets that are expected to contribute to the production of revenues over a period longer than one year are referred to as long-term assets. They are divided into two main groups: tangible assets and intangible assets (intellectual property). Tangible assets include real estate, office equipment, production equipment, long-term financial assets, and stocks in other companies. These assets are usually recorded according to their historical value, i.e., according to the price of purchase, adjusted for depreciation.

    The term "depreciation" attempts to reflect the devaluation of assets over their economic life span or usage. The periodic depreciation of an asset is part of the expenses reflected in the income statement. There are various methods for calculating depreciation that are deployed in accordance with the character of the assets, the industry, and the company holding the asset. The most widely-used method is that of the "straight line": First, the asset's economic life span is estimated, and a proportionate part of the cost is recorded every year as an expense. For instance, if a car was bought for $20,000, and its economic life span is five years, then $4,000 are recorded every year as an expense, and the asset is reported on the balance sheet with a value that decreases by such amount every year. Another common method is that of the "accelerated depreciation," whereby the asset is depreciated more in the first years. This method reflects an accelerated depreciation in the first years of the asset's life. The value of a new car, for instance, is known to decline faster in its first few years.

    There are other depreciation methods, and in many cases the chosen method takes into account the amount of use made of the asset. For instance, consider the case of a factory where one million cars can be manufactured before it needs to be renovated. Obviously, it would be logical to express the depreciation of the factory over time as a function of the number of cars actually manufactured in it.

    Assets appear on the balance sheet according to their historical value, less depreciation and any other devaluation resulting from a decline in their market value below their cost. In fact, the net fixed assets will be equal, at the end of each period, to the net fixed assets at the end of the previous period, plus new fixed assets acquired, minus the net cost of fixed assets sold and minus periodic depreciation and any other reduction in the recorded value of the fixed assets.

    Where the statements of non-American companies are concerned, it is important to understand that in different countries the value of assets may be expressed differently, and in many cases assets may be revalued according to their market value at the time. Fixed assets may be revalued, for instance, in the United Kingdom and in the Netherlands. The principle in these countries is that assets are reflected according to the cost to the company of replacing them. In other words, if the car on Speed's balance sheet (which, for purposes of this example, will be reported according to British rules) is one year old, then, instead of reporting a depreciated value of $16,000 ($20,000 $4,000), the cost of a similar used car on the market will be checked. If such cost is $21,000, then the car will be recorded in the balance sheet with this value. This change in value will concurrently be reflected under the item of the company's shareholders' equity. In all countries, if the market value of an asset considerably declined below its depreciated cost, and such devaluation is not expected to be remedied, then the value of the asset has to be reduced in the balance sheet by recording a loss as a result of the devaluation of the asset (since such devaluation is in lieu of future depreciation).

    Intangible assets include items such as the cost of acquired patents, trademarks and trade names, franchises, and the cost of investments in other companies above the value of their tangible assets (goodwill). These assets also appear on the balance sheet and are depreciated in accordance with their expected life span, with certain restrictions (in accordance with the accounting rules applicable in each country) with respect to the manner of recording of various assets and liabilities. For example, if Speed bought a license to use a patent that will expire in ten years in consideration for one million dollars, then it will be depreciated over ten years, unless the patent is expected to become worthless after a shorter period of time, or is expected to continue being valuable after it expires.

    Following an accounting rule change, effective from the year 2002, goodwill does not have to be depreciated if its value, as deemed by the company's management, has not declined.


  • Short-term liabilities This section includes overdrafts, commercial paper issued by the company, and any component of long-term debt payable in the coming year. This item also includes all short-term debts to suppliers of various services and products (accounts payable) and accumulated expenses (expenses accumulated but not yet paid), such as unpaid salaries and taxes not yet paid to the tax authorities.

  • Long-Term debt This section includes sub-items reflecting liabilities due later than one year after the date of the balance sheet. It includes, for instance, bonds issued by the company and deferred tax liabilities resulting from differences of timing between the recording of revenues and expenses for tax purposes and their reflection in the financial statements. Let us assume, for example, that the car bought by Speed for $20,000 may be depreciated for tax purposes over two years (namely, with an annual depreciation of $10,000). As mentioned above, for the purpose of the financial statements, a straight-line depreciation over five years was calculated (i.e., $4,000 per year). Since the difference between the two depreciation methods is $6,000, the company is deferring the payment of tax on revenues in the amount of $6,000. Assuming that the applicable tax rate is 20%, then the tax authorities are, in fact, lending the company $1,200 per year in the first two years, to be paid back from the third year forth. This loan from the tax authorities is itemized on the balance sheet as deferred taxes liability. This item includes differences of timing vis-à-vis the tax authorities under several items, and in many cases increases every year due to ever-increasing assets, assuming that the rates of depreciation for tax purposes are higher than the rates of depreciation in the financial statements. However, since these are timing differences, the company should record a deferred tax item on its balance sheet. Note that similarly, if the company accumulates losses over several periods, but forecasts profits amounting at least to these losses, then the company can record a tax asset in the amount of the tax it will not have to pay over the coming years due to its accumulated losses.

  • Equity The company's equity represents the value of its assets after deduction of its liabilities, and it belongs to the company's shareholders. This item includes the company's paid-up capital (namely, the amounts paid by the shareholders in consideration for their shares), the company's retained earnings and other items reflecting various reserves due to unrealized changes in the value of various assets and liabilities.

    Another important component of a company's equity is treasury stocks, namely, shares issued by the company but re-purchased by it. From the economic point of view, a purchase of the company's own shares constitutes an alternative to paying dividends, since the company is, in fact, spending money that is transferred to the shareholders, who may sell their shares to the company. From the taxation point of view, a re-purchase of shares is usually better for shareholders than the distribution of dividends that is subject to each individual shareholder's highest tax bracket (in the United States). A re-purchase of shares, on the other hand, affects the price of the shares but does not impose any tax liability on the shareholders, unless they choose to sell their shares (and even then they pay a capital gains tax, which, in the United States, is lower than the tax imposed on dividends).

Income Statement

In contrast with the balance sheet that reflects the situation of the company at a fixed point in time, an income statement reflects the company's activity over a period of time. The income statement presents the company's accounting revenues and expenses. A later section will discuss the difference between revenues and expenses and cash movements. The purpose of this statement is to present a summary of the company's activities over this period of time.

The principle guiding the reflection of revenues is that revenues are recognized in the period in which the transaction was made, when uncertainty with respect to its possible closing and to the payment therefore has been resolved. In other words, the transaction may be recorded in a different period from that in which payment therefore will be received. For instance, Speed will record the revenue from the equipment it sold when it closed the sale transaction, although the payment may actually be received later on.

Another important principle is the matching of revenues and expenses. According to this guiding principle, expenses incurred in the production of revenues from products and services are recorded in the same period as the revenues from the sale of such services or products. Thus, Speed will record the cost of the tractor as an expense in the above example only when it records the revenue from the sale of the equipment.

The expenses recorded in the statements reflect all the costs involved in deriving the company's revenues. Expenses are reported under various items in different parts of the statement and include, among others, the cost of materials, labor, marketing, advertising, research and development, and various administrative expenses.

An income statement comprises various items, including the following (see Table 3-1):

  • Revenues Usually, the first line of an income statement reflects the company's revenues. Such revenues may be recorded as gross revenues, in which case the expenses incurred in their production appear in the line "cost of goods sold"; conversely, the company can present the results on a net basis, in which case the first line will be calculated after deducting various costs relating to the sold goods. Amazon (the world's largest online bookstore), for instance, reports the entire turnover of goods sold by it, and records the cost of the books as an expense. eBay (the world's largest auction site) on the other hand, records as revenue only the commissions it receives on sales made through its site. The difference results from the fact that a company's revenue is tied to the transfer of principal risks and returns on the asset. In eBay's case, the company is not exposed to any risk resulting from the maintenance of inventories, and does not bear various risks of payment transfers and shipments. Consequently, it does not own the sold goods at any stage of the transaction. Amazon, on the other hand, bears the risk involved in the stocking of the goods it sells (including, in many cases, the maintenance of inventories), and therefore recognizes the sale and cost of the goods.

    In many areas involving brokerage and production, lengthy, numerous, and deep discussions are held with respect to the nature of transactions, since these companies often sell products they do not stock. In such cases, a comprehensive examination is required in order to determine who bears the risk of stocking goods during the course of the transactions. In the aftermath of the collapse of the energy trading company Enron and the telecommunications company Global Crossing, issues pertaining to net versus gross recording of revenue are in the center of the public discussion. While there is typically no impact on cash flows from the transactions at different points in time, market participants tend to value firms based on revenue multiples (see Chapter 9 for further discussion), and hence these definitions become acute.

  • Cost of Goods Sold As mentioned above, costs of goods sold reflects the costs incurred in producing the service or product recorded as a revenue. The components of this cost vary from one company to another in accordance with the nature of the company. In retail companies, for instance, this cost is composed mainly of the cost of the goods themselves, whereas in software companies, the cost of goods sold is composed primarily of the employment costs directly related to the sale. The cost of goods sold will usually also include various components of depreciation, the value of which is loaded onto the price of the sold equipment or service.

  • Gross Profits Gross profits are revenues minus the cost of goods sold. The gross profits and their percentage of the revenues are two of the main parameters for estimating a company's performance. Investors often regard changes in the rates of gross profitability as an indicator of changes in the company's future prospects.

    Profit margins vary dramatically from one industry or market to another. The pharmaceutical industry, for instance, is characterized by a gross profit margin of up to 90%, whereas many retail chains are characterized by gross profit margins of below 25%.

  • Operating Profit The company's operating profit is calculated by deducting depreciation and amortization, general and administrative expenses, research and development expenses, and marketing expenses from the gross profits. Operating profit is an indicator of the company's profit that is disassociated from the company's capital structure. In other words, this profit disregards the company's financing expenses. The assumption underlying the examination of operating profit margins is that the company's capital structure is a variable that depends on a mere managerial decision, whereas the focus on the company's basic data should be made without regard for the company's capital structure considerations.

  • EBIT Earnings Before Interest and Taxes EBIT is calculated by adding additional items to the operating profit, such as the sale of assets outside the company's ordinary operating activities.

  • Net Income Net income is reached by deducting financing costs, taxes, and irregular items from EBIT. The net income is added to the shareholders' equity after deducting any dividends distributed to the shareholders.

Table 3-1 presents an example of an income statement. The company's revenues amounted to $1 million, and the cost of goods sold was $600,000. Consequently, the gross profit was $400,000. The company's other operating expenses were the salaries of research and development employees ($100,000), marketing and sales ($150,000), general and administrative expenses ($25,000), and depreciation ($50,000). The company's operating profit was therefore $75,000, and after deducting financing expenses of $20,000 and paying tax at the rate of 20%, the company's net income was $44. After distributing a $5,000 dividend to the shareholders, the company's retained earnings increased by $39,000.

Table 3-1. Sample income statement

Speed Inc. Income Statement for the twelve months ending December 31, 2001 (amounts in $000)




Cost of goods sold



Gross profit



Operating expenses:




Marketing and sales


General and administrative



Depreciation and amortization






Operating profit



Special items






Financing costs



Earnings before taxes



Income tax 20%



Net income (earnings after taxes)





Balance transferred to retained earnings


Cash Flow Statement

Like the income statement, the cash flow statement also reflects changes over a period of time, rather than being a snapshot at a fixed point in time as in the balance sheet. This statement reflects all the movements of cash into the company (cash inflow) and out of the company (cash outflow) in a given period of time. This statement is essential for understanding the company's ability to survive over time. It is possible, for example, for a company to be profitable, yet to consume more cash than it has (for instance, due to a delay in receiving some of its revenues) and therefore to find itself in a cash shortage. (A later section on accounting revenues and actual cash flows will give a more detailed discussion.)

The cash flow statement is divided into three components describing the changes in the company's cash flows from operating, investing, and financing activities. We will first demonstrate how the cash flow statement may be constructed on the basis of the company's other main financial statements, namely the balance sheet and the income statement. We will then review the three components of the cash flow statement: the cash flows from operating activities, investing activities, and financing activities. The analysis proposed here is essentially economic, and although it is consistent with the accounting standards for the reporting of cash flows in countries such as the United States, it is not constructed according to such reporting (GAAP) standards.

The starting point for analyzing a company's cash flows is the cash item in the company's balance sheet at the beginning of the period, and the end point is the cash item at the end of the forecasted or analyzed period. The change in the company's cash positions is the difference in its cash between these two points in time. This difference takes into account all of the movements and transactions in which the company was involved. Therefore, this figure alone is insufficient to understand the company's cash needs, cash generation, and cash consumption over the period. Clearly, the value of cash infused into the company as a result of the sale of products or services is different from an inflow of cash to the company created by raising new capital.

The company's cash flow from operating activities is composed, in principle, of actions revolving the sale of products and services. Accordingly, expenses relating to the creation of such cash flows, such as the acquisition of raw materials, sale expenses, marketing expenses, and general expenses, as well as tax payments, are some of the components of the company's cash outflow resulting from operating activities.

The company's cash flow from investing activities is composed of actions such as the sale of real and financial assets or the repayment of long-term loans given to third parties. Accordingly, acts such as the acquisition of assets and investments in equipment and long-term financial assets are some of the components of the company's cash outflow resulting from investing activities, as are the receipt of dividends and interest from real and financial investments. The main component of the cash flow from investing activities is usually the change in the company's net fixed assets. As mentioned above, the company's net fixed assets at the end of a period are equal to its net fixed assets at the beginning of the period, plus assets purchased over the period, minus depreciation accumulated over the period and minus net sales of assets sold over the period.

Finally, the company's cash flow from financing activities is composed of shares and notes and debentures issued and long- or short-term loans taken. Accordingly, the re-purchase of the company's own shares, repayment of notes and debentures and other long-term debts, and the payment of dividends and interest on debts compose the company's cash outflow resulting from financing activities.

At this point it should be mentioned that there might be material differences between the classification of the cash flows for internal company analysis and the classification required by GAAP. The main differences typically relate to the company's financing expenses. In the above description, they are included in the cash flows from financing activities, whereas, according to GAAP, they are included in the cash flows from operating activities. The analytical difference between the two is that decisions with respect to the taking of loans are managerial decisions pertaining to the company's capital structure and should therefore be classified as cash flows from financing activities for an internal analysis of the business, as well as for free cash flow-based valuation (which is detailed in Chapter 9).

The Relationship between the Balance Sheet, the Income Statement, and the Cash Flow Statement

The company's balance sheet at a certain point in time is a reflection of the previous balance sheet, with the addition of changes in the company's business cycle that are reflected in the company's income statement over this period, and changes that are reflected directly in the balance sheet, such as loans and equity raising. Changes involving changes in cash will also be represented in the company's cash flow statement.

In most cases the change in the shareholders' equity from one period to another may be presented by using the following simple equation:

Shareholders' equity at the end of the period = shareholders' equity at the beginning of the period + profits earned over the period dividends distributed over the period + capital raised over the period

The Difference between Accounting Revenue and Actual Cash Flows

There are significant differences between accounting revenues and profits and the company's cash flow. These differences may derive from several sources, such as the following:

  • Timing differences between sales and receipt of payments The main differences are the result of timing differences between when sales are made and when payment for them is received. Cash will flow to the company only when payment is received for a transaction it made, unless the company has made an agreement whereby it sold the debt related to the sale to a finance provider, who gave it cash in consideration for the debt.

  • Barters Besides the provision of credit to customers, another difference results from transactions in which the consideration is not given in cash. Such barters are far more common among high tech companies, and particularly startups, than in other companies. The reason for this is that in many cases neither party has the cash required to pay for various services and products it consumes. Therefore, they render services or supply other products, whose cost to the supplier is low, but that have a high market value, in consideration for products and services consumed by the company. The price at which such transactions are recorded is the subject of constant discussion by the authorities. Without going too much into accounting rules, the customary rule is that the price of barters must be based on the market price of similar transactions. One of the indicators of such price is similar transactions recently performed by the company in consideration for cash.

  • Accounting depreciation Another material factor that creates a vast difference between the revenue and the cash generated by a company's business is investment in fixed assets such as communication networks or equipment. Although these assets may be paid for in cash, they serve the company over long periods of time. They will appear in the company's balance sheet and be reflected in the income statements only by depreciation over their expected useful life span, generally several years.

    Let us assume, for example, that a certain software development company buys equipment which it can use for two years for $1,000. Therefore, every year $500 will appear as an expense in the income statement to reflect the depreciation of this asset. Let us further assume that the payment for the equipment was made in cash. In the year it bought the equipment, the company was still engaged in development, and incurred additional expenses of $2,000 for salaries. In that year, the company will report expenses of $2,500, namely the depreciation of the equipment and the salaries paid. The company's cash account, however, was reduced in that year by $3,000 for the same equipment bought and salaries paid. In the following year, the company finishes developing the product and sells it for $4,000, paid in cash, having incurred expenses of $1,000 for advertising (paid in cash), $2,000 for salaries and another $500 for the depreciation of the equipment. The company will therefore report a profit of $500, although its cash account increased by $1,000.

  • Leasing and relying on credit from suppliers Many startups significantly reduce their cash needs by making intensive use of leasing, i.e., receiving long-term credit (usually from the manufacturer or an entity specializing in this type of financing) to finance equipment that is received by the company immediately but is not legally owned by it. The manner by which such transactions are recorded in the income statement depends on many variables pertaining to the economic ownership of the asset. Another customary form of financing is relying on credit from suppliers, i.e., receiving credit from suppliers in order to pay for a purchase.

EBITDA and Cash Earnings

Many investors adjust the EBIT upwards by disregarding various deductions entailed by operating expenses, thus arriving at the EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization).

Changes in the company's capital structure naturally affect the rate of interest paid by the company and its tax liability, due to the tax shield afforded to interest paid on debts (interest is recognized as an expense for tax purposes). Therefore, the argument follows, there is logic in examining the profits produced by a company, irrespective of its capital structure, which are dependent upon managerial decisions.

Another argument in favor of focusing on this parameter is that depreciation and amortization are not a genuine expression of the devaluation of assets used by the company. The reason for this is that many assets may serve the company for years after they are fully depreciated. The use of EBITDA is common in industries with high levels of investment in equipment. However, it may also lead to erroneous conclusions since, as it does not take into account the level of investments required in order to preserve the company's operating condition, let alone improve it.

In recent years and particularly in view of a wave of mergers and acquisitions, the term cash earnings has become common usage. Many high tech companies now report this data, although it is not defined by U.S. GAAP (and consequently its composition may vary from one company to another). Like EBITDA, this figure refers to the company's pre-tax earnings, in addition to the various depreciations and amortizations included in the income statement. However, it too may misguide investors since not all companies include the required investments in equipment, the amount of which is supposed to be at least roughly indicated by depreciation. Nor does it reflect the company's cash flow with respect to the investments required by the company. In addition, it does not reflect changes in the operating capital required to support a growth of business.

Reporting Holdings in Other Companies and Consolidation of Statements

The company's share in other companies is reflected in the balance sheet and income statement in accordance with the nature of the holdings. If the holding is long-term and represents less than 20% of the control or capital of such company (more detailed tests lie beyond the scope of this chapter), the company will typically report the holdings according to its historical cost, unless their value has declined, in which case the company will recognize a loss equal to the decline in value (the lower of cost or market method).

Holdings exceeding 20% but awarding the company no control over the held company are typically reported according to the company's share in the held company. The guiding principle is that the cost is expressed after adjusting it to changes in the held company's shareholders' equity, changes that are affected by the profits of the held company and by capital raised by it (the equity method).

Companies controlled by the company will be reported in accordance with the equity method (while reflecting the appropriate rate of holdings). Alternatively, in the case of consolidated statements by the holding company, the controlled company's business assets, liabilities and results will be presented in the controlling company's statements. Appropriate items will be included in the balance sheet and in the income statement to reflect the minority interest in the controlled company. The balance sheet will include a liability reflecting the minority shareholders' interest in the controlled company, and the income statement will include a cost reflecting the minority shareholders' interest in the controlled company's profits over the period.

From Concept to Wall Street(c) A Complete Guide to Entrepreneurship and Venture Capital
From Concept to Wall Street: A Complete Guide to Entrepreneurship and Venture Capital
ISBN: 0130348031
EAN: 2147483647
Year: 2005
Pages: 131

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