Non-Controlling Interest can be described as the minority ownership of one business in another business. A business is said to have a non-controlling interest in another business if the shareholder of that particular company owns less than 50% of the outstanding shares of the company.
Therefore, because of the fact that non-controlling interest is described as the minority interest, it can be seen that there is no control over the corporate decisions that are taken by the company.
Hence, their shareholding is just representative of their ownership, but is it not substantial or significant enough for it to be categorized as a ‘controlling element.’
In other words, having a non-controlling interest does not make a company entitled to the decision-making process in the company in which they own the non-controlling interest.
Given the fact that individuals or business with a non-controlling interest has no individual decision over corporate decisions, it can be seen that they are still entitled to receive their proportionate allocation of the amounts respective to their ownership in the company.
How to calculate Non-Controlling Interest?
Non-Controlling Interest is the proportion of shareholding of one company in the other company. Regardless of the fact that it is minority ownership, yet it is still declared on the financial statements of both the companies to represent the ownership stake.
However, in order to calculate the non-controlling interest in the company, it is also important to ensure that there are certain steps that are undertaken by the accountants in order to accurately calculate to Non-Controlling Interest.
The first step in this regard is to ensure that companies are able to find the book value of the subsidiary. The book value is calculated using the net assets of the company (which are net assets minus net liabilities).
After book value has been duly calculated, businesses are then required to multiply the book value of the company, with the percentage of ownership of the Non-Controlling Interest.
This would render the dollar value of the non-controlling interest that is to be described on the balance sheet, and the income statement of the company.
The second step in this regard is to ensure that net income is computed, relevant to the non-controlling interest percentage.
Hence, it can be seen that non-controlling interest is mainly computed by ensuring that the relevant share of profits of the non-controlling interest is duly calculated by both, the company, as well as the subsidiary.
Example of Non-Controlling Interest
Non-Controlling Interest can further be explained using the following illustration:
Pop Co. purchased 20% shares in Kid Co. on 1st January 2019. During the year ended, Kid Co. was able to generate $200,000 as Net Income for the year. In the same manner, the book value of the assets of Kid Co. is estimated to be $3,000,000.
In the example above, it can be seen that Net Co has a Net Income of $200,000 that is attributable to all the shareholders.
Assuming there are two main shareholders, Pop Co. and Kid Co., it can be seen that by default Pop Co. is a minority stakeholder since they only have 20% ownership in the company.
In this regard, the value for non-controlling interest for the Income Statement and Balance Sheet is as follows:
Non-Controlling Interest – Income Statement
Non-Controlling Interest – Pop Co. 20%
Net Income for the year = $200,000
Non-Controlling Interest share = $40,000
Non-Controlling Interest – Balance Sheet
Non-Controlling Interest – Pop Co. 20%
Net Income for the year = $3,000,000
Non-Controlling Interest share = $600,000
Treatment of Non-Controlling Interest in Balance Sheet
Non-Controlling Interest is specifically mentioned in the balance sheet for both companies. In the example given above, it can be seen that the Non-Controlling Interest is declared in the Financial Statements of both, the parent, as well as the subsidiary.
The calculation that is carried out includes the retained earnings, as well as dividends that might have been paid out to the shareholders.
In the same manner, it is also important to ensure that organizations are able to include for non-controlling interest so that shareholders and users of the financial statement have a clear idea about the proportion of assets (as well as net income) that is attributable to the Non-Controlling Interest.
Non-Controlling Interest and Retained Earnings
By definition, retained earnings are the earnings that are withheld by the company to be used for any future expansionary projects a company might have.
In this regard, it is highly important to ensure that even if the consolidated earnings are retained by the company, then to the financial statements represent the part of retained earnings that are attributable to the Non-Controlling Interest.
An intangible asset can be defined as an asset that is not physical in nature. However, it is treated as an asset because of the fact that having that on the financial statements of the company is resourceful on numerous different grounds. Organizations can either create intangible assets, or they can acquire those assets.
However, they cannot be arbitrarily purchased in order to inflate assets of the company. They are mainly assets that are created in order to facilitate better business practices, which can ensure sustainability for the company.
Intangible assets can broadly be categorized as either definite intangible assets, or indefinite intangible assets.
As far as definite intangible assets are concerned, they can be defined as assets that are meant to be kept intact on the balance sheet, because their valuation or their existence is not contingent on any other factor, other than the organization’s existence.
An example in this regard is that of the brand name. On the other hand, as far as definite intangible assets are concerned, these are those assets that have a finite and limited life.
They are not meant to exist across the lifespan of the company. Hence, the types of intangible assets are classified as definite intangible assets.
Regardless of the fact that intangible assets have no physical presence or no directly attributable benefit, yet it can be seen that they are an increasingly valuable resource for the company and is extremely critical for the long-term success or failure of the organization.
In the same manner, it can also be seen that intangible assets are important from the perspective of external investors, and users of the financial statements.
Therefore, companies prefer acquiring intangible assets in order to make their financial statements more attractive for their potential customers.
Accounting for Intangible Assets
Accounting for Intangible Assets has two broad categories: valuation, as well as accounting for those intangible assets once these assets have been subsequently acquired.
As far as valuation is concerned, it can be seen that intangible assets are only recorded on the financial statement of the company in the case where they are acquired externally.
For the intangible assets that are created internally, for example, patents, the accounting treatment is such that the processing costs associated with the patent creation are expensed, whereas the legal expenses that are associated with the patent registration are capitalized.
On the other hand, intangible assets are amortized. Amortization of intangible assets is similar in concept as depreciation of fixed assets.
However, they are treated differently. Intangible assets are mainly amortized across using their useful life, using straight line method. Given the fact that they have no salvage value, year on year amortization is calculated by dividing the total life of the asset over its useful life.
However, it must be noted that amortization of intangible assets only takes place in the case of definite intangible assets. Since indefinite intangible assets exist over a continuum, they don’t have a useful life to be amortized over.
Example of Intangible Assets:
Intangible assets are mentioned on the balance sheet in the case after they have been acquired. An example of a case and subsequent treatment of Intangible Assets is given below.
Let’s suppose, Company X purchases a patent from Company Y, for an agreed amount of $200 million, then the transaction would be reflected in the financial statements of Company X in the following manner.
Dr. Intangible Asset – Patents Purchased from Company Y
Types of Intangible Assets
There are numerous examples of intangible assets. Some of the major examples of intangible assets include:
Copyrights: Although copyrights are in place in order to protect the organization’s products and services, yet they are considered intangible assets because of the fact that the copyrighting cost is spread across a multitude of years and expensing it one singular year is not the correct treatment.
Patents: Registering patents is greatly helpful for the company in terms of ensuring that they are able to maintain their supremacy without any duplication of their ideas. Patents also stay with the organization for a considerable time period, and therefore, they are regarded as intangible assets.
Trademarks: Trademarks are also maintained within the company for protective reasons. They are also declared as intangible assets on the balance sheet.
Goodwill: Goodwill is perhaps the most important intangible asset. Goodwill is mostly acquired as a result of business combinations. Therefore, only that goodwill is included in the financial statements, which is externally acquired. Internally generated goodwill is not maintained in the balance sheet.
Fictitious assets can be defined as assets that are fake. They do not have a physical presence, and hence, these assets are not really assets in the true sense, but in fact, they are defined as assets that are mainly categorized as huge expenses or losses that occur within the company over the course of time, and tend to be unclaimed in the year in which they take place.
The main reason as to why these expense heads are treated as assets, and then expensed across several different years is the fact that this is considered to be a major expense for the business, and hence they are then spread across a number of years, as opposed to being treated as such during the course of one year only. Therefore, they are categorized as assets using journal entries that just convert expenses with a considerable value into assets.
Therefore, it can be seen that fictitious assets are intangible assets, with no physical existence. They are expenses that are treated as assets. Since they are not purchased by the company (with an intention of keeping them as assets), they have no realizable value.
They are continually amortized over the course of time, across a span of more than one financial year. The main reason for this particular categorization is the fact that these expenses, like assets, are expected to give returns over the course of more than one year.
However, since it is a considerable amount of money, recording them in one year altogether might have an adverse repercussion on the financials. Therefore, they are categorized as assets first, and then continually amortized over the course of time, as soon as the company is making profits, and it is certain that the company is generating a positive return.
Fictitious assets may, or may not exist on the balance sheet of a particular company. However, the following illustration shows how fictitious assets work, and in what circumstances do companies treat expenses at fictitious assets.
Newton Co. got incorporated on 1st January, 2020. Upon incorporation, they paid $60,000 as incorporation charges. However, during the first year of operations, they were not able to make substantial profit.
They also incurred marketing promotional expenses of $40,000, in addition to a discount at which they issued shared. The total discount amount was $55,000. End of the year, Newton Co. decided to categorize all three expenses as fictitious assets. They are expected to earn profits from the next year, so they decided to amortize these fixed assets as soon as they are able to generate profits.
Difference between Fictitious Assets and Fixed Assets
The main difference between fictitious assets and fixed assets is the fact that fixed assets are mostly tangible in nature (except for goodwill). They normally have a realizable value, and they are subsequently expected to generate returns over the useful life of the assets. In the same manner, fictitious assets have no realizable value.
They are only placed on the balance sheet as per the amount that has already been paid. It cannot be depreciated, or sold once it is paid for. It carries forward from one year to the next, unless the amount is fully amortized over the course of time.
In the same manner, it can also be seen that fictitious assets do not drive a tangible value. Estimating the amount of value addition as a result of this particular transaction is questionable. However, in the case of fixed assets, the returns that are expected to be generated can be estimated and calculated well in advance.
List of Fictitious Assets
There are numerous different examples of fictitious assets. Some of the examples of fictitious assets are as follows:
Promotional Marketing Expenditures: Professional and promotional marketing is considered to be a significant investment for the company. For organizations that have considerable marketing budgets (mainly in the case of ATL Marketing), the benefits of such marketing campaigns are rendered over a period of more than one year. Therefore, they are categorized as fictitious assets, and then amortized over the period with which it is expected to return considerable value.
Preliminary Expenditures: Preliminary expenditures are expenses that occur in the initial stages of the business. This might include costs associated with incorporation, legal and licensing fees, as well as other expenses that are associated to bring the business in a running condition. These expenses are considered significant in nature, and therefore, they are often treated as fictitious assets, and then amortized over the forthcoming years.
Discount allowed on the issue of shares: In the case where the company issues shares at a discount, the discount amount is not considered as an expense (or a loss). Instead, it is considered to be a fictitious asset, and then it is expensed over the course of the year.
Company valuation tends to be one of the most important calculations for any company, simply because of the reason that it defines how much they are worth in the market.
It tends to be a highly important metric for investors, and other various stakeholders, because they are able to get an idea if their investment in the company is going to render positive returns for them in the near future.
Despite the fact that there are numerous different methods for company valuations, yet it can be seen that capitalized cash flow is one of the most commonly used methods of valuation.
Capitalized Cash Flow method can be described as a method that is used to value companies, depending on the cash flows of the company. This method mainly involves a single economic benefit being capitalized at the capitalization ratio, which subsequently provides the firms valuation at a certain date.
Here, the capitalization rate is defined as the spread between the required rate of return and the company’s expected growth rate.
This particular method to valuate companies is used when the company is expected to have relatively stabilized level of margins (and hence, cash flows), as well as growth in the future.
This particular method is described as an income-based approach to value companies, and it contingent on the projection that the company will have similar streams of income in the coming future.
Therefore, it can be seen that this particular method involves valuing business based on the existing cash flow stream that is subsequently capitalized by the risk-adjusted return.
The underlying premise in the Capitalized Cash Flow method is the fact that the company is perceived to be a growing perpetuity. The assumption here is the fact that the company will continue to grow at a constant rate.
Therefore, this particular approach is only valid for companies and organizations where the company is expected to grow at a constant rate.
In order to calculate the value of the company using Capitalized Cash Flow Model, the following formula is used:
Value of the company = (Expected Free Cash Flow of the Firm) / (WACC– expected growth rate)
The above formula is used in the case where Free Cash Flow is given, along with weighted average cost of capital for the company.
However, in the case where valuation is to be derived using Free Cash Flow to Equity, the formula changes. In that case, Free Cash Flow to Equity is divided by the spread between the required return of equity and the expected growth rate of the company.
Therefore, in this case, the following formula is used for calculating the value of the company:
Value of the company = (Free Cash Flow to Equity) / (Required Rate of Return on Equity – Expected growth rate of the company).
How to Value a Company Based on Capitalized Cash Flow Method?
The main steps taken when valuing a company using Capitalized Cash Flow Method are as follows:
Determination of a sustainable earnings base
Making necessary adjustments in order to convert projected earnings into projected cash flows (this also requires making adjustments for capital expenditures, depreciation, and changes in the working capital as well as other debt instruments.)
Figuring out a suitable capitalization rate
Application of the chosen capitalization rate in order to calculate the value of the company
The steps that are mentioned above are necessary in order to correctly evaluate the free cash flow, and then subsequently arriving at the valuation of the company.
Non-cash expenditures (like depreciation) need to be adjusted in order to arrive at a free and fair value of free cash flow. In the same manner, it is also important to have proper clarity about the growth rate of the company.
Example of Valuation using the Capitalized Cash Flow Method
In order to illustrate the steps mentioned above, the following illustration is provided:
Adjustments to the Net Income
Changes in Working Capital
Changes in Debt
Estimated Cash Flow
Projected Cash Flow Growth
Projected Cash Flow
Required Rate of Return
Value of Company’s Equity
Therefore, as per the example mentioned above, it can be seen that the value of the company’s equity, according to the Capitalized Cash Flow Method turns out to be $ 7,210,000.
In the process above, it can be seen that certain adjustments are made to the net income. This is because the premise of this particular method lies in using income, and then making adjustments to it in order to arrive at the value of the company’s equity.
Permanent Current Assets can be described as assets that are supposed to be maintained by the business over the course of time in order to ensure that the company is able to run its operations. These assets are considered to be current assets that tend to stay persistent on the balance sheet of the company over the course of time.
These are the base accounts based which are carried forward from one year to another, and their sustenance is simply proof of the fact that the business is maintaining itself for the near future. Regardless of the fact that the figures within these accounts change and fluctuate from one year to another, yet these categories of accounts will stay intact.
However, they are still classified as ‘current’ assets, because they are expected to convert into cash over the period of the current year. In other words, they are categorized as current assets because the time to the liquidation of these current assets is within a time frame of 12 months, and hence, by definition of current assets, they are classified as such.
Example of Permanent Current Assets
Permanent Current Assets are classified as assets that are consistently presented on the balance sheet from one year to the next. Some examples of permanent current assets include the following:
Inventory: This mainly includes the inventory that is held by the company for purposes of reselling (in the case where the company is a trading concern) or inventory that is in the form of finished goods, ready to be sold to the market (if the businesses is a manufacturing concern). It would make sense for the businesses to have inventory at any given point in time because it is representative of the fact that the company is a going concern.
Accounts Receivable: During the normal course of the business, a lot of transactions are carried out on credit. In this case, businesses have certain receivables that need to be collected from the customers of the business. This is an account that is carried forward from one year to the next, and it is highly unlikely for businesses to have absolutely no receivables at the end of the particular business year.
Cash: Cash in Bank or cash in hand is the running balance that every company needs to maintain in order to pay day-to-day expenses. This includes petty cash, as well as all the current accounts that the business is maintaining. It is necessary for the bare survival of the businesses, and hence, it is considered as a permanent current asset, because it tends to exist with the business at all times.
Permanent Current Assets vs Temporary Current Assets
The underlying difference between permanent current assets and temporary current assets is the fact that temporary current assets, as suggested by the name, are current asset classes that exist on the financials for a short while.
A business may, or may not have temporary current assets at the end of a given financial year. Just like permanent current assets, they are assets the utility of which is expected to be derived within a period of 12 months. Hence, it is classified as a current asset.
In the same manner, it can also be seen that temporary current assets tend to fluctuate with time, and may or may not exist, at all on the balance sheet.
Temporary assets can be defined as any current asset that is not pivotal for the company’s existence, and therefore, having those assets are good, but is not entirely essential for the survival of the company.
Example of Temporary Current Assets
All current assets which are on a temporary basis on the balance sheet of the company are categorized as temporary current assets. Some examples of temporary current assets are as follows:
Seasonal inventory items: Depending on the nature of the business involved, it can be seen that business often has inventories that are not really finished goods, but are kept either to upsell inventory or for packaging purposes. Therefore, since they are only present with the company for a shorter time duration, they are classified as temporary current assets.
Prepaid Rent (or any other utility): It often occurs that businesses pay an excess of utility, or rent, during the normal course of the business. Hence, in this regard, it is quite important to note that these prepaid entries are considered to be temporary, since they do not always exist on the books, and only occur occasionally.
Therefore, these current assets are categorized as temporary current assets, because they may or may not be carried forward from one year to another.
Prepayment is an accounting term referred to the types of expenses not incurred yet but for which payment is made in advance.
As the economic benefits from such resources are not taken yet this is why it is classified as an asset rather than an expense and shown on the face of the balance sheet rather charging in the profit and loss statement.
Prepayments are those payments, the benefits of which are expected to flow in the future. Here it is necessary to note the difference between the prepayments and advance payments.
Pre-paid is an amount more often paid for the expenses, the benefits from such payments will flow to the entity in the following financial years however the advance payment is the payment made for goods/services without the receipt of goods/services.
In almost all cases, the payment for goods and services is made after the benefits of such services and goods are taken. For example, a payment to the contractor for building a five-story building is made after the completion of the whole project or on an installments basis as per the stage of completion.
In both of the cases whether payment is made at the end of the project after completion or installments basis are made after taking the benefits from the contractor’s services.
However, there are some services, for which payment is compulsory to be at the beginning of the period before taking economic benefits from such goods/services such as the pre-paid rent and payment made for insurance cover under a contract.
There are certain rules set by the accounting standards-setting organizations, according to which the economic resources owned by the entity must be recorded in books of the entity.
According to these rules, all those economic resources the benefits from which yet to taken are classified as an asset and the benefits of the resources of which are already taken shall be charged in the profit and loss statement.
This is the reason the pre-paid expense is classified as an asset and shown on the face of the balance sheet because the benefits from such payments will flow to the entity in upcoming financial years. Thus in short prepayment is the payment made in advance before its accrual.
There are many types of prepayments these payments are mostly made in a corporate environment but it can also be made on an individual basis.
Prepayments made in a corporate environment are made in one accounting period and it will provide benefit in upcoming accounting periods. The main difference between usual expenses is prepaid expense is the recording of expense i.e the usual expense is charged to profit and loss in a single step.
However the pre-paid expense is two steps, that is first it is recorded on the balance sheet as an asset and then charge to the profit and loss statement upon the fulfillment of conditions attached to the pre-paid expenses.
The prepayments made for any expense is a business activity, which is needed to be recorded in order to show the true and fair and clear financial picture of the entity.
For example, if we are making a prepayment to any insurance company for ensuring the factory building then we will record the event as a debit to the prepaid insurance account and credit to the cash or bank account.
Such prepaid insurance amount will be classified on the asset side of the balance sheet and charge to the profit and loss account as an expense upon completion of the insured period.
There are many examples where the business entity is required to pay for expenses in advance. Such payments are made in advance and upon the payment it is recorded as an asset, the examples of such payments are listed as under:
Advance rent paid for the occupation of a space for carrying on a business activities
Payments made for the insurance of a business asset in order to minimise the loss in case of any mishap
Assets acquired in order to complete the business operations and preparation of goods and services
Salaries paid to the employees if paid in advance according to the terms of contract defined in the employment contract
Any payments made to the authorities in advance under the law or regulation
Payments made for the utilities in advance; and
Interest payment made in advance
This is not an exhaustive list of the prepayments made by the business entities, there may be many other examples of payments made for the expenses according to the nature of the business entity.