Accounting for short-term stock investments and for long-term stock investments of less than 20 percent Accountants use the cost method to account for all short-term stock investments. When a company owns less than 50% of the outstanding stock of another company as a long-term investment, the percentage of ownership determines whether to use the cost or equity method. A purchasing company that owns less than 20% of the outstanding stock of the investee company, and does not exercise significant influence over it, uses the cost method. A purchasing company that owns from 20% to 50% of the outstanding stock of the investee company or owns less than 20%, but still exercises significant influence over it, uses the equity method. Thus, firms use the cost method for all short-term stock investments and almost all long-term stock investments of less than 20%. For investments of more than 50%, they use either the cost or equity method because the application of consolidation procedures yields the same result. Cost method for short-term investments and for long-term investments of less than 20 percentWhen a company purchases stock (equity securities) as an investment, accountants must classify the stock according to management’s intent. If management bought the security for the principal purpose of selling it in the near term, the security would be a trading security. If the stock will be held for a longer term, it is called an available-for-sale security. Trading securities are always current assets. Available-for-sale securities may be either current assets or noncurrent assets, depending on how long management intends to hold them. Each classification is accounted for differently. This topic will be discussed later in this chapter. Securities can be transferred between classifications; however, there are specific rules that must be met for these transfers to be allowed. These rules will be addressed in intermediate accounting. Under the cost method, investors record stock investments at cost, which is usually the cash paid for the stock. They purchase most stocks from other investors (not the issuing company) through brokers who execute trades in an organized market, such as the New York Stock Exchange. Thus, cost usually consists of the price paid for the shares, plus a broker’s commission. For example, assume that Brewer Corporation purchased as a near-term investment 1,000 shares of Cowen Company’s $10 par value common stock at $14.22 per share, plus a $180 broker’s commission. Brokers quote most stock prices in dollars and cents. Brewer’s entry to record its investment is:
FASB Statement No. 115 (1993) governs the subsequent valuation of marketable equity securities accounted for under the fair market value method.[1] Marketable refers to the fact that the stocks are readily saleable; equity securities are common and preferred stocks. The Statement also addresses the subsequent valuation of debt securities. FASB Statement No. 159 (2007) amends FASB Statement No. 115 and gives a fair value alternative that allows companies to elect to measure certain items at fair value at a specified date. The subsequent valuation of debt securities will be addressed in intermediate accounting classes.
The FASB Statement requires that at year-end, companies adjust the carrying value of each of their two portfolios (trading securities and available-for-sale securities) to their fair market value. Fair market value is considered to be the market price of the securities or what a buyer or seller would pay to exchange the securities. An unrealized holding gain or loss will usually result in each portfolio. Trading securities To illustrate the application of the fair market value to trading securities, assume that Hanson Company has the securities shown in Exhibit 1 in its trading securities portfolio. Applying the fair market value method reveals that the total fair market value of the trading securities portfolio is $1,000 less than its cost. The journal entry required at the end of the year is:
Available-for-sale securities
Hanson Company Partial Balance Sheet December 31
Note that the unrealized loss for available-for-sale securities appears in the balance sheet as a separate negative component of stockholders’ equity rather than in the income statement (as it does for trading securities). An unrealized gain would be shown as a separate positive component of stockholders’ equity. An unrealized loss or gain on available-for-sale securities is not included in the determination of net income because it is not expected to be realized in the near future. These securities will probably not be sold soon. The sale of an available-for-sale security results in a realized gain or loss and is reported on the income statement for the period. Any unrealized gain or loss on the balance sheet must be recognized at that time. Assume the stock discussed above is sold on January 1 of the next year for $31,000 (assuming no change in market value from the previous day) after the company had held the stock for three years. The entries to record this sale are:
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