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:
Trading securities [(1,000 shares x $14.22) + $180 commission] |
Debit 14,400 |
Credit |
Cash | 14,400 | |
Purchased 1,000 share of Cowen common stock as a near-term investment at 14.22 plus commission. |
Debit | Credit | |||
Dec. | 1 | Dividends receivable | 1,000 | |
Dividends revenue | 1,000 | |||
To record $1 per share cash dividend on Cowen common stock, payable 2010 January 15. |
Debit | Credit | |||
Jan. | 15 | Cash | 1,000 | |
Dividends receivable | 1,000 | |||
To record the receipt of a cash dividend on Cowen common stock. |
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.
Company |
No. of shares |
Cost per Share |
Market Price per share Dec 31 |
Total cost |
Total market Dec 31 |
Increase/(decrease) in market value |
A | 200 | $35 | $40 | $ 7,000 | $ 8,000 | $ 1,000 |
B | 400 | 10 | 15 | 4,000 | 6,000 | 2,000 |
C | 100 | 90 | 50 | 9,000 | 5,000 | (4,000) |
$20,000 | $19,000 | $ (1,000) |
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:
Debit | Credit | |||
Dec. | 31 | Unrealized loss on trading securities | 1,000 | |
Trading securities | 1,000 | |||
To record unrealized loss from market decline of trading securities. |
Debit | Credit | |||
Jan. | 1 | Cash | 5,000 | |
Trading securities- Company C Stock | 5,000 | |||
To record sale of Company C Stock. |
Available-for-sale securities
For another example assume a marketable equity security that management does not intend to sell in the near term has a cost of $32,000 and a current market value on December 31 of $31,000. The treatment of the loss depends on whether it results from a temporary decline in market value of the stock or a permanent decline in the value. Assume first that the loss is related to a “temporary” decline in the market value of the stock. The required entry is:Debit | Credit | |||
Dec. | 31 | Unrealized loss on available-for-sale securities | 1,000 | |
Available-for-sale securities | 1,000 | |||
To record unrealized loss from market decline of available-for-sale securities. |
Hanson Company
Partial Balance Sheet
December 31
Investments (or Current Assets)*: | |
Available-for-sale securities | $31,000 |
Stockholders’ equity: | |
Capital stock | $xxx,xxx |
Additional paid-in capital | X,xxx |
Total paid-in capital | $xxx,xxx |
Less: Unrealized loss on available-for-sale securities | 1,000 |
$xxx,xxx | |
Retained earnings | Xx,xxx |
Total stockholders’ equity | $xxx,xxx |
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:Debit | Credit | |||
Jan. | 1 | Realized loss on available-for-sale securities | 1,000 | |
Unrealized loss on available-for-sale securities | 1,000 | |||
Cash | 31,000 | |||
Available-for-sale securities | 31,000 |
Realized loss on available-for-sale securities | 1,400 | |
Available-for-sale securities | 1,400 | |
To record loss in value of available-for-sale securities. |
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- Accounting Principles: A Business Perspective. Authored by: James Don Edwards, University of Georgia & Roger H. Hermanson, Georgia State University. Provided by: Endeavour International Corporation. Project: The Global Text Project. License: CC BY: Attribution
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