Accounting: The Language of Business (Part 88)

I went to a special public school that was much more focused on academics and learning. My two best teachers were in accounting and calculus, so I fell in love with that, which made me want to go into business.

Stacy Brown-Philpot

Income Taxes, Unusual Income Items, and Investments in Stocks (Part D) 

by

Charles Lamson

Accounting for Investments in Stocks

Corporations not only issue stock, but they also purchase stocks of other companies for investment purposes. Like individuals, businesses have a variety of reasons for investing in stocks, called equity securities. A business may purchase stocks as a means of earning a return (income) on excess cash that it does not need for its normal operations. Such investments are usually for a short period of time. In other cases, a business may purchase the stock of another company as a means of developing or maintaining business relationships with the other company. A business may also purchase common stock as a means of gaining control of another company's operations. In these two latter cases, the business usually intends to hold the investments for a long period of time.

The equity securities in which a business invests may be classified as trading securities or available-for-sale securities. Trading securities are securities that management intends to actively trade for profit. Businesses holding trading securities are those whose normal operations involve buying and selling securities. Examples of such businesses include banks and insurance companies. Available-for-sale securities are securities that management expects to sell in the future but which are not actively traded for profit. In this section, we describe and illustrate the accounting for available-for-sale equity securities.

Short-Term Investments in Stocks

Rather than allow excess cash to be idle until it is needed, a business may invest in available-for-sale securities. These Investments are classified as temporary investments or marketable securities. Although such investments may be retained for several years, they continue to be classified as temporary, provided they meet two conditions. First, the securities are readily marketable and can be sold for cash at any time. Second, management intends to sell the securities when the business needs cash for operations.

Temporary investments in available-for-sale securities are recorded in a current asset account, Marketable Securities, at their cost. This cost includes all amounts spent to acquire the securities, such as brokers commissions. Any dividends received on the investment are recorded as a Debit to cash and a credit to Dividend Revenue.

To illustrate, assume that on June 1 Crabtree Co. purchased 2,000 shares of Inis Corporation common stock at $89.75 per share plus a brokerage fee of $500. On October 1, Inis declared a $0.90 per share cash dividend payable on November 30. Crabtree's entries to record the stock purchased and the receipt of the dividend are as follows:

On the balance sheet, temporary Investments are reported at their fair market value. Market values are normally available from stock quotations in financial publications and websites. Any difference between the fair market values of the securities and their cost is an unrealized holding gain or loss. The gain or loss is termed "unrealized" because the transaction (the sale of the securities) is necessary before a gain or loss becomes real (realized).

To illustrate, assume that Crabtree Co.'s portfolio of temporary investments was purchased during 2023 and has the following fair market values and unrealized gains and losses on December 31, 2023:

If income taxes of $18,000 are allocated to the unrealized gain, Crabtree's temporary investments should be reported at their total cost of $690,000, plus the unrealized gain (net of applicable income tax) of $42,000 ($60,000 - $18,000), as shown in Exhibit 4.

EXHIBIT 4 Temporary Investments on the Balance Sheet

The unrealized gain (net of applicable taxes) of $42,000 should also be reported as an other comprehensive income item, as was mentioned in the preceding section. For example, assume that Crabtree Co. has net income of $720,000 for the year ended December 31, 2023. Crabtree elects to report comprehensive income in the statement of comprehensive income, as shown in Exhibit 5. In addition, the accumulated other comprehensive income on the balance sheet would also be $42,000, representing the beginning balance of zero plus other comprehensive income of $42,000, as shown in Exhibit 4.

    EXHIBIT 5 Statement of Comprehensive Income

Unrealized losses are reported in a similar manner. Unrealized gains and losses are reported as other comprehensive income items until the related securities are sold. When temporary securities are sold, the unrealized gains or losses become realized and are included in determining net income.

Long-Term Investments in Stocks

Long-term investments in stocks are not intended as a source of cash in the normal operations of the business. Rather, such investments are often held for their income, long-term gain potential, or influence over another business entity. They are reported in the balance sheet under the caption investments, which usually follows the Current Assets section.

Long-term investments in stock are treated as available-for-sale securities, as we illustrated previously for short-term available-for-sale securities. However, if the investor (the buyer of the stock) has significant influence over the operating and financing activities of the investee (company whose stock is owned), the equity method is used.

When the investor does not have a significant influence over the investee, the investment is recorded at cost and reported at fair market value net of any applicable income tax effects. In addition, any unrealized gains and losses are reported as part of the comprehensive income.

When the investor has a significant influence and the equity method is used, a stock purchase is recorded at cost, as shown previously. Evidence of significant influence includes the percentage of ownership, the existence of intercompany transactions, and the interchange of managerial personnel. Generally, if the investor owns 20% or more of the voting stock of the investee, it is assumed that the investor has significant influence over the investee.

Under the equity method, the investment is not subsequently adjusted to fair market value. Rather, the book value of the investment is adjusted as follows:

1. The investor's share of the periodic net income of the investee is recorded as an increase in the investment account and as income for the period. Likewise, the investor's share of an investee's net loss is recorded as a decrease in the investment account and as a loss for the period.

2.  The investor's share of cash dividends from the investee is recorded as an increase in the cash account and a decrease in the investment account.

To illustrate, assume that on January 2, Hally Inc. pays cash of $350,000 for 40% of the common stock and net assets of Brock Corporation. Assume also that, for the year ending December 31, Brock Corporation reported net income of $105,000 and declares and pays $45,000 in dividends. Using the equity method, Hally Inc. (the investor) records these transactions as follows:

The combined effect of recording 40% of Brock Corporation's net income and dividends is to increase Hally's interest in the net assets of Brock by $24,000 ($42,000 - $18,000), are shown below.

The equity method causes the investment account to mirror the proportional changes in the book value of the investee. Thus, Brock Corporation's book value increased by $60,000 ($105,000 - $45,000), while the investment in Brock account increased by Hally's proportional share of that increase, or $24,000 ($60,000 * 40%). Both the book value of Brock Corporation and Holly's investment in Brock increased at the same rate from the original cost.

Sale of Investments in Stocks

Accounting for the sale of stock is the same for both short-term and long-term investments. When shares of stock are sold, the investment account is credited for the carrying amount (book value) of the shares sold. The cash or receivables account is debited for the proceeds (sales price less commission and other selling costs). Any difference between the proceeds and the carrying amount is recorded as a gain or loss on the sale and is included in determining net income.

To illustrate, assume that an investment in Drey Inc. stock has a carrying amount of $15,700 when it is sold on March 1. If the proceeds from the sale of the stock are $17,500, the entry to record the transaction is as follows: 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 571-575*

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