SECURITIES

EQUITY SECURITIES

A company may have idle cash that it does not need immediately for its current
operations. Just like individuals, a company may seek to invest this money so that
its value grows over time. Rather than placing the cash in checking or savings
accounts in banks, where interest rates are relatively low, companies may choose
to invest in other corporations or government entities for potentially higher rates
of return.
One option is for the company to invest in equity securities, which involves
purchasing stock in other corporations. Equity is actual ownership, and stock can
be considered a receipt that confirms that ownership. The investor buys a number
of shares of stock at a purchase price per share. The investor becomes a partial
owner of the corporation and is called a stockholder.

The stock investor may then benefit in two ways. First, the investee (company
invested in) may pay dividends, which are payouts of profits, to stockholders.
Secondly, the market value per share may increase over time, and the investor may
experience a gain on the value of the shares owned. Although there is not necessarily
a guarantee of dividends or appreciation of the value of the shares of stock owned,
these are the two main incentives that attract companies and individuals to invest
in stock. There is no repayment due date on the ownership of shares of stock.
Investments in stock may be classified as either short or long-term assets,
depending on the length of time that the buyer intends to hold the equities. Shortterm stock
investments held for less than one year may be called marketable
securities and appear as a current asset on the investor’s balance sheet. Longterm
investments in stocks are held for more than one year—often many
years—by the investing corporation. These are listed in the Investments section
of the firm’s balance sheet.

A second investment choice for the company is debt securities, such as

corporate or governmental bonds. Bonds are loans made collectively by smaller
lenders, such as other corporations and individual people, to a corporation. The
people or companies who invest in corporate bonds are called bondholders. They
do not become owners of a corporation like stockholders do; they are just lenders.
Bondholders lend their money to corporations in order to be paid interest on
the loan amount throughout the number of years in the term of the bond. Interest
on corporate bonds is often paid semi-annually—every six months. On the maturity
date, bondholders are repaid the original amount that they loaned the corporation.
Investments in bonds may be classified as either short or long-term assets,
depending on the length of time that the buyer intends to hold the investment.
Short-term bond investments held for less than one year may be called marketable
securities or trading securities and appear as a current asset on the investor’s
balance sheet. Long-term investments in bonds are held for more than one
year—usually many years—by the investing corporation. These are listed in the
Investment section of the firm’s balance sheet for most of their life and only become
current assets within one year of their maturity date. Long-term investments in
bonds are classified as either held-to-maturity or available-for-sale securities,
which will be explained in the following section.

Certain types of stock and bond investments may be sold at breakeven, at

a gain, or at a loss, similar to the sale of fixed assets. Again, it is important to
note that any gain or loss is incurred on an investment transaction is outside of
what occurs in normal business operations. When a gain or loss on the sale of
an investment is recognized in the same transaction as the receipt of cash, it is
considered a realized gain or loss, because it occurs only at the time of the sale
and is based on the amount of cash received.

Other types of stock and bond investments are adjusted to fair value, or the
current trading price on the open market, throughout the time they are owned by
the investor. Adjustments just prior to preparing financial statements may result in reporting a
gain or loss, but in this case any gain or loss is considered unrealized
since a sale has not transpired and no cash has been received yet. These concepts
will be elaborated on in the discussions of investments that follow.
The following Accounts Summary Table summarizes the accounts relevant to
investing in stocks and bonds.

Investments in Stock
A company may invest in the stock of other corporations if it has no immediate
need for its cash. A separate account that mentions the unique name of the
corporation for each stock investment is used. For example, a company might
invest in the stock of three other corporations and use Investment in ABC Stock,
Investment in Home Depot Stock, and Investment in Delta Airlines Stock as
their three distinct asset account names. (On the balance sheet, these individual
investment accounts may be combined in the Marketable Securities listing for
short-term investments and/or the Equities Securities listing for long-term
investments for an efficient presentation.)

There are five possible journal entries related to investing in stock, as follows:
1. Purchase the stock investment
2. Receive dividend payments
3. Recognize net income of the issuing corporation
4. Adjust to fair value
5. Sell the stock investment

Each stock investment is accounted for using one of two methods, either the
fair value through net income method or the equity method. The choice for
each investment depends on the percentage of another corporation’s outstanding
shares that the investing company purchases.

If a company purchases less than 20% of another corporation’s outstanding

shares, the fair value through net income method is used. Investors who
own less than 20% of the outstanding shares are not considered to have significant
influence over the company they are investing in. An example would be the purchase
of 1,000 shares of another corporation that has 100,000 shares outstanding. The
investor owns only 1% (1,000 / 100,000).

If a company purchases between 20% and 50% of another corporation’s

outstanding shares, the equity method is used. Investors who own between 20%
and 50% of the outstanding shares are considered to have significant influence over
the company they are investing in. An example would be the purchase of 40,000
shares of another corporation that has 100,000 shares outstanding. The investor
owns 40% (40,000 / 100,000).

The purchase of more than 50% of another corporation’s outstanding shares is

considered a consolidation and will not be discussed.
Two versions of the five journal entries related to investing in stock are
illustrated side by side in the journal entries that follow. The transactions on the
left illustrate the fair value through net income method where the investor owns
10% (less than 20%) of the outstanding shares. Those on the right show the equity
method, where the investor owns 25% (more than 20%) of the outstanding shares.
Explanations are included.

1. PURCHASE THE STOCK INVESTMENT

There is no difference between the fair value through net income and equity
methods when stock is purchased. The accounts used in the journal entries are
identical under both methods.

2. RECEIVE DIVIDEND PAYMENTS

One difference between the fair value through net income and equity methods
is seen when the issuing corporation pays cash dividends.

Fair value through net income method

Under the fair value through net income method, the investor simply reports
dividend receipts as revenue. The Dividends Revenue account is credited.

Equity method
Under the equity method, dividend receipts are reported as a reduction of the
investment account. The investing company’s significant ownership percentage
results in a transaction that is analogous to the corporation paying itself.
3. RECOGNIZE NET INCOME OF THE ISSUING CORPORATION
Another difference between the fair value through net income and equity
methods is seen when the issuing corporation reports net income.

Fair value through net income method

There is no journal entry under the fair value through net income method,
where the percentage of investor ownership is not considered significant enough
to participate in the issuing company’s earnings.

Equity method
Under the equity method, the investing corporation owns such a significant
percentage of the issuing corporation’s shares that it actually takes ownership of
its percentage of the issuing corporation’s net income and reports it as its own. In
this case, Your Corporation owns 25% of ABC Corporation’s outstanding shares, so
it recognizes 25% of ABC Corporation’s net income ($100,000 x 25% = $25,000).
This results in an increase in the value of the investment account as well.
4. ADJUST TO FAIR VALUE

Fair value through net income method

A third difference between the two methods is that the carrying value of the
investment under the fair value through net income method must be adjusted to
fair value at the end of each accounting period. Fair value is the current trading
price of the stock on the market, which is readily available for public corporations
in financial newspapers and online sites.
For investments that involve less than 20% of the issuing corporation’s
outstanding stock, a gain or loss is recorded if fair value is different than carrying
value. However, it is an unrealized gain or loss since the investment has not yet
been sold and there are no cash proceeds yet. The investment account is debited
if the fair value increases, and an unrealized gain is recognized by crediting the
Unrealized Holding Gain/Loss – Net Income account. These accounts in the
journal entry are reversed and an unrealized loss results if the fair value of the
investment declines.
The Unrealized Holding Gain/Loss – Net Income account appears on the income
statement under a category heading called other comprehensive
income section, after the net income line. An unrealized gain is added to net
income and/or an unrealized loss is deducted from it to arrive at the final income
statement amount of comprehensive income. Unrealized gains and losses are
 treated similarly to realized gains and losses—which occur when the stock is
actually sold for cash—in terms of arriving at the final income statement amount.
The Unrealized Holding Gain/Loss – Net Income account is adjusted at least
annually to reflect the current trading price of the stock investment.

Equity method
For investments that involve 20% or more of the issuing corporation’s
outstanding stock, there is no adjustment to fair value.

5. SELL THE STOCK INVESTMENT

Fair value through net income method

A final difference between the two methods is on the sale of the investment. The
carrying value of the investment under the fair value through net income method
must be adjusted to fair value at the time the shares are sold. The investment account
is debited if the fair value increases, and an unrealized gain is recognized by crediting
the Unrealized Holding Gain/Loss – Net Income account. These accounts in the
journal entry are reversed if the fair value of the investment declines.

Equity method
For investments that use the equity method, there is no adjustment to fair
value at the time of sale.
Investments in Stock on the Financial Statements
The investment in stock accounts appear in the assets section of the balance
sheet. Those that are intended to be sold or traded within one year are current
assets. Those that are intended to be held for more than one year are categorized
as long-term investments.

LESS THAN 20% OWNERSHIP (FAIR VALUE THROUGH NET

INCOME METHOD)
The Unrealized Holding Gain/Loss – Net Income account appears on the
income statement as part of other comprehensive income. It represents the
amount of gain or loss on investments that have not yet been sold, but whose fair
value has changed since their initial cost. A fair value greater than cost represents
an unrealized gain; a fair value less than cost represents an unrealized loss. The
Unrealized Holding Gain/Loss – Net Income account is adjusted over time,
particularly before financial statements are prepared, to update the unrealized
gain or loss amount based on the most current fair value.
The Gain on Sale of Investment and Loss on Sale of Investment accounts that
represent actual gains and losses from the sale of investments are not used for
stock investments that are less than 20% of outstanding shares. This is because
the Unrealized Holding Gain/Loss – Net Income account is updated just prior to
the sale to bring the investment account to fair value, which is the amount of cash
received from the sale. Therefore, no realized gain or loss is recognized at that time.

20% TO 50% OWNERSHIP (EQUITY METHOD)

For investments that involve 20% or more of the issuing corporation’s
outstanding stock, there is no adjustment to fair value and the Unrealized Holding
Gain/Loss – Net Income account is not used.
The Gain on Sale of Investment and/or Loss on Sale of Investment accounts
appear on the income statement as other income. These represent realized gains
or losses that result from the sale of stock investments under the equity method.
The following table includes financial statements with select accounts for a
company that holds equity investments.