Investments, whether in equities or debt securities, are always recorded at cost in the balance sheet.
Any premium or discount, brokers fee or tax is not recorded, but is ingrained in the cost.
Any dividend or interest revenue is debited to cash and credited to respective revenue accounts.
The investments need not be revalued, as they are only for short term.
dividend revenue 1 10000
6. Good will is not amortized
Between 20 and 50% (equity method)
In this case if the acquiring company has significant influence over the target company, then the equity method is used or else cost method is used. In the equity method, the investment is shown at cost same as in the cost method used in investments below 20% and temporary investments.
The only difference is in the re valuation of the investments every year and the treatment of dividends.
Instead of revaluing the investment, according to the average market value every year, as in cost method, the investments are not revalued at all and no gain/loss is shown in the income statement.
Instead a portion of the net income of the target company, proportional to the stake percentage is debited(added) to the investments and a portion of net loss credited (subtracted) if it is a loss. This portion of net income or loss is also credited/debited to the investment revenue account to balance the entry. This come into the income statement, thus balancing the balance sheet.
Instead of recording the dividends as a revenue as in cost method, it is shown as a decrease in value of the investment. This is because dividend reduces the retained earnings of a the company, thus, here reducing the equity of the target company.
Also if excess amount is paid above the book value of the company, then the assets are revalued and gains are reduced from the excess, rest accorded to the goodwill. All the gains/losses are NOT recorded in the net income calculation, and the additional depreciation, net of tax is also subtracted from the net income. Good will is not amortized
This method is thoroughly illustrated in the example given below.
A holding company buys 40% of Target company's outstanding stock for $50,000. The book value of Target company, according to its books, is $100,000(500 nos of 100 par and $50000 additional paid in capital).
Since 40% of $100,000 is only $40,000, Company A has overpaid for this investment by $10,000.
Let us assume that $5,000 of this difference is due to an understatement in the fixed asset and $5,000 is due to unrecorded goodwill and the holding company has significant good will.
Target company earned $50,000 net income after the purchase in year 1. And declares a dividend of 10%. Tax rate is 30%.
The entries are:
For the purchase:
For recording the income portion
investment in long term securities 14650
Investment revenue 14650
( depreciation exp on the $ 5000 increase in asset value is $500 per year (10 yr life), and net of tax is 500(1-.30).)
For recording the dividend revenue@10% of 500*100 par*40%
investment in long term securities 2000
LONG TERM DEBT SECURITIES
Long term debt securities are recorded in the exact manner as an issue of long term debt security by a company is recorded. Only the credits and debits are reversed.
Discounts and premiums are amortized with either the straight line method or the Effective interest method.
Stock dividends increases the number of shares held in a company. The causes the cost per share to fall in the exact proportion. The new cost is just mentioned in a memorandum entry and not recorded in any manner. No thought is given for the change in the value of shares outstanding. EPS etc in the target company.
Suppose a company has $20000 (100 shares of $200 market and $100 par) shares as investment. Suppose it receives 10% stock dividend ie 10 shares. The total cost is the same, but the number increases by 10. So now the cost per share is $181.81
If the company even sells 100 shares for $190 then also it makes a gain of $8.19 per share.
STOCK OPTION WARRANTS
Warrants are always allocated a value in proportion to the market values of the security with which the warrants are issued and the market value of the warrants.
Suppose a warrant is issued per share of a company and another company buys the total package of 1000 warrants with a market value of $30 and 100 shares with market value of $175, for a total consideration of $200000. A warrant can be exchanged for a share for a price of $145. Then the recording is as below.
Investment in equity securities 170731
Investment in stock option warrants 29269
(the total consideration is split in the ratio of 175:30)
Suppose a company buys 1000 shares of $200. And then the target company issues warrants in the ratio of a warrant for a share, which can be converted to a share for a price of $145. If the market value of the shares is $175 and warrant is $30, the recording is as follows.
Investment in equity securities 200000
investment in stock option warrants 29269
investment in equity securities 29269
In both cases a single warrant has a price of $29.27
Suppose 400 are sold for $35 each, 400 are converted, 200 are expired, then
cash 14000 (400 warrants sold for $35)
Investment in stock option warrants 11708 (400 warrants of$29.27)
gain on sale of security 2292
investment in equity securities 69708 (400 shares of 174.27)
investment in stock option warrants 11708
cash 58000 ($145*400)
loss on expiration of warrants 5854
investment in stock option warrants 5854