Sunday, 21 October 2012

Recording Investments in securities

TEMPORARY INVESTMENTS (Trading securities)

          The cost method is used to record temporary investments.

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.


consider the following examples

100 par shares of 1000 nos are bought at $150 a piece, with a brokers fee and tax of $2000. Dividend of 10% is declared while the shares are still held during the date of record.

investment in short term equity securities     152000
cash                                                                                               152000

and sold @ 160, brokerage of 2500

cash                                                           157500
investment in short term equity securities      152000
gain on sale of securities                                                                    5500

cash                                                             10000
dividend revenue                                                                       1      10000


consider the following example

1000 bonds of 100 par bonds are purchased at a premium of $2000, with additional costs of $2000

inv in sh term dbt sec                                 104000
cash                                                                                                  104000

and gain and losses are marked over book value when sold.

Dividend revenue and interest revenue are recorded yearly or accrued (in case of interest, if the interest date is different from the year end)

If a $100000 12% bond is issued at a later date at april 1, than the interest date of dec 31st, the bond is sold at a premium of the accrued interest as and is recorded as follows

inv in sh term dbt sec                                100000
interest revenue                                            4000
cash                                                                                                  104000

when the interest of $12000 is earned, it is recorded as

cash                                                          12000
interest revenue                                                                                   12000


Long term equity investments

Above 50%

If the investment is more than 50% of the equity in a company, then the statements have to be consolidated. The following procedures are done prior to preparing consolidated statements.

1. The excess amount above the book value of the target company to be paid by the acquiring company is calculated.

2. All the assets of the target company are revalued.

3. If there is a gain in re valuation, then the excess amount paid by the acquiring company is reduced by this amount. The rest is the goodwill of the target company. If there is a loss, it is added to the excess amount of the company, and the total amount is shown as the good will. This is because, a acquirer company pays excess amount only when it feels that the assets of the target company are understated or there is a goodwill for the target company which more than compensates the excess price paid even if the assets are over valued.

4. The gains/losses in re valuation are shown in the consolidated income statement. 

5. In addition to this the increased or decreased depreciation expense due to gain/loss in the revaluation of assets are also reflected in the consolidated income statements.

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:

investment in long term equity securities     40000
cash                                                                                               40000

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%

cash                                                           2000
investment in long term securities                                                     2000


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.


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
Cash                                                                                 200000

(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
cash                                                                                 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

for sales

cash                                                    14000                               (400 warrants sold for $35)             
Investment in stock option warrants                                   11708 (400 warrants of$29.27)
gain on sale of security                                                         2292        

for conversion

investment in equity securities               69708                                (400 shares of 174.27)
investment in stock option warrants                                    11708
cash                                                                                   58000 ($145*400)

for expiration

loss on expiration of warrants             5854
investment in stock option warrants                                     5854

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