COST METHOD AND EQUITY METHOD

     Generally, for recording investment in securities, Cost method and Equity method are used.

EQUITY METHOD

Equity Method is used to record Long term investment in securities ( Available for sale securities) where the holding company has significant influence over the target company or if the stake in the target company is more than 50%.

The method is elaborated in the blog on recording temporary investments.

COST METHOD

Under this method, whether the investment is in debt or equity securities, the securities are divided into different categories.

Held-to-maturity securities



Held-to-maturity securities are securities which a holding company intends to and has the ability to hold till their maturity. Equity securities do not fall into this criteria, as they do not mature.  Held-to-maturity debt securities are reported on the balance sheet at amortized cost (acquisition cost adjusted for premium and discount amortization). They are not revalued according to their FMV.

Trading securities

Trading securities are held to be sold in a short term period.  Discounts and premiums in debt securities are not amortized, and the securities are revalued according to their FMV. The gain/loss is reported in the net income.

For eg if it is a gain

Valuation Allowance                             xxx
Unrealised Holding income-net income            xxx

Available-for-sale securities

Available-for-sale securities (both debt and equity are securities being held for an indefinite time. These are not intended to be sold in short term or held to maturyty. These, like trading securities, are revalued according to their fair market value but is different from trading securities.  All gains and losses are reported  in the other comprehensive income.

For eg if it is a loss

Unrealised Holding Loss-OCI              xxx
Valuation Allowance                                        xxx

TRANSFER FROM ONE CATEGORY TO ANOTHER

If the securities are transferred to or from trading security  category, then they are re valued and the gain/ loss goes to the net income. If the securities are transferred to or from held to maturity category to the available for sale category, then they are re valued and the gain/ loss goes to the other comprehensive income.

To and from trading securities

If it is a loss after valuation


Unrealised Holding Loss-Net income            xxx
Valuation Allowance                                                xxx

From held to maturity to available for sale

If it is a gain after valuation



Valuation Allowance                                  xxx
Unrealised Holding income-OCI                            xxx

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.

Equity

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

Debt

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 INVESTMENTS

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

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

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
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

Bonds Vs Preferred Stock

1. Bonds are considered as a debt, while preferred stock are considered as equity, though both the bond holder and the preferred share holder may be completely different from a common share holder, and both don't have voting rights.

2. Both bonds and preferred stock can be issued at a premium or a discount. In preferred stock, the premium is called additional paid in capital.

3. The interest has to be paid regularly for a bond (failure causes bankruptcy), while the dividends have to be paid for a preferred stock, when it is declared for the common stock.

4. Preferred stock to bonds in the claim to assets on liquidation,

5. Interest is prorated on the EPS calculation, while preferred dividend is not. Because, the dividend is paid in full, irrespective of the issue date of the preferred stock, unlike the interest for bonds outstanding.

Warrants and Employee stock options

STOCK OPTION  WARRANTS

          A warrant is a right given to the holder to buy shares in a company at a fixed price mentioned in the warrant, until tehdate of expiry, irrespective of the market price. The price, the holder has to pay, is generally lower than the expected market price during conversion. The company issues fresh shares in leu of the submitted warrants as described later.

         A warrant can be attached to a bond, which can be detached and traded in the market, or can be issued without being attached to any securities.

         A warrant always has a market value, which is derived from the following parameters

1. Price, the holder has to pay to convert the warrants into fresh shares from the company.

2. The profit of the warrant holder, if he chooses to submit the warrants. This is the difference between the price the holder has to pay, and the current market price of the shares.

3. The time remaining for the warrants to expire.

         Various models are used to value the warrants from the above parameters.

DETACHABLE WARRANT ISSUED ALONG WITH A BOND

Consider a 100 bonds issued at 100 par, with a warrant for buying a share at 110 of 100 par stock for a total of $10000. At the time of sale, the bonds sell for 102and the warrants have a market value of $30.

Here the total consideration of $10000 for the bond means that it also has a discount attached to it as the interest rate for such bonds are much lower when compared with bonds issued without warrants.

In order to value that discount, we proportion the total consideration in the ratio of the market values of bonds and warrants. As we know both values, we use the proportional method. Or else, incremental method can be used.

According to the proportional method, the price apportioned for the bond is 7727 and for the warrant is 2273.

This proportion of the warrants is used as the discount on the bond issue. This is because, the discount account is used to compensate for the lower interest rate. And the lower interest rate is accepted by the buyers, because of the profit expectation from warrant conversion, which is exactly equal to the market value proportion of the warrant.

 The journal entries are

cash                                                     7727

discount                                               2273

bonds payable                                                                 10000

cash                                                     2273

paid in capital- stock warrants                                           2273

on conversion

cash                                                    11000

paid in capital-stock warrants               2273

common stock                                                                  10000

paid in capital in excess of par                                            3273

  

when retired

paid in capital - stock warrants             2273

paid in capital- expired stock warrants                                2273

from the entries we can find that the common stock is created at 132.73 a share including the additional paid in capital.

If the market value of the shares is close to the value of fresh shares (132.73 in the above situation) issued in leu of the warrants, then the warrants and the bond are priced exactly as required on the market ie, the bond holder, will get the exact discount (as a profit in the warrant conversion) as required by the prevailing market interest rates.

If the market value of the shares is much more, then the bond holder makes a profit equal to the difference between the value of fresh shares created with the additional paid in capital and the market value of the shares. 

The losers are the existing shareholders as the earnings has to be spread over a greater number of shares. But if the market value of the shares is the same as the value of fresh shares created with the additional paid in capital, then the price paid on the conversion, along with the discount paid at the time of the bond purchase ($13273 in the above case)  creates a capital which will soon restore the earnings to a value which will compensate the dilution, when warrants are converted.

STAND ALONE WARRANTS

 Stand alone warrants are rights to buy share of a company at a pre designated price until the date of expiry , irrespective of the market price. They are not attached to any debt or equity instruments.

Consider the following example

100 warrants are issued with a right to buy 100 shares, 100 par at a designated price of 110. The market value of the warrants is $30 per warrant.

No journal entries are made to record the warrants, unlike in the previous case of those attached with bonds. This is because, no cash is given or apportioned (as in the previous case) for the market value of the warrants.

When converted

cash                                                   11000
common stock                                                            10000
paid in capital in excess of par                                      1000

Thus we see that the fresh shares issued against the warrants have a value of only 110 per share, no additional paid in capital is formed which incorporates the apportioned market value of the warrants, unlike in the previous case.

This means that even if the market value of the shares is the sum of   the amount given at conversion and the market value of the warrant ie per share $140 ( $110 +$30), the warrant holder makes a neat profit of $30 per warrant.

The losers are the then existing shareholders,who loses due to dilution in the EPS. There is no additional cash given for the market value of the warrant as apportioned as discount in the previous case of warrants attached with bonds. Therefore there is no additional capital to overcome the deficit in the EPS  as argued in the previous case.

One method to record the lost value to the existing share holders is by expensing the market value of the warrant, similar to the treatment of Employee stock options as given below.

Warrant expense                             3000
Paid in capital-stock warrants                                   3000

But since this expense is not spread between the service years as the ESOPs, this expense becomes too large to be absorbed in the net income of a single year.

WARRANTS WITH STOCK OFFERINGS

Warrants are issued with IPOS or FPOS or Private placements or offered to existing share holders . Here also, like the warrants issued with debt securities, they are apportioned a value proportional to their market value. Consider the following.

An IPO, FPO or Private Placement of 1000 shares 100 par, is offered at an issue price of 160, and a warrant per share, convertable to a share apiece, at $165. The market price of the warrant is $10 and market price of the share is $175, then

The total consideration of $160000 is divided in the ratio of 175:10, and $151351 is apportioned to stock and $8649 is apportioned to the warrants,

Cash                                                    151351
common stock                                                                         100000
paid in capital in excess of par                                              51351

cash                                                    8649
paid in capital-stock warrants                                                8649

when the warrants are converted,

cash                                                    165000
paid in capital-stock warrants         8649
common stock                                                                         100000
paid in capital in excess of par                                              73649

suppose the common stock outstanding is $100000, with additional paid in capital of $60000, additional warrants are issued, a warrant per a share outstanding, the market values shares and warrant prevailing is $175 and $10,

Then the total common stock equity (including the additional paid in capital) $160000 is divided in the ratio of the market values, ie, 175:10 apportioning  $151351 to shares and $8649 to the warrants. The entry is

paid in capital in excess of par      8649
paid in capital-stock warrants                                              8649



EMPLOYEE STOCK OPTIONS

Employee stock options are similar to stand alone stock option warrants, except they are given to employees  as compensation.

The difference is, the value of the ESOPS is recorded as an expense, instead of just mentioning in a memorandum.

The total value of the ESOP which is valued during the measurement date, is split and spread evenly between the service period. The measurement date is the date when the options are valued ie how much the value of the option is which has to be expensed, and at what price the employee can purchase the stock. It is also the date at which how much shares the employee is entitled to recieve is determined. THe service period starts from the date of grant to the date from which the employee can start exercising the options. There is also an expiry date when the options lapse.

Consider the following example

Options are granted to purchase 1000 shares of 10 par  @ $45 and the market price on grant date is $50. So the value of the options at the grant date is (50-45)*1000=$5000. If the service period is 5 yrs, then it is spread evenly across 5 yrs..
   The journal entry for each year is

    Compensation expense            1000
    Paid in capital- ESOP                                 1000

When excercised

    cash                                         45000
    paid in capital-ESOP                5000
    common stock                                            10000
    paid in capital in excess of par                     40000


Now if the market price when the options are exercised, if the market price is $50 itself, then the loss for the existing share holders is $5000, which is recognized evenly. But if the market price is  and can be a lot higher, say $120, then the loss is ($120-$50)*1000+$5000= $120000. This is because, $50 is the value of the fresh shares issued including the additional paid in capital, and also $5000, the value of the options, is not paid by the employee, but is expensed.

The basic assumption for accepting this loss is that the employees will work hard to increase the value of the company so that the market price of the stock is increased consequently

Stock dividends, stock splits, donated capital for quasi-reoganisation and Total market value of the company

INTRODUCTION

              All the dividends, when declared, are debited to the retained earnings account except liquidating dividends. Liquidating dividends are debited to the additional paid in capital itself.

              Dividends cannot debited directly to the stocks out standing in any case. 

              A debit to the stock outstanding happens only when shares are donated , through treasury shares, as seen below.

DONATED CAPITAL

             Suppose 10% of 1000 shares 100 par outstanding with a market value of 160 per share are donated back to the company, then the journal entry is as below(for further clarification, see the blog on treasury stocks)

     treasury stock                           10000

     additional paid in capital             6000

     donated capital                                                              16000

     Common stock                         10000

     treasury stock                                                                10000

     Here the donated shares are bought at market value as treasury shares, and are retired (if not re issued )

      This donated capital can be used to clear the deficit in retained earnings during reorganisation, if there is no additional paid in capital in any other capital accounts.

      

STOCK DIVIDENDS

     Here, if the stock dividends declared is less than 25% of common stock outstanding, then the operation is as below.

      Suppose 10% stock dividend on 1000 shares, 100 par with an FMV of 160 are declared, then the journal entry is as follows.

      retained earnings                         16000

      stock dividend distributable                                  10000

      additional paid in capital                                        6000

      stock dividend distributable         10000

      common stock                                                     10000

   If it is more than 25%, then at par value is only used

     suppose it is 30% of common stock outstanding,

     retained earnings                          30000

     stock dividends distributable                                  30000

     stock dividends distributable          30000

     common stock                                                       30000

     A stock dividend is actually capital transferred from the retained earnings account to the common stock and paid in additional capital.

But in the market, when additional stock is created, all the stocks are distributed to the shareholders existing at the time of declaration. Though the EPS would have decreased, if the earnings had been the same the previous year, because of the increase in denominator, the per share value of the stock actually increases. This is because, stock dividends are declared, only when there is a considerable increase in the earnings over the previous year, which more than compensates for the increase in the denominator.

STOCK SPLITS

      Stock splits are done to decrease the market price in rupees, so that more shares can be bought with a small capital, to encourage small retail buyers and liquidity.

      

       Stock splits, though often described as bonus shares, are not stock dividends at all, as nothing additional is given to the existing shareholders from the retained earnings or any other capital account.

      Stock spits happen, when the par value of the common stock, is reduced by a certain ratio, so that the number of outstanding shares are increased proportionally, bringing down the market value proportionately.

This is caused, because the EPS decreases in the exact ratio of the split.

Stock dividend vs Stock split

Consider the following example:

The capital account of a company consists of

common stock                                                  100000

additional paid in capital                                     50000

The company has 1000 shares 100 par, with a premium of 50, and a FMV of 160

For a 2:1 split, no entry is done, because, the par value is halved and the number of stock is doubled. Therefore common stock outstanding remains the same. The split is mentioned in a memorandum note.

But if it is 100% stock dividend, then the following entry is made

retained earnings                     100000

stock dividend distributable                               100000

stock dividend distributable     100000

common stock                                                  100000

The capital account after the dividend is distributed, is as below

common stock                                                  200000
additional paid in capital                                     50000

Here also the common stock number doubled but the par value is not halved (FMV is ignored). The additional value of shares is created from the retained earnings of the company.

Both in 100% stock dividend, and 1:1 stock split, the number of shares is doubled. And since the EPS is halved in both cases, the market value, which depends on PE multiple, gets halved.

IN BOTH CASES, THE TOTAL SHARE HOLDER EQUITY WHICH INCLUDES THE RETAINED EARNINGS IS THE SAME, the number of shares outstanding also is the same. Only the par value is different.

TOTAL MARKET VALUE OF THE COMPANY

The total market value of the company is the market value of the stocks multiplied by the number of shares outstanding. Treasury shares are not counted for market value because

1. They are a decrease in the capital until reissued.
2. Therefore, they are not counted for when calculating the EPS, and for distributing dividends.

Stock splits and stock dividends do not affect the total market value of the company. This is because of the following reason

If the earnings do not change over the previous year, when stock dividend or a split is declared, the decrease in the market value of share of the shares caused by a reduced earnings per share(no of shares increases) is compensated exactly by the increase in the number of shares.

THEREFORE THE TOTAL MARKET VALUE OF THE COMPANY DEPENDS ONLY ON THE EARNINGS IN THAT YEAR. AND THE MARKET VALUE OF A SHARE DEPENDS ON THE EPS.

Treasury Stock Simplification

            There are two methods for accounting treasury stocks, the cost method and the par method. In cost method the treasury stock is recorded at cost and in par method, it is done at par.

            Two additional capital  accounts, paid in capital from treasury stock and paid in capital from treasury stock requirement,  are used in these methods.

            I would prefer to simplify the recording of treasury stocks, without using either of the additional capital accounts.

            For eg: if 100 shares of 100 par are bought back for 140, we just need to record the transaction as follows, irrespective of what the ratio of par to premium /discount

             treasury stock                                   10000

             paid in capital in excess of par           4000

             cash                                                                              14000

if paid in capital account has a balance of only 2000, then,

             treasury stock                                   10000

             paid in capital in excess of par           2000

             retained earnings                               2000

             cash                                                                               14000

if we sell  these shares at 180 later, then

            treasury stock                                                                  10000

            paid in capital in excess of par                                           8000

            cash                                                  18000

while retiring

            treasury stock                                                                   10000

            common stock                                   10000

if donated and FMV = 180 then

            treasury stock                                    10000

            paid in capital in excess of par             8000

            donated capital                                                              18000

Inventory assessment error and Cash flow statement

           We know that decrease in inventory has to be added to the net income to arrive at the cash flow statement using indirect method.

           Inventory assessment errors affect

1.  Change in inventory under periodic method. This is because, under this method, the estimation error can happen while estimating the ending inventory at the end of the year. Beginning inventory can also have the error because of the faulty estimation of ending inventory in the previous year.

2.   COGS directly under perpetual system. Here whenever the sales happens, COGS is estimated for the corresponding sales and is subtracted from the merchandise inventory to arrive at the endong inventory.

Either ways the error in calculation of the inventory will always cancel out when the decrease in inventory is added to the net income figure. This is because the error in inventory causes the same error in the non cash expense of the COGS, in the net income figure . When we add  the decrease in inventory, we actually cancel the non cash COGS in the net income figure along with the error.For further details see the earlier blog on the indirect method of preparing the cashflow from operations.