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Pro trading profits review
The first four articles see related links introduce the financial accounting concepts utilized in this and future articles. Last week we explored the accounting for debt securities.
Like investment in debt, many entities invest substantial sums of wealth into equity securities. When managers purchase equity securities they record them as an asset at the price paid. They then classify the equity securities into one of four categories as shown in the table. These four categories are important because the accounting differs among them. Like debt, the different categories and accounting exist because the FASB acknowledges that entities purchase equity for different reasons.
The key perspective the FASB has taken when an entity purchases equity is to categorize equities and account for them based on percentage of ownership signaling level of influence over the investee the entity whose stock was purchased. Suppose an entity purchases a few shares of stock in another company. The FASB then reasoned that fair value is an appropriate method for measuring the value of the investment because the purchasing entity has no influence over share price.
Fair value means that the value shown on the balance sheet is the market price of the equity shares at the date of the balance sheet. Contrast fair value with, say, property owned by the entity, which is shown on the balance sheet at historical cost. While most assets are not recorded at fair value, many capital market participants agree that fair values are sensible for trading securities.
Since the purchasing entity intends to earn short term trading gains they record any short-term share price gains or losses as part of net income. Very few entities hold trading securities. They want control because they often earn bonuses based on earnings and are expected to attain certain levels of earnings by security analysts, banks, creditors, customers and equity investors.
The problem with trading securities is that any market price change is reflected in net income. If market-wide bad news occurs during the last week of the year, then the entity would record the decrease in fair value of trading securities as a loss included in net income. Most managers consider such an event outside their control, so they want to avoid this scenario. They have done so by engaging in minimal or no trading activities.
You will find only a few examples of non-financial entities with material trading securities listed as assets. Like trading securities, the FASB reasoned that fair value is an appropriate method for measuring the asset value. If the shares are eventually sold, then gains and losses recorded in other comprehensive income are reclassified to net income. All they have to do is sell AFS equity or bond securities that have gone up in value and the price gains are reclassified from other comprehensive income to net income.
Academic surveys of managers indicate that they do engage in this sort of behavior, although it may not be material to the financial statements except in a few cases. When an entity purchases a significant percentage of the shares of another entity, they will have influence over that entity.
Accounting principles assume that ownership of shares between 20 and 50 percent implies influence over the investee. Influence means that the purchasing entity can influence operational decisions. Examples include influencing whether to expand capacity, raise or lower products prices, outsource operations, engage in research, issue shares or debt, etc. Given influence over operational decisions, the FASB reasoned that also means influence over net income and share price of the investee.
Therefore, fair value is an inappropriate accounting approach to record equity method investments in investee equity because the purchaser influences fair value thus it is no longer fair. For example, if entity A purchases 30 percent of the shares of investee B, then entity A records the cost of its investment as an asset. If investee B declares dividends, a further adjustment is made. Equity method accounting is utterly different from fair value accounting, motivated by influence over the investee.
Many investors will look to footnotes or other information to ascertain a fair value estimate for the equity method investment. Equity method disclosures are informative, however. If an investee generates high net income, it may signal future good fortune for the purchasing entity. The reason is that many equity method investments are in suppliers, distributors and other entities with similar or related business activities. The footnotes contain abbreviated financial statements for the bottlers.
Here are those financials:. Coca-Cola owns a percentage of these bottlers, ranging from 17 to 29 percent. Close Window Loading, Please Wait! This may take a second or two.