Accounting for Equity Securities
Summary
TLDRThis session focuses on accounting for equity investments when ownership is less than 20%. It covers the initial recognition at cost, including brokerage fees, and subsequent accounting for dividends received. The session also discusses year-end valuation adjustments based on fair value, using examples to illustrate unrealized gains and losses. It concludes with a reminder to visit the speaker's website for additional resources and emphasizes the importance of adjusting equity securities to market value, affecting the income statement.
Takeaways
- 📈 Equity investments between 0% and 20% are considered passive for accounting purposes.
- 💼 Initial purchase of equity securities is recognized at cost, including brokerage fees.
- 💵 Cash dividends received from passive investments are recorded as dividend revenue.
- 📊 End-of-year portfolio valuation involves comparing cost to fair value to determine unrealized gains or losses.
- 📉 Unrealized losses reduce the balance sheet value of the investment portfolio.
- 🔗 Fair value adjustments are recorded as a counter asset, affecting the income statement.
- 💻 The instructor emphasizes the importance of understanding how to adjust equity securities to market value.
- 🔄 When selling securities at a loss, the unrealized loss is reversed through fair value adjustment.
- 🔝 Recoveries in security value before sale affect the income statement and require adjustment.
- 🌐 Market recoveries or declines in subsequent years require revaluation and adjustment of the portfolio's fair value.
- 📚 The instructor recommends visiting foreheadlectures.com for additional resources to aid in CPA exam preparation.
Q & A
What is considered a passive investment in terms of equity ownership?
-A passive investment in terms of equity ownership is when an investor holds between zero and 20 percent of another company's stocks.
How is the initial purchase of equity securities recognized in accounting?
-The initial purchase of equity securities is recognized at cost, which includes the price of the stock plus any brokerage commission and fees related to the purchase.
What is the journal entry for the initial purchase of equity securities?
-The journal entry for the initial purchase of equity securities is to debit 'Equity Investment' and credit 'Cash' for the total cost of the investment.
How is a cash dividend received from an equity investment accounted for if the ownership is less than 20 percent?
-If the ownership is less than 20 percent, a cash dividend received is accounted for by debiting 'Cash' and crediting 'Dividend Revenue' for the amount of the dividend.
What is the difference in accounting treatment of dividends received when the ownership is more than 20 percent but less than 50 percent?
-When the ownership is more than 20 percent but less than 50 percent, the equity method is used to account for dividends received, which is different from the passive investor treatment.
How is the value of an equity portfolio reported at the end of the year if the investor is a passive investor?
-The value of an equity portfolio reported at the end of the year for a passive investor is compared to the fair value, and any unrealized gains or losses are recorded.
What is the journal entry to reflect a loss in the value of an equity portfolio for a passive investor?
-The journal entry to reflect a loss in the value of an equity portfolio includes crediting 'Fair Value Adjustment' and debiting 'Unrealized Loss' for the amount of the loss.
If an equity security is sold at a loss, how is this transaction recorded in the books?
-If an equity security is sold at a loss, the transaction is recorded by debiting 'Cash' for the amount received, debiting 'Fair Value Adjustment' for the loss, and crediting 'Equity Investment' for the cost of the investment.
What is the purpose of the 'Fair Value Adjustment' account in equity security accounting?
-The 'Fair Value Adjustment' account is used to record the difference between the cost and the fair value of equity securities, affecting the balance sheet by reducing the portfolio value.
How does the unrealized holding gain or loss account affect the income statement?
-The unrealized holding gain or loss account affects the income statement by recording the unrealized gains or losses from the adjustment of equity securities to fair value, which flows through to the income as part of the income statement.
What is the significance of adjusting a portfolio to market for equity securities?
-Adjusting a portfolio to market for equity securities is significant as it reflects the current value of the investments, allowing for accurate financial reporting and a true reflection of the investor's financial position.
Outlines
📈 Equity Investments for Passive Investors
This paragraph discusses investments in equity securities, specifically focusing on passive investments where the ownership is less than 20%. It explains that owning between zero and 20% of a company's stocks makes you a passive investor for accounting purposes. The initial purchase of these investments is recognized at cost, which includes the price of the stock and any related fees. An example is given where Adam purchased three securities for a total of $760,000. The paragraph also covers how to account for cash dividends received from these investments, with a debit to cash and a credit to dividend revenue. It emphasizes that the treatment of dividends will differ if the ownership is more than 20%, which will be covered in a future session. The value of the portfolio at the end of the year is also discussed, including how to adjust the investment to market value and prepare the journal entry to reflect a loss of $45,000.
📊 Adjusting Equity Securities to Market Value
This paragraph delves into the process of adjusting equity securities to their fair market value. It introduces two key accounts: 'Fair Value Adjustment' and 'Unrealized Gain/Loss'. The rules for adjusting these accounts are reiterated, emphasizing that adjustments to equity securities affect the income statement. An example is used to illustrate how to record a $45,000 loss in the portfolio by crediting the 'Fair Value Adjustment' account and debiting the 'Unrealized Loss' account. The paragraph also discusses a scenario where Adam Company sells its investment in Economic Integration for $175,000, resulting in a total loss of $25,000. The steps for adjusting the fair value and recording the sale are broken down in detail, showing how to handle the journal entries for both the fair value adjustment and the sale of the security.
📉 Impact of Market Changes on Portfolio Value
The third paragraph continues the discussion on adjusting equity securities by considering market changes. It explains how to adjust the portfolio when the market recovers, using the prior year's 'Fair Value Adjustment' and 'Unrealized Holding Gain/Loss' as a starting point. An example is given where the market value of the portfolio increases from a loss of $45,000 to a gain of $26,000. The necessary journal entries are detailed, showing how to debit the 'Fair Value Adjustment' account and credit the 'Unrealized Gain' account to reflect the new market value. The paragraph also provides another example for the year 20x7, where the portfolio value changes from a gain of $26,000 to a gain of $2,000, and the corresponding journal entries are adjusted accordingly.
🎓 Encouragement for Continued Learning
The final paragraph serves as a motivational note, encouraging the audience to continue their education and study hard for their CPA and accounting careers. It mentions the value of the speaker's subscription service, which offers multiple-choice questions to help reinforce learning. The paragraph concludes with well-wishes for the audience's success in their studies and future endeavors.
Mindmap
Keywords
💡Equity Securities
💡Passive Investor
💡Fair Value
💡Initial Purchase
💡Cash Dividend
💡Unrealized Gain/Loss
💡Fair Value Adjustment
💡Journal Entry
💡Portfolio
💡Realized Gain/Loss
💡Accounting Standards
Highlights
Equity securities investment focus when ownership is between zero and 20 percent.
Passive investor status is achieved with less than 20 percent ownership.
Initial purchase of equity securities is recognized at cost, including brokerage fees.
Example of initial purchase journal entry for three securities.
Accounting for cash dividends received from less than 20 percent ownership.
Difference in dividend treatment when ownership is more than 20 percent.
Year-end portfolio valuation comparing cost to fair value.
Portfolio adjustment for unrealized losses.
Journal entry for reflecting a loss in the portfolio.
Explanation of fair value adjustment and unrealized gain/loss accounts.
Detailed example of adjusting a portfolio to market value with a loss.
Scenario of selling securities and adjusting for realized loss.
Step-by-step breakdown of journal entries for selling investments.
Adjusting the portfolio for a gain in market value.
Example of portfolio adjustment when market recovers from a loss to a gain.
Final example of adjusting portfolio for a decrease in gain.
Encouragement to use foreheadlectures.com for additional study resources.
Transcripts
hello and welcome to the session in
which we would look at investments in
equity securities specifically we're
going to be focusing on when we purchase
between zero and 20
of other companies stocks
whether you own one
or 99 once you buy equity it means you
are an owner of the business
however your degree of ownership will
determine how you account for that
investment so as long as you own between
zero and 20 percent
for accounting purpose purposes you are
considered a passive investor although
in the real world even if you own five
percent you could be considered a large
large shareholder but for purpose of
accounting you need more than twenty
percent
how do we report these investments once
we have zero to twenty percent we report
the investment at fair value and this is
basically the big picture i discussed
those topics in a prior recording this
slide but in this session i will focus
specifically
on this passive investor so holding less
than 20 percent how do we recognize the
initial purchase well we recognize the
initial purchase just like any other
asset purchase at cost
which will include the price of the
security the price of the stock you are
buying plus any brokerage commission and
fees related to that purchase it gets
added to the cost let's take a look at
an example on january 15th
20x5 adam purchased three securities
each represent less than 20 percent of
the company's total stocks and here are
the three stocks we bought
we invested 200 000 in economic
integration
415 000 in best software inc
and 145 and emc robotics in total we
invested 760 000
the in the journal entry will be debit
equity investment 760 and credit cash
760. so this is the basic journal entry
now we're going to assume on december 6
20 x5 adam received cash dividend of
3250 from best software how do we
account for cash dividend if we are if
we receive this money
assuming we are using the assuming we
own less than 20 percent we debit cash
32.50 we credit dividend revenue 32.50.
now i want you to remember this point
remember we own less than
20
in the next session we are going to be
looking at
the scenario where we own more than 20
percent but less than 50 so between 20
to 50 percent when we receive dividend
the transaction will be treated
differently this is where we're going to
be using the equity method so just want
to i want to point this out because i
don't want you to think that every time
the company receive dividend you debit
cash credit dividend revenue yes you're
going to always debit cash if you
receive cash but you might have to
credit something else if the ownership
is more than 20 again
we'll keep this for the next recording
let's take a look at the value of our
portfolio at the end of the year
december 31st 20x5
well we have the cost of each security
which are right here we paid
760 000 then we have to compare the cost
of the securities to the fair value so
this is the cost this is how much we
paid for this and we saw the journal
entry this is how much these securities
are worth today
well actually we didn't do we didn't do
very well economic integration we have
an unrealized loss of 30 000
best software inc went up 10 000
and amc went from 145 to 120 we lost 25
thousand overall we have a total loss of
forty five thousand in our portfolio
now this is a year one portfolio
adjustment therefore we have no previous
fair value adjustment well how do we
prepare the journal entry to reflect a
loss of 45 000. before we look at the
journal entry i would like to remind you
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twitter and reddit so now we need to
adjust our investment to market well
here's what we need to learn and this is
basically the same strategy that we used
when we adjust the debt securities here
we are dealing with equity securities
when we adjust our portfolio to market
we have two accounts that we we need to
know how to deal with and those two
accounts one of them is called
fair value adjustment
fair value adjustment that's one account
and the other account whatever we debit
here we have to credit
another account called on
realized gain slash loss and this goes
to income simply put when we adjust
equity securities the adjustment goes to
income so if we debited this account we
credit this account
if we credited this account we're gonna
debit this account so those are the two
accounts that's used now
i'm going to tell you the rules once
again just like as
as if i never mentioned them in the
prior recordings okay for some of you
this might be boring because i mentioned
them a few times when we dealt with
available force available for sales
securities and when when i went over
trading securities for that but i'm
gonna have to do it again because i
cannot assume that you guys viewed those
recording so how do you adjust well
here's what's gonna happen you look at
your total portfolio loss or gain here
we have a loss of
45 000. okay why well we didn't do very
well here we go 45 000. if we have a
loss
it means we're supposed to have a
credit balance
of that amount so the credit balance on
fair value adjustment should be
45 000. this is the balance and if it's
a credit it's a loss okay so the fair
value let me write it up here fair value
if it's a loss
it's a
credit balance the balance is credit not
the entry the entry could be debit could
be credit but the balance should be
credit now let's start with fair value
well how do i make an account go from
zero to forty five thousand i'm gonna
have to
credit this account forty five thousand
this is the entry i will make the
balance forty five thousand again what
did i say whatever i do in the fair
value i will have to do a corresponding
in the unrealized game therefore i'm
gonna debit unrealized laws for this
matter because it's a loss of forty five
thousand
and therefore my balance is forty five
thousand and here's the entry to adjust
my portfolio to market remember
unrealized holding gain loss which is
this account here is an income statement
account
now forty five thousand went to the
income statement of losses fair value
adjustment is a balance sheet account
it's a counter asset it reduces my
portfolio of securities
now let's take a look at the second
scenario let's assume adam company
sold all the securities and economic
integration by the way adam company is
the company that owns
these securities
sold economic integration this
investment here for hundred and seventy
five thousand so during twenty x five at
twenty x six student one the x six what
we did you know the fair value of it
went up five thousand we decided to get
rid of this investment
and we sold it for one seventy five so
initially we bought it at 200 000 now we
sold it for 175.
what do we have to do so i'm going to
break down this instruction for you step
by step
okay because in most cpa review courses
in most textbooks they don't do this
detailed explanation so i'm going to
have to go through it okay here's what's
going to happen
let's think about it for a moment you
purchase the investment for 200 000
right notice right here when we purchase
it initially and you end up selling it
for 175 what does that mean it means you
have a total loss
you got it of 25 000.
now if this total loss you already
recorded 30 000 of this total loss right
here okay do you see here i'm just you
know 30 000. well if my total loss is
thirty thousand
if my total loss is twenty five already
recorded thirty thousand of losses
but this stock recovered five thousand
before i sold it remember i sold it for
175 so it recovered five thousand so the
first thing i'm gonna do i'm gonna do a
fair value adjustment
okay and increase my fair value and re
report five thousand dollar of income
for that increase in
the economic integration what i did i
increased the value of economic
integration by 5000 therefore
in 20x5 i recorded 30 000 of losses
in 20x6 i recovered 5 you got it my
total loss is 25 000. so this is the
first thing i did so now as far as the
income statement is concerned i'm
satisfying
my actual loss of 25 000. now i received
money they paid me 175 000 let's do the
journal entry i'm going to debit cash
175 000
debit fair value adjustment 25 and get
get rid of the investment i remove the
investment for 200 000 i debit my cash
75 000 and the fair value adjustment is
debited 25 000 and this is the fair
value adjustment is the net loss
the net loss but i i wanted to show you
this in two separate
journal entries because most cpa review
courses they don't show it to you this
they tell you you have to
remove the adjustment from the
from fair value but i'm just showing you
in detail how you would do it okay so
this is how you will record the
adjustment obviously i can i can combine
those stuff simply put
i don't have to have too fair value if i
want to do the adjustment i will do it
in one shot simply put what i can do i
can basically make this fair value
adjustment equal to 30 000
why because i can combine this entry and
i can have an unrealized
holding
gain of 5000 which will give me the same
thing if i want to combine those two i
just showed it to you separately so you
understand how we did this now most cpa
the reason why they don't go over it in
detail really on the cpa exam it's they
don't really test you at this level and
also in your intermediate accounting
they don't go down to that level but
nevertheless i wanted i wanted to do so
now let's assume for the sake of
simplicity adam did not sell any
securities in 20 x5 so we did not sell
economic integration forum
now we need to take a look at our
portfolio and 20x6 and make an
adjustment remember
before we start our fair value
adjustment is 45000 from 20x6 this is
the value from 20x6 and let's do the
unrealized
holding gain loss
income we had in that account 45 000 as
well
okay this is from the prior year
now we look at at our portfolio and it
seems in 2006
the market recovered
economic integration went up to 210 000
we have a gain on it best software went
up to 430 we have 15 000 gain on it emc
robotics went from 145 to 146 we have a
1 000 gain on it so notice what happened
between 25 20 x5 and 20 x6
our portfolio went from a loss of 45 to
a gain of 26.
again what i'm going to do i'm going to
show you the
line the number line and here's where we
were
in 20x 5
20 x5 the market wasn't doing well and
we were at negative
45 000.
okay
in 20x6
the market recovered and our investment
now they are at a gain
of
26 000. remember what i said in the
prior recording sorry but i'm gonna i
always say this but i'm gonna explain it
to you now when you move when you move
on the number line to the right
it means you are doing better we moved
from negative 45 to positive 26.
well
how many units are you moving from the
left to the right you have to move 71
000 units therefore you debit fair value
adjustment 71 000 because in fair value
because you have a gain your balance
should be 26 right this should be your
balance well to go to from credit 45
to
to debit 26 i have to debit this account
71 000. for every corresponding debit to
fair value i will credit the unrealized
gain so now unrealized gain will have a
balance of 26 and those two should match
so i will debit fair value credit
unrealized holding gain or loss of 71
000 therefore now my portfolio is
adjusted now let me just show you
another example what's going to happen
in 20x7 so i'm just going to make up
some numbers in 20x7
the cost
i'm going to keep the same portfolio i'm
going to keep the same portfolio my
total cost i'm going to keep it 760 to
keep it simple and my fair value happens
to be
762 000 my total portfolio what happened
is
in 20x7 i have a 2 000 gain
what does that mean well i still have a
gain but here's what happened to my
portfolio it went from 26 000
i'm gonna move him back to
2000 gain 2k gain what do i have to do
well
under those circumstances i'm moving to
the left i'm still positive but i'm
moving to the left what i would do is i
will debit first of all what does that
mean it means i have to have a balance
now of 2000.
i have to have a balance of 2000 debit
it's still a gain what do i have to do
then i have to move i have to credit
this account 24 000
to make it twenty to make this two
thousand the balance two thousand and if
i credited this i have to debit this
twenty four thousand to make the balance
here only two thousand credit unrealized
gain therefore i debit
unrealized gain
income
gain loss income of 24 000
and i credit fair value adjustment 24
000 this will be the entry so i just
basically the reverse of this but it's
for 24 000 to reflect
2 000 gain and 2 000 debit and fair
value adjustment it's very important
that you understand how you adjust your
portfolio to market what should you do
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