Accounting for Equity Securities

Summary

This 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

00:00

📈 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.

05:00

📊 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.

10:01

📉 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.

15:02

🎓 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.

Keywords

💡Equity Securities

Equity securities refer to investments in the stocks of other companies. In the context of the video, these are the shares of stock that an investor or a company like Adam Company might buy. The script discusses how to account for these investments, particularly when the ownership is less than 20%, making the investor a passive investor.

💡Passive Investor

A passive investor is someone who owns between zero and 20 percent of another company's stock. The script explains that for accounting purposes, an investor in this range is considered passive, meaning they do not have significant influence over the company's operations. This affects how the investment is reported on financial statements.

💡Fair Value

Fair value is the estimated amount for which an asset should exchange on the open market. The video script describes how investments in equity securities are reported at fair value when the ownership is less than 20%. It is used to determine the current worth of the investment, which can lead to unrealized gains or losses.

💡Initial Purchase

The initial purchase refers to the act of buying equity securities for the first time. In the script, it is explained that the initial purchase is recognized at cost, which includes the price of the stock plus any brokerage commissions and fees. This cost becomes the starting point for accounting and valuation.

💡Cash Dividend

A cash dividend is a payment made by a corporation to its shareholders. The script provides an example where Adam Company receives a cash dividend from Best Software. For passive investors, the cash dividend is recorded as dividend revenue, affecting the income statement.

💡Unrealized Gain/Loss

Unrealized gain or loss represents the change in the fair value of an investment that has not been sold. The script explains how at the end of the year, the cost of the securities is compared to their fair value to determine any unrealized gains or losses, which are then recorded in the income statement.

💡Fair Value Adjustment

Fair value adjustment is the process of adjusting the carrying amount of an investment to its fair value at the end of the reporting period. The script describes how to make this adjustment, which affects both the balance sheet and the income statement through the unrealized gain or loss account.

💡Journal Entry

A journal entry is a record of a financial transaction, showing the effect on the accounts involved. The video script provides examples of journal entries for purchasing securities, receiving dividends, and adjusting for fair value, which are crucial for understanding the accounting process.

💡Portfolio

In the context of the script, a portfolio refers to the collection of equity securities that an investor or company holds. The video discusses how to evaluate the portfolio's performance by comparing the cost of the securities to their fair value at different points in time.

💡Realized Gain/Loss

Realized gain or loss is the profit or loss that is recognized when an investment is sold. The script explains that when Adam Company sells an equity security, the difference between the sale price and the cost is the realized gain or loss, which is recorded in the income statement.

💡Accounting Standards

Accounting standards provide guidelines on how to record and report financial transactions. The video script refers to accounting standards when discussing how to account for equity securities, particularly the distinction between passive investments (less than 20% ownership) and more significant influence (between 20% and 50% ownership).

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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