Cost Method

Accounting for short-term stock investments and for long-term stock investments of less than 20 percent

Accountants use the cost method to account for all short-term stock investments. When a company owns less than 50% of the outstanding stock of another company as a long-term investment, the percentage of ownership determines whether to use the cost or equity method. A purchasing company that owns less than 20% of the outstanding stock of the investee company, and does not exercise significant influence over it, uses the cost method. A purchasing company that owns from 20% to 50% of the outstanding stock of the investee company or owns less than 20%, but still exercises significant influence over it, uses the equity method. Thus, firms use the cost method for all short-term stock investments and almost all long-term stock investments of less than 20%. For investments of more than 50%, they use either the cost or equity method because the application of consolidation procedures yields the same result.

Cost method for short-term investments and for long-term investments of less than 20 percent

When a company purchases stock (equity securities) as an investment, accountants must classify the stock according to management’s intent. If management bought the security for the principal purpose of selling it in the near term, the security would be a trading security. If the stock will be held for a longer term, it is called an available-for-sale security. Trading securities are always current assets. Available-for-sale securities may be either current assets or noncurrent assets, depending on how long management intends to hold them. Each classification is accounted for differently. This topic will be discussed later in this chapter.

Securities can be transferred between classifications; however, there are specific rules that must be met for these transfers to be allowed. These rules will be addressed in intermediate accounting. Under the cost method, investors record stock investments at cost, which is usually the cash paid for the stock. They purchase most stocks from other investors (not the issuing company) through brokers who execute trades in an organized market, such as the New York Stock Exchange. Thus, cost usually consists of the price paid for the shares, plus a broker’s commission.

For example, assume that Brewer Corporation purchased as a near-term investment 1,000 shares of Cowen Company’s $10 par value common stock at $14.22 per share, plus a $180 broker’s commission. Brokers quote most stock prices in dollars and cents. Brewer’s entry to record its investment is:

 

Trading securities [(1,000 shares x $14.22) + $180 commission]
Debit

14,400
 Credit

 
     Cash 14,400
 Purchased 1,000 share of Cowen common stock as a near-term investment at 14.22 plus commission.
Accounting for cash dividends received Investments in stock provide dividends revenue. As a general rule, investors debit cash dividends to Cash and credit Dividends Revenue. The only exception to this general rule is when a dividend declared in one accounting period is payable in the next. This exception allows a company to record the revenue in the proper accounting period. Assume that Cowen declared a  $1 per share cash dividend on December 1, to stockholders of record as of December 20, payable on January 15 of the next year. Brewer should make the following entry in December:

 Debit Credit
Dec. 1 Dividends receivable 1,000
  Dividends revenue 1,000
 To record $1 per share cash dividend on Cowen common stock, payable 2010 January 15.
When collecting the dividend on January 15, Brewer debits Cash and credits Dividends Receivable:

 Debit Credit
Jan. 15 Cash 1,000
  Dividends receivable 1,000
 To record the receipt of a cash dividend on Cowen common stock.
Stock dividends and stock splits As discussed in Unit 15, a company might declare a stock dividend rather than a cash dividend. An investor does not recognize revenue on receipt of the additional shares from a stock dividend. The investor merely records the number of additional shares received and reduces the cost per share for each share held. For example, if Cowen distributed a 10% stock dividend in February, Brewer, which held 1,000 shares at a cost of $14,400 (or $14.40 per share), would receive another 100 shares and would then hold 1,100 shares at a cost per share of  $13.09 (computed as $14,400/1,100 shares). Similarly, when a corporation declares a stock split, the investor would note the shares received and the reduction in the cost per share.

FASB Statement No. 115 (1993) governs the subsequent valuation of marketable equity securities accounted for under the fair market value method.[1] Marketable refers to the fact that the stocks are readily saleable; equity securities are common and preferred stocks. The Statement also addresses the subsequent valuation of debt securities. FASB Statement No. 159 (2007) amends FASB Statement No. 115 and gives a fair value alternative that allows companies to elect to measure certain items at fair value at a specified date. The subsequent valuation of debt securities will be addressed in intermediate accounting classes.

Company No. of

shares
Cost per

Share
Market Price

per share

 Dec 31
Total

cost
Total

market

Dec 31   
Increase/(decrease)

in market value
A 200 $35 $40 $ 7,000 $ 8,000 $ 1,000
B 400 10 15 4,000 6,000 2,000
C 100 90 50 9,000 5,000 (4,000)
$20,000 $19,000 $ (1,000)
Exhibit 1: Stock portfolio of Hanson company

The FASB Statement requires that at year-end, companies adjust the carrying value of each of their two portfolios (trading securities and available-for-sale securities) to their fair market value. Fair market value is considered to be the market price of the securities or what a buyer or seller would pay to exchange the securities. An unrealized holding gain or loss will usually result in each portfolio.

Trading securities To illustrate the application of the fair market value to trading securities, assume that Hanson Company has the securities shown in Exhibit 1 in its trading securities portfolio. Applying the fair market value method reveals that the total fair market value of the trading securities portfolio is  $1,000 less than its cost. The journal entry required at the end of the year is:

 Debit Credit
Dec. 31 Unrealized loss on trading securities 1,000
  Trading securities 1,000
 To record unrealized loss from market decline of trading securities.
Note that the debit is to the Unrealized Loss on Trading Securities account. This loss is unrealized because the securities have not been sold. However, the loss is reported in the income statement as a deduction in arriving at net income. The credit in the preceding entry is to the Trading Securities account so as to adjust its balance to its fair market value. (An unrealized holding gain would be an addition to net income.)

If Hanson sold investment C on January 1 of the next year, the company would receive $5,000 (assuming no change in market values from the previous day). The loss on the sale results from market changes last year rather than in the current year; the fair market value procedure placed that loss in the proper year. The entry for the sale is:

 Debit Credit
Jan. 1 Cash 5,000
  Trading securities- Company C Stock 5,000
 To record sale of Company C Stock.
No adjustment needs to be made to the unrealized loss account previously debited because the unrealized loss recorded last year has flowed through the income statement and been closed to retained earnings through the closing process.

Available-for-sale securities



For another example assume a marketable equity security that management does not intend to sell in the near term has a cost of  $32,000 and a current market value on December 31 of  $31,000. The treatment of the loss depends on whether it results from a temporary decline in market value of the stock or a permanent decline in the value. Assume first that the loss is related to a “temporary” decline in the market value of the stock. The required entry is:

 Debit  Credit
Dec. 31 Unrealized loss on available-for-sale securities 1,000
  Available-for-sale securities 1,000
 To record unrealized loss from market decline of available-for-sale securities.
These accounts would appear on the balance sheet as follows:

Hanson Company

Partial Balance Sheet

December 31

Investments (or Current Assets)*:
  Available-for-sale securities $31,000
Stockholders’ equity:
  Capital stock $xxx,xxx
  Additional paid-in capital X,xxx
   Total paid-in capital $xxx,xxx
  Less: Unrealized loss on available-for-sale securities 1,000
$xxx,xxx
  Retained earnings Xx,xxx
   Total stockholders’ equity $xxx,xxx
*Depending on the length of time management intends to hold the securities.

Note that the unrealized loss for available-for-sale securities appears in the balance sheet as a separate negative component of stockholders’ equity rather than in the income statement (as it does for trading securities). An unrealized gain would be shown as a separate positive component of stockholders’ equity. An unrealized loss or gain on available-for-sale securities is not included in the determination of net income because it is not expected to be realized in the near future. These securities will probably not be sold soon.

The sale of an available-for-sale security results in a realized gain or loss and is reported on the income statement for the period. Any unrealized gain or loss on the balance sheet must be recognized at that time. Assume the stock discussed above is sold on January 1 of the next year for $31,000 (assuming no change in market value from the previous day) after the company had held the stock for three years. The entries to record this sale are:

 Debit Credit
Jan. 1 Realized loss on available-for-sale securities 1,000
  Unrealized loss on available-for-sale securities 1,000
Cash 31,000
  Available-for-sale securities 31,000
The account debited in the first entry shows that the unrealized loss has been realized with the sale of the security; the amount is reported in the income statement. The second entry writes off the security and records the cash received and is similar to the entry for the sale of trading securities.

A loss on an individual available-for-sale security that is considered to be “permanent” is recorded as a realized loss and deducted in determining net income. The entry to record a permanent loss of  $1,400 reads:

Realized loss on available-for-sale securities 1,400
  Available-for-sale securities 1,400
 To record loss in value of available-for-sale securities.
No part of the $1,400 loss is subject to reversal if the market price of the stock recovers. The stock’s reduced value is now its “cost”. When this stock is later sold, the sale will be treated in the same manner as trading securities. The loss or gain has already been recognized on the income statement. Therefore, the entry would simply record the cash received and write off the security sold for its fair market value. If the market value of the security has fluctuated since the last time the account had been adjusted (end of the year), then an additional gain or loss may have to be recorded to account for this fluctuation.

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