A company may invest in the stock of other corporations if it has no immediate need for its cash. A separate account that mentions the unique name of the corporation for each stock investment is used. For example, a company might invest in the stock of three other corporations and use Investment in ABC Stock, Investment in Home Depot Stock, and Investment in Delta Airlines Stock as their three distinct asset account names. (On the balance sheet, these individual investment accounts may be combined in the Marketable Securities listing for short-term investments and/or the Equities Securities listing for long-term investments for an efficient presentation.)
There are five possible journal entries related to investing in stock, as follows: 1. Purchase the stock investment
2. Receive dividend payments
3. Recognize net income of the issuing corporation 4. Adjust to fair value
5. Sell the stock investment
Each stock investment is accounted for using one of two methods, either the
fair value through net income method or the equity method. The choice for
each investment depends on the percentage of another corporation’s outstanding shares that the investing company purchases.
If a company purchases less than 20% of another corporation’s outstanding shares, the fair value through net income method is used. Investors who own less than 20% of the outstanding shares are not considered to have significant influence over the company they are investing in. An example would be the purchase of 1,000 shares of another corporation that has 100,000 shares outstanding. The investor owns only 1% (1,000 / 100,000).
If a company purchases between 20% and 50% of another corporation’s outstanding shares, the equity method is used. Investors who own between 20% and 50% of the outstanding shares are considered to have significant influence over the company they are investing in. An example would be the purchase of 40,000 shares of another corporation that has 100,000 shares outstanding. The investor owns 40% (40,000 / 100,000).
The purchase of more than 50% of another corporation’s outstanding shares is considered a consolidation and will not be discussed.
Two versions of the five journal entries related to investing in stock are illustrated side by side in the journal entries that follow. The transactions on the left illustrate the fair value through net income method where the investor owns 10% (less than 20%) of the outstanding shares. Those on the right show the equity method, where the investor owns 25% (more than 20%) of the outstanding shares. Explanations are included.
1. PURCHASE THE STOCK INVESTMENT
There is no difference between the fair value through net income and equity methods when stock is purchased. The accounts used in the journal entries are identical under both methods.
FAIR VALUE THROUGH NET INCOME method EQUITY method
Your Corporation purchases 5,000 shares of ABC Stock for $10 per share. ABC Corporation has 50,000 shares outstanding, so Your purchases 10% of those shares.
Your Corporation purchases 5,000 shares of ABC Stock for $10 per share. ABC Corporation has 20,000 shares outstanding, so Your purchases 25% of those shares.
Account Debit Credit
▲ Investment in ABC Stock 50,000
▼ Cash 50,000
Account Debit Credit
▲ Investment in ABC Stock 50,000
▼ Cash 50,000
▲ Investment in ABC Stock is an asset account that is increasing.
▼ Cash is an asset account that is decreasing.
▲ Investment in ABC Stock is an asset account that is increasing.
▼ Cash is an asset account that is decreasing. Investment in ABC Stock debit balance: $50,000
Carrying amount per share: $10.00 ($50,000 / 5,000) Number of shares owned: 5,000
Percentage of shares owned to outstanding: 10% (5,000 / 50,000)
Amount: $10 x 5,000
Investment in ABC Stock debit balance: $50,000 Carrying amount per share: $10.00 ($50,000 / 5,000) Number of shares owned: 5,000
Percentage of shares owned to outstanding: 25% (5,000 / 20,000)
Calculation: $10 x 5,000 Ledger account balance:
Investment in ABC Stock
Date Item Debit Credit Debit Credit 50,000 50,000
Ledger account balance:
Investment in ABC Stock
Date Item Debit Credit Debit Credit 50,000 50,000
2. RECEIVE DIVIDEND PAYMENTS
One difference between the fair value through net income and equity methods is seen when the issuing corporation pays cash dividends.
Fair value through net income method
Under the fair value through net income method, the investor simply reports dividend receipts as revenue. The Dividends Revenue account is credited.
Equity method
Under the equity method, dividend receipts are reported as a reduction of the investment account. The investing company’s significant ownership percentage results in a transaction that is analogous to the corporation paying itself.
FAIR VALUE THROUGH NET INCOME method EQUITY method
Your Corporation receives $5,000 in dividends from ABC
Corporation. Your Corporation receives $5,000 in dividends from ABC Corporation.
Account Debit Credit
▲ Cash 5,000
▲ Dividends Revenue 5,000
Account Debit Credit
▲ Cash 5,000
▼ Investment in ABC Stock 5,000
▲ Cash is an asset account that is increasing. ▲ Dividends Revenue is a revenue account that is
increasing.
▲ Cash is an asset account that is increasing. ▼ Investment in ABC Stock is an asset account that is
decreasing. Investment in ABC Stock debit balance: $50,000
Carrying amount per share: $10.00 ($50,000 / 5,000) Number of shares owned: 5,000
Percentage of shares owned to outstanding: 10% (5,000 / 50,000)
Investment in ABC Stock debit balance: $45,000 Carrying amount per share: $9.00 ($45,000 / 5,000) Number of shares owned: 5,000
Percentage of shares owned to outstanding: 25% (5,000 / 20,000)
Ledger account balance:
Investment in ABC Stock
Date Item Debit Credit Debit Credit 50,000 50,000
Ledger account balance:
Investment in ABC Stock
Date Item Debit Credit Debit Credit 50,000 50,000
5,000 45,000
3. RECOGNIZE NET INCOME OF THE ISSUING CORPORATION
Another difference between the fair value through net income and equity methods is seen when the issuing corporation reports net income.
Fair value through net income method
There is no journal entry under the fair value through net income method, where the percentage of investor ownership is not considered significant enough to participate in the issuing company’s earnings.
Equity method
Under the equity method, the investing corporation owns such a significant percentage of the issuing corporation’s shares that it actually takes ownership of its percentage of the issuing corporation’s net income and reports it as its own. In this case, Your Corporation owns 25% of ABC Corporation’s outstanding shares, so
FAIR VALUE THROUGH NET INCOME method EQUITY method
ABC Corporation reports net income of $100,000. ABC Corporation reports net income of $100,000.
Account Debit Credit Account Debit Credit
▲ Investment in ABC Stock 25,000
▲ Investment in ABC Stock 25,000
NO JOURNAL ENTRY REQUIRED to account for ABC
net income ▲ Investment in ABC Stock is an asset account that is increasing.
▲ Investment Income is a revenue account that is increasing.
Investment in ABC Stock new debit balance: $70,000 Carrying amount per share: $14.00 ($70,000 / 5,000) Number of shares owned: 5,000
Percentage of shares owned to outstanding: 25% (5,000 / 20,000)
Calculation: $100,000 x 25% Ledger account balance:
Investment in ABC Stock
Date Item Debit Credit Debit Credit 50,000 50,000
Ledger account balance:
Investment in ABC Stock
Date Item Debit Credit Debit Credit 50,000 50,000
5,000 45,000 25,000 70,000
4. ADJUST TO FAIR VALUE
Fair value through net income method
A third difference between the two methods is that the carrying value of the investment under the fair value through net income method must be adjusted to fair value at the end of each accounting period. Fair value is the current trading price of the stock on the market, which is readily available for public corporations in financial newspapers and online sites.
For investments that involve less than 20% of the issuing corporation’s outstanding stock, a gain or loss is recorded if fair value is different than carrying value. However, it is an unrealized gain or loss since the investment has not yet been sold and there are no cash proceeds yet. The investment account is debited if the fair value increases, and an unrealized gain is recognized by crediting the Unrealized Holding Gain/Loss – Net Income account. These accounts in the journal entry are reversed and an unrealized loss results if the fair value of the investment declines.
The Unrealized Holding Gain/Loss – Net Income account appears on the income statement under a category heading called other comprehensive
income and/or an unrealized loss is deducted from it to arrive at the final income statement amount of comprehensive income. Unrealized gains and losses are treated similarly to realized gains and losses—which occur when the stock is actually sold for cash—in terms of arriving at the final income statement amount. The Unrealized Holding Gain/Loss – Net Income account is adjusted at least annually to reflect the current trading price of the stock investment.
Equity method
For investments that involve 20% or more of the issuing corporation’s outstanding stock, there is no adjustment to fair value.
FAIR VALUE THROUGH NET INCOME method EQUITY method
The fair value of the 5,000 shares of ABC Corporation stock is $12.00 per share at the end of the accounting period.
Account Debit Credit
▲ Investment in ABC Stock 10,000
▲ Unrealized holding Gain/Loss - Net Income 10,000
Account Debit Credit
▲ Investment in ABC Stock is an asset account that is increasing.
▲ Unrealized Holding Gain/Loss – Net Income is a gain that is increasing.
NO JOURNAL ENTRY REQUIRED to adjust to fair value.
Investment in ABC Stock debit balance: $60,000 Carrying amount per share: $12.00 ($60,000 / 5,000) Number of shares owned: 5,000
Percentage of shares owned to outstanding: 10% (5,000 / 50,000)
Amount: 5,000 x ($12.00 fair value – $10.00 cost) Ledger account balance:
Investment in ABC Stock
Date Item Debit Credit Debit Credit 50,000 50,000
10,000 60,000
Ledger account balance:
Investment in ABC Stock
Date Item Debit Credit Debit Credit 50,000 50,000
5,000 45,000 25,000 70,000 Ledger account balance:
5. SELL THE STOCK INVESTMENT
Fair value through net income method
A final difference between the two methods is on the sale of the investment. The carrying value of the investment under the fair value through net income method must be adjusted to fair value at the time the shares are sold. The investment account is debited if the fair value increases, and an unrealized gain is recognized by crediting the Unrealized Holding Gain/Loss – Net Income account. These accounts in the journal entry are reversed if the fair value of the investment declines.
Equity method
For investments that use the equity method, there is no adjustment to fair value at the time of sale.
FAIR VALUE THROUGH NET INCOME method EQUITY method
The fair value of the 5,000 shares of ABC Corporation
stock is $11.60 per share at the time the shares are sold. NO JOURNAL ENTRY REQUIRED to adjust to fair value
Account Debit Credit
▲ Unrealized Holding Gain/Loss – Net Income 10,000
▼ Investment in ABC Stock 10,000
Account Debit Credit
▲ Unrealized Holding Gain/Loss – Net Income is a loss that is increasing.
▼ Investment in ABC Stock is an asset account that is decreasing.
Amount: 5,000 x ($12.00 carrying value – $11.60 fair value) Your Corporation sells all 5,000 shares of ABC
Corporation stock for the fair value of $11.60 per share.
Account Debit Credit
▲ Cash 58,000
▼ Investment in ABC Stock 58,000
Your Corporation sells all 5,000 shares of ABC Corporation stock for $15.00 per share.
Account Debit Credit
▲ Cash 75,000
▼ Investment in ABC Stock 70,000
▲ Gain on Sale of Investment 5,000
▲ Cash is an asset account that is increasing. ▼ Investment in ABC Stock is an asset account that is
decreasing.
▲ Cash is an asset account that is increasing. ▼ Investment in ABC Stock is an asset account that is
decreasing.
▲ Gain on Sale of Investment is a revenue account that is increasing.
Investment in ABC Stock debit balance: $58,000 Carrying amount per share: $11.60 ($58,000 / 5,000) Number of shares owned: 5,000
Percentage of shares owned to outstanding: 10% (5,000 / 50,000)
Amount: 5,000 x $11.60
Cash amount: 5,000 x $15.00
Investment amount: debit ledger balance Gain amount: 75,000 – 70,000
Ledger account balance:
Investment in ABC Stock
Date Item Debit Credit Debit Credit 50,000 50,000
10,000 60,000 2,000 58,000 58,000 0
Ledger account balance:
Investment in ABC Stock
Date Item Debit Credit Debit Credit 50,000 50,000
5,000 45,000 25,000 70,000
70,000 0 Ledger account balance:
Unrealized Holding Gain/Loss - Net Income
Date Item Debit Credit Debit Credit 10,000 10,000
2,000 8,000