STOCKS
Accounting Theory
Investments that are not readily marketable and are not to be used in the current operating business cycle are
classified as long-term investments. In accordance with the cost principle long-term investments are recorded
at cost. Stock acquired for consideration other than cash is recorded at the fair market value of the
consideration given up if determinable or the fair market value of the stock acquired if that is more definitely
determinable. When stock is acquired by exchanging existing stock the acquired stock is recorded at its fair
market value or the fair market value of the stock given up whichever is more determinable. An example would
be acquiring common stock by exchanging preferred stock. The cost of the acquired common stock is its fair
market value if more determinable than the fair market value of the preferred stock. An investment in a closely
held company or an unlisted stock for consideration other than cash will require appraisals and estimates to
determine cost. When more than one class of stock is purchased for a single sum the cost is allocated among the
classes according to the relative sales value of the classes.
Each purchase should be separately recorded and if sold the shares sold should be identified with the purchase
in order to properly calculate gain or loss. If the shares sold cannot be identified by a particular purchase then
either a cost flow such as First-In First-Out of average cost can be used to determine the cost of stock sold.
Stocks held as long-term investments are accounted for by one of various methods after acquisition. The
accounting method depends upon the type of stock, the ownership percentage and the characteristics of the
companies whose stock is owned.
Investment in Voting Common Stock – Non controlling Interest
Ownership is 50% or less
Cost or market value method of accounting if ownership is less than 20% of voting common stock.
Equity method of accounting if ownership is from 20% to 50%.
Investment in Voting Common Stock - Controlling Interest
Ownership greater than 50%
Equity method of accounting for an unconsolidated subsidiary.
Consolidated statements for parent-subsidiary relationship:
Cost or Equity method of accounting for parent-subsidiary relationship.
Investment in Non Voting Common Stock and Preferred Stock – Non controlling Interest
Cost method of accounting for investments.
Cost Method
Long-term investments are not subject to lower of cost or market accounting. Minor declines are usually not
material and therefore not recorded in accordance with the exception principle for materiality. A significant
and permanent decline is material and should be reported in the income statement as an extraordinary item. If
there is a further loss of market value the allowance account is credited. If there is a recovery in market value
the allowance account is debited. See Balance Sheet reporting below for a discussion of the allowance to reduce
long-term investments from cost to market value. Subsequent gains in market value above cost are not recorded
because of the exception principle for conservatism and the concept of lower of cost or market.
Market Value Method
After acquisition the investment in stocks is reported at fair market value by recording a gain or loss even
though it has not been realized. The adjustment is recorded when interim and end of year financial statements
are prepared The gain or loss is reported on the income statement as an extraordinary item.
STOCKS
Equity Method
An investment of 20% or more of the voting common stock of an investee indicates that in the absence of
evidence to the contrary the investor has the ability to exercise influence over the investee. After acquisition the
investment in stocks is adjusted by recording the investor or parent share of the investee or subsidiary
respectively as follows:
Net income or loss.
Extraordinary gains or losses.
Dividends.
Amortization of purchased goodwill.
Depreciation on any increase in depreciable assets in the purchase.
Gain or loss from the sale of the investee or subsidiary.
Consolidated Statements - Controlling Interest
The parent maintains the investment account at either the cost or equity method of accounting. The financial
statements are prepared on a consolidated basis. When the subsidiary is less than 100% owned there is a
minority interest that is reported in the consolidated financial statements.
Balance Sheet Reporting
Long-term investments in stocks is reported on the balance sheet under the heading Investments and Funds
which appears between the headings Current Assets and Fixed Assets. Instead of crediting the long-term
investment account an allowance account should be created to record a material and permanent decline in the
market value of long-term investments from cost to lower of cost or market. If there is a further loss of market
value the allowance account is credited. If there is a recovery in market value the allowance account is debited.
Only when the long- investments are sold and the loss realized is the long-term investment account credited. If
long-term investments consists of only a single investment the allowance account is adjusted at the time
the long-term investment is sold because a loss was previously recorded at the time of the material and
permanent decline in market value.
If long-term investments consist of more than a single investment the balance in the allowance account is
ignored when a long-term investment is sold. The allowance account is adjusted at the end of the year to report
the excess of cost over market value. If there is a further loss of market value the allowance account is
credited. If there is a recovery in market value the allowance account is debited.
Income Statement Reporting
Dividend and interest income from investments both temporary and long-term is reported as non operating
income. Gains and losses from the sale of long-term investments are recorded as extraordinary items. A
material and permanent decline in the market value of long-term investments is reported as an extraordinary
item.
STOCKS
Business Combinations
A merger is a business combination whereby the acquiring company remains and the acquired company
becomes a subsidiary or becomes part of the acquiring company including a division. A consolidation is a
business combination whereby a new company is formed and the acquiring and acquired company become
wholly owned subsidiaries or cease being in business.
Merger - Acquired Company Becomes Subsidiary of Acquiring Company (Parent)
Purchase Method
The investment by the parent can be a complete purchase of 100% of the outstanding stock of the acquired
company or a purchase of a majority interest over 50% of the outstanding stock of the acquired company. The
investment is recorded at cost as described above. When consolidated financial statements are done the
minority interest will be reported for the subsidiary outstanding stock and retained earnings.
The amount paid by the acquiring company (the purchase price) may exceed the book value of the acquired
company. The excess payment is apportioned to the fair market value of the assets acquired and to purchased
goodwill. These assets are reported on the consolidated financial statements and the investment in the
subsidiary is eliminated.
Any financial reporting of the merged companies after the combination that address the period prior to the
merger must report the financial data of the acquiring company only.
Merger - Acquired Company Merged With Acquiring Company
Purchase Method
The purchase method of business combination is in the form of a purchase. The acquiring company records the
purchase of the assets of the acquired company at their fair market value the same as any purchase of assets.
Purchased goodwill is recorded at cost.
The assets and liabilities of the acquired company are recorded at cost in accordance with the cost
principle. Assets are recorded at their fair market values. Liabilities are recorded at their present amount of
debt owed.
The difference of the total purchase cost and the fair market value of the net assets is purchased goodwill.
Purchased goodwill is amortized as an expense on the income statement.
The capital stock and retained earnings balance of the acquired company are eliminated except for the minority
interest. The retained earnings of the acquiring company and the retained earnings of the minority interest of
the acquired company become the retained earnings balance of the combined company
Any financial reporting of the merged companies after the combination that address the period prior to the
merger must report the financial data of the acquiring company only.
STOCKS
Stock Dividends
A stock dividend is a distribution to shareholders of its own stock as payment of a declared dividend. A stock
dividend does not decrease the assets of the company, it only affects the capital structure. Retained earnings is
capitalized at the fair market value of the stock. The investor does not recognize any income from a stock
dividend for book purposes. The cost basis of the stock remains unchanged. The average price per share
changes because more shares are held. For tax purposes stock dividends are exempt from taxation except
where the shareholder can elect to take cash rather than stock for the dividend.
The stock dividend may be of a different class of stock other than that on which the dividend is declared. In
this case the stock acquired from the stock dividend and the existing stock on which the dividend is declared
can be recorded and adjusted respectively by apportionment of purchase cost by the fair market value of the
stocks at the time of the stock dividend. For example if 1,000 shares of purchased common stock cost $82,500
and the board of directors declared a 10% stock dividend at the time the fair market value of the stock was
$100,000. The stock dividend is $10,000 and was paid by issuing 200 shares of preferred stock. The cost of
$82,500 is apportioned as follows:
Existing common stock $100,000 divided by $110,000 times $82,500 = Apportioned cost $75,000
Cost per share is $75.00
New preferred stock $10,000 divided by $110,000 times $82,500 = Apportioned cost $7,500
Cost per share is $37.50
Stock Split
A stock split is when a corporation issues to shareholders new or additional shares of its own stock without
capitalizing retained earnings. A stock split only affects the capital structure by proportionally reducing the par
or stated value of the class of stock that was split. A stock split proportionally reduces the fair market value per
share of the stock because of the increase in the number of shares issued and outstanding. A stock split
proportionally reduces the par or stated value per share of the stock because of the increase in the number of
shares issued and outstanding. The investor does not recognize any income from a stock split. The cost basis
of the stock remains unchanged. The average price per share changes proportionally because more shares are
held.
Convertible Securities
Convertible securities are preferred stocks and bonds that are convertible into common stock. At the time of
the conversion the cost of the convertible securities is different from the fair market value of the common stock
received. The cost of the common stock received is recorded at its fair market value if more determinable than
the convertible security given up and a gain or loss is recognized on the conversion.
An alternative accounting for the conversion is to record the cost of the convertible security given up as the
cost of the new security received if it is more determinable than the security received whereby no gain or loss
would be recognized upon the conversion.
STOCKS
Stock Rights
This is a very interesting topic. A stock right is an opportunity for a stockholder to purchase additional shares
of stock at a specific price and by a specific date in the future. The rights can be granted subsequent to the
purchase date of the stock when the market price of the stock has appreciated. The number of shares owned is
the number of stock rights even though the number of shares that can be subscribed for is not the same as the
shares owned. The value of the stock rights is the opportunity to purchase additional shares at a lower price
than the current fair market value of the stock. As the market value of the stock changes so does the market
value of the stock rights.
Stock rights can be sold, exercised or allowed to expire. If the stock rights are sold a gain or loss must be
determined so an allocation of the cost of the stock purchase is made between the stock and the stock rights.
The allocation of cost is calculated by the relative sales value method.
Stock Rights - Issue Provides Subscribed Shares Same as Shares Owned -
Market Price of Stock Rights Determinable
For example 1,000 shares of common stock cost $100,000 which is $100 per share. The fair market value of
the stock at the time of the issuance of the stock rights is $147 per share (ex rights) and the fair market value
of the stock rights at the time of issuance is $28 per share for a total value of $175 per share (rights on) for
both. The cost of $100,000 is allocated as follows:
Existing common stock $147 (ex rights) divided by $175 (rights on) times $100,000 = Apportioned cost
$84,000
Cost per share is $84.00
New stock rights $28 divided by $175 (rights on) times $100,000 = Apportioned cost $16,000
Cost per right is $16.00
Assume further that the issue of stock rights provides a subscription for one share of stock at a price of $119 for
each one share owned. The new stock rights value can be determined as follows:
Existing common stock $175 (fair market value) minus $119 (conversion price) =$56 divided by sum of one
plus one (2) = $28 value per right
Ex rights price is $175 (fair market value) minus $28 (value of rights) = $147
Value of stock rights is $147 (ex rights price) minus $119 (conversion price) = $28 divided by 1 = $28 value of
stock
rights.
If the rights are exercised the cost of the acquired stock includes the cost of the rights and the conversion price
of the stock acquired. Per the above example there are 1,000 stock rights providing for a subscription of 1,000
shares of stock. If all 1,000 stock rights are exercised the purchase cost is as follows:
Cost of stock 1,000 shares at $119 per share = $119,000
Cost of stock rights 1,000 rights $ 16,000
Total $135,000
STOCKS
If one right is exercised the purchase cost is as follows:
Cost of stock 1 shares at $119 per share = $ 119.00
Cost of stock rights 1 right $ 16.00
Total $ 135.00
Stock Rights - Issue Provides Subscribed Shares Less Than Owned Shares -
Market Price of Stock Rights not Determinable
When the market price of a stock right cannot be determined in the market the parity value of the right can be
used. The parity value is the sales value of the right calculated based on the fair market value of the stock and
the lower price that the holder of the right can purchase the additional shares. The parity value is determined
by calculating the difference between the fair market value of the purchased stock prior to issuance of the stock
rights (rights on) and the lower price that the holder of the right can purchase the additional shares and
dividing that by the number of rights required to purchase one new share plus one. For example the fair
market value of the purchased stock is $175 per share (rights on) and the issue of stock rights provides a
subscription for one share of stock at a price of $125 for each four shares owned.
Existing common stock $175 (fair market value) minus $125 (conversion price) =$50 divided by sum of four
plus one (5) = $10 parity value per right.
Ex rights price is $175 (fair market value) minus $10 (parity value) = $165
Parity values is $165 (ex rights price) minus $125 (conversion price) = $40 divided by 4 = $10 parity value
per right.
Existing common stock $165 (ex rights) divided by $175 (rights on) times $100,000 = Apportioned cost is
$94,286 Cost per share is $94.286.
New stock rights $10 divided by $175 (rights on) times $100,000 = Apportioned cost $5,714
Cost per right is $5.714.
If the rights are exercised the cost of the acquired stock includes the cost of the rights and the conversion price
of the stock acquired. Per the above example there are 1,000 stock rights providing for a subscription of 250
shares of stock. If all 1,000 stock rights are exercised the purchase cost is as follows:
Cost of stock 250 shares at $125 per share = $31,250
Cost of stock rights 1,000 rights $ 5,714
Total $36,964
If four rights are exercised the purchase cost is as follows:
Cost of stock 1 shares at $125 per share = $125.00
Cost of stock rights 4 rights $ 22.86
Total $147.86
STOCKS
If stock rights are not sold or exercised they will expire and a loss is recognized equal to the cost allocated to
the stock rights.
Small Business is the Engine that Drives our Economy. The Men and Women who Work to make our Country Great
Should be Recognized for their Achievement and Courage in Very Difficult Economic Times.