Fair Value Accounting and Financial Statements
Fair value accounting, also known as mark-to-market accounting, can change values on the balance sheet as market conditions change. In contrast, historical cost accounting, based on past transactions, is simpler, more stable, and easier to perform, but does not represent current market value. It summarizes past transactions instead. Mark-to-market accounting can become inaccurate if market prices fluctuate greatly or change unpredictably. Buyers and sellers may claim a number of specific instances when this is the case, including inability to value the future income and expenses on the income statement accurately and collectively, often due to unreliable information, or overly-optimistic/ overly-pessimistic expectations.
Reporting Stock Investments of Less Than 20% of Shares
Ownership of less than 20% of a company's stock dictates that the investor is not able to exercise significant influence in the company or participate in shareholder meetings where business decisions affecting the company are made. Ownership of this quantity of stock is recorded using the cost method.
The following is an example of how to report investments of less than 20% of shares -- assume ABC Corporation purchases 10% of XYZ's Corporation's common stock, or 50,000 shares. The market price of the stock is USD 1. When purchasing less than 20% of a company's stock, the cost method is used to account for the investment. ABC records a journal entry for the purchase by debiting Investment in XYZ Corp. for USD 50,000 and crediting Cash for USD 50,000. The investment in XYZ Corporation is reported at cost in the asset section of the balance sheet.
If the investee declares dividends, the investor records a journal entry for their share of the investment. Assume XYZ Corporation declares a dividend of USD 1 per share. ABC records a journal entry debiting Dividends Receivable for USD 50,000 and crediting Dividend Income for USD 50,000. The Dividend Receivable is reported on the balance sheet under current assets and Dividend Income is reported on the income statement under a section for other income.
Reporting Adjustments in Fair Value
As required by FAS 115, the value of an investment accounted for under the cost method should be adjusted to current fair value at the end of each accounting period, in cases where the fair value is readily determinable. Changes in fair value are debited (for gains in fair value) or credited (for losses) to a fair value adjustment account reported on the balance sheet to adjust the investment account balance to its end of period fair value.
If the investment is considered a "trading security" or stock purchased for the purpose of selling it in the near term, the balancing debit or credit is charged to an unrealized loss or gain reported on the income statement. If the investment is an "available for sale" security, the balancing debit or credit goes to an unrealized loss or gain account reported in the other comprehensive income section of owner's equity on the balance sheet. When the investment is sold, all losses or gains from the transaction become realized and flow through into the income statement to adjust revenues for the period.