What is trading on equity in accounting for investments
Equity instruments are securities that represent residual ownership interest in a company, for example, shares of common stock, etc. They are contracts whose value depend on another variable, for example, price of a common share of a company or its bond price or on price of a commodity, etc.
However, new accounting standards IFRS 9 require classifying debt investments into two categories: They require such equity investments to be accounted for either as a fair value through profit and loss or b fair value through other comprehensive income. You are a Treasury Accountant at Flow, Inc. A newly appointed Treasury Manager embarked on an aggressive investment spree.
During the year, the company entered into the following transactions:. At the year end, i. Classify the above investments into different traditional investment categories and outline the accounting treatment of related gains or losses.
Unrealized gains or losses related to available for sale debt securities is recognized as other comprehensive income. Interest income is recognized in the period in which it is earned. Held for trading investments are reported at fair value and any resulting gain or loss or interest income is recognized in income statement. Equity securities Accounting for equity investments depends on the extent of ownership: Like investment in debt, many entities invest substantial sums of wealth into equity securities.
When managers purchase equity securities they record them as an asset at the price paid. They then classify the equity securities into one of four categories as shown in the table. These four categories are important because the accounting differs among them.
Like debt, the different categories and accounting exist because the FASB acknowledges that entities purchase equity for different reasons. The key perspective the FASB has taken when an entity purchases equity is to categorize equities and account for them based on percentage of ownership signaling level of influence over the investee the entity whose stock was purchased.
Suppose an entity purchases a few shares of stock in another company. The FASB then reasoned that fair value is an appropriate method for measuring the value of the investment because the purchasing entity has no influence over share price.
Fair value means that the value shown on the balance sheet is the market price of the equity shares at the date of the balance sheet. Contrast fair value with, say, property owned by the entity, which is shown on the balance sheet at historical cost. While most assets are not recorded at fair value, many capital market participants agree that fair values are sensible for trading securities.
Since the purchasing entity intends to earn short term trading gains they record any short-term share price gains or losses as part of net income. Very few entities hold trading securities.
They want control because they often earn bonuses based on earnings and are expected to attain certain levels of earnings by security analysts, banks, creditors, customers and equity investors. The problem with trading securities is that any market price change is reflected in net income. If market-wide bad news occurs during the last week of the year, then the entity would record the decrease in fair value of trading securities as a loss included in net income.
Most managers consider such an event outside their control, so they want to avoid this scenario. They have done so by engaging in minimal or no trading activities. You will find only a few examples of non-financial entities with material trading securities listed as assets. Like trading securities, the FASB reasoned that fair value is an appropriate method for measuring the asset value.
If the shares are eventually sold, then gains and losses recorded in other comprehensive income are reclassified to net income.