8.3: Debt for Sale

8.3.1: Accounting for Sale of Debt

Learning Objective

Summarize how to record the sale of a held-to-maturity, trading security and available for sale debt

Key Points

• Because of fluctuations in market value, held-to-maturity debt is not periodically adjusted while owned. Recording the sale is simply a matter of recording how much cash was received and recording any gain or loss from the transaction.
• The book value of trading security debt changes based on its market value. Any increase or decrease in the value of the debt is recorded as an unrealized gain or loss in a company’s income statement. Any gain or loss from the sale is based on the current book value of the debt.
• The book value of available-for-sale debt changes based on market value. Any increase/decrease in the value of the debt is recorded as an unrealized gain/loss in equity. When debt is sold, the company should recognize all unrecognized gain/loss, and the gain/loss based on the current book value.

Key Terms

trading securities

any financial instrument an investor acquires and intends to resell in the short-term

available-for-sale

securities that do not qualify as “held-to-maturity” or as a “trading security”

Held-to-maturity

any security that an investor intends to retain until its term expires

Under FASB 115, a part of US GAAP (Generally Accepted Accounting Principles), a company must classify all of the debt securities it owns into one of three categories. If the company intends to hold the debt until it matures, it must be classified as a “held-to-maturity” security. If the company acquires the debt with the intent to resell it in the short-term, then it must be listed as a “trading security. ” If the debt is acquired without the intent to resell it in the short-term, nor the intent to hold it to maturity, it should be classified as “available-for-sale” . Each of these three classifications is treated differently for accounting purposes, both prior to sale and during the sale.

Held-to-Maturity

When debt is acquired and is intended to be held until maturity, it is recorded first by debiting a “Debt Investment Account,” and then by crediting “Cash” for the amount the debt was purchased. For example, if a company purchased $1000 in debt securities, the transaction would be recorded like this:

Investments – Corporate Debt : $1000

Cash : $1000.

While the market value of the debt may vary over time, the company does not need to adjust the value of the debt on its books. Once the company sells the bond, it must report any gains or losses on the sale of the debt. So, in the example above, if the company sold the debt for $1200, it would need to make the following journal entry.

Investments : $1000

Net Gain on Sale : $200

Cash : $1200

If the company sold the debt for $800, it would need to make the following journal entry:

Investments : $1000

Cash : $800

Net Loss on Sale : $200

Trading Securities

If a company acquires debt that it intends to sell in the short-term, it must still record the sale. If a company acquired debt for $1000, and this debt is classified as a trading security, the company would still need to make the first journal entry in the aforementioned manner.That being said, the value of the debt on the owner’s books must be adjusted to match the market value of the debt. For example, if the market value of the debt declined $200 from its original value to $800, a company would need to make the following journal entry:

Unrealized loss on trading security : $200

Investments : $200

The unrealized loss would be included on the company’s income statement for the period it was recorded. If immediately after the accounting period, the company sold the debt for $800, it would need to make the following journal entry:

Cash : $800

Investments : $800

Because both the loss and the decrease in the debt asset’s value were already recorded in the prior accounting period, the company would not have to make any additional adjustments.

Available-for-Sale

If a company acquires debt that is available-for-sale, it would still need to make a first journal entry in the same way that it would if the debt was “held-to-maturity” or a “trading security. ” It would also need to adjust the value of its debt asset in relation to its current market value. Using the same example above, assume a debt asset was acquired for $1000 but declined in value by $200. In the case of an available-for-sale asset, the following journal entry should be made in the following accounts:

(Equity) Unrealized loss on security investment : $200

(Asset) Investments : $200

Unlike trading securities, the unrealized gain is recorded in the equity section of the balance sheet and does not effect the current year income statement at all. This is because, unlike trading securities, the loss from an available-for-sale security is not expected to be realized in the near future. Returning to the example, assume that the debt asset is sold immediately after the end of the accounting period where it first recognized the unrealized loss. The asset is sold for $800. In such a case, the following entries would be appropriate:

(Asset) Cash : $800

(Income Statement) Loss on Investment : $200

(Asset) Investments : $800

(Equity) Unrealized loss on security investment : $200

The result of the journal entry is that the unrealized loss is realized, so the company’s profit for the period is decreased by $200. The debt asset, as well as the unrealized loss, is removed from the company’s books.

8.3.2: Accounting for Sale of Stock

Learning Objective

Summarize how to account for the sale of common stock, preferred stock and treasury stock

Key Points

• For common stock at par value, debit cash and credit common stock. For common stock sold above par, debit cash, credit common stock, and credit additional paid in capital.
• For preferred stock, debit cash and credit preferred stock.
• For sales of treasury stock, debit cash and credit treasury stock.

Key Terms

preferred

Preferred stock.

par value

The amount or value listed on a bill, note, stamp, etc.; the stated value or amount.

Accounting for the Sale of Stock

Often times companies offer their stock for sale as a way to generate cash. How the stock sale is accounted for depends on the type of stock sold. Most stock sales involve common stock or preferred stock.

Common Stock-sold at par value

Journal
entry

Debit cash

Credit common stock

If the common stock is sold above par value the journal entry is slightly different.

Debit cash

Credit common stock

Credit additonal paid in capital (to account for the difference between par value and sell value)

Preferred Stock

The sale of preferred stock is similarly treated, but a separate accounts should be established to record preferred stock and any additional paid in capital for preferred stock sold at above par value.

Journal entry

Debit cash

Credit preferred stock

Credit additional paid in capital preferred stock (if needed)

Treasury stock

Treasury stock is issued stock that the company has bought back from its shareholders. Since a corporation can’t be its own shareholder, the “bought back” stocks are not considered assets of the corporation. Treasury stock also doesn’t have the right to vote, receive dividends or receive liquidation value.

If the company plans to re issue the shares in the future, it would hold them in treasury and report the reduction in stockholder’s equity on the balance sheet.

There are several reasons a company may purchase treasury stock, it may need it for employee compensation plans, to buy another company or to reduce the number of outstanding shares.

Journal entry

Debit treasury stock

Credit cash

When treasury stock is sold the accounts used to record the transaction will vary depending on whether the stock sold above or below the cost of purchase.

Sold above purchase cost

Debt cash

Credit treasury stock

Credit additional paid in capital (the difference between sale price and purchase price)

8.3.3: Assessing Fair Value

Learning Objective

Explain why a company calculates the fair market value of available for sale securities

Key Points

• The difference between the purchase price and the current fair market value results in a an unrealized gain or loss.
• Realized gains and losses are included in income; unrealized amounts are included in income (trading investments) or in other comprehensive income (available-for-sale investments).
• Unrealized holding gains (unrealized because asset is not sold yet)-increase in fair value of an asset while held.
• Realized holding gain (realized through sale) increase in fair value of an asset while held.

Key Term

unrealized

Not realized; possible to obtain, yet not obtained.

Fair Value Method

Often companies use excess cash to purchase stocks and bonds from other companies. If a company purchases stocks or bonds with the intent to sell these items at a future date when they need cash, these are referred to as “Available-for-sale securities”.

A company initially records the “available for sale securities” at cost. While holding onto the securities the company must calculate the fair market value for these securities at the end of each subsequent accounting period.

8.4: Holding Less than 20% of Shares

8.4.1: Fair Value Method

Learning Objective

Explain how the Fair Value Method is used to calculate the value of holding of less than 20%

Key Points

• Fair market value (FMV) is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market.
• An estimate of Fair Market Value is usually subjective due to the circumstances of place, time, the existence of comparable precedents, and the evaluation principles of each involved person.
• The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
• For assets carried at historical cost, the fair value of the asset is not used.

Key Terms

book value

The value of an asset as reflected on an entity’s accounting books, net of depreciation, but without accounting for market value appreciation.

fair market value

The price at which the buyer and seller are willing to do business.

eminent domain

(US) The right of a government over the lands within its jurisdiction. Usually invoked to compel land owners to sell their property in preparation for a major construction project such as a freeway.

Fair Value Method

The ownership of less than 20% creates an investment position carried at historic book value or fair value (if available for sale or held for trading) in the investor’s balance sheet.

In accounting, fair value (also knows as “fair market value”) is used as a certainty of the market value of an asset (or liability) for which a market price cannot be determined (usually because there is no established market for the asset). Under US GAAP (FAS 157), fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for assets carried at historical cost, the fair value of the asset is not used.

Since market transactions are often not observable for assets such as privately held businesses and most personal and real property, fair value must be estimated. An estimate of fair value is usually subjective due to the circumstances of place, time, the existence of comparable precedents, and the evaluation principles of each involved person. Opinions on value are always based upon subjective interpretation of available information at the time of assessment. This is in contrast to an imposed value, in which a legal authority (law, tax regulation, court, etc.) sets an absolute value upon a product or a service.

A property sale, in lieu of an eminent domain taking, would not be considered a fair market transaction since one of the parties (i.e., the seller) was under undue pressure to enter into the transaction. Other examples of sales that would not meet the test of fair market value include a liquidation sale, deed in lieu of foreclosure, distressed sale, and similar types of transactions.

In United States tax law, the definition of fair value is found in the United States Supreme Court decision in the Cartwright case: the fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

The term fair market value is used throughout the Internal Revenue Code among other federal statutory laws in the USA including bankruptcy, many state laws, and several regulatory bodies.

8.4.2: Calculating Fair Value

Learning Objective

Summarize how to calculate fair value for holdings of less than 20%

Key Points

• Fair value, also called “fair price”, is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset.
• In accounting, a three-level framework is used to calculate an asset or liability’s fair value — Level 1 is based on quoted market prices, Level 2 is based on estimated market observables, and Level 3 uses unobservable inputs derived internally by the company.
• Under US GAAP, when purchasing less than 20% of a company’s stock, the cost method is used to account for the investment.
• As required by FAS 115, investments 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.

Key Terms

supply vs. demand

Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price), resulting in an economic equilibrium of price and quantity.

return on capital

Return on capital (ROC) is a ratio used in finance, valuation, and accounting. The ratio is estimated by dividing the after-tax operating income (NOPAT) by the book value of invested capital.

Example

• An example of how to determine fair value can involve the purchase of company shares of less than 20% total equity — 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.

Determining Fair Value

Fair value, is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as:

• acquisition/production/distribution costs, replacement costs, or costs of close substitutes
• actual utility at a given level of development of social productive capability
• supply vs. demand
• subjective factors such as: risk characteristics; cost of and return on capital; individually perceived utility

In accounting, fair value is used as an approximation of the market value of an asset (or liability) for which a market price cannot be determined (usually because there is no established market for the asset). When an active market does not exist other methods have to be used to estimate the fair value. Assumptions used to estimate fair value should be from the perspective of an unrelated market participant. This necessitates identification of the market in which the asset or liability trades. If more than one market is available, the “most advantageous market” should be used. Both the price and costs to do the transaction must be considered in determining which market is the most advantageous market.

A three-level framework is used to determine an asset or liability’s fair value:

1. Level One — The preferred inputs to valuation are “quoted prices in active markets for identical assets or liabilities,” with the caveat that the reporting entity must have access to that market. An example would be a stock trade on the New York Stock Exchange. Information at this level is based on direct observations of transactions involving the identical assets or liabilities being valued.
2. Level Two — This valuation is based on market observables. FASB indicates that assumptions enter into models that use Level 2 inputs, a condition that reduces the precision of the outputs (estimated fair values), but nonetheless produces reliable numbers that are representationally faithful, verifiable and neutral.
3. Level Three — The FASB describes Level 3 inputs as “unobservable.” If observable inputs from levels 1 and 2 are not available, the entity may only rely on internal information if the cost and effort to obtain external information is too high. Within this level, fair value is also estimated using a valuation technique. Significant assumptions or inputs used in the valuation technique are based upon inputs that are not observable in the market and are based on internal information. This category allows “for situations in which there is little, if any, market activity for the asset or liability at the measurement date.

Under US GAAP (FAS 157), fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties or transferred to an equivalent party other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for assets carried at historical cost, the fair value of the asset is not used.

An example of how to determine fair value can involve the purchase of company shares of less than 20% total equity — 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.

Adjusting Fair Value

As required by FAS 115, investments 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. Adjustments are debited (for gains in fair value) or credited (for losses) to a fair value adjustment account that will adjust the investment account balance to its fair value at the end of the reporting period.

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 account. If the investment is an “available for sale” security, the balancing debit or credit also goes to an unrealized loss or gain account. For investments where the fair value is not readily determinable, the investment is carried at cost.

8.4.3: Reporting Fair Value

Learning Objective

Explain how to record stock investments of less than 20% using Fair Value

Key Points

• 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 the past transactions, is simpler, more stable, and easier to perform, but does not represent current market value.
• 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 are made.
• Dividends declared on investments of less than 20% equity are reported as current assets on the balance sheet and other income on the income statement.

Key Terms

journal entry

A journal entry, in accounting, is a logging of transactions into accounting journal items. The journal entry can consist of several items, each of which is either a debit or a credit. The total of the debits must equal the total of the credits or the journal entry is said to be “unbalanced. ” Journal entries can record unique items or recurring items, such as depreciation or bond amortization.

dividend

A pro rata payment of money by a company to its shareholders, usually made periodically (eg, quarterly or annually).

Example

• 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.

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.