# OCW041: Holding Less than 20% of Shares

## Fair Value Method

The ownership of less than 20% creates an investment position carried at fair market value in the investor’s balance sheet.

### Learning Objectives

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

### Key Takeaways

#### 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

• 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 market value: The price at which the buyer and seller are willing to do business.
• 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 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.

A gold nugget: Fair market value (FMV) is an estimate of the market value of a property.

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.

## Calculating Fair Value

Calculating fair value involves considering objective factors including acquisition, supply vs. demand, actual utility, and perceived value.

### Learning Objectives

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

### Key Takeaways

#### 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.

### 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:

Fair value: Fair value is defined as a rational and unbiased estimate of the potential market price of a good, service, or asset.

• 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.

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.

## Reporting Fair Value

Stock investments of 20% or less are recorded at cost (considered its fair value) and reported as an asset on the balance sheet.

### Learning Objectives

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

### Key Takeaways

#### 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

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

### 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.

Source: Accounting