Short – Term Investments


Short – Term Investments

10.1 Introduction

Companies use cash to acquire assets and to pay expenses and obligations, good mangers plan to maintain a cash balance large enough to meet expected payments plus some surplus for unexpected needs. Also, idle cash balance may exist during some months of each year because of seasonal fluctuations in sales volume. Rather than leave this unneeded cash in checking accounts that pay low rate of interest at best, most companies invest them in securities that earn higher returns and that can be quickly sold when cash is needed. Such securities are known as short – term investments or temporary investments.

Short – term investments consist of marketable debt securities and marketable equity securities. These investments are usually low risk and can be quickly and easily converted to cash.

The objectives of acquiring short – term investments are to maximize the return on assets and to minimize the risk of loss from price fluctuations. The investment media typically used are certificates of deposits (promissory notes issued by banks for varying period of time). Commercial paper (short – term unsecured promissory notes issued by corporations and sold at discount by government) and bonds (both government and corporate) with near – term maturities (in order to minimize price fluctuations)

The problems of accounting for investments involve recording, valuation (measurement) and disclosure (accounting methods used).


10.2 Recording Transactions in Short – Term Investments

At acquisition, short – term investments are recorded at cost, the price of the item in the market plus any costs incident to the acquisitions, such as brokerage commission and transfer taxes.


   10.2.1 Investment in Bonds

Bonds acquired between interest dates are traded on the basis of the market price plus the interest accrued since the most recent interest payment. The accrued interest is a separate asset acquired with the bonds. The cost of these two assets should be separated in the accounting records to achieve a clear picture of the results of the investment in bonds.

When short – term investments are sold; the difference between the carrying amount and the proceeds is recognized as a gain or a loss. A business enterprise that has numerous short-term investments may have a single short – term investments (or marketable securities) controlling account in the general ledger and a subsidiary ledger account for each individual investment showing cost, maturity date, interest or dividends earned, and gain or loss on disposal.

Gain or loss is the result of a change in the market price of bonds, which may have occurred for a number of reasons. The two most likely causes are the change in the level of interest rates and investor appraisal of bond issue.

       Discount and Premium on Short-Term Investment in Bonds

In accounting for short-term investment in bonds, it is usually unnecessary to amortize premiums or to accumulate discounts. Such temporary investments generally have near-term maturities, consequently any premium or discount is likely to be negligible. The holding period by the investor also is likely to be short, which means that any change in market price usually is attributable to changes in interest rates and risk factors rather than to the approach of the maturity date. In theory, the amortization of premium or the accumulation of discount on short-term investments in bonds always is proper, but as a practical matter such amortization or accumulation would add little to the accuracy of financial statements.


   10.2.2 Investetment in Commercial paper and Treasury Bills

Unlike bonds, commercial paper and Treasury bills are non interests bearing. The interest revenue earned on these investments is measured by the discount (the difference between the face amount and the issuance price). The discount is accumulated in short-term investment ledger account and recorded as interest revenue at the end of each accounting period during the stated term of the commercial paper or Treasury bills.

10.3 valuation of short-term investments

Normally, an asset is recorded at cost, and this cost is associated with the revenue generated from the use of the asset. If the asset loses its value without generating revenue, the cost is written off as a loss. The revenue realization principle usually allows recognition of increases in the value of an asset only when it is sold. Whether realization should be limited to the point of sale for short-term investments is a question worth considering. By definition, short-term investments are readily salable at a quoted market price. This same characteristics usually is not found in inventories or plant assets. This basic difference between these type of assets suggest that the traditional tests of revenue realization should not control the valuation of short-term investments.


   10.3.1 Valuation at Market Value

The use of market price to value short-term investments at the end of an accounting period has some advantages:

  1. The income statement will show the results of decisions to hold or sell such investments period by period (For example, if the market price rises in one accounting period and falls in the next, the gain from holding short-term investments in the first period and the loss sustained by failure to sell at the higher price will be disclosed)
  2. Valuation at current market price eliminates the anomaly of carrying identical securities at different amounts because they were acquired at different prices
  3. Market value is more meaningful to creditors who use the current section of the balance sheet to judge the debt-paying ability of the business enterprise.

The following example illustrates the issues that would arise if the market value were used as the basis for valuation of short-term investments. On December 31, year 1, Dixon Foundry has a portfolio of short-term investments that cost Br. 148,000 and had a market value of Br. 151,500. The question at issue is whether on December 31, year 1, there has been a gain of Br. 3,500 (Br. 151,500 – Br. 148,000 = Br. 3,500). If we follow the traditional tests of revenue realization, no gain would be recognized until the investments are sold. If valuation at market price is accepted, the following journal entry would be recorded:

Short-term investments -----------------3,500

         Gain in market value of short-term investments --------3,500

To record increase in value of short-term investments

Thus, the gain would be recognized in the accounting period in which the price increased rather than in the period in which investments are sold.

On March 28, year 2, the investments are sold for Br. 149,800. Has there been a gain or loss on the sale of investment? If the traditional revenue realization principle were followed, the increase in market price was not recognized earlier, because a sale has now taken place, a gain of Br. 1800 (Br. 149,800 – Br. 148,000) is recognized. If the investments were valued at market price on December 31, year 1, the journal entry to record the sale on March 25, year 2, would show a loss of Br. 1,700 (Br. 151,500 – Br. 149,800) sustained since December 31, year 1.

The question which must be answered is, “what events gives rise to the recognition of gains or losses from holding short-term investments?”. The traditional answer has been “sale of the investments” but the logic of this answer is questionable. Rather the current market value of investment is the most relevant valuation since it is most likely to aid users in making decision.


   10.3.2 Valuation at Cost or at Lower of Cost or Market

Despite the forcefulness of the arguments in fauor of reporting short-term investments at market value, most business enterprises reported marketable securities at cost until the FASB issued statement No. 12, “Accounting for certain marketable securities,” in 1975. However, valuation at lower of cost or market was required when the decline in market value was substantial and was not “due to a mere temporary condition”

Recoveries in the market value of short-term investments that had been written down generally were not recognized.

Because of the wide diversity of accounting practices applied to short-term and long-term investments in marketable securities, the FASB attempted to answer the following two questions in statement No. 12

  1. Under what circumstances should marketable equity securities be written down below cost?
  2. Should marketable equity securities that had been written down be written up at a later date?

The FASB defined the following terms relating to marketable equity securities:

1. Equity Securities: - include instruments representing ownership shares or the right to acquire or dispose of ownership shares at fixed or determinable prices.

Equity securities include common stocks, most preferred stock (including convertible preferred stocks), stock warrants, and call or put options. The following are not equity securities. Preferred stock that by its terms either must be redeemed by the issuing enterprise or is redeemable at the option of the investor, treasury stock, and convertible bonds.

2. Marketable: - means that sales prices (or bid and ask prices) are currently available for an equity security on a national securities exchange or in the publicity reported over-the-counter market.

3. Market price refers to the price of a single share or unit of a marketable equity securities.

4. Market value refers to the aggregate of the market price times the number of shares or units of each marketable equity security in a portfolio.

5. Cost  refers to the original cost of marketable equity security, unless a new cost basis has been assigned or recognition of an impairment of value that was deemed. Other than temporary. In such cases, the new cost basis is the cost.

6. Valuation allowance for a marketable equity securities portfolio represents the net unrealized loss in that portfolio.

7. Carrying amount of a marketable equity securities portfolio is the amount at which that portfolio of marketable equity securities is reported in the balance sheet,. That is cost reduced by the valuation allowance.

8. Realized gain or loss represents the difference between the net proceeds from the sale of a marketable equity security and its cost. (Such gain or loss results only on sale of a security)

9. Net unrealized gain or loss on a marketable equity securities portfolio represents on any date the difference between the aggregate market value and aggregate cost. (Such gain or loss is recognized for financial accounting only at the end of an accounting period and is not a factor in the computation of taxable income).


   Accounting for Current Marketable Equity Securities

The FASB stated that the carrying amount of marketable equity securities should be the lower of its aggregate cost or market value, as determined on each balance sheet date. The amount, if any, by which the aggregate cost of the portfolio exceeds market value is accounted for by use of a valuation allowance. The treatment of changes in the valuation allowance depends on whether the securities are current or non current assets. In the case of a classified balance sheet, marketable equity securities are grouped into separate current and non-current portfolios for the purpose of comparing aggregate cost and market value. In the case of an unclassified balance sheet, marketable equity securities are treated as non current assets.

Realized gains and losses from sale of current or non current marketable equity securities are included in the determination of net income of the accounting period in which they occur changes in the valuation allowance for a marketable equity securities portfolio included in current assets also are included in net income of the period in which they occur.

Such changes in the valuation allowance result in unrealized gains and losses. A recovery in the aggregate market value of securities that had been written down to a market value below cost requires the recognition of an unrealized gain that is included in net income. However, increases in the aggregate market value of the current portfolio of marketable equity securities above aggregate cost are not recognized in the accounting period. Unrealized losses on securities held in the non-current portfolio are not included in net income of the accounting period in which they occur; such losses are reported as direct reductions in stock holders’ equity and the adjusted valuation allowance is deducted from the cost of the non current marketable equity securities).

If there is a change in the classification of a marketable equity security between current and non-current, the security should be transferred between the corresponding posflios at the lower of its cost or market value on the date of transfer. If market value is less than cost, the market value becomes the new cost basis; and the difference is recorded as a realized loss.

Unrealized gains and losses on marketable equity securities are not used to compute taxable income. Such gains and losses result in temporary difference between taxable income and pretax accounting income reported in the income statement. Income tax allocation procedures are applied to determine whether a net unrealized gain or loss should be affected by the applicable tax effect.


10.4 Disclosure issues

The following information with respect to marketable equity securities included in the current portfolio is disclosed either in the financial statements or in a note to the financial statements:

  1. As of the date of each balance sheet presented, aggregate cost and aggregate market value, with identification as to which is the carrying amount.
  2. As of the date of the latest balance sheet presented, the gross unrealized gains representing the excess of market value over cost for all marketable equity securities in the portfolio, and the gross unrealized losses representing the excess of cost over market value for all marketable equity securities in the portfolio.
  3. For each accounting period for which an income statement is presented:
    1. Net realized gain or loss included in the determination of net income.
    2. The basis on which cost was determined in the computation of realized gain or loss (that is, average cost FIFO or other methods used)

Financial statements are not adjusted for realized gains or losses or for changes in market prices when such events occur after the date of the financial statements bur prior to their issuance. However, significant net realized and net unrealized gains and losses arising after the date of the financial statements, but prior to their issuance, applicable to securities owned on the date of the most recent balance sheet, are disclosed.


10.5 Summary

Temporary investments consist of marketable debt securities and marketable equity securities. To be classified as a temporary investment, an item must be readily marketable and intended to be converted into cash within one year or the operating cycle, whichever is longer.

Marketable equity securities are recorded at cost when acquired. When a balance sheet is prepared, the lower of its aggregated cost of market value. If the total cost of the portfolio exceeds the total market value of the portfolio, the difference is shown in a valuation allowance account in the current asset section of the balance sheet. Any change in the valuation allowance account must be taken into account in the determination of net income of the period in which the change occurs.

If the valuation allowance account increases, an unrealized loss on valuation of marketable equity securities will be included on the income statement. If the valuation allowance account decreases, the income statement will show a recovery of an unrealized loss on valuation of marketable equity securities, classified as “other income”. It is important to note that the recovery of loss on valuation of marketable equity securities can never exceed the amount included in the valuation allowance account. Thus, the recovery is recognized only to the extent unrealized losses were previously recognized. For example, assume the valuation allowance account has a credit balance of Br. 25,000 representing past recognition of unrealized losses. If during the current year the marketable equity securities portfolio shows total market value exceeding total cost by Br. 36,000, the “recovery” account would be credited for Br. 25,000 and the “valuation allowance” account would be debited for Br. 25,000

When marketable equity securities are sold, cash is debited for the total proceeds less any selling costs incurred. The marketable equity securities account is credited for the cost of the securities, and any difference between the net proceeds and cost is shown as a realized gain or loss. At the date of sale no regard is given to unrealized losses or recoveries or the amount accumulated in the valuation allowance account.

Marketable debt securities are generally accounted for at cost. However, applications of the lower of costs or market approach to debt securities that are readily marketable and classified as current assets is acceptable.

Balance sheet disclosures related to marketable equity securities include: the aggregate cost, the aggregate market value, gross unrealized gains, and gross unrealized losses. For each period for which an income statement is prepared disclosures should be made of the net realized gain or loss, the basis on which cost was determined in computing realized gain or loss, and the change in valuation allowance included in net income.



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