Investors include various asset classes as a part of their investment portfolios. They may consist of a mix of equity and debt instruments. On top of that, they may also want to expand their selection beyond the traditional investment options. In that case, they can consider alternative investments.
They may consider various factors while building their portfolio. The most crucial of these include risks and returns.
Investors usually invest in securities. These are tradable financial assets that they can obtain from a market. Usually, these come in various types and have several characteristics.
Securities are one of the most common forms of investment. These allow investors to invest their funds into tradable or liquid instruments.
Similarly, these instruments come with specific benefits and rewards for the investor.
Like individuals, companies can also invest in securities. Since they can act as a separate legal entity, companies can get the same rights as other investors.
Companies can invest in various securities as a part of their assets. However, they must also account for those securities. This process may differ based on the type of instrument. On the other hand, the other entity issuing these securities must also account for them.
One of the most common forms of investment securities includes equity securities. The accounting for these items can be complex. Before discussing that process, though, it is crucial to understand equity securities.
What are Equity Securities?
Equity securities are investments that involve ownership of a company. These are financial assets that represent a proportion of a company’s stock.
Usually, it includes common stock. Sometimes, it also consists of preferred shares and other instruments. Equity securities are financial instruments that give the holder various rights.
Equity securities come with the ownership of the underlying company. The holder gets proportionate ownership in that company for the period they hold those securities.
On top of that, these securities also come with voting rights. Consequently, the holder can influence the decision made by the company and its management.
Similarly, equity securities also involve a right to receive earnings. These earnings are not always available, though.
Investors can invest in equity securities through stock markets. Usually, they can get public companies through that market. On top of that, they can also invest in private equity.
However, obtaining the equity securities for those companies may not be as straightforward. Those shares fall under alternative investments. Investors can acquire those through other markets.
On the other hand, companies issuing these securities use them to obtain finance. This finance constitutes the funds they can use in their operations. By issuing equity securities, companies also dilute their ownership.
On top of that, they may pay dividends to the holders after specific periods. However, there is no guarantee of those dividends. The accounting for the issuer and holder differs for those equity securities.
Overall, equity security represents a financial asset that comes with ownership rights to a company. It may include ordinary or preferred shares issued by companies to raise finance.
They come with specific features. Usually, these include ownership, voting rights, and access to a specific portion of earnings. These investments are available through markets, such as the stock market.
What is the accounting for Equity Securities?
The accounting for equity securities is straightforward for the company issuing them. It involves recording the funds received through this process and increasing equity in the balance sheet.
However, it requires companies to separate those securities into various heads. For example, companies must split the finance obtained through equity securities into share capital and premium accounts.
Similarly, preferred stocks appear under a different heading.
The accounting for equity securities for the investor is more complex. Several accounting standards can apply to those securities based on various criteria.
Usually, investments in equity securities fall under the accounting standard for financial instruments. However, companies may also have to treat them as an investment in associates or business combinations. In each situation, the accounting for equity securities will differ.
When accounting for equity securities, investors must determine the relationship with the other company. Essentially, they must establish if they hold control or significant influence on the investee.
If the company owns less than 20% of the stock of the investee company, it will not have any control or influence. In that case, the investor can account for those securities as a financial instrument. This process will fall under the cost method.
However, if the company holds 20% – 50% of the investee company’s shares, it will have a significant influence. In this case, the company will become an associate of the other company.
However, it will not hold any control over the investee company. The investor can treat this circumstance under the equity method of accounting. It will also report this investment separately from others.
Lastly, if a company holds over 50% equity securities in another company, it will fall under the definition of control. In this case, the company must treat the process as a business combination. The investor will then prepare consolidated financial statements.
However, other factors may determine if the investor controls the investee company.
What are the journal entries for Equity Securities?
The journal entries for equity securities will differ based on their classification. Depending on the accounting standards, companies must account for these securities differently.
Companies can treat equity securities under the cost, equity, or consolidation methods. The journal entries for the first two cases vary. In essence, though, they are similar. The last method requires a whole consolidation process.
Under either method of accounting for equity securities, companies treat the investment like a purchase.
When a company acquires these securities, it will record the transaction. Similarly, it will use a credit entry, usually the cash or bank account. The journal entries, in that case, will be as follows.
|Cash or bank||XXXX|
The primary difference between the cost and equity method is the subsequent transactions. When a company receives dividends from its investee company, it treats it as income. In the cost method, the accounting is straightforward. It involves the following journal entries.
|Cash or bank||XXXX|
Under the equity method, it won’t constitute a dividend income. Instead, it will reduce the recorded value of the underlying investment. In that case, the journal entries will be as below.
|Cash or bank||XXXX|
However, it also requires the company to record the share of its profits from the investee as income. In that case, the journal entries will be as below.
|Revenue from investment||XXXX|
The accounting for subsidiaries differs from these circumstances. However, it was already discussed in one of the previous articles.
A company, ABC Co., acquires 10% of shares in another company. The company paid $10,000 for those shares through the bank. These shares constitute equity securities for ABC Co.
Therefore, ABC Co. must account for them accordingly. Since there is no control or significant influence involved in this case, ABC Co. can use the cost method.
The journal entries for this acquisition will be as follows.
A few months later, ABC Co. received dividends of $500 from the investment. The company records this receipt as below.
Equity securities are investments that come with ownership rights to a company. These include ordinary or preferred shares to an investee company.
Similarly, they come with other features such as voting rights or dividends. The accounting for equity securities differs based on various factors. This process can fall under the cost, equity, or consolidation methods.