The balance sheet contains many items, including assets owned by the business, liabilities to be paid by the business, and equity in the financing structures. The presentation of all these items on a single page help to understand the financial position of the business. Generally speaking, the balance sheet is an equation where assets equal to capital and liabilities and must be true for each balance sheet to be accurate.
The balance sheet analysts analyze different items that help understand and interpret the business’s financial position. One of the crucial items on the assets side is investments, considered one of the most important line items in the balance sheet. Let’s discuss the nature of the investments, how investments are measured, recognized, recorded, and presented in the financial statements.
Nature of the investment
The investment can be different in nature. These may include investment in stocks, bonds, property, mutual funds, exchange-traded funds, commodities, hedge funds, etc. It’s important to note that investments are made by a business to generate a return. However, some investments can be riskier in nature and generating higher returns and vice versa. All the investments are recorded as an asset of the business irrespective of their nature. Further, the return generated by the investments is credited in the profit and loss statement and debited to increase the worth of the assets/cash depending on the generated return.
The initial measurement of the investment
As per accounting standards, investments are recorded in the books at the fair value of the investment. Fair value is usually equivalent to consideration given for the purchase of the asset. However, the cost of the transaction needs to be taken into account while initially measuring the investment.
In other words, the investment to be recognized is debited, and cash consideration is credited to initially record the investments in the books.
The investments can be classified as short-term investment/long-term investment depending on the business’s length of maturity and intention to hold. For instance, if the business makes an investment in bonds for a few days, it’s considered a short-term investment and classified as a current asset.
On the other hand, if the business wants to hold an investment for a period greater than a year, it’s classified as a long-term investment. The classification of the investment can be technical and complex when it comes to subsequent measurement in the financial instruments and accounting treatment of the returns generated by the investments.
The investment (equity securities) can be classified as consolidation, equity, and fair value. Let’s discuss these classifications and applicable circumstances for each of the concepts.
The consolidation method is adopted by the business when controlling power is acquired by purchasing the shares. The controlling power is usually acquired by acquiring more than 50% of the shares, and the power can be acquired if control is proved. For instance, company-A has purchased 40% of the interest in company B. However, as per the contract, company-A can significantly control company B’s operational and financial policies. Hence, strategic control is proved, and company-A has to consolidate the financial statement.
There are some important aspects of the consolidation process that include goodwill calculations, NCI calculations, and eliminating the balances within the group. Since both of the companies are consolidated. So, if the subsidiary performs well, it contributes to the profit of the business. On the other hand, if the subsidiary does not perform well, it even reduces the parent company’s profit in the consolidated financial statement.
Equity accounting is when the buying business does not get significant control over the purchased business. However, the buying business does get in a position to influence the decision-making process of the purchased business. The 20% of the holding is considered to bring significant influence, and the business follows equity accounting.
When the purchased business does not fulfill the consolidation/equity accounting criteria, the investment needs to be recorded using the fair value method. The changes in the fair value are recorded in the net income. However, if fair value is not available within the market, the cost approach can be adopted.
The classification can be different when the business purchases debt securities. Similarly, the recording of the investment properties requires different treatment in the financial statement.
Impairment review is the process of assessing the current worth of the business and comparing it with the book value to ensure assets are not overstated in the books of accounts. The impairment testing can be carried by assessing the expected cash flow from the underlying assets or comparing the asset’s book value with the fair value.
The impairment review needs to be performed if there is an indication regarding a reduction in the underlying asset value. For instance, there may be adverse news about subsidiary in the market, and parent needs to assess if recorded goodwill is not overstated in the books of account.
If the business identifies impairment in the asset, the value of the impairment loss is debited in the profit and loss statement, and the same amount reduces the asset in the balance sheet. It is important to note that companies must assess the value of goodwill at least once a year under US GAAP.
Investment is a crucial item in the balance sheet of the business. The business can decide to invest in a range of financial assets, including equity securities, debt securities, or even hybrid securities. Initially, investments are recorded for the consideration given to acquire the assets. However, subsequent treatment of the investment varies depending on the nature of the assets. Further, some investments are recorded in the net income, and some are recorded in the other comprehensive income. Further, impairment testing needs to be performed if there is any indication regarding a reduction in the worth of the asset or fair value has declined.