What is trading on equity in accounting for investments
Investments can be made in debt securities, equity securities, commodities, derivative securities, etc. Debt securities are financial instruments that represent right to a determined stream of cash flows for a definite period of time. For example, government bonds, corporate bonds, municipal bonds, notes receivable, etc. Equity instruments are securities that represent residual ownership interest in a company, for example, shares of common stock, etc.
They are contracts whose value depend on another variable, for example, price of a common share of a company or its bond price or on price of a commodity, etc. However, new accounting standards IFRS 9 require classifying debt investments into two categories: They require such equity investments to be accounted for either as a fair value through profit and loss or b fair value through other comprehensive income. You are a Treasury Accountant at Flow, Inc.
Unrealized gains or losses related to available for sale debt securities is recognized as other comprehensive income. Since the purchasing entity intends to earn short term trading gains they record any short-term share price gains or losses as part of net income. Very few entities hold trading securities.
They want control because they often earn bonuses based on earnings and are expected to attain certain levels of earnings by security analysts, banks, creditors, customers and equity investors. The problem with trading securities is that any market price change is reflected in net income. If market-wide bad news occurs during the last week of the year, then the entity would record the decrease in fair value of trading securities as a loss included in net income.
Most managers consider such an event outside their control, so they want to avoid this scenario. They have done so by engaging in minimal or no trading activities. You will find only a few examples of non-financial entities with material trading securities listed as assets. Like trading securities, the FASB reasoned that fair value is an appropriate method for measuring the asset value.
If the shares are eventually sold, then gains and losses recorded in other comprehensive income are reclassified to net income. All they have to do is sell AFS equity or bond securities that have gone up in value and the price gains are reclassified from other comprehensive income to net income.
Academic surveys of managers indicate that they do engage in this sort of behavior, although it may not be material to the financial statements except in a few cases. When an entity purchases a significant percentage of the shares of another entity, they will have influence over that entity.
Accounting principles assume that ownership of shares between 20 and 50 percent implies influence over the investee. Influence means that the purchasing entity can influence operational decisions. Examples include influencing whether to expand capacity, raise or lower products prices, outsource operations, engage in research, issue shares or debt, etc.
Given influence over operational decisions, the FASB reasoned that also means influence over net income and share price of the investee.
Therefore, fair value is an inappropriate accounting approach to record equity method investments in investee equity because the purchaser influences fair value thus it is no longer fair. For example, if entity A purchases 30 percent of the shares of investee B, then entity A records the cost of its investment as an asset.
If investee B declares dividends, a further adjustment is made. Equity method accounting is utterly different from fair value accounting, motivated by influence over the investee.