In this video, learn how to identify the valuation issues associated with securities and derivatives. This includes how to best account for these.
- It is often the case that one company will store its temporary excess cash by investing in the stocks and bonds of other companies. And some companies invest in the stocks and bonds of other companies as part of their business strategy, seeking to earn returns through careful investing. After making the investments, the value of the investments will move up and down daily as stock and bond prices fluctuate. Now the important accounting question is this. Should the investment security assets be reported in the balance sheet at their original cost or at their current market value? Well in a break from accounting tradition, almost all investment securities are reported in the balance sheet at current market value, not cost. For example, on December 31st, 2018, Berkshire Hathaway, which is the large investment company run by Warren Buffet, owned a portfolio of stocks in other companies, including American Express, Apple, Bank of America, Coca-Cola, and Wells Fargo. The total cost of this portfolio was $102.867 billion. On that same date of December 31st, 2018, this portfolio of stocks had a market value of $172.757 billion. In other words, since Berkshire Hathaway had purchased these shares, they had gone up in value by $69.890 billion, not bad. This $69.890 billion represents an economic gain to Berkshire Hathaway through wise and perhaps lucky investing. Accountants call this type of gain an unrealized gain, because Berkshire Hathaway has not yet sold its investments to receive the increased cash to which they are entitled. In common usage, we call these unrealized gains paper gains, because they are gains on paper but we haven't yet confirmed the gain by selling the investment. Here's another accounting question. Should these unrealized gains, or paper gains, be reported in the income statement? The answer is yes, those unrealized gains, those paper gains, or losses, are reported in the income statement. Now many business people and financial statement users don't like this accounting treatment. They don't think that unrealized or paper gains and losses should be shown in the income statement. Here's what Warren Buffet had to say on this topic in his 2018 letter to the Berkshire Hathaway shareholders. "Neither Berkshire's Vice Chairman, Charlie Munger, "nor I believe that rule to be sensible. "Rather, both of us have consistently thought "that at Berkshire this mark-to-market change "would produce what I described "as wild and capricious swings in our bottom line." Note that Warren Buffett called this investment security market value accounting by its frequent label of mark-to market accounting. This is not meant to be a compliment. In the case of Berkshire Hathaway, Warren Buffet's complaint is that the accounting rule requires short-term investment gains and losses to be reported in the income statement, when in fact, the company intends to hold these investments for the long term. For example, as of the end of 2018, Berkshire Hathaway had held its $14.5 billion investment in American Express for eight years, without selling any of the shares. Warren Buffet's complaint, which is common in the business community, is that short-term price fluctuations on long-term investments should not be reported as part of normal net income. But alas, dissatisfaction by Warren Buffet notwithstanding, mark-to-market accounting is the worldwide financial accounting rule. Now as a footnote, the paper gains and losses from some investments in bonds, not stocks, bonds, are not reported in the income statement, but instead are shown in a separate equity category called Accumulated Other Comprehensive Income, or AOCI. Accountants call these investments Available-for-Sale Securities. The only investments classified as Available-for-Sale Securities are long-term bond investments. For most companies, this is not a major part of their investment security portfolio. In summary, almost all investment securities are reported in the balance sheet at their current market value. And the unrealized gains and losses resulting from annual price fluctuations are reported in the income statement.
- Describe line items that appear on financial statements.
- Differentiate between the three types of financial statements.
- Interpret current accounting issues and trends.
- Calculate the market capitalization of a company.
- Identify the most important expense for a retail company.
- Explain the use of common size financial statements.