Investment in Equity Securities: Accounting & Tax Treatment

An equity security, most often stock, represents an ownership interest in another entity. Companies invest in other businesses to form strategic alliances, access new markets, or earn returns on cash reserves. The size and intent of these investments dictate their financial reporting and tax consequences under a complex set of rules designed to reflect the economic reality of the investor’s relationship with the investee.

Types of Equity Securities

Equity securities primarily come in two forms: common stock and preferred stock. Common stock is the most basic form of ownership and typically includes voting rights, allowing participation in corporate decisions like electing directors. Common stockholders have a residual claim on assets, meaning they are paid last in a liquidation after creditors and preferred stockholders.

Preferred stock has a higher claim on a company’s earnings and assets. A primary feature is a dividend preference, meaning preferred shareholders receive dividends before common shareholders. These dividends can be cumulative, where missed payments must be paid before common dividends resume, or non-cumulative. Preferred stock also has a liquidation preference, giving its holders priority in being repaid during a business wind-up.

Other types of equity securities exist, such as stock warrants, which give the holder the right to purchase a company’s stock at a specific price before an expiration date. Warrants are often issued with other securities like bonds as an incentive. The core distinction for investors remains the trade-off between the growth potential of common stock and the income stability of preferred stock.

Accounting for Equity Investments

The accounting treatment for equity investments under U.S. Generally Accepted Accounting Principles (GAAP) is determined by the level of influence an investor has over an investee, which is measured by the percentage of voting stock owned. The reporting method is aligned with the economic substance of the investment relationship.

Investments with No Significant Influence

When an investor owns less than 20% of a company’s voting stock, it is presumed to have no significant influence. These investments are accounted for using the fair value method under Accounting Standards Codification (ASC) 321. The investment is first recorded at its purchase price and then adjusted to its current fair value at each reporting date.

Any unrealized gains or losses from these adjustments are recognized in net income, along with any dividend income received. On the balance sheet, these investments are reported at fair value, often as a single line item like “Marketable Securities” within current assets. For investments without a readily determinable fair value, such as stock in a private company, a measurement alternative allows the investment to be carried at its original cost, less any impairment.

Investments with Significant Influence

When an investor holds between 20% and 50% of an investee’s stock, it is presumed to have “significant influence,” requiring the equity method of accounting under ASC 323. The investment is recorded at cost and then adjusted each period by the investor’s proportionate share of the investee’s net income or loss. For example, a 30% owner would increase its investment account by $300,000 if the investee earns $1 million.

Dividends received from the investee decrease the investment account and are not reported as income. This is because the dividend is considered a return of capital. On the balance sheet, the investment is shown as a single, non-current asset line item that reflects the investor’s share of the investee’s net assets.

Investments with Control

If an investor acquires more than 50% of the voting stock, it has control and must consolidate the subsidiary’s financial statements with its own, as prescribed by ASC 810. Consolidation involves combining the subsidiary’s assets, liabilities, revenues, and expenses with the parent company’s line by line. All intercompany transactions are eliminated to avoid double-counting.

If the parent paid more for the subsidiary than the fair value of its net assets, the excess is recorded as goodwill. The parent’s consolidated statements present the combined entity as if it were a single company, with no separate investment line item for the subsidiary. This approach provides a comprehensive view of the entire economic entity under the parent’s control.

Tax Treatment of Equity Investments

The tax implications for a corporation holding equity securities are distinct from accounting rules and focus on the cash consequences of the investment. Federal tax law has specific provisions for dividend income and gains from the sale of stock that can affect a company’s tax liability.

Taxation of Dividends

For corporate investors, the significant provision for dividends is the Dividends-Received Deduction (DRD). The DRD mitigates the effect of triple taxation by allowing a corporation to deduct a percentage of the dividends it receives from other domestic corporations. The deduction percentage is based on the level of ownership.

• If ownership is less than 20%, the deduction is 50% of the dividend received.
• If ownership is between 20% and 80%, the deduction increases to 65%.
• For corporations that own 80% or more of another company, they can deduct 100% of the dividends received.

Taxation of Capital Gains and Losses

When a corporation sells an equity security, the tax consequence is a capital gain or loss, determined by the difference between the sale price and the security’s cost basis. A gain or loss is short-term if the security was held for one year or less and long-term if held for more than one year. For corporations, net capital gains are taxed at the same rate as ordinary income.

Corporate capital losses can only be used to offset capital gains and cannot reduce a corporation’s ordinary income. If a corporation has a net capital loss for the year, it cannot be deducted in that year. Instead, the loss must be carried back three years and then forward up to five years to offset capital gains in those periods.

Financial Statement Presentation

The presentation of equity investments on financial statements is a direct result of the accounting method used. As detailed previously, the balance sheet and income statement will reflect the investment differently depending on whether the fair value method, equity method, or consolidation is applied. This structure ensures financial statement users can understand the value and performance of a company’s equity holdings based on its level of influence over the investee.