Introduction to Investments in Securities - Online Tutor, Practice Problems & Exam Prep

Companies invest excess cash to earn income or influence other firms. Investments are classified as equity securities, which provide income through dividends and capital gains, or debt securities, which involve lending money for interest. Securities are categorized as trading, available for sale, or held to maturity, affecting their balance sheet classification. Trading securities are current, while held to maturity can be current or long-term. Initial investments are recorded at cost, with fair value adjustments for trading and available for sale securities impacting income statements and comprehensive income.

Introduction to Cost Method Investments

All right, now let's discuss some of the investments a company can make to earn investment income and how we classify those investments. Alright? Let's do an introduction now. So a company may choose to invest for one of two main reasons. The first one would be if they have excess cash. Right? They've been generating a lot of cash through their business, and they have more cash than they can invest back into their business. Maybe they can't specifically grow their business, so they might buy some investments to earn a little extra money. So they're going to earn some income off of these investments that they make, or they can do it to exercise influence over another company. If you buy enough stock in another company, you can say that you influence the company. Imagine if you owned all the stock in a company, well, then you would be able to control that company, right? So buying enough stock in another company allows you to affect its decision-making. Okay? You can have influence over the decision-making, and we say that when you generally have more than 20% of the company, you're able to influence the company, okay? So at this point, we're going to focus on less than 20% investments, so small investments that you make. Maybe you buy 10 shares of Apple stock or something like that. Well, you're not going to be able to control the company with just a few shares of the stock, but you might be able to make some income. So we're kind of focused more on this idea where you're just trying to make a little extra income off excess cash. Okay? We'll talk about influence in later videos, but for now let's discuss some of these securities that you might buy. So security, we use this word security for basically any kind of investment that you make. If you buy stock, if you buy bonds, right, any kind of financial instrument that holds monetary value, right? That's a security, okay? So it's kind of a generic term and it could represent an ownership in the company or a creditor relationship. So creditor is where they owe you money, right? So we have two types of securities. We talk about equity securities, which is an ownership interest, right? This is where you have an ownership interest in the company. So that's like buying common stock of the company, or you might buy a special type of stock called preferred stock. Okay? It's similar to common stock, but it has special rules. Not too much to talk about it now, but it's basically just buying ownership interest in the company. Okay? So the way that you earn money off of an equity security is through the dividends that it pays. So we've talked about dividends before, but now we're on the receiving end, right? The company is going to pay dividends, and we're going to receive a dividend, that's income to us, and through capital gains. Capital gains well, capital gains are when there's an increase in the value of the security. So you buy it at one price, and the price goes up, and you sell it at a higher price, right? Buy low, sell high, those are capital gains there. So let's do a quick example about equity securities and income. So what do we got here? You purchase 10 shares of banana stock for $400. The company paid a dividend of $1 per share, you sell the banana stock when the price has increased to $55 per share. How much income did you earn on your investment? Okay. So there's two sources of income here, right? You earn income from the dividends you receive and you earn income from the capital gains. So let's check each of them separately. First, let's $1 per share, and you bought 10 shares, right? So if you bought 10 shares and you got $1 per share in dividends, ten times $1 well, that's $10 in dividends that you received, right? Not too nothing too crazy there. Let's think about the capital gains now. You earn some money on, the change in the price between when you bought it and you sold it. So let's see what you bought it for. You bought you bought 10 shares for $400, right? So there's two ways you can go about this. Let's go about it two different ways. You can think about the investment as a whole and think about how much you earned on the total investment. So if you bought 10 shares for $400, how much did you sell those shares for? $55 per share and there were 10 shares, right? So the selling price was $550 for the 10 shares, right? And you bought them for $400, so your earnings were a $150 in capital gains, right? So you can think of it in total or you can do it on a per-share basis, but you're going to get to the same answer, right? So what you could do is you could find out you sold each one for $55 per share, let's find out how much you bought each one's So sorry. So you bought each one for $55 per share. How much did you purchase them for? Well, you bought you spent 400 on 10 shares, so you paid $40 per share, right? So that means you earned 55 minus 40, you earned $15 per share was your earnings and you bought 10 shares, so you got $150, right? Either way, you got $150 in capital gains and $10 from dividends. So how much income did you earn? Well, you earned 160, right? You earned the sum of the two. $150 plus the $10 equals $160 total earnings, right? The total of the two earnings would be your total investment income. So with equity securities, you can earn from two different places, from dividends and from capital gains. Now, what about debt securities? These are the other type of security. We're going to either have an equity security where we buy equity in a company or debt security where we loan money to another company. So in a debt security, it's money that is borrowed, and it must be repaid with interest. So, in this case, we're the ones lending out the money, right? So we're lending money to somebody, and they're going to pay us back with interest eventually. So this is usually bonds that we're going to see as the investment. We'll see we'll buy bonds in another company. Okay? So in that case, we'll be dealing with how much interest that we earned. Nothing too crazy there. So lets go ahead and pause here, and we'll talk about the different classifications of securities, how we classify them on our books.

Investment Classification Summary

So regardless of whether we bought a debt security or an equity security, we're going to classify them on our books depending on what we plan to do with them. Okay, so the first one is a trading security. A trading security, and we usually are going to use TS as an acronym for a trading security, and this is a security, an investment that we make that we're expecting to sell within the near term and that we're going to be doing active trading with it, okay? So generally, when they talk about these classifications, they're going to have to tell you which category it falls into, but sometimes they won't be so explicit, and you'll have to be able to gauge based on what they tell you. If you're trying to sell it quickly, well then you're going to have to assume it's a trading security. Compare that, let's skip available for sale, and let's go to the last one, held to maturity. Held to maturity, we'll call it HTM as an acronym, held to maturity. Well, these are going to have to be debt securities because if you think about an equity security, if you buy common stock in a company, you can't really hold it to maturity. Right? A corporation has an unlimited life, it's going to go on forever. So this is strictly for debt securities and that these are going to be that the investor tends to hold until the maturity date. So if you think about a bond, right? A bond might be a 10-year bond, and in 10 years they are going to repay the principal. Well, if you're expecting to hold it for the whole 10 years and receive all the interest payments, right, then you're going to have this as a held-to-maturity investment. And they will have to tell you in the problem. The company intends to hold this investment till maturity, right? Something like that. Now, let's look at the middle one here. Available for sale which we call AFS, available for sale securities. And this is somewhere in the middle. This is where we intend to sell them, right? They're available for sale, but we're not doing any active trading like we are with the trading securities, okay? So when we have available for sale, it's like yeah, we'll sell them if the right opportunity comes along, but we're not actively trying to trade them. We're not, you know, buying and selling quite a bit available for sale. So this is kind of a middle ground here and they're going to again have to tell you, be pretty explicit when they're telling you which category it fits into. So let's learn a little bit more about these different securities, these different classifications. And when we talk about a trading security, this could be current. So when we talk about classification is where can it show up on the balance sheet. So I'll say BS for balance sheet classification, and those have to be current, right? Because we're actively trading them. So we're actively trying to rid of it in the near term, so those are going to be current investments available for sale. These could be current or long term as well as held to maturity. They can be current or long term depending on when the maturity date is. But they'll have to tell you in all of these examples and you'll be able to tell if it's current or long term, right? If we're going to have that 1-year threshold like we have always had on our balance sheet. Cool? So that's where we would classify it on the balance sheet. Now, the initial measurement, this is what happens when we initially buy the investment. So we're going to go and buy the shares of stock, how are we going to make the journal entry and show it on our books? We're going to show it at cost just like we've done with all other investments or all things that we've purchased. Let's say we purchased a piece of machinery. How did we put it on our books? At the cost, right? Whatever we paid for it, it goes on the books. How about with inventory? When we purchase the inventory, how does it get on our books? At the cost, right? Whatever we paid for it, that's how it's going to get onto our books. However, as time passes, we're going to change the value of these investments based on a few factors. So when it's a trading security or an available for sale security, we are going to use the fair value. Okay? We're going to use the fair value of the investment. What does that mean? The fair value, so if you think about, let's say you bought shares of Apple, and let's say hypothetically they were trading for $50 a shoe when you bought them. And then at the end of the year, when it's time to show your balance sheet, they're trading for $75 a share. Well, you're going to change the value in your book to show on your balance sheet that they have a value of $75 rather than the $50 you purchased them, but when you make that change from the cost to the fair value, well you're going to have to take a gain or a loss, right? And that's these unrealized gains or losses. We're going to talk more about those once we get into the details of each of these securities, but those unrealized gains or losses, those are the changes in fair value before you've sold the investment, okay? So when we're talking about a trading security, those unrealized gains or losses are going to go on the income statement. Okay? But for available for sale security, these are going to go in other comprehensive income. We've talked about comprehensive income briefly because it's not a big topic in this class. This is more for advanced-level classes, but if you're going to have to deal with other comprehensive income, this is probably the only situation you'll deal with it with available for sale securities, and I promise you it's going to be very easy. Okay? The last one is here behind me, the held-to-maturity securities. So since you're holding these to maturity, you're going to be earning interest and you're going to be doing what's called amortization. So you're going to keep them on your book at the amortized cost. When you learn about bonds or if you've learned about bonds already at this point, well, that is the we're basically going to use the same logic that we did when we do bonds for held-to-maturity securities. So if you haven't learned about bonds yet, then you're probably not going to have to do held-to-maturity securities at this point, so you don't have to worry about it. Okay? And these unrealized gains or losses, well there are none when we're doing a held-to-maturity investment because we're not changing the fair value. Remember, these unrealized gains or losses, these are changes in fair value since you purchased the investment, okay? But from so that's an NA behind me because it's not applicable there. But for health to maturity, that's not the case at all, we don't deal with that. So this is a little cheat sheet that you can keep, once we start going through you'll kind of have this as a summary, but we're going to go into a lot more details about each of these. So if you're still not feeling a 100%, don't worry, we're going to go into a lot more details coming up. Alright, so let's go ahead and start that in the next video.

Here’s what students ask on this topic:

What are the main reasons companies invest in securities?

Companies invest in securities primarily for two reasons: to earn investment income from excess cash and to exercise influence over other companies. When a company has more cash than it can reinvest in its own operations, it may purchase securities to generate additional income. Additionally, by acquiring a significant amount of another company's stock (typically more than 20%), a company can influence the decision-making processes of that company. These investments can be in the form of equity securities (like common or preferred stock) or debt securities (like bonds).

How do companies classify their investments in securities on the balance sheet?

Companies classify their investments in securities on the balance sheet based on their intended use. There are three main categories: trading securities, available for sale (AFS) securities, and held to maturity (HTM) securities. Trading securities are intended for short-term resale and are classified as current assets. AFS securities can be either current or long-term assets, depending on the company's intent to sell them. HTM securities, which are debt securities intended to be held until maturity, can also be current or long-term assets based on the maturity date.

What is the difference between equity securities and debt securities?

Equity securities represent ownership interest in a company, such as common or preferred stock. Investors earn income from equity securities through dividends and capital gains. Debt securities, on the other hand, represent a creditor relationship where the investor lends money to a company or government entity. The borrower must repay the principal amount with interest. Bonds are a common type of debt security. The primary income from debt securities comes from the interest payments received over the life of the bond.

How are unrealized gains or losses treated for different types of securities?

Unrealized gains or losses arise from changes in the fair value of securities before they are sold. For trading securities, these gains or losses are reported on the income statement. For available for sale (AFS) securities, unrealized gains or losses are recorded in other comprehensive income, which is part of equity but not included in net income. Held to maturity (HTM) securities do not recognize unrealized gains or losses because they are carried at amortized cost, not fair value.

What is the initial measurement of investments in securities?

The initial measurement of investments in securities is recorded at cost, which is the purchase price of the investment. This is similar to how other assets, such as machinery or inventory, are initially recorded. Over time, the value of trading and available for sale (AFS) securities may be adjusted to reflect their fair value, resulting in unrealized gains or losses. Held to maturity (HTM) securities, however, are kept at their amortized cost, reflecting the gradual repayment of the principal over time.