Temporary Investments

Nature of Temporary Investments

The next item to be considered for valuation in the current assets section of the balance sheet is temporary investments. These are assets, such as stocks and bonds of ready marketability, in which current funds are tied up temporarily. Investments in stocks and bonds for purposes of securing business connections and privileges essential to the most efficient conduct of the business do not belong to this category. The term usually covers only those assets representing the investment of temporarily surplus cash or those acquired in settlement with debtors with the expectation of early realization. As A. L. Dickinson[44] so well says, “such investments have no relation whatever to the business and can be disposed of without in any way interfering with its earning capacity, other than the loss of the dividends thereon.”

In the case of concerns affected by seasonal changes in volume of business, there are periods when sums of surplus cash lie unemployed, unless the concern depends upon borrowed money to take care of seasonal increases. Business policy, therefore, demands that the surplus cash be put where it will earn something. Such investments are frequently of a somewhat speculative character. In fact, other things being equal, business acumen demands that the investment be made in those securities in which there is a chance of gain in addition to the regular income therefrom. It cannot be stated too strongly, however, that safety, freedom from great fluctuations, and ready marketability are always prime essentials to be observed in securing stocks and bonds for temporary investment. While the procedure is unusual, there may at times be circumstances under which such investments may be bought on a margin basis.

Valuation of Temporary Investments

The usual rule for valuing temporary investments at the time of drawing up a balance sheet is at cost or market, whichever is the lower. Inasmuch as they may be needed on short notice, the information desired is what they will be likely to realize. This is particularly true in the case of a concern with a rapidly expanding market, for which provision may need to be made by increasing the plant as well as the working assets. Where reserved profits have become tied up in fixed plant, the need for ready funds is apparent.

It may be argued that inasmuch as realizable value is the information desired, valuation at market, whether lower or higher than cost, is the only proper basis. The rule stated is, however, held to be the correct one from the standpoint of conservatism and the further fundamental objection to bringing unrealized profits into the current period, as would result from a market valuation higher than cost. Of course, a lower valuation than cost brings unrealized loss into the period’s operations, but this is not regarded with the same disfavor. Where the market price is fluctuating from day to day, as is normally the case, the market valuation on the date of the balance sheet is perhaps no nearer to the amount that will be actually realized than the cost value, since cost value merely represents one of the many changing points in the market. If a distinct market tendency in one direction or the other were likely to continue until the time of realization on the investments, there might be good reason for taking the profit or loss accrued to the date of the balance sheet. However, these considerations are of too speculative and uncertain a character to be given any weight.

There is some valid objection, on theoretical grounds at least, to the results of the period being affected by the unrealized profits or losses caused by taking the market valuation of temporary investments onto the balance sheet. Valuation at cost, with a footnote to show market value, gives all the information essential to a full understanding of the exact condition of the investment. The habit of adding footnotes to the balance sheet may, however, become objectionable and the practice is to be avoided wherever possible. Also, really essential information usually carries greater weight when incorporated in the balance sheet figures.

Reserve for Investment Fluctuations

To meet the foregoing objection and, at the same time, that of allowing unrealized items to affect the period’s profit and loss, use may be made of an account called, say, “Reserve for Investment Fluctuations.” The account should be operated in the same way as the Reserve for Market Valuation of Merchandise discussed in the preceding chapter. That is, if market is lower than cost, at the close of a fiscal period, surplus is charged and the reserve credited for the difference. On the balance sheet the reserve is treated as an offset to the investment account carried at cost. This incorporates the market valuation as a significant figure of the balance sheet and shows the cost for purposes of information. The charge to surplus avoids fluctuation in the current profit and loss results because of an unrealized item and so makes it more useful for comparative purposes. In case market is higher than cost, the difference is charged to the asset and credited to the reserve. On the balance sheet, cost is thus the effective figure and the market price is given for informational purposes. When the investment is sold, the entry creating the reserve should be reversed in either case. This brings on the books in the period when the sale takes place, the actual profit or loss realized, being the difference between cost and sale prices. The adjusting entries on account of valuation do not thus permanently affect surplus, while the actual profit or loss reaches surplus in the usual way—a valuable desideratum.

“Stock Rights” on Investments

It may occasionally happen that while stocks are held for purposes of temporary investment, stock rights arise. Such a “right” is a privilege of subscription to a new issue of stock, granted holders of stock on a certain date, at a rate below the market quotation of the old stock. The stock records are closed temporarily to any transfers of stock in order to determine those entitled to these rights. Up to the date of closing the records, the market value of the stock carries an increased value to cover the value of the rights belonging to it, and the stock is quoted “rights-on.” After this date the rights are dealt in separately and quoted separately on the exchange. Stock then sells “ex-rights.” Should the end of the fiscal period of a concern holding stocks subject to rights fall after their issue, the stock and rights may be booked separately, though often shown together.

An illustration will show the theoretical method of valuation of rights. Take a corporation whose stock now sells at 125, issuing the right to subscribe at par for additional stock to the extent of 10% of present holdings. The case of a stockholder with fifty shares would work out as follows:

50sharesat $125$6,250.00
5”at  100500.00
55”at a cost of  $6,750.00

The average cost of one share is $122.73. Based on the former quotation of $125, the right is seen to be worth theoretically the difference, or $2.27. The quoted market price will usually be less.

Cost of Investments

In connection with the cost of temporary investments it may be well to point out that cost means full cost to the purchaser, including brokerage and other costs in connection with the purchase or subsequent thereto. If the investment is being carried on margin, the customary practice is to charge to the investment account the interest on the funds borrowed by the broker to finance the transaction and to credit thereto any dividends or interest received. The difference between the asset account kept with the investment and the liability account with the broker thus shows at any time the original equity in the investment. A credit to the investment account when the stocks are sold develops the net profit or loss on the entire transaction. There may be circumstances under which it will be desirable to separate from the asset account all charges and credits subsequent to the original purchase, carrying them in a suitable expense and income account.

Valuation of Bonds

In the case where bonds are held for temporary investment, purchased either at a premium or discount, it is not customary to take account of amortization, because the investment is temporary. The problem of amortization is postponed to Chapter XV, in which permanent or long-term investments are treated.

In brokerage firms, where stocks and bonds comprise the stock-in-trade, the same principle of valuation applies as with a merchandise stock except that the rule of valuation at cost or market, whichever is the lower, is applied to each individual holding. In this way, decreases in the value of one stock are not offset by increases in the value of others as would be the case if total market and cost values for the entire lot were first determined and then the valuation formula applied. In this chapter the principle of valuation of stocks and bonds as stock-in-trade is mentioned only by way of contrast.

Valuation of Unissued Stock

Under the head of temporary investments, the company’s unissued and treasury stocks or bonds are sometimes included. Such unissued stocks or bonds manifestly represent an inflation of asset values, offset, it is true, by an equal inflation of capital stock. In the first place, conceding for the sake of argument that the inclusion of unissued stocks among the assets is legitimate, the principle of equilibrium requires that they be valued at par on the balance sheet, a figure which is not cost and which may be very far from market. Again, the company’s unissued stocks may be in no sense current assets. Furthermore, stocks which have never been issued have no owners and so can command no proprietorship in the enterprise. The most that can be said about them is that they are contingent assets, showing that certain legal formalities have been met which authorize their issue if so desired. The remaining necessary procedure, viz., that the stock be placed on the market and sold, is, however, the condition which must be met to create a real asset and to create proprietorship. Until that has been done there is neither proprietorship nor asset. Reference to Volume I, Chapter XLIX, where the various methods of opening the books of a corporation are illustrated, will show that the method to be preferred is one which eliminates the account Unissued Stock from the books. However, where it is set up, correct classification would seem to require that it be treated as of the nature of a valuation or offset account for capital stock. In other words, the two accounts, Capital Stock and Unissued Capital Stock, must be read together to show the true status of the proprietorship stockholdings. The correct method of presentation on the balance sheet is here only indicated but will be illustrated in [Chapter XXI] where the problem of valuation of capital stock is treated.

Valuation of Treasury Stock

The case against the inclusion of treasury stock in temporary investments is not quite so apparent, but equally convincing upon examination. Treasury stock differs from unissued stock only in that it has once been issued but has, through various channels, found its way back into the possession and control of the company. While outstanding in the hands of stockholders and under their individual control, the increased stock proprietorship is reflected in increased assets. If the stock comes back into the treasury through donation, the decrease in proprietorship stockholdings is compensated by a new proprietorship element under donated surplus. Thus, while there are not so many shares outstanding, the value of each is enhanced by a combined or common proprietorship in donated surplus, which reflects exactly the status of the treasury stock. Whereas formerly there was individual control over the stock, now that it is in the treasury, control is common or combined. Stock proprietorship has been diminished and the balance sheet should show it by treating Treasury Stock as an offset account and not as a part of current assets under Temporary Investments.

As to the valuation of treasury stock at some other figure than par, the same argument holds as in the case of unissued stock. If the treasury stock has been acquired by purchase on the open market, its price may be a good and sufficient basis for valuation; but even here individual ownership and control has been exchanged for common and combined ownership. The individual stockholdings are decreased, and the decrease is reflected on the assets by the amount paid for the stock. It would seem, therefore, that a showing more in accord with the facts would require treasury stock to be treated as a deduction from the capital stock authorized. Thus the best practice eliminates a company’s own stocks from the list of its assets. Where such holdings are small and insignificant, they may without any serious impropriety be included among the assets and even under the caption “Temporary Investment” so long as substantial accuracy obtains.

Summary of Valuation Formula

To sum up, then, the valuation formula for current investments requires their showing at cost or market, whichever is the lower. The most satisfactory method of applying the formula is by means of the Reserve for Investment Fluctuations which makes possible the incorporation of market value whether lower or higher than cost, with the differences between market and cost carried in the reserve account. Thus the conservatism of the valuation formula is made effective and at the same time information is given as to the present market values of the investment.