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: