Clark Galvan
A company's balance sheet is a financial statement that provides a snapshot of its finances at a specific point in time. It is split into three sections: assets, liabilities, and shareholder equity. When a company makes an investment, it can either be recorded as equity or cost. Equity investments are recorded in three accounts: common stock, preferred stock, and additional paid-in capital. Debt investments, on the other hand, are generally recorded in three categories: trading, available-for-sale, and held-to-maturity. These classifications depend on the company's intent and the nature of the investment.
What You'll Learn
Long-term debt
When recording long-term debt, it is important to note the difference between short-term and long-term debt. Short-term debt is due within a year and includes debts such as accounts payable, taxes, payroll, and short-term loans. On the other hand, long-term debt includes financial obligations that are paid off over more than a 12-month period, such as bonds, mortgages, and long-term leases.
When a company issues long-term debt, it debits assets and credits long-term debt. As the company pays back its long-term debt, it must carefully track these debt payments to ensure that short-term and long-term debt liabilities are separated and accounted for properly. The portion of the long-term debt that becomes due within a year will move to the current liabilities section of the balance sheet.
For example, consider a company that borrows $12 million from a bank and must repay $100,000 of the loan every month for the next 10 years. In this case, the $1.2 million due within the first year is classified as a current liability, while the remaining $10.8 million is classified as long-term debt.
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Equity method
The equity method is an accounting technique used to record the profits earned by a company through its investment in another company. This method is generally used when an investor company holds significant influence over the company it is investing in, usually owning 20% or more of the company's stock.
Under the equity method, the initial investment is recorded at historical cost, and adjustments are made based on the investor's percentage ownership in net income, losses, and dividend payouts. Net income from the company being invested in increases the investor's asset value on their balance sheet, while losses or dividend payouts decrease it. The investor also records the percentage of the company's net income or loss on their income statement.
For example, if Company A invests $3 million in Company B, and this investment represents a 35% stake, the investment is initially recorded on the books at the acquisition cost of $3 million. If Company B then has a good year and reports an income of $1.5 million, Company A's share of this profit would be $525,000 (35% x $1.5 million). Company A then reports this $525,000 profit on its income statement and increases the investment value to $3,525,000.
The equity method acknowledges the substantive economic relationship between the two companies. It is important for investors to understand how to use, analyse and read a balance sheet, as it provides a snapshot of a company's financial position and can give insight or reason to invest in a stock.
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Cost method
The cost method is used when an investor makes a passive, long-term investment and does not have any influence over the company they are investing in. This usually applies when the investor owns less than 20% of the company's stock. However, the level of influence is a more important consideration than the percentage of ownership.
Under the cost method, the investment is recorded at the cost of acquisition. This is usually the market price paid for the stock, plus any investment fees or broker's commissions. The value of the investment is then modified only if shares are sold or additional shares are purchased. Income from dividends is recognised when they are distributed and received. If dividends exceed the earnings of the company, they are considered a return on investment, and the cost of the investment is reduced.
For example, if a company makes a 12% investment of $1 million in another company, the investment is recorded at $1 million and does not change until shares are sold or additional shares are purchased. If the company pays out $250,000 in dividends to its shareholders, the investor would record $30,000 (12% of $250,000) as income and may be required to pay taxes on this amount. The value of the investment would not change.
One disadvantage of the cost method is that the investor's financial statements may not reveal any significant changes in the operations or conditions of the company they are investing in.
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Common stock
The value of common stock issued is reported in the stockholder's equity section of a company's balance sheet. The balance sheet is a key financial statement that provides a snapshot of a company's finances. It is split into three sections: assets, liabilities, and owner's equity. A balance sheet must balance out where assets = liabilities + owner's equity.
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Additional paid-in capital (APIC)
The formula for calculating APIC is:
APIC = (Issue Price – Par Value) x Number of Shares Acquired by Investors
APIC is recorded in the shareholders' equity (SE) section of a balance sheet. It is viewed as a component of shareholders' equity, reflecting the price investors are willing to pay above the par value of issued stock.
APIC is derived from the difference between the issue price and the par value, which gives the premium per share resulting from the stock issue. This premium per share is then multiplied by the number of shares outstanding to calculate the company's APIC value.
It is important to note that APIC only occurs in the primary market when investors buy shares directly from the company itself. Transactions that occur in the secondary market, or between shareholders after the IPO, do not result in cash for the company and are, therefore, not included in APIC calculations.
APIC provides a layer of defence for companies against potential losses. It is a great way for companies to generate cash without having to provide any collateral in return. Additionally, issuing shares does not raise the company's fixed costs, and there is no obligation to pay dividends or provide a claim on the company's existing assets.
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Frequently asked questions
A balance sheet is a financial statement that summarises a company's liabilities, assets, and shareholders' equity at a specific point in time. Debt equity investments can be recorded in three categories: trading, available-for-sale, and held-to-maturity.
Trading securities are investments made to benefit from short-term price fluctuations. Available-for-sale securities are similar but with a difference in the reporting of changes in market value. Held-to-maturity securities are purchased as long-term investments with the intent to hold them until the date of maturity.
For early-stage VC fundraising, direct costs such as legal fees should be capitalised and netted against the Additional Paid-In Capital (APIC) account on the balance sheet. Small, recurring expenses may be run through the P&L, but major expenses need to be capitalised.
When raising equity funding, the direct costs associated with the equity fund raise should be capitalised and netted against the APIC account in the equity section of the balance sheet. These costs are not amortised.
Long-term liabilities are financial obligations that are paid over a period of more than 12 months. This includes bonds, mortgages, and long-term leases. Short-term liabilities, or current liabilities, are due within one year, such as accounts payable and taxes.
