GAAP Accounting Rules on Unrealized Capital Gains

By Motley Fool StaffFool.com

When a company or individual makes an investment, the obvious goal is for that investment to increase in value over time. However, until the investment is sold, these capital gains are unrealized-- in other words, they are just on paper. Here's how companies should account for unrealized capital gains, according to GAAP principles.

For small investmentsBy a "small investment," we generally mean an investment that results in a stake of less than 20% in the investee. Bear in mind, however, that more important than the size of the investment is whether or not it results in influence over the company -- such as a seat on the board or influence of some other form.

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If the investment does not result in considerable influence, the accounting process depends on whether the investment is readily available for sale or not. For tradeable securities (investments to be held for less than 12 months), unrealized gains are reported as "other comprehensive income" on the income statement, and accumulate on a separate line on the owners' equity portion of the balance sheet.

However, if the investment in question is a debt security that the investor intends to hold to maturity, or is otherwise not considered "tradeable", unrealized gains are not recognized. In this case, the original cost of the investment is recorded, and this amount is not changed until the investment matures or is sold.

Investments that result in influence Generally, a stake of 20% to 50% in another company results in some level of influence. Keep in mind, however, that these numbers are not set-in-stone rules, and it's entirely possible to have influence over a company with a smaller stake.

In this case, the investor would use the equity method of accounting to record the investment. With this method, the investor does not recognize unrealized capital gains based on the market value of the investment, but it does record its share of the investee's income. For example, if a company buys a 25% stake in another, and the investee company earns $1,000,000 this year, the investor would record $250,000 as income on its books.

If the investment results in a majority stakeFinally, if the investment results in more than 50% ownership in another company, the investee must be considered a subsidiary for accounting purposes, and its finances must be incorporated into the controlling company's financial statements.

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