- It is often the case that one company
will store its temporary excess cash
by investing in the stocks and bonds
of other companies.
And some companies invest in the stocks and bonds
of other companies as part of their business strategy,
seeking to earn returns through careful investing.
After making the investments,
the value of the investments will move
up and down daily as stock and bond prices fluctuate.
Now the important accounting question is this.
Should the investment security assets be reported
in the balance sheet at their original cost
or at their current market value?
Well in a break from accounting tradition,
almost all investment securities are reported
in the balance sheet at current market value, not cost.
For example, on December 31st, 2018,
Berkshire Hathaway, which is the large investment company
run by Warren Buffet, owned a portfolio of stocks
in other companies, including American Express,
Apple, Bank of America, Coca-Cola, and Wells Fargo.
The total cost of this portfolio was $102.867 billion.
On that same date of December 31st, 2018,
this portfolio of stocks had a market value
of $172.757 billion.
In other words, since Berkshire Hathaway
had purchased these shares,
they had gone up in value by $69.890 billion, not bad.
This $69.890 billion represents an economic gain
to Berkshire Hathaway through wise
and perhaps lucky investing.
Accountants call this type of gain
an unrealized gain, because Berkshire Hathaway
has not yet sold its investments to receive
the increased cash to which they are entitled.
In common usage, we call these unrealized gains
paper gains, because they are gains on paper
but we haven't yet confirmed the gain
by selling the investment.
Here's another accounting question.
Should these unrealized gains, or paper gains,
be reported in the income statement?
The answer is yes, those unrealized gains,
those paper gains, or losses, are reported
in the income statement.
Now many business people and financial statement users
don't like this accounting treatment.
They don't think that unrealized or paper gains and losses
should be shown in the income statement.
Here's what Warren Buffet had to say on this topic
in his 2018 letter to the Berkshire Hathaway shareholders.
"Neither Berkshire's Vice Chairman, Charlie Munger,
"nor I believe that rule to be sensible.
"Rather, both of us have consistently thought
"that at Berkshire this mark-to-market change
"would produce what I described
"as wild and capricious swings in our bottom line."
Note that Warren Buffett called this investment security
market value accounting by its frequent label
of mark-to market accounting.
This is not meant to be a compliment.
In the case of Berkshire Hathaway,
Warren Buffet's complaint is that the accounting rule
requires short-term investment gains and losses
to be reported in the income statement,
when in fact, the company intends to hold these investments
for the long term.
For example, as of the end of 2018,
Berkshire Hathaway had held its $14.5 billion investment
in American Express for eight years,
without selling any of the shares.
Warren Buffet's complaint, which is common
in the business community, is that short-term
price fluctuations on long-term investments
should not be reported as part of normal net income.
But alas, dissatisfaction by Warren Buffet notwithstanding,
mark-to-market accounting is the worldwide
financial accounting rule.
Now as a footnote, the paper gains and losses
from some investments in bonds, not stocks, bonds,
are not reported in the income statement,
but instead are shown in a separate equity category
called Accumulated Other Comprehensive Income, or AOCI.
Accountants call these investments
Available-for-Sale Securities.
The only investments classified
as Available-for-Sale Securities
are long-term bond investments.
For most companies, this is not a major part
of their investment security portfolio.
In summary, almost all investment securities
are reported in the balance sheet
at their current market value.
And the unrealized gains and losses
resulting from annual price fluctuations
are reported in the income statement.