When a company invests in another company's stock, the accounting treatment depends entirely on two factors: the percentage of ownership and the investment intent. Three separate frameworks apply: mark-to-market through net income (trading), mark-to-market through other comprehensive income (available-for-sale), and the equity method for significant influence. Each framework is built on a specific economic logic — not arbitrary rules.
The threshold question for investment accounting is: how much influence does the investor have over the investee? GAAP defines three categories based on ownership percentage and expressed intent, and each has fundamentally different accounting:
Investment Accounting — Three Methods
The accounting treatment depends on ownership % and intent
Critical distinction: Trading and AFS use fair value on the balance sheet. The difference: trading marks unrealized gains/losses through net income each period; AFS parks them in Other Comprehensive Income (bypasses the income statement until sold).
GAAP presumes significant influence at 20% ownership or above. Below 20%, the investor is assumed to have no significant influence — trading or AFS treatment applies. Above 50%, the investor controls the investee — consolidation applies (Lesson 8). The 20–50% range is the equity method zone. These are presumptions, not rules: an investor with 15% ownership but board representation may be required to use the equity method; an investor with 25% ownership in a company where another investor holds 51% may have no real influence and might use AFS treatment. Intent and practical influence always override the arithmetic threshold if evidence is clear.
Both trading and AFS securities are reported at fair market value on the balance sheet. The critical difference is where unrealized gains and losses flow:
Jan 1: Buy 1,000 shares at $20 → DR Investment $20,000 / CR Cash $20,000. Dec 31: Market price = $24 → DR Investment $4,000 / CR Unrealized Gain–OCI $4,000 (equity; not income statement). Feb 15 next year: Sell all at $26 → DR Cash $26,000 / CR Investment $24,000 / CR Realized Gain $2,000 (income). ALSO: reclassify the $4,000 OCI → DR Unrealized Gain–OCI $4,000 / CR Realized Gain $4,000. Total realized gain through income: $6,000 ($4 + $2 appreciation).
The equity method is economically logical: if you own 25% of a company, you own 25% of its net assets. When it earns income, your investment grows. When it pays dividends, it distributes assets back to you (reducing what you own). The balance sheet account always equals your proportional share of the investee's book value:
| Event | Journal Entry | Logic |
|---|---|---|
| Initial purchase | DR Investment in XYZ / CR Cash | Record at cost — your initial stake |
| Investee reports net income | DR Investment in XYZ / CR Investment Income | Your % × investee net income; your investment grows because the investee's equity grew |
| Investee pays dividends | DR Cash / CR Investment in XYZ | Your % × dividends paid; dividend is return of your investment, not income; reduces investment balance |
| Investee reports a net loss | DR Loss on Investment / CR Investment in XYZ | Your % × loss; investment decreases |
Key Takeaways
An investor holds 500 shares of AFS stock purchased at $30. At year-end, the market price is $38. What is the year-end journal entry and where does the gain appear?