Disposition
Refers to the act of selling or otherwise disposing of an asset. It involves transferring ownership or liquidating an investment to generate returns or manage risk
What is a Disposition?
In finance, disposition refers to the act of selling or otherwise disposing of an asset. It involves transferring ownership or liquidating an investment to generate returns or manage risk.
A common example of a disposition is the disposal of shares, but it includes various forms of transferring or assigning assets, not limited to shares. Imagine an investor who has been a long-time stockholder for a specific company. However, this company isn't doing so great.
If they settle to end this investment, it will be known as a disposition of that investment or shares. They're more likely to sell those shares on a stock exchange through a broker. In this case, they would have chosen to "dispose" of the investment.
If the sales result in any capital gain, the investor will need to pay capital gains tax on the profits if they are operating under the requirements set by the IRS.
When someone assigns or transfers specific shares to a party, whether a charity or family, these are considered types of disposals. This is usually done to relieve the disposer of tax or other debts.
Key Takeaways
- In finance, disposition refers to the act of selling or transferring ownership of an asset, whether it's shares, equipment, or even entire business units.
- Disposition can include selling shares of a company's stock, transferring assets to another party, or liquidating investments to manage risk or generate returns.
- When disposing of assets, businesses must update their records to reflect the removal of the assets from their ownership. This involves adjusting accounts for book value, accumulated depreciation, and recognizing gains or losses from the disposal.
- Companies may dispose of entire entities or business segments through divestitures, such as spin-offs or split-offs. The Securities and Exchange Commission (SEC) regulates reporting requirements for such disposals, with specific criteria triggering the need for pro forma financial statements.
Recording a Disposition
Disposing of assets involves the action of exchanging or selling assets to remove them from the company's ownership.
This might also happen when the company wants to remove stolen or damaged assets. Moreover, no matter the disposal method, the accounts of these assets must be deleted from the company's records.
Normally, the book value of an asset is seldom and rarely the same as its market value. This means the company will experience losses and gains when undergoing sales and disposal.
Let's say that company A decides to sell some of its machinery for $45,000. A bought this machinery for $60,000, which devalued over a few years. The accumulated depreciation on this machinery was $30,000.
To calculate the gain or loss of this disposal, we calculate as follows:
- Cost of Machinery = $60,000
- Accumulated Depreciation = $30,000
- Proceeds from Sale = $45,000
Net Book Value = $60,000 – $30,000 = $30,000
Gain from the Disposition of Equipment Z = $45,000 – $30,000 = $15,000
When disposing of machinery, the journal entries should reflect debiting the accumulated depreciation and crediting the machinery account, along with recognizing any gain or loss on disposal. The proceeds from the sale will also be accounted for accordingly.
In addition, the journal entries will be reflected in the agreement period.
Business Disposition
Businesses and companies do not only dispose of equipment or machinery. Sometimes, they eliminate and dispose of entire entities, segments, and units. This is known as divestiture and is done through a spin-off, split-off, or split-up.
The SEC Securities and Exchange Commission presents very particular regulations on the reports of these disposals and how they will be handled.
The significance test is triggered based on specific criteria, such as the investment value or income of the disposed unit. Therefore, pro forma financial statements will be needed if the company meets the requirements.
An income or investment test is taken to determine the "significance." In the investment test, the investment value of the disposed unit is compared to the total assets.
The significance of a disposal can be determined by various benchmarks, such as income or investment value, and the threshold may vary depending on company policy or specific situations.
On the other hand, the income test will measure the equity on income before taxes and the cumulative effects of changes in the accounting principles.
It is considered significant if the value is greater than 10% of such income at the latest FY end. Some companies can increase the threshold level to 20% in specific situations.
Disposition Effect
This effect mainly refers to the likelihood of a firm immaturely disposing of properties or assets that can have future gains and holding on to those that might cause losses.
Essentially, the disposition effect occurs when investors sell profitable investments too early and hold onto losing investments too long, driven by psychological biases.
Hersh Shefrin and Meir Statman first introduced this effect in 1985. They introduced the effect in their paper, "The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence."
Many studies have shown the detrimental impact of the disposition effect on investment performance, emphasizing the importance of investors mitigating its influence through informed decision-making rather than simply doing the opposite.
By ignoring the psychological urges behind this effect, one may avoid losses and wasting profitable assets.
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