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Recording of Unrealized Gain or Loss on Financial Statements - PDF

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					Investments

ACCOUNTING FOR INVESTMENT SECURITIES

There are two potential types of investments that a corporation might hold: investments in equity
securities and investments in debt securities. The type of investment has an impact on the
accounting treatment. In addition, management’s intent with respect to the holding of the
investment affects how the investment is accounted for in the financial statements. The following
is a schedule of the accounting treatment based on the type of investment and management’s
intentions.

                      Reporting
    Control           Category                Management Intent             Type of Security
    < 20%          Held-to-Maturity Positive intent and ability to hold          Debt
    < 20%          Available-for-Sale Sale subject to market factors and     Debt or Equity
                                      company financial requirements
    < 20%               Trading       Subject to immediate sale               Debt or Equity
  20% - 50%         Equity Method Significant influence                          Equity
    > 50%           Consolidation Control                                        Equity

Securities to Be Held to Maturity
Debt securities that are classified as held-to-maturity indicate that the company has both the
ability and intent to hold the securities until maturity. The investor company does not have any
influence over the operating or financial policies of the investee company. The investment in
debt securities that are held-to-maturity are recorded at the market value (original cost) on the
date of acquisition.

Example: Spencer Company purchased $40,000 of the 8%, 5-year bonds of Alexander
Company for $43,412, which provides a 6% return. The bonds pay interest semiannually.
Spencer Company has both the ability and intent to hold the securities until the maturity date.
The journal entry to record the investment would be as follows:

    Date                         Account                        Debit          Credit
   1/1/00      Investment in bonds                              $40,000
               Premium on bonds                                   3,412
                Cash                                                            $43,412
               To record the purchase of held-to-maturity bonds


The following amortization table has been prepared to assist in the discussion related to the
recording of interim interest revenue and reporting the investment on the balance sheet at the end
of the accounting period.




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         Amortization Schedule, 8% 5-Year Bonds to Yield 6%
                                       Amortization     Carrying
     Date      Payment      Interest    of Premium      Amount
    1/1/00                                                $43,412
   6/30/00        $1,600        $1,302         $298        43,114
  12/31/00          1,600        1,293           307       42,807
   6/30/01          1,600        1,284           316       42,491
  12/31/01          1,600        1,275           325       42,166
   6/30/02          1,600        1,265           335       41,831
  12/31/02          1,600        1,255           345       41,486
   6/30/03          1,600        1,245           355       41,131
  12/31/03          1,600        1,234           366       40,765
   6/30/04          1,600        1,223           377       40,388
  12/31/04          1,600        1,212           388       40,000

We are assuming that the first interest payment will be received on June 30, 2000. The bond is
scheduled to pay $1,600 but the company paid a premium so the effective interest earned is
$1,302, the cash received net the amortization of the premium. The following journal entry
would be recorded to reflect this transaction.

   Date                              Account                           Debit       Credit
  6/30/00      Cash                                                     $1,600
                Premium on bonds                                                     $298
                Interest revenue                                                    1,302
               To record interest received, amortization of premium, and interest rearned
               on the first payment

The debt securities classified as held-to-maturity are carried in the accounting records at
amortized cost (face amount plus premium/less discount). No interim unrealized gains or losses
are recognized. If Spencer Company prepares financial statements at December 31, 2001 the
investment would be reported on the balance sheet as follows:

Held-to-Maturity Investments
Corporate bonds                                              $40,000
Plus: unamortized premium                                      2,166
 Book value (amortized cost)                                             $42,166


Available-For-Sale Securities
Equity or debt securities that are classified as available-for-sale indicate that the company is
holding these securities for some purpose other than short-term trading. The timing of the
disposition of such securities would be dictated by changes in the market for the securities or
changes in the cash flow requirements of the investor company. At the end of each accounting



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period these securities are marked-to-market. Because the securities are held for an unspecified
period, the resulting gain or loss is recorded in a special equity account, Unrealized holding
gain/loss on investments-Equity. When a company has a portfolio of investments it can be
difficult to keep track of the original or amortized cost of investments. To maintain a clean
record a separate account is established to record the resulting adjustment to the asset account,
Available-for-Sale Investments. This is an accretion or contra-asset account, Available-for-
Sale Securities Fair Value Adjustment, depending on whether the adjustment increases or
decreases the carrying amount of the investment.

Example: Spencer Company purchased $50,000 of the 9%, 5-year bonds of Alexander
Company $46,304, which provides an 11% return. Management intends to hold this debt
security until there is a change in interest rates or the company requires the cash. The fair value
of the bonds at year-end is $47,200. To record the original purchase the company would prepare
the following journal entry.

    Date                         Account                          Debit         Credit
   1/1/00      Investment in bonds                                $50,000
                Discount on bonds                                                 $3,696
                Cash                                                              46,304
               To record the purchase of available-for-sale bonds

The following amortization table has been prepared to assist in the discussion related to the
recording of interim interest revenue, recording unrealized gains (or losses) at the end of the
accounting period, reporting the investment at market on the balance sheet at year-end.

      Amortization Schedule, 9% 5-Year Bonds to Yield 11%
                                     Amortization Carrying
    Date     Payment       Interest   of Discount    Amount
   1/1/00                                              $46,304
   1/1/01        $4,500       $5,093         $593       46,897
   1/1/02         4,500        5,159          659       47,556
   1/1/03         4,500        5,231          731       48,287
   1/1/04         4,500        5,312          812       49,099
   1/1/05         4,500        5,401          901       50,000

We are assuming that the first interest payment will be made on January 1, 2001. In order to
prepare the year end financial statements for December 31, 2000 the company will have to
accrue the interest that will be received on the first day of 2001. The following journal entry will
accomplish this.




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    Date                       Account                         Debit          Credit
  12/31/00 Interest receivable                                  $4,500
           Discount on bonds                                        593
            Interest revenue                                                     $5,093
           To record interest receivable, amortization of discount, and interest rearned
           on the first payment at December 31, 2000.

Available-for-sale securities are marked-to-market for financial reporting purposes. If we
assume that the fair value of the bonds at year-end are $47,200 then the following journal entry
needs to be made in order to properly reflect the fair value of the securities for financial reporting
purposes.

    Date                     Account                          Debit        Credit
  12/31/00 Unrealized holding loss on AFS investments              $303
            FVA, AFS investments                                              $303
           To mark-to-market the available-for-sale securities at year-end

                              Analysis of unrealized holding gain (loss)
               Market value, December 31, 2000                  $47,200
               Carrying value                                    46,897
                Unrealized holding gain (loss)                                        $303

             T-Account: Fair value adjustment, AFS debt securities
    Date                  Description                   Debit                    Credit
   1/1/00 Beginning balance                                   $0
  12/31/00 Required AJE                                      303
  12/31/00 Ending balance                                   $303

               T-Account: Unrealized holding (gain) loss, equity
    Date                  Description                     Debit                  Credit
   1/1/00 Beginning balance                                                              0
  12/31/00 Required AJE                                                               $303
  12/31/00 Ending balance                                                             $303


To calculate this year-end adjustment, refer to the amortization table above. The carrying
amount of the investment is $46,897 and the fair market value is $47,200. The difference of
$300 increases the carrying value of the investment and end up separately stated in the equity
section of the balance sheet as presented below:




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                                 ASSETS
Available-for-Sale Debt Securities:
 Corporate bonds                                             $50,000
 Less: unamortized discount                                    3,103
 Carrying value (amortized cost)                              46,897
 Fair value adjustment, AFS investments                          303
 Investment at fair value                                                $47,200

                     SHAREHOLDERS' EQUITY
Unrealized holding gain on AFS investments                                  $303


If the ownership of available-for-sale investments continues for several accounting periods the
accounting for unrealized gains or losses becomes a little more complicated. The change in
market value is recorded from the end of the previous accounting period.

Example: At December 31, 2000, Spencer Company had the following balances in its available-
for-sale investment account and the related available-for-sale securities adjustment, and
unrealized holding gain accounts.

                                                             Original               Unrealized
Available-for-Sale Equity Securities:                         Cost      Fair Value Gain (Loss)
Baker Equipment, common stock                                 $103,000     $101,000    ($2,000)
Sizemore Corporation, common stock                               45,000      51,000       6,000
Totals                                                        $148,000     $152,000      $4,000

                   T-Account: Fair value adjustment, AFS equity securities
    Date                  Description                     Debit         Credit
   1/1/00 Beginning balance                                      $0
  12/31/00 Required AJE                                       4,000
  12/31/00 Ending balance                                    $4,000

                      T-Account: Unrealized holding (gain) loss, equity
    Date                  Description                      Debit        Credit
   1/1/00 Beginning balance                                                    $0
  12/31/00 Required AJE                                                     4,000
  12/31/00 Ending balance                                                  $4,000

The journal entry to record this fair value adjustment is as follows:




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    Date                      Account                            Debit       Credit
  12/31/00 Fair value adjustment, AFS equity securities            $4,000
            Unrealized holding gain, AFS equity securities                      $4,000
           To mark-to-market the available-for-sale securities at December 31, 2000

No available-for-sale investments have been purchased or sold during 2001. As of December 31,
2001 the fair market values of the two equity investments are as follows:

Baker Equipment, common stock                                  $97,500
Sizemore Corporation, common stock                              44,000
 Total market value                                                        $141,500


In order to prepare the December 31, 2001 financial statements the available-for-sale
investments account and related available-for-sale securities adjustment and unrealized holding
gain accounts need to be adjusted to reflect the new fair values of the equity investments. The
following provides such an analysis:

                                                             Original               Unrealized
Available-for-Sale Equity Securities:                         Cost      Fair Value Gain (Loss)
Baker Equipment, common stock                                 $103,000      $97,500    ($5,500)
Sizemore Corporation, common stock                               45,000      44,000     (1,000)
 Totals                                                       $148,000     $141,500    ($6,500)

            T-Account: Fair value adjustment, AFS equity securities
    Date                  Description                   Debit                         Credit
   1/1/01 Beginning balance                                $4,000
  12/31/01 Required AJE                                                                 $10,500
  12/31/01 Ending balance                                                                $6,500

               T-Account: Unrealized holding (gain) loss, equity
    Date                  Description                     Debit                       Credit
   1/1/01 Beginning balance                                                              $4,000
  12/31/01 Required AJE                                    $10,500
  12/31/01 Ending balance                                   $6,500


The required adjusting journal entry at the end of December 31, 2001 is as follows:




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    Date                     Account                          Debit        Credit
  12/31/01 Unrealized holding loss, AFS equity securities      $10,500
            Fair value adjustment, AFS equity securities                    $10,500
           To mark-to-market the available-for-sale securities at December 31, 2001

If an available-for-sale security has been marked-to-market and then subsequently sold the sale
must be recorded by removing the marked-to-market amounts in the available-for-sale securities
adjustment and unrealized holding gains/losses accounts. For example, if on January 1, 2002
Spencer Company sold the stock in Baker Equipment for $100,000 the following journal entry
would be prepared to record the transaction.

                                                             Original              Unrealized
Available-for-Sale Equity Securities:                         Cost     Fair Value Gain (Loss)
Sizemore Corporation, common stock                             $45,000     $44,000    ($1,000)

                     T-Account: FVA, Available-for-Sale Securities
    Date                      Description                   Debit                  Credit
   1/1/02      Beginning balance                                                      $6,500
               Required AJE                                    $5,500
               Ending balance                                                         $1,000

                      T-Account: Unrealized Holding Gain, Equity
    Date                      Description                   Debit                  Credit
   1/1/02      Beginning balance                              $6,500
               Required AJE                                                           $5,500
               Ending balance                                 $1,000

    Date                             Account                           Debit       Credit
   1/1/02      Cash                                                    $100,000
               FVA, available-for-sale securities                         5,500
               Loss on sale of investments                                3,000
                Investment in AFS, Baker Equipment                                 $103,000
                Unrealized holding loss on AFS securities                             5,500
               To record the sale of Baker Equipment stock and remove the allocation of
               unrealized holding losses from the FVA, available-for-sale securities and
               the unrealized holding loss on AFS equity accounts on January 1, 2002.

As with impairment losses on plant, property and equipment or intangible assets, if the decline in
value of an available-for-sale investment is other than temporary, it is considered an impairment
and must be recognized in the accounting period discovered. The carrying value of the asset is
written down to the market value and recorded in the income statement.




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Trading Securities
Equity and debt securities that are classified as trading securities indicate that the company has
purchased the securities for the purposes of making a short term profit. These securities are not
being held for interest income but rather for short-term appreciation on the market price of the
security. At the end of each accounting period the securities are marked-to-market with the
resulting gains and losses reported in the income statement. A nominal account is used to report
such gains and losses, Unrealized holding gain/loss on investments-Income. Unlike the
available-for-sale investments the carrying value of the trading securities are actually written up
or down to their new market values, therefore there is no need for an accretion or contra-asset
account.

The purchase of trading securities is record at net cost. At the end of each accounting period the
market value is determined and the carrying value of the securities is marked-to-market.

Example: Spencer Company purchased the following securities during 2000.

Supreme Products, 490 shares stock                            $240,000
Alexander Company, 5,200 shares stock                          132,800
 Total cost of trading securities                                         $372,800


At December 31, 2000 management determined that the fair market values of the trading
securities were as follows.

                                                             Original              Unrealized
Trading Securities:                                           Cost     Fair Value Gain (Loss)
Supreme Products, 490 shares stock                            $245,000    $240,000    ($5,000)
Alexander Company, 5,200 shares stock                          130,000     132,800       2,800
 Totals                                                       $375,000    $372,800    ($2,200)

                      T-Account: FVA, Trading Securities
    Date                  Description                   Debit                        Credit
   1/1/00 Beginning balance                                   $0
  12/31/00 Required AJE                                                                 $2,200
  12/31/00 Ending balance                                                               $2,200


The company will record an adjusting journal entry to reflect this unrealized loss. The loss will
be reported on the income statement and the carrying value of the investments will be adjusted to
market value at December 31, 2000. Any realized gain or loss on the subsequent sale of the
investments will be based on the carrying value as of December 31, 2000. The journal entry
would be as follows:




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    Date                     Account                          Debit          Credit
  12/31/00 Unrealized holding loss, income                      $2,200
            FVA, trading securities                                            $2,200
           To record the unrealized holding loss on trading securities at December 31,
           2000.

Transfers between Reporting Categories

If management decides to transfer an investment security from one category to another the
resulting unrealized gain or loss is recognized or deferred based on the follow schedule:

                      Transfer
         From                         To                  Unearlized Gain or Loss from Transfer
   Held-to-Maturity            Available-for-Sale        Unrealized Gain/Loss, Equity
   Held-to-Maturity                 Trading              Unrealized Gain/Loss, Income
   Available-for-Sale          Held-to-Maturity          Amortize over remaining life of security
   Available-for-Sale               Trading              Unrealized Gain/Loss, Income
        Trading                Available-for-Sale        None, already at FMV
        Trading                Held-to-Maturity          None, already at FMV




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