Financial Accounting Module 20

Module 20Investments

Types of investments

Companies invest in the stocks and bonds of other entities for many reasons including putting excess cash to use (usually for short-term). investment for returns. investment for influence or control.

The first two types of investments above are called passive investments, where the investor has no ability to exercise significant influence over the policies of the investee.Significant influence is presumed to exist with holdings of 20% or more (but less than the majority) of the voting stock. If a company holds more than 50% of the voting stock of another company, then the investing company is termed the parent company and the investee company is termed the subsidiary company.

Statement of Financial Accounting Standard (SFAS) No. 115 provides guidance on accounting for passive investments. APB Opinion No. 18 prescribes the accounting requirements for investments that involve significant influence. The equity method of accounting is used for such investments (involving ownership of 20% or more of the investee). In situations involving a company owning more than 50% of the stock of another company, consolidated financial statements are prepared.

SFAS 115 classifies passive investments in debt and equity securities in three categories. Held to maturity (HTM) securities involve only debt securities, and the company

holding such securities has both the intent and the ability to hold until they mature. Only debt securities can be classified as HTM because equity securities do not have a maturity date –because they are assumed to be perpetual.

Trading securities are debt and equity securities purchased with the intent of selling within a short period of time. Trading securities are purchased with the intent of generating profit on short-term changes in price.

Available-for-sale (AFS) securities involve debt and equity securities that are not classified as held-to-maturity or trading.

Purchase of securities

Purchase of securities is recorded at cost, like the purchase of any other asset. When debt or equity securities are purchased, the investment is recorded at the price paid including brokers’ commissions, taxes, and any other related fees.

When debt securities are purchased between interest payment dates, then adjustments have to be made for any interest accrued since the last payment. For example, assume that Smith Company purchased a 10 year bond with a face value of $10,000 for $102,000 on May 1, 2002. The bond’s stated rate is 12% and interest is paid on January 1 and July 1 each year. Thus, the bond will pay interest of $600 on January 1 and July 1 each year.

When Smith Company purchased the bond on May 1, four months have elapsed since the last interest payment date. In two months time, Smith Company as the current holder of the bond will be eligible to receive the July 1 interest payment of $600. Thus, when Smith Company purchased the bond it also purchased the accrued interest of $400 for four months (from January 1 to May 1). The seller of the bond is entitled to this accrued interest for four months because the it was the seller who held the bonds from January 1 to May 1.

Thus, the total amount paid by Smith Company will be $102,400 ($102,000 as purchase price for the bond and $400 towards accrued interest). There are two ways of recording this transaction.

The first (Asset Approach) is as follows :On May 1, when the bond is purchased.

Account Debit CreditInvestment in Bonds $ 102,000Interest Receivable 400 Cash $ 102,400

Later, on July 1 when the interest is received: Account Debit Credit

Cash $ 600 Interest Receivable $ 400 Interest Revenue 200

The alternative (Revenue Approach) is as follows:On May 1, when the bond is purchased.

Account Debit CreditInvestment in Bonds $ 102,000Interest Revenue 400 Cash $ 102,400

Later, on July 1 when the interest is received: Account Debit Credit

Cash $ 600 Interest Revenue $ 600

Note that under both approaches, the net result is the same. The interest revenue for the two months ending July 1 will be $200 under both approaches.

Changes in value of securities

The primary difference between the different types of securities is in the treatment of temporary changes in the value of the securities. That is, when the market price of securities is different from the price at which they were purchased earlier the treatment of the three types of securities differs.

Accounting for changes in the value of held-to-maturity securities is easiest –no temporary changes in value are recognized. By definition the company has the intent to hold on to the debt securities classified as held-to-maturity until the time the bond (or other debt security) becomes due, so the company will receive the face value of the bond at maturity. Hence, changes in the market value of the security at intermediate periods (before maturity) are not relevant.

Temporary changes in the value of trading and available-for-sale securities are recognized each period. However, the treatment is different for these two types of securities. Any gains or losses because of changes in value of trading securities are recognized in the income statement. However, any gains or losses because of changes in value of available-for-sale securities are directly included in the stockholders’ equity section of the balance sheet, bypassing the income statement.

Accounting for change in value of Trading securities

Changes in value of trading securities are recorded by recognizing any unrealized gains or losses in the value of the securities. (The gains or losses are called “unrealized” because actual gain or loss is realized only when the security is sold. Before that, all gains and losses are only “paper gains or losses.”) The matching entry is recorded in a valuation account. This valuation account is included in the balance sheet, and increases or decreases the value of the securities depending on whether it has a debit or credit balance.

Example.Dell Company purchased the following securities during 2002, and classified them as trading securities. The cost and market value of the securities on December 31, 2002 and December 31, 2003 are given below.

Security Cost Market valueDecember 31 2002

Market valueDecember 31 2003

A 20,000 22,000 19,700B 12,000 11,500 11,900

The total market value of Trading securities as of December 31, 2002 is $33,500 ($22,000 + $11,500). The cost of these securities was $32,000 ($20,000 + $12,000). Thus, the market price of the Trading securities is higher than their cost by $1,500. That is, the value of the securities must be increased by $1,500 to reflect market value. Since debits reflect increases in assets, the Market Adjustment –Trading Securities account must have a debit balance of $1,500.

Since this is the first year, the beginning balance in the Market Adjustment account must be zero. To go from a zero balance to a debit balance of $1,500 requires a debit entry for $1,500. Gains (whether realized or unrealized) are recorded with a credit. Hence, the corresponding credit is for the Unrealized Gains on Trading Securities account.

The journal entry for the market value adjustments is:Account Debit Credit

Market Adjustment –Trading Securities $ 1,500 Unrealized Gain on Trading Securities $ 1,500

The unrealized gain is included in the income statement (under “Other revenues and gains”). The debit balance of $1,500 in the Market Adjustment account is taken to the balance sheet, where it increases the value of the Trading Securities from $32,000 (the cost) to $33,500 (market value).

Note that the Unrealized Gain (or Loss) account is a nominal account that is closed each year to the income statement. In contrast, the Market Adjustment account is a permanent (balance sheet) account that is not closed. The ending balance in the Market Adjustment account for any period equals its beginning balance plus any changes during the period.

Journal entries as of December 31, 2003:The total market value of Trading securities as of December 31, 2002 is $31,600 ($19,700 + $11,900). The cost of these securities was, as before, $32,000 ($20,000 + $12,000). Thus, the market price of the Trading securities is lower than their cost by $400. Hence, the Market Adjustment –Trading Securities account must have a credit balance of $400.

At the end of 2002, the balance in the Market Adjustment –Trading Securities account was a debit balance of $1,500. To go from a debit balance of $1,500 to a credit balance of $400 requires a credit entry of $1,900. To make debits equal credits, a debit entry for $1,900 is needed. Since debits indicate losses (while credits indicate gains), the corresponding debit entry is to the Unrealized Loss on Trading Securities Account.

The journal entry at the end of 2003 for the market value adjustments is:Account Debit Credit

Unrealized Loss on Trading Securities $ 1,900 Market Adjustment –Trading Securities $ 1,900

The unrealized loss of $1,900 is taken to the income statement. The credit balance of $400 in the Market Adjustment account is taken to the balance sheet, where it reduces the value of the Trading Securities from $32,000 (the cost) to $31,600 (market value).

Accounting for change in value of AFS securities

Changes in value of available-for-sale (AFS) securities are recorded by recognizing any unrealized gains or losses in the value of the securities. However, the treatment of any unrealized gains or losses is different from that for trading securities. In the case of AFS securities, any unrealized gains and losses are taken directly to stockholders’ equity as part of “Accumulated other comprehensive income.” The specific account in which the gains or losses are reported is called “Unrealized Increase/Decrease in Value of Available-for-Sale Securities” or “Unrealized Holding Gains (losses) on Available-for-Sale Securities.”

The matching entry is recorded in a valuation account, as in the case of trading securities. This valuation account is included in the balance sheet, and increases or decreases the value of the securities depending on whether it has a debit or credit balance.

Example.Garner Company purchased the following securities during 2002, and classified them as available-for-sale securities. The cost and market value of the securities on December 31, 2002 and December 31, 2003 are given below.

Security Cost Market valueDecember 31 2002


X $ 40,000 $ 38,000 $43,000Y 35,000 33,000 32,700

Journal entries as of December 31, 2002:The total market value of Available-for-Sale securities as of December 31, 2002 is $71,000 ($38,000 + $33,000). The cost of these securities was $75,000 ($40,000 + $35,000). Thus, the market price of the Available-for-Sale securities is lower than their cost by $3,000. That is, the value of the securities must be decreased by $3,000 to reflect market value. Since credits reflect reduction in the value of assets, the Market Adjustment –AFS Securities account must have a credit balance of $3,000.

Since this is the first year, the beginning balance in the Market Adjustment account must be zero. To go from a zero balance to a credit balance of $3,000 requires a credit entry for $3,000. Losses (whether realized or unrealized) are recorded with a debit. Hence, the corresponding debit is for the Unrealized Increase/Decrease in Value of AFS Securities account.

The journal entries for the market value adjustments are:Account Debit Credit

Unrealized Increase/Decrease in Value of AFS Securities $ 3,000 Market adjustment –AFS Securities $ 3,000

The (credit) balance in the Market Adjustment account is taken to the balance sheet, where it decreases the value of the AFS securities account from $75,000 (cost) to $72,000 (market value). The (debit) balance in the Unrealized Increase/Decrease in Value of AFS Securities account is taken to the Stockholders’ Equity section where it reduces the value of the Stockholders’ equity. (Thus, both assets and owners’ equity are reduced by $3,000 keeping the basic accounting equation of A = L + OE in balance.)

Note that unlike the case with trading securities, both of the accounts involved in the market value related adjustment are permanent accounts, which are taken to the balance sheet.

Journal entries as of December 31, 2003:The total market value of AFS securities as of December 31, 2002 is $75,700 ($43,000 + $32,700). The cost of these securities was, as before, $75,000. Thus, the market price of the AFS securities is higher than their cost by $700. Hence, the Market Adjustment –AFS Securities account must have a debit balance of $700.

At the end of 2002, the balance in the Market Adjustment –AFS Securities account was a credit balance of $3,000. To go from a credit balance of $3,000 to a debit balance of

$700 requires a debit entry of $3,700. To make debits equal credits, a credit entry for $3,700 to the Unrealized Increase/Decrease in Value of AFS Securities is needed.

The journal entry at the end of 2003 for the market value adjustments is:Account Debit Credit

Market Adjustment –AFS Securities $ 3,700 Unrealized Increase/Decrease in Value of AFS Securities $ 3,700

After this market value adjustment entry, the Market Adjustment account will have a debit balance of $700 and the Unrealized Increase/Decrease in Value of AFS Securities account will have credit balance of $700. The balance in the Market Adjustment account will add to the balance of the AFS securities on the asset side, and the balance in the Unrealized Increase/Decrease in Value of AFS Securities account will add to the balance of stockholders’ equity.

Transfer of Securities

Companies may change the classification of securities due to changed circumstances. For example, securities previously classified as Trading Securities may be reclassified as Available-for-Sale Securities.

SFAS No. 115 requires that all transfers be effected at the fair (market) value at the time of the transfer. That is, the new asset should be debited at the market value. However, since the old asset no longer exists, it should be eliminated from the books. This means the old asset is credited for the amount it is carried in the books (that is, book value). Further, since the old asset is eliminated any Market Adjustment account associated with the old asset is also eliminated.

TRANSFER FROM OR INTO TRADING SECURITIES:Any unrealized gains or losses from securities currently classified as trading securities would already have been recognized in earnings. Hence, if securities are transferred from trading to any other type, such previously recognized gains or losses should not be reversed. However, it is possible that the market value of the trading securities has changed during the period from the end of the last period up to the date of the transfer. Such unrealized gains or losses should be recognized in the income statement of the period.

When securities are transferred from other categories into trading, any unrealized holding gains or losses should be recognized in earnings immediately.

TRANSFERS INVOLVING HELD-TO-MATURITY AND AVAILABLE-FOR-SALE SECURITIES:Debt securities currently classified as Held-to-Maturity or Available-for-Sale may be moved from one category to another. Securities classified as held-to-maturity (HTM) would not have been adjusted for changes in market value up to the date of transfer. Hence, any difference between the book value and market value as of the transfer date would be recorded in the Unrealized Increase/Decrease in Value of AFS Securities.

If securities are transferred into the HTM category, then any unrealized holding gain or loss as of the transfer date continues to be reported as a separate component of stockholders’ equity. This amount is treated as a discount or premium, and is amortized over the remaining life of the security.

Sale of Securities

When securities are sold, there may be realized gains and losses depending on the sale price and the book value of the securities sold. If the sales price is higher than the book value, then the company has a realized gain. However, if the sales price is lower than the book value, then the company has a realized loss.

Sale of Available-for-Sale (AFS) securities:Step 1. Debit cash for the sales price.

Step 2. Credit the book value of the securities sold, to remove them from the books.

Step 3. Debits must equal credits, so the plug number is a debit to Realized Loss from AFS Securities or a credit to Realized Gain from AFS Securities

Note that the Market Adjustment account is NOT adjusted at the time of the sale of any particular security. Changes in the Market Adjustment account are only calculated as of the end of each period, and the appropriate journal entry is made at that time.

Sale of Trading Securities:There are two approaches to recording the sale of Trading Securities. The first approach is to follow the same procedures as used for AFS securities. This approach is useful if a company holds many securities.

The second approach is as follows.Step 1. Debit cash for the sales price.

Step 2. Credit the book value of the securities sold, to remove them from the books.

Step 3. Since the securities have been sold, remove the balance in the Market Adjustment account associated with the securities that have been sold. This may require a debit or credit entry, depending on the balance in the Market Adjustment account associated with the securities that have been sold.

Step 4. Debits must equal credits, so the plug number is a debit to Realized Loss from AFS Securities or a credit to Realized Gain from AFS Securities

Sale of Held-to-Maturity (HTM) securities:If the HTM securities are returned to the issuer on the maturity date, then Cash is debited and the HTM securities are credited, for maturity value. By definition, there are no gains or losses.

Sometimes, HTM securities may be sold before the maturity date in the open market. The market price may be different from the maturity value. In such instances, Cash is debited for the sales price, and the HTM securities are credited for their book value. The plug number is a gain or loss from sale of HTM securities.

Two issues may complicate the accounting for the sale of HTM securities: (a) when the debt securities have been issued at a premium or discount from face value, and/or (b) when the securities are sold between interest dates. In such instances, the premium or discount must be amortized up to the date of sale, and the interest revenue up to the date of sale must be accrued. Finally, cash is debited for the sales price, the adjusted book value of the HTM securities is credited, and any gain or loss on sale is recognized.

Equity Method

The equity method of accounting for securities is applicable when a company exerts “significant influence” over the policies of another company. “Significant influence” is presumed to exist when a company owns 20% or more (but less than 50%) of another company’s voting stock. The intent in such situations is not just to earn returns on the investment, but to affect the operations of the investee.

The 20% cutoff is only a guide, and not a rigid rule. In some instances, a company may own more than 20% of another company but yet not be in a position to influence the policies of the investee (especially if the investee resists the activities of the investing company to exert control). Further, “significant influence” may exist even when a company owns less than 20% of the investee’s common stock. However, the 20% rule is used in the absence of other evidence.

The rules for equity method securities are as follows.1. The purchase of equity securities is recorded at cost.

2. Subsequent change in market value of the securities is ignored.

3. The proportionate share of the investee’s income is recorded as an increase in the Investment account (with a credit to Investment Income account). Any losses are recorded with a reduction of the Investment account (and a debit to Invesment Loss account).

4. Dividends represent a reduction of the equity investment in the investee, so dividends paid by the investee are recorded with a debit to Cash and a credit (decrease) to Investment account.

5. If the price paid is more than the proportionate share of the fair market value of the net assets of the investee (that is, if there is goodwill arising from the transaction) amortize the goodwill. This is recorded with a reduction of both the Investment Income and Investment accounts.

6. In addition, at the time of the purchase the fair market value of the net assets of the investee may be greater than the book value. Such “excess” amounts relating to depreciable assets must be depreciated over the remaining useful lives of such assets.

As with goodwill amortization, the journal entry involves a debit to Investment Income and a credit to Investment (thereby reducing both accounts).

Glossary

Available-for-sale (AFS) securities involve debt and equity securities that are not classified as held-to-maturity or trading

Equity method of accounting for investments is used when a company has significant influence over the policies of another (investee) company. This method is usually applicable when the investing company owns 20% or more of another company.

Held to maturity (HTM) securities involve only debt securities, and the company holding such securities has both the intent and the ability to hold until they mature.

Passive investments are investments where the investor has no ability to exercise significant influence over the policies of the investee.

Significant influence is presumed to exist with holdings of 20% or more (but less than the majority) of the voting stock of the investee.

Parent company is the company that holds more than 50% of the voting stock of another company.

Subsidiary company is the company whose majority of voting stock is held by another company.

Trading securities are debt and equity securities purchased with the intent of selling within a short period of time. Trading securities are purchased with the intent of generating profit on short-term changes in price.

Unrealized gains or losses are “paper gains or losses” and represent changes in the value of securities before the securities are sold.

Demonstration Problem 1Johnson Company

Johnson Company purchased some securities during the year 2002. The cost and market value of the securities on December 31, 2002 and December 31, 2003 are given below.

Security Type Cost Market valueDecember 31 2002


X Trading 10,000 11,000 8,700Y Trading 5,000 7,000 4,000Z Held-to-maturity 50,000 57,000 49,000

1. Prepare the necessary journal entries on (a) December 31, 2002(b) December 31, 2003.2. What is the value of the different types of securities on the balance sheet as of (a) December 31, 2002, and (b) December 31, 2003?

Solution to Demonstration Problem 1, Johnson Company

1a. Journal entries as of December 31, 2002:The total market value of Trading securities as of December 31, 2002 is $18,000 ($11,000 + $7,000). The cost of these securities was $15,000 ($10,000 + $30,000). Thus, the market price of the Trading securities is higher than their cost by $3,000.

Note that Held-to-Maturity securities are not adjusted for market value, no journal entry is needed as of December 31, 2002 or December 31, 2003 for such securities.

The journal entries for the market value adjustments are:For Trading securities

Account Debit CreditMarket Adjustment – Trading Securities $ 3,000 Unrealized Gain on Trading Securities $ 3,000

1b. Journal entries as of December 31, 2003:The total market value of Trading securities as of December 31, 2002 is $12,700 ($8,700 + $4,000). The cost of these securities was $15,000 ($10,000 + $30,000). Thus, the Market Adjustment for Trading Securities account must have a credit balance of $2,300 as of December 31, 2003.

However, the balance in the Market Adjustment account of Trading securities as of the end of the previous year was a debit of $3,000 (see part 1a above). Hence, to bring down the Market Adjustment account balance from a debit of $3,000 to a credit of $2,300, a credit entry for $5,300 is needed. This in turn leads to a corresponding debit entry to Unrealized Loss on Trading Securities Account.


Account Debit CreditUnrealized Loss on Trading securities $ 5,300 Market adjustment – Trading securities $ 5,300

Demonstration Problem 2Surrey Company

Surrey Company purchased some securities during the year 2002. The cost and market value of the securities on December 31, 2002 and December 31, 2003 are given below.



A Available-for-Sale $ 20,000 $ 24,000 -B Available-for-Sale 30,000 28,000 30,400C Held-to-maturity 50,000 57,000 49,000

The Company sold all the “A” securities on July 1, 2003 for $24,500. There were no other purchases or sale of the other securities held by the Company. 1. Prepare the necessary journal entries on (a) December 31, 2002(b) July 1, 2003(c) December 31, 2003.2. What is the value of the different types of securities on the balance sheet as of (a) December 31, 2002, and (b) December 31, 2003?

Solution to Demonstration Problem 2, Surrey Company

1a. Journal entries as of December 31, 2002:The total market value of Available-for-Sale securities as of December 31, 2002 is $52,000 ($24,000 + $28,000). The cost of these securities was $50,000 ($20,000 + $30,000). Thus, the market price of the Available-for-Sale securities is higher than their cost by $2,000.


The journal entries for the market value adjustments are:For Available-for-Sale (AFS) securities

Account Debit CreditMarket adjustment – AFS Securities $ 2,000 Unrealized Increase/Decrease in Value of AFS Securities $ 2,000

1b. On July 1, 2003, the Company sold all the “A” securities for $24,500. Since the original cost of these securities was $20,000, the Company has realized a gain of $4,500.

Journal entry for the sale of “A” securities:Account Debit Credit

Cash $ 24,500 AFS Securities $ 20,000 Gain on Sale of Securities 4,500

1c. Journal entries as of December 31, 2003:The total market value of Available-for-Sale securities as of December 31, 2003 is $30,400 (note that “A” securities have been sold). The cost of these securities was $20,000. Thus, the market price of the Available-for-Sale securities is higher than their cost by $400. Hence, the Market Adjustment account of Available-for-Sale securities must have a debit balance of $400 as of December 31, 2003.

However, the balance in the Market Adjustment account of Available-for-Sale securities as of the end of the previous year was a debit of $2,000 (see part 1a above). Hence, to bring down the Market Adjustment account balance from a debit of $2,000 to a debit of $400, a credit entry for $1,600 is needed. This in turn leads to a corresponding debit entry to Unrealized Increase/Decrease in Value of AFS Securities account.


Account Debit CreditUnrealized Increase/Decrease in Value of AFS Securities $ 1,600 Market Adjustment – AFS Securities $ 1,600

Demonstration Problem 3Hughes Company

Hughes Company purchased some securities during the year 2002. The cost and market value of the securities on December 31, 2002 are given below. On March 1, 2003 the Company reclassified the securities as noted in the table (AFS = Available-for-sale and HTM = Held-to-maturity).Security Type Cost Market value

12/31/2002Reclassified

AsMarket value

3/1/2003 A HTM $ 5,000 $ 7,000 AFS $ 7,200 B Trading 20,000 18,000 AFS 16,500 C AFS 10,000 9,000 HTM 9,400D AFS 30,000 33,700 Trading 34,000

Prepare the necessary journal entries on (1) December 31, 2002, and (2) July 1, 2003.

Solution to Demonstration Problem 3, Hughes Company

1. Journal entries as of December 31, 2002:The market value of trading securities ($18,000) is $2,000 lower than the cost ($20,000). The market value of available-for-sale securities ($42,700) is $2,700 higher than cost ($40,000). So the year-end adjustments are:

(a) For Trading securitiesAccount Debit Credit

Unrealized Loss on Trading Securities $ 2,000 Market Adjustment – Trading Securities $ 2,000

(b) For Available-for-Sale (AFS) securities Account Debit Credit

Market adjustment – AFS Securities $ 2,700 Unrealized Increase/Decrease in Value of AFS Securities $ 2,700

Note that there is no adjustment for held-to-maturity securies.

2. Journal entries as of March 1, 2003

(a) For the transfer from HTM to AFS:Before the transfer, the changes in the values of the HTM securities are not recognized. To eliminate the old securities, the old securities account must be credited at cost (since they have been carried at cost). The new securities must be debited at market value as of the transfer date. The plug number is a debit or credit to the Unrealized Increase/Decrease in Value of AFS Securities account. This represents the adjustment to market value as of the transfer date.

Account Debit CreditInvestment in AFS securities (step 2) $ 7,200 Unrealized Increase/Decrease in Value of AFS Securities (step 1) $ 2,200 Investment in HTM Securities (step 1) 5,000

(b) For the transfer from Trading to AFS:The market value of the trading securities has decreased from $18,000 on December 31, 2002 to $16,500 on March 1, 2003. This will be recognized with a debit to Unrealized Loss on Transfer of Securities account. The transfer is recorded by crediting the old asset and debiting the new asset. Finally, the Market Adjustment account associated with the old asset is closed (with a debit entry, because it had a credit balance [indicating a reduction in value from cost] before the transfer).

Account Debit CreditInvestment in AFS securities (step 3) $ 16,500Unrealized Loss on Transfer of Securities (step 1) 1,500Market Adjustment – Trading Securities (step 4) 2,000 Investment in Trading Securities (step 2) $ 20,000

(c) For the transfer from AFS to HTM:The market value of the AFS securities transferred to HTM has increased from $9,000 on December 31, 2002 to $9,400 on March 1, 2003. This increase will be recognized with a credit to Unrealized Increase/Decrease in Value of AFS Securities account. The transfer is recorded by crediting the old asset and debiting the new asset. Finally, the Market Adjustment account associated with the old asset is closed (with a debit entry, because it had a credit [indicating a reduction in value from cost] before the transfer).

Account Debit CreditInvestment in HTM securities (step 3) $ 9,400 Market Adjustment – AFS Securities (step 4) 1,000 Unrealized Increase/Decrease in Value of AFS Securities (step 1) 400 Investment in AFS Securities (step 2) 10,000

(d) For the transfer from AFS to Trading:Step 1: The market value of the trading securities is $34,000 on March 1, 2003. Hence, at the time of the transfer the Investment in AFS securities account is debited by $34,000.Step 2: As of the previous financial statement date, the AFS securities had a cost of $30,000 and a debit balance in the Market Adjustment account of $3,700. Since the trading securities have now been transferred, all balances relating to the transferred trading securities must be eliminated. Hence, the Investment in Trading Securities account is credited by $30,000.Step 3: The Market Adjustment account is credited by $3,700.Step 4: Related to step 3, the balance in the Unrealized Increase/Decrease in Value of AFS Securities (in the amount related to the transferred securities) is eliminated. Since Step 5: The total unrealized gain on the transferred securities will now be included in the Income Statement for the year.

Account Debit CreditInvestment in Trading securities (step 1) $ 34,000Unrealized Increase/Decrease in Value of AFS Securities (step 4) 3,700 Unrealized Gain on Transfer of Securities (step 5) $ 4,000 Market Adjustment – AFS Securities (step 3) 3,700 Investment in AFS Securities (step 2) 30,000

Demonstration Problem 4Boston Company

On January 1, 2002, Boston Company purchased 25% of the common stock of Teknix Company for $700,000. At the time of the purchase, the fair market value and book value of the net assets of Teknix Company were $2,600,000 and $2,300,000, respectively. The difference between the book value and fair value of the net assets was due to the value of depreciable assets which had a remaining useful life of 10 years. Boston Company decided to amortize the goodwill related to the purchase over 20 years. During 2002, Teknix Company had a net income of $160,000 and paid a dividend of $20,000.Prepare the journal entries for Boston Company for the year 2002, related to its transactions with Teknix Company.

Solution to Demonstration Problem 4, Boston Company

1. Journal entry for purchase of 25% of the sellerAccount Debit Credit

Investment in Teknix $ 700,000 Cash $ 700,000

2. Journal entry for net income of the seller The net income of Teknix Company was $160,000 for the year.Boston Company owns 25% of Teknix Company, so its share of net income = $40,000 ($160,000 x 0.25)

Account Debit CreditInvestment in Teknix $ 40,000 Investment income $ 40,000

3. Journal entry for receipt of dividendTotal dividends paid by Teknix Company was $20,000Boston Company owns 25% of Teknix Company, so its share of dividend = $5,000

Account Debit CreditCash $ 5,000 Investment in Teknix $ 5,000

4. Amortization of GoodwillThe purchase price was $700,000 for 25% of the seller.However, 25% of fair market value of net assets of the seller = $650,000 ($2,600,000 x 0.25).Hence, goodwill related to the purchase = $50,000 ($700,000 – $650,000).This amount will be amortized over 20 years (given).Hence, goodwill amortization each year = $2,500 ($50,000/20).

Account Debit CreditInvestment income $ 2,500 Investment in Teknix $ 2,500

5. Excess depreciationExcess value of depreciable assets of the seller = $2,600,000 – $2,300,000 = $300,000.Since Boston Company purchased only 25% of the stock of the seller, its share of excess depreciable assets = $75,000 ($300,000 x 0.25).This is the amount of excess depreciation required over 10 years (useful life given).Hence, additional depreciation each year = $7,500 ($75,000/10)

Account Debit CreditInvestment income $ 7,500 Investment in Teknix $ 7,500

Practice Problem 1Samson Company

Samson Company purchased some securities during the year 2002. The cost and market value of the securities on December 31, 2002 and December 31, 2003 are given below.



K Trading 40,000 37,000 42,500L Trading 25,000 26,000 24,000M Held-to-maturity 60,000 57,000 62,300


Solution to Practice Problem 1, Samson Company

1a. Journal entries as of December 31, 2002:The total market value of Trading securities as of December 31, 2002 is $63,000 ($37,000 + $26,000). The cost of these securities was $65,000 ($40,000 + $25,000). Thus, the market price of the Trading securities is lower than their cost by $2,000.



Account Debit CreditUnrealized Loss on Trading Securities $ 2,000 Market Adjustment – Trading Securities $ 2,000

1b. Journal entries as of December 31, 2003:The total market value of Trading securities as of December 31, 2002 is $66,500 ($42,500 + $24,000). The cost of these securities was $65,000. Thus, the Market Adjustment for Trading Securities account must have a debit balance of $1,500 as of December 31, 2003.

However, the balance in the Market Adjustment account of Trading securities as of the end of the previous year was a credit of $2,000 (see part 1a above). Hence, to change the Market Adjustment account balance from a credit of $2,000 to a debit of $1,500, a debit entry for $3,500 is needed. This in turn leads to a corresponding credit entry to Unrealized Gain on Trading Securities Account.


Account Debit CreditMarket adjustment – Trading securities $ 3,500 Unrealized Loss on Trading securities $ 3,500

Practice Problem 2Essex Company

Essex Company purchased some securities during the year 2002. The cost and market value of the securities on December 31, 2002 and December 31, 2003 are given below.




The Company sold all the A securities on July 1, 2003 for $38,000. There were no other purchases or sale of the other securities held by the Company. 1. Prepare the necessary journal entries on (a) December 31, 2002 (b) July 1, 2003(c) December 31, 2003.

Solution to Practice Problem 2, Essex Company

1a. Journal entries as of December 31, 2002:The total market value of Available-for-Sale securities as of December 31, 2002 is $61,000 ($37,000 + $24,000). The cost of these securities was $65,000 ($40,000 + $25,000). Thus, the market price of the Available-for-Sale securities is lower than their cost by $4,000.



Account Debit CreditUnrealized Increase/Decrease in Value of AFS Securities $ 4,000 Market adjustment – AFS Securities $ 4,000

1b. On July 1, 2003, the Company sold all the “A” securities for $38,000. Since the original cost of these securities was $40,000, the Company has realized a gain of $2,000.

Journal entry for the sale of “A” securities:Account Debit Credit

Cash $ 38,000Loss on Sale of Securities 2,000 AFS Securities $ 40,000

1c. Journal entries as of December 31, 2003:The total market value of Available-for-Sale securities as of December 31, 2003 is $26,500 (note that “A” securities have been sold). The cost of these securities was $25,000. Thus, the market price of the Available-for-Sale securities is higher than their cost by $1,500. Hence, the Market Adjustment account of Available-for-Sale securities must have a debit balance of $1,500 as of December 31, 2003.

However, the balance in the Market Adjustment account of Available-for-Sale securities as of the end of the previous year was a credit of $4,000 (see part 1a above). Hence, to go from a credit balance of $4,000 to a debit balance of $1,500, a debit entry of $5,500 to the Market Adjustment account is needed. This in turn leads to a corresponding credit entry to Unrealized Increase/Decrease in Value of AFS Securities account.


Account Debit CreditMarket Adjustment – AFS Securities $ 5,500 Unrealized Increase/Decrease in Value of AFS Securities $ 5,500

Practice Problem 3Perkins Company

Perkins Company purchased some securities during the year 2002. The cost and market value of the securities on December 31, 2002 are given below. On March 1, 2003 the Company reclassified the securities as noted in the table (AFS = Available-for-sale and HTM = Held-to-maturity).Security Type Cost Market value


AsMarket value

3/1/2003 K HTM $ 25,000 26,000 AFS 25,700 L Trading 40,000 43,000 AFS $ 43,900 M AFS 30,000 28,000 HTM 27,700


Solution to Practice Problem 3, Perkins Company

1. Journal entries as of December 31, 2002:The market value of trading securities ($43,000) is $3,000 higher than the cost ($40,000). The market value of available-for-sale securities ($28,000) is $2,000 lower than cost ($30,000). So the year-end adjustments are:


Market Adjustment – Trading Securities $ 3,000 Unrealized Gain on Trading Securities $ 3,000


Unrealized Increase/Decrease in Value of AFS Securities $ 2,000 Market adjustment – AFS Securities $ 2,000

Note that there is no adjustment for held-to-maturity securies.



Account Debit CreditInvestment in AFS securities (step 2) $ 25,700 Unrealized Increase/Decrease in Value of AFS Securities (step 3) $ 2,700 Investment in HTM Securities (step 1) 25,000

(b) For the transfer from Trading to AFS:The market value of the trading securities has increased from $43,000 on December 31, 2002 to $43,900 on March 1, 2003. This will be recognized with a credit to Unrealized Gain on Transfer of Securities account. The transfer is recorded by crediting the old asset and debiting the new asset. Finally, the Market Adjustment account associated with the old asset is closed (with a credit entry, because it had a debit balance [indicating an increase in value from cost] before the transfer).

Account Debit CreditInvestment in AFS securities (step 3) $ 43,900 Unrealized Gain on Transfer of Securities (step 1) $ 900 Market Adjustment – Trading Securities (step 4) 3,000 Investment in Trading Securities (step 2) 40,000

(c) For the transfer from AFS to HTM:The market value of the AFS securities transferred to HTM has decreased from $28,000 on December 31, 2002 to $27,700 on March 1, 2003. This decrease will be recognized with a debit to Unrealized Increase/Decrease in Value of AFS Securities account. The transfer is recorded by crediting the old asset and debiting the new asset. Finally, the Market Adjustment account associated with the old asset is closed (with a debit entry, because it had a credit [indicating a reduction in value from cost] before the transfer).

Account Debit CreditInvestment in HTM securities (step 3) $ 27,700 Market Adjustment – AFS Securities (step 4) 2,000 Unrealized Increase/Decrease in Value of AFS Securities (step 1) 300 Investment in AFS Securities (step 2) 30,000

Practice Problem 4Houston Company

On January 1, 2002, Houston Company purchased 20% of the common stock of TCX Company for $900,000. At the time of the purchase, the fair market value and book value of the net assets of TCX Company were $4,000,000 and $3,600,000, respectively. The difference between the book value and fair value of the net assets was due to the value of depreciable assets that had a remaining useful life of 8 years. Houston Company decided to amortize the goodwill related to the purchase over 20 years. During 2002, TCX Company had a net income of $360,000 and paid a dividend of $60,000.Prepare the journal entries for Houston Company for the year 2002, related to its transactions with TCX Company, using the equity method to account for the purchase.

Solution to Practice Problem 4, Houston Company

1. Journal entry for purchase of 20% of the seller.Account Debit Credit

Investment in TCX $ 900,000 Cash $ 900,000

2. Journal entry for net income of the seller. The net income of TCX Company was $360,000 for the year.Houston Company owns 20% of TCX, so share of net income = $72,000 ($360,000 x 0.20)

Account Debit CreditInvestment in TCX $ 72,000 Investment income $ 72,000

3. Journal entry for receipt of dividend.Total dividends paid by TCX Company were $60,000.Houston Company owns 20% of TCX, so its share of dividend = $12,000 ($60,000 x 0.20).

Account Debit CreditCash $ 12,000 Investment in TCX $ 12,000

4. Journal entry for amortization of Goodwill.The purchase price was $900,000 for 20% of the seller.However, 20% of fair market value of net assets of the seller = $800,000 ($4,000,000 x 0.20).Hence, goodwill related to the purchase = $100,000 ($900,000 – $800,000).This amount will be amortized over 20 years (given).Hence, goodwill amortization each year = $5,000 ($100,000/20).

Account Debit CreditInvestment income $ 5,000 Investment in TCX $ 5,000

5. Journal entry for excess depreciation.Excess value of depreciable assets of the seller = $4,000,000 – $3,600,000 = $400,000.Since Houston Company purchased only 20% of the stock of TCX, its share of excess depreciable assets = $80,000 ($400,000 x 0.20).This is the amount of excess depreciation required over 8 years (useful life given).Hence, additional depreciation each year = $10,000 ($80,000/8)

Account Debit CreditInvestment income $ 10,000 Investment in TCX $ 10,000

Homework Problem 1Thomson Company

Thomson Company purchased some securities during the year 2002. The cost and market value of the securities on December 31, 2002 and December 31, 2003 are given below.



X Trading 15,000 16,500 17,200Y Trading 30,000 28,000 26,400Z Held-to-maturity 20,000 21,000 18,000


Solution to Homework Problem 1, Thomson Company

1a. Journal entries as of December 31, 2002:The total market value of Trading securities as of December 31, 2002 is $44,500 ($16,500 + $28,000). The cost of these securities was $45,000 ($15,000 + $30,000). Thus, the market price of the Trading securities is lower than their cost by $500.



Account Debit CreditUnrealized Loss on Trading Securities $ 500 Market Adjustment – Trading Securities $ 500

1b. Journal entries as of December 31, 2003:The total market value of Trading securities as of December 31, 2002 is $43,600 ($17,200 + $26,400). The cost of these securities was $45,000. Thus, the Market Adjustment for Trading Securities account must have a credit balance of $1,400 ($45,000 – $43,600) as of December 31, 2003.

The balance in the Market Adjustment account of Trading securities as of the end of the previous year was a credit of $500 (see part 1a above). Hence, to change the Market Adjustment account balance from a credit of $500 to a credit balance of $1,400, a credit entry for $900 is needed. This in turn leads to a corresponding debit entry to Unrealized Loss on Trading Securities Account.

Account Debit CreditUnrealized Loss on Trading Securities $ 900 Market Adjustment – Trading Securities $ 900

Homework Problem 2Westex Company

Westex Company purchased some securities during the year 2002. The cost and market value of the securities on December 31, 2002 and December 31, 2003 are given below.




The Company sold all the A securities on July 1, 2003 for $16,400. There were no other purchases or sale of the other securities held by the Company. 1. Prepare the necessary journal entries on (c) December 31, 2002 (d) July 1, 2003(e) December 31, 2003.

Solution to Homework Problem 2, Westex Company

1a. Journal entries as of December 31, 2002:The total market value of Available-for-Sale securities as of December 31, 2002 is $41,000 ($17,000 + $24,000). The cost of these securities was $38,000 ($15,000 + $23,000). Thus, the market price of the Available-for-Sale securities is higher than their cost by $3,000.



Account Debit CreditMarket adjustment – AFS Securities $ 3,000 Unrealized Increase/Decrease in Value of AFS Securities $ 3,000

1b. On July 1, 2003, the Company sold all the “A” securities for $16,400. Since the original cost of these securities was $15,000, the Company has realized a gain of $1,400.Journal entry for the sale of “A” securities:

Account Debit CreditCash $ 16,400 AFS Securities $ 15,000 Gain on Sale of Securities 1,400

1c. Journal entries as of December 31, 2003:The total market value of Available-for-Sale securities as of December 31, 2003 is $24,800. The cost of these securities was $23,000. Thus, the market price of the Available-for-Sale securities is higher than their cost by $1,800. Hence, the Market Adjustment account of Available-for-Sale securities must have a debit balance of $1,800 as of December 31, 2003.

However, the balance in the Market Adjustment account of Available-for-Sale securities as of the end of the previous year was a debit of $3,000 (see part 1a above). Hence, to go from a debit balance of $3,000 to a debit balance of $1,800, a credit entry of $1,200 to the Market Adjustment account is needed. This in turn leads to a corresponding debit entry to Unrealized Increase/Decrease in Value of AFS Securities account.


Account Debit CreditUnrealized Increase/Decrease in Value of AFS Securities $ 1,200 Market Adjustment – AFS Securities $ 1,200

Homework Problem 3Jenkins Company

Jenkins Company purchased some securities during the year 2002. The cost and market value of the securities on December 31, 2002 are given below. On March 1, 2003 the Company reclassified the securities as noted in the table (AFS = Available-for-sale and HTM = Held-to-maturity).Security Type Cost Market value


AsMarket value

3/1/2003 X HTM $ 45,000 43,000 AFS 44,200 Y Trading 50,000 49,000 AFS $ 48,300 Z AFS 30,000 30,500 HTM 30,700


Solution to Practice Problem 3, Jenkins Company

1. Journal entries as of December 31, 2002:The market value of trading securities ($49,000) is $1,000 lower than the cost ($50,000). The market value of available-for-sale securities ($30,500) is $500 higher than cost ($30,000). So the year-end adjustments are:


Unrealized Loss on Trading Securities $ 1,000 Market Adjustment – Trading Securities $ 1,000


Market adjustment – AFS Securities Unrealized Increase/Decrease in Value of AFS Securities $ 500 $ 500

There is no adjustment for held-to-maturity securities.



Account Debit CreditInvestment in AFS securities $ 44,200 Unrealized Increase/Decrease in Value of AFS Securities 800 Investment in HTM Securities $ 45,000

(b) For the transfer from Trading to AFS:The market value of the trading securities has decreased from $49,000 on December 31, 2002 to $48,300 on March 1, 2003. This will be recognized with a debit to Unrealized Loss on Transfer of Securities account. The transfer is recorded by crediting the old asset and debiting the new asset. Finally, the Market Adjustment account associated with the old asset is closed (with a debit entry, because it had a credit balance [indicating an decrease in value from cost] before the transfer).

Account Debit CreditInvestment in AFS securities $ 48,300Unrealized Gain on Transfer of Securities 700Market Adjustment – Trading Securities 1,000 Investment in Trading Securities $ 50,000

(c) For the transfer from AFS to HTM:The market value of the AFS securities transferred to HTM has increased from $30,500 on December 31, 2002 to $30,700 on March 1, 2003. This increase will be recognized with a credit to Unrealized Increase/Decrease in Value of AFS Securities account. The transfer is recorded by crediting the old asset and debiting the new asset. Finally, the Market Adjustment account associated with the old asset is closed (with a credit entry, because it had a debit balance [indicating an increase in value from cost] before the transfer).

Account Debit CreditInvestment in HTM securities $ 30,700 Market Adjustment – AFS Securities $ 500 Unrealized Increase/Decrease in Value of AFS Securities 200 Investment in AFS Securities 30,000

Homework Problem 4Denver Company

On January 1, 2002, Denver Company purchased 30% of the common stock of NetZ Company for $750,000. At the time of the purchase, the fair market value and book value of the net assets of NetZ Company were $2,300,000 and $2,000,000, respectively. The difference between the book value and fair value of the net assets was due to the value of depreciable assets that had a remaining useful life of 15 years. Denver Company decided to amortize the goodwill related to the purchase over 20 years. During 2002, NetZ Company had a net income of $400,000 and paid a dividend of $80,000.Prepare the journal entries for Denver Company for the year 2002, related to its transactions with NetZ Company, using the equity method to account for the purchase.

Solution to Homework Problem 4, Denver Company

1. Journal entry for purchase of 30% of the seller.Account Debit Credit

Investment in NetZ $ 750,000 Cash $ 750,000

2. Journal entry for net income of the seller. The net income of NetZ Company was $400,000 for the year.Denver Company owns 30% of NetZ, so share of net income = $120,000 ($400,000 x 0.30).

Account Debit CreditInvestment in NetZ $ 120,000 Investment income $ 120,000

3. Journal entry for receipt of dividend.Total dividends paid by NetZ Company were $80,000.Denver Company owns 30% of NetZ, so its share of dividend = $24,000 ($80,000 x 0.30).

Account Debit CreditCash $ 24,000 Investment in NetZ $ 24,000

4. Journal entry for amortization of Goodwill.The purchase price was $750,000 for 30% of the seller.However, 30% of fair market value of net assets of the seller = $690,000 ($2,300,000 x 0.30).Hence, goodwill related to the purchase = $60,000 ($750,000 – $690,000).This amount will be amortized over 20 years (given).Hence, goodwill amortization each year = $3,000 ($60,000/20).

Account Debit CreditInvestment income $ 3,000 Investment in NetZ $ 3,000

5. Journal entry for excess depreciation.Excess value of depreciable assets of the seller = $2,300,000 – $2,000,000 = $300,000.Since Denver Company purchased only 30% of the stock of NetZ, its share of excess depreciable assets = $90,000 ($300,000 x 0.30).This is the amount of excess depreciation required over 15 years (useful life given).Hence, additional depreciation each year = $6,000 ($90,000/15)

Account Debit CreditInvestment income $ 6,000 Investment in NetZ $ 6,000

Documents

Financial Accounting Module 20