1. Accounting Clinic III

2. Accounting Clinic III Accounting for Marketable Securities
Prepared by: Nir Yehuda
With contributions by
Stephen H. Penman – Columbia University

3. Why do Firms Hold Debt and Equity Securities?
To invest idle funds (usually in debt securities)
As part of their operational plan (usually equity securities)
In an investment portfolio where investments are bought or sold
As a permanent investment in affiliates and subsidiaries

4. Classifying Debt and Equity Securities by their Accounting Treatment
Held to Maturity
Available for Sale
Trading
Equity
Less than 20% ownership
Greater than 20% ownership
Available for Sale
Trading
Go to clinic V

5. What are Marketable Securities?
Debt securities
Equity securities representing less then 20% interest in another corporation
For the accounting for equity securities with greater than 20% ownership go to Accounting Clinic V

6. Classifications of Marketable Securities
Debt securities are classified into one of three categories:
held-to-maturity
available-for-sale
trading.
Equity securities (representing less then 20% ownership) are classified into one of two categories:
The appropriateness of the classification should be reassessed at each reporting date.

7. Held-to-Maturity Debt Securities
Investments in debt securities should be classified as held-to-maturity only if the reporting enterprise has the positive intent and ability to hold those securities to maturity.
An enterprise should not classify a debt security as held-to-maturity if it intends to hold the security for only an indefinite period.

8. Held-to-Maturity Debt Securities – The Accounting Rule
Held to maturity are measured at their historical cost.
If debt were purchased at a discount or premium over par value, the discount of premium is amortized to the income statement.

9. The Effective Interest Rate Method
The effective interest rate is the internal rate of return or yield to maturity at the time of issue.
Under the effective interest rate method, the interest expense for a period is calculated as the effective interest rate times the bonds’ book value at the beginning of the period. Thus, under this method, the implied interest rate is constant.

10. Trading Securities and Available-for-Sale Securities (both Debt and Equity)
Investments in debt securities (not classified as held-to-maturity) and equity securities that have readily determinable fair values should be classified as either:
Trading
available-for-sale

11. Trading Securities
Securities that are bought and held principally for the purpose of selling them in the near term (thus held for only a short period of time) should be classified as trading securities.
Trading generally reflects active and frequent buying and selling, and trading securities are generally used with the objective of generating profits on short-term differences in price.

12. Available-for-Sale Securities
Investments not classified as trading securities (nor as held-to-maturity securities) should be classified as available-for-sale securities.

13. Reporting Changes in Fair Value - Unrealized
Unrealized holding gains and losses for trading securities should be included in earnings.
Unrealized holding gains and losses for available-for-sale securities (including those classified as current assets) should be excluded from net income and reported as a net amount in other comprehensive income within shareholders' equity until realized.

14. Reporting Changes in Fair Value - Realized
Dividend and interest income, including amortization of the premium and discount arising at acquisition, should be included in net income (for all securities).
Realized gains and losses should be included in net income (for all securities).

15. Financial Statement Presentation
An enterprise that presents a classified statement of financial position should report all trading securities as current assets and should report individual held-to-maturity securities and individual available-for-sale securities as either current or noncurrent, as appropriate.

16. Statement of Cash Flows
Cash flows from purchases, sales, and maturities of available-for-sale securities and held-to-maturity securities should be classified as cash flows from investing activities and reported gross for each security classification in the statement of cash flows.
Cash flows from purchases, sales, and maturities of trading securities should be classified as cash flows from operating activities.

17. Example : Marketable Equity Securities – Journal Entries
Alexis Co. purchased 100 common shares of Ball Co. on February 1, 2004, for $500,000. The market value of the shares on December 31, 2004, was $560,000. Alexis Co. sold these shares on June 30, 2005, for $600,000.
Give the journal entries to record this transaction assuming:
the shares are classified as trading securities
the shares are classified as available for sale securities

18. If the shares were classified as trading securities
February 1, 2004
Marketable Securities 500,000
Cash ,000
December 31, 2004
Marketable Securities 60,000
Unrealized Holding Gain ,000
on Trading Securities
The unrealized gain is reported in the income statement

19. June 30, 2005
Cash ,000
Marketable Securities ,000
Realized Gain on Sale ,000
of Trading Securities
The realized gain is reported in the income statement

20. If the shares were classified as available for sale securities
February 1, 2004
Marketable Securities 500,000
Cash ,000
December 31, 2004
Marketable Securities 60,000
Unrealized Holding Gain ,000
on Available for sale Securities
The unrealized holding gain is reported in “other comprehensive income”

21. June 30, 2005
Cash ,000
Marketable Securities ,000
Realized Gain on Sale ,000
of Trading Securities
The realized gain is reported in the income statement

22. At December 31, 2005 the security adjustment account had a debit balance of $60,000 ($560,000-$500,000). The adjustment entry is as follows:
Unrealized Holding Gain 60,000
on Available for sale Securities
Marketable Securities 60,000
To remove the unrealized gain from shareholder’s equity.

23. Example : Different Accounting Treatments for Marketable Equity Securities
Wonder Corporation has the following portfolio of marketable equity securities:
Cost in
Dividends received
Market
Value on
Dec. 31,
Selling
Price on
June 30,
Security
2003
2004 A
$16,000
$1,000
$19,000
$1,200
$17,500 - B
20,000
1,600
25,000
800
$28,500 C
15,000
12,000
400
10,500
$51,000
$3,400
$56,000
$2,400
$39,000

24. Assume that these securities represent trading securities.
How much income would be recognized during 2003 and 2004?
How would these securities be presented on the balance sheet on December 31, 2003 and 2004?
Assume that these securities represent available for sale securities by Wonder Corporation. How would your answer to part A change?

25. Solution A. Trading Securities 2003 2004 Income Statement:
Dividend Revenue
(the total in the dividend column)
Unrealized Holding Gain (Loss):
2003: ($56,000 - $51,000)
2004: ($17,500 - $19,000)
Realized Holding Gain $39,000 -
($12,000 + $25,000)
$3,400
5,000 --
$8,400
$2,400
(1,500)
2,000
$2,900
Balance Sheet:
Current Assets:
Marketable Securities
$56,000
$17,500

26. B. Securities Available for Sale
2003
2004
Income Statement:
Dividend Revenue
Realized Holding Gain:
[$39,000 – ($15,000 + $20,000)]
$3,400 --
$2,400
4,000
$6,400

27. B. Securities Available for Sale
2003
2004
Balance Sheet:
Current Assets:
Marketable Securities
$56,000
$17,500
Shareholder’s Equity:
Net Unrealized Holding Gain (Loss) on
Securities Available for Sale:
($56,000 - $51,000)
($17,500 - $16,000)
5,000 --
(1,500)

28. Disclosures About Securities
FASB Statement No. 115 requires the following disclosures each period:
The aggregate market value, gross unrealized holding gains, gross unrealized holding losses, and amortized cost for debt securities held to maturity and debt and equity securities available for sale
The proceeds from sales of securities available for sale and the gross realized gains and gross realized losses on those sales

29. Disclosures About Securities
The change during the period in the net unrealized holding gain or loss on securities available for sale included in a separate shareholders’ equity account
The change during the period in the net unrealized holding gain or loss on trading securities included in earnings

30. Controversy Surrounding the Accounting for Marketable Securities
The accounting for marketable securities has been controversial. The accounting issues are as follows:
Whether to report the investments at historical cost or at market value on the balance sheet date
If reported at market value, when to record the gain/loss from the change in market value in the income statement
Each period?
Only when the firm disposes of the investments?

31. Keep in mind…
We have seen that there are two measurement basis for recording securities:
Amortized cost
Market value
Which method gives us the a better estimate of the value of the securities?

32. Amortized cost is based on the historical cost measurement rule and avoids manipulation in the financial statements. But historical cost does not capture any change in value since acquisition.
Market prices give the change in value since acquisition. But (fair) market values can be biased if market values are estimated. Actual market prices can be bubble prices which are not “fair” value.