I'm Larry Wolther, this is princeplesofaccounting.com, Chapter 6.
This final module for Chapter 6 looks at account for highly-liquid investments.
Also known as trading securities.
In a subsequent chapter, Chapter 9, you will be introduced to other types
of investments, such as held to maturity securities or available for
sale securities, but for now our focus is on what we call trading securities.
Trading securities are investments acquired with the intent of generating
profits by reselling those investments in the very near future.
It's a temporary type of investment in other words.
The investments are initially reported at their cost.
However, they are subsequently and
continuously adjusted to their fair value at each financial reporting date.
The fair value is the price that would be received from the sale of an asset
In orderly transaction between market participants.
That's a very specific definition.
This is also sometimes called mark-to-market accounting.
Let us look at an illustration.
Webster company purchased 5,000 shares of Merriam stock at $10 per share,
with the intent of selling those shares in the near future for a profit.
So, on the date of acquisition,
we debit trading securities $50,000 and credit cash $50,000.
Now, on March 31, the end of the month,
assume that Merriam's stock had declined to $9 per share.
Remember we paid $10 a share, so we have a $1 loss or per share,
our $5,000 total loss to record.
We'll debit an account lost on investments,
typically called an unrealized loss, and we're crediting the trading securities
account $5,000 to reflect the reduction in that asset.
Now, continuing by the end of April, the stock has gone up to $12 a share, so
we're happy about that.
Our total investment is now worth $60,000.
So we need to debit Trading Securities $15,000 to bring it from
45,000 at the end of last month up to 60,000 at the end of this month.
Debit Tradings Securities, and here we have the offsetting income statement
credit this time reflecting the unrealized gain on the investments.
These gains and losses are unrealized, events are recorded or
recognized in the financial statements,
even thought the final cash consequences have not yet been determined.
It's an unrealized but recognized gain or loss.
Now thinking about this illustration, the three journal entries have now
taken the trading securities to their current $60,000 value.
We have our $50,000 initial value.
We subtract 5,000 for
the March decrease to get to our March carrying value of 45,000.
We add the $15,000 April increase,
bringing us to our $60,000 value at the end of April.
The 5,000 shares at $12,000 a share are now carried at their $60,000 value.
To think further about fair value accounting,
the rationale for this approach is that the market value for
the trading of securities is readily determinable by reference to the market.
And the periodic fluctuations have a definite impact on the company
that should be recognized as those occurred.
Given the intent to dispose of the investment in the near future,
the belief is that the changes in value likely have a corresponding effect on
the ultimate cash flow of the firm.
And is therefore appropriately recognized,
accounting rules recognize those changes as they happen.
Now, some companies might weld in debiting or
crediting the trading security account directly for
change in value, maintain a separate valuation account for the change in value.
It's an alternative in lieu of directly adjusting the Trading Securities account.
It's a separate account.
It's not unlike the accumulated depreciation account.
If it's a reduction, it would be a contra account, or it could be adjunct or
an add to the account if the values increased.
You get the same results.
However, it provides additional information about the valuation
changes and the securities.
And it can be very useful for more complex scenarios or
tax scenarios where maybe you have a tax book difference.
You will not recognize these changes in taxable income ordinarily til
the securities are actually disposed of.
So it's important to maintain accountability over the difference
between your accounting records and your tax basis for those securities.
Let's consider dividends and interest on the investments.
If those investments pay interest or dividends,
those changes in value are typically recognized or reported as income.
So here I assumed we also received a $5,000 dividend.
We debited cash and credited dividend income to reflect that income stream.
Finally, there's this complex issue of derivatives.
There's an endless array of investment options.
Commodity futures, interest rate swaps and other related agreements.
These are ordinarily referred to as derivatives, their value is based upon or
derived from something else.
For example a cotton futures contract takes its value from
the underlying cotton.
The underlying accounting approach is the same that's followed for
trading securities.
That is, derivatives are initially measured at fair value, and
changes in those fair values are recognized as they occur.
Now, this is a complex subject well beyond what I'm covering here,
but these are the very basic principles that apply to derivatives accounting.
And you'll often hear or read about a particular derivatives transaction that
may sound very interesting or intriguing,
it's based on fair value accounting as well.
Just as our trading securities.