Chapter 12, Problem 12.11E

Available -for-sale securities

• LO12-1, LO12-4

[This is a variation of E 12–2 focusing on available-for-sale securities.]

Mills Corporation acquired as a long-term investment $240 million of 6% bonds, dated July 1, on July 1, 2018. Company management Mills determined that it should account for the bonds as an available-for-sale investment. The market interest rate (yield) was 4% for bonds of similar risk and maturity. Mills paid $280 million for the bonds. The company will receive interest semiannually on June 30 and December 31. As a result of changing market conditions, the fair value of the bonds at December 31, 2018, was $270 million.

Required:

1. Prepare the journal entry to record Mills’ investment in the bonds on July 1, 2018.

2. Prepare the journal entries by Mills to record interest on December 31, 2018, at the effective (market) rate.

3. At what amount will Mills report its investment in the December 31, 2018, balance sheet? Why?

4. Suppose Moody’s bond rating agency upgraded the risk rating of the bonds, and Mills decided to sell the investment on January 2, 2019, for $290 million. Prepare the journal entry to record the sale.

To determine

Available-for-sale (AFS) securities: These are short-term or long-term investments in debt and equity securities with an intention of holding the investment for some strategic purposes like meeting liquidity needs, or manage interest risk.

Journal entry: Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Debit and credit rules:

• Debit an increase in asset account, increase in expense account, decrease in liability account, and decrease in stockholders’ equity accounts.
• Credit decrease in asset account, increase in revenue account, increase in liability account, and increase in stockholders’ equity accounts.

To journalize: The purchase $240,000,000 of 6% bonds in the books of Corporation M

Explanation of Solution

Prepare journal entry for purchase of $240,000,000 of 6% bonds for $200,000,000.

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
July	1	Investment in Bonds		240,000,000
		Premium on Bond Investment		40,000,000
		Cash			280,000,000
		(To record purchase of investment)

Table (1)

• Investment in Bonds is an asset account. Since bonds investments are purchased, asset value increased, and an increase in asset is debited.
• Premium on Bond Investment is an adjunct-liability account. The adjunct-liability account generally has a credit balance. To record the purchase of bonds at cost, the additional amount is debited.
• Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Working Notes:

Compute the premium amount on bonds.

$\begin{array}{c}\text{Premium = Price of bonds}–\text{Face amount of bonds }\\ \text{=\$280,000,000–\$240,000,000}\\ \text{=\$40,000,000}\end{array}$

To determine

To journalize: The receipt of semiannual interest on December 31, 2018 in the books of Corporation M

Answer to Problem 12.11E

Prepare journal entry for semiannual interest on December 31, 2018.

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Cash		7,200,000
		Premium on Bond Investment			1,600,000
		Interest Revenue			5,600,000
		(To record receipt of interest)

Table (2)

Explanation of Solution

• Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
• Premium on Bond Investment is an adjunct-liability account. The adjunct-liability account generally has a debit balance. Since the liability amount is increased, the account is credited.
• Interest Revenue is a revenue account. Since revenues increase equity, equity value is increased, and an increase in equity is credited.

Working Notes:

Calculate interest received on December 31, 2018.

$\begin{array}{c}\text{Interest received =}\left(\begin{array}{l}\text{Face amount of bonds}\times \\ \text{Stated interest rate}\times \\ \text{Semiannual interest time period}\end{array}\right)\\ \text{=\$240,000,000 × }\frac{6}{\text{100}}\times \frac{6}{12}\\ \text{=\$7,200,000}\end{array}$ (1)

Calculate interest revenue on December 31, 2018.

$\begin{array}{c}\text{Interest revenue = }\left(\begin{array}{l}\text{Outstanding balance on bonds }\times \\ \text{Effective interest rate}\times \\ \text{Semiannual interest time period}\end{array}\right)\\ \text{=\$280,000,000 × }\frac{4}{\text{100}}\times \frac{6}{12}\\ \text{=\$5,600,000}\end{array}$ (2)

Calculate premium amortized on December 31, 2018.

$\begin{array}{c}\text{Premium amortized = Interest received }–\text{Interest revenue }\\ \text{= \$7,200,000}\text{– \$5,600,000}\\ \text{= \$1,600,000}\end{array}$

Note: Refer to Equations (1) and (2) for the value and computations of interest revenue and interest received.

To determine

To indicate: The amount of investment value as on December 31, 2018 in the books of Corporation M

Explanation of Solution

Since the bonds are classified as available-for-sale securities, the bonds are reported at fair value, $270,000,000 as on December 31, 2018.

To determine

To journalize: The sale of bonds on January 2, 2019 in the books of Corporation M

Explanation of Solution

Step 1: Prepare journal entry to adjust the AFS securities to fair value as on January 2, 2019.

Date		Account Titles and Explanations	Post. Ref.	Debit ($)	Credit ($)
2019
January	2	Fair Value Adjustment		20,000,000
		Unrealized Holding Gain–OCI			20,000,000
		(To record unrealized gain on trading securities)

Table (3)

• Fair Value Adjustment is a contra-asset account which serves the purpose of valuation allowance account. The account is adjusted to update the fair value as on sale date.
• Unrealized Holding Gain–OCI is an adjustment account used to report gain or loss on adjusting cost of investment at fair market value. Since gain has occurred and gains increase stockholders’ equity value, stockholders’ equity value is credited.

Working Notes:

Compute the unrealized gain (loss) as on January 2, 2019.

Step 1: Determine the amortized cost of bonds as on December 31, 2018.

Particulars	Amount ($)	Amount ($)
Investment in bonds		$240,000,000
Plus: Unamortized premium:
Premium on bonds	$40,000,000
Less: Amortized premium in the year	(1,600,000)	(38,400,000)
Amortized cost		$278,400,000

Table (4)

Step 2: Compute the unrealized gain (loss) as on December 31, 2018 by adjusting the amortized cost of $278,400,000 (Refer to Table-4) to the fair value of $270,000,000.

Details	Amount ($)
Fair value adjustment balance as on July 1, 2018	$0
Adjustment needed to update fair value (Balancing figure)	8,400,000
Fair value adjustment balance needed on December 31, 2018 $\left(\$270,000,000–\$278,400,000\right)$	$(8,400,000)

Table (5)

Step 3: Compute the unrealized gain (loss) as on January 2, 2019 by adjusting the amortized cost of $278,400,000 (Refer to Table-4) to the fair value of $290,000,000 as on sale date.

Details	Amount ($)
Fair value adjustment balance as on December 31, 2018 (Table-5)	$(8,400,000)
Adjustment needed to update fair value (Balancing figure)	20,000,000
Fair value adjustment balance needed on January 2, 2019 $\left(\$290,000,000–\$278,400,000\right)$	$11,600,000

Table (6)

Step 2: Prepare journal entry to reverse the effect of fair value changes as on sale date.

Date		Account Titles and Explanations	Post. Ref.	Debit ($)	Credit ($)
2019
January	2	Reclassification Adjustment–OCI		11,600,000
		Fair Value Adjustment			11,600,000
		(To record the reversal effect of fair value adjustment)

Table (7)

• Reclassification–OCI is an adjustment entry made to reverse the effect of fair value changes or unrealized holding gains and losses. Thus, the fair value adjustment account becomes zero.
• Fair Value Adjustment is a contra-asset account which serves the purpose of valuation allowance account. The account is credited to reverse the effect of balance of unrealized holding gains and losses and close this account.

Working Notes:

Calculate the unrealized holding gain (loss) on date of sale of bonds.

Details	Amount ($)
Unrealized loss as on December 31, 2018	$8,400,000
Unrealized gain as on January 2, 2019	(20,000,000)
Unrealized holding loss as on January 2, 2019	$(11,600,000)

Table (8)

Step 3: Prepare journal entry for sale of bonds.

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2019
January	2	Cash		290,000,000
		Premium on Bond Investment			38,400,000
		Gain on Sale of Investments			11,600,000
		Investment in Bonds			240,000,000
		(To record sale of bonds)

Table (9)

• Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
• Premium on Bond Investment is an adjunct-liability account. Since the premium amount is closed on the sale date, the account is credited to make the premium balance zero.
• Gain on Sale of Investments is a gain account. Since revenues and gains increase equity, equity value is increased, and an increase in equity is credited.
• Investment in Bonds is an asset account. Since the investments are sold, asset value decreased, and a decrease in asset is credited.

Working Notes:

Refer to requirement 3 for value and computation of premium amortized.

Compute the gain (loss) on sale of bonds.

Step 1: Compute the book value of bonds as on January 2, 2019.

Particulars	Amount ($)
Investment in bonds	$240,000,000
Add: Unamortized premium	(38,400,000)
Book value as on January 2, 2019	$278,400,000

Table (10)

Step 2: Compute gain or loss on sale of bonds as on January 2, 2019.

Particulars	Amount ($)
Cash proceeds from sale of bonds	$290,000,000
Less: Book value as on January 2, 2019 (Table-10)	(278,400,000)
Realized gain (loss) on sale of investment	$11,600,000

Table (11)