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
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.
(1)
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 ($) | |
2018 | |||||
July | 1 | Investment in Bonds | 240,000,000 | ||
Premium on Bond Investment | 40,000,000 | ||||
Cash | 280,000,000 | ||||
(To record purchase of investment) |
Table (1)
- Investment in Bonds is an asset account. Since bonds investments are purchased, asset value increased, and an increase in asset is debited.
- Premium on Bond Investment is an adjunct-liability account. The adjunct-liability account generally has a credit balance. To record the purchase of bonds at cost, the additional amount is debited.
- Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.
Working Notes:
Compute the premium amount on bonds.
(2)
To journalize: The receipt of semiannual interest on December 31, 2018 in the books of Corporation M
Answer to Problem 12.11E
Prepare journal entry for semiannual interest on December 31, 2018.
Date | Account Titles and Explanation | Post Ref. | Debit ($) | Credit ($) | |
2018 | |||||
December | 31 | Cash | 7,200,000 | ||
Premium on Bond Investment | 1,600,000 | ||||
Interest Revenue | 5,600,000 | ||||
(To record receipt of interest) |
Table (2)
Explanation of Solution
- Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
- Premium on Bond Investment is an adjunct-liability account. The adjunct-liability account generally has a debit balance. Since the liability amount is increased, the account is credited.
- Interest Revenue is a revenue account. Since revenues increase equity, equity value is increased, and an increase in equity is credited.
Working Notes:
Calculate interest received on December 31, 2018.
Calculate interest revenue on December 31, 2018.
Calculate premium amortized on December 31, 2018.
Note: Refer to Equations (1) and (2) for the value and computations of interest revenue and interest received.
(3)
To indicate: The amount of investment value as on December 31, 2018 in the books of Corporation M
Explanation of Solution
(4)
To journalize: The sale of bonds on January 2, 2019 in the books of Corporation M
Explanation of Solution
Step 1: Prepare journal entry to adjust the AFS securities to fair value as on January 2, 2019.
Date | Account Titles and Explanations | Post. Ref. | Debit ($) | 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
|
$(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
|
$11,600,000 |
Table (6)
Step 2: Prepare journal entry to reverse the effect of fair value changes as on sale date.
Date | Account Titles and Explanations | Post. Ref. | Debit ($) | 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)
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Chapter 12 Solutions
SPICELAND GEN CMB LL INTRM ACCTG; CNCT
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