Chapter 13, Problem 8P

Available-for-Sale Securities Holly Company invests its excess cash in marketable securities. At the beginning of 2016, it had the following portfolio of investments in available-for-sale securities:

During 2016, the following transactions occurred:

The December 31 closing market prices were as follows: Igor Company common stock, $25 per share; Ozone Company common stock, $31 per share; Union Company 8% bonds, 101.

Required:

1. 1. Prepare journal entries to record the preceding information.
2. 2. Show what is reported on Holly’s 2016 income statement.
3. 3. Assuming the investment in Igor Company stock is considered to be a current asset and the remaining investments are noncurrent, show how all the items are reported on Holly’s December 31, 2016, balance sheet.
4. 4. If GAAP required that unrealized holding gains and losses on available-for-sale securities be included in income, how much would Holly recognize in 2016?

To determine

Prepare the journal entries to record the available-for-sale securities transactions.

Explanation of Solution

Investment: It refers to the process of using the currently held excess cash to earn profitable returns in future. The investments can be made in equity securities such as shares or debt securities such as bonds.

Available for sale securities: these are the securities which are not intended to be sold in the near future and there is no intension to hold the securities till their maturity.

Record the purchase of 8% bonds on March 31, 2016.

On March 31, 2016, Company H purchased 8%, bond with a par value of $10,000 for $10,000 plus accrued interest for 3 months from March 31 to June 30.

Determine the amount of interest income paid by Company H.

$\begin{array}{c}\text{Interest income = Face value of bond}\times \text{Interest rate }\times \frac{\text{Number of months accrued}}{12\text{months}}\\ =\$10,000\times 8\%\times \frac{3}{12}\\ =\$200\end{array}$

Date	Account Title and Explanation	Debit	Credit
March 31, 2016	Investment in Available-for-sale Securities	$10,000
	Interest income	$200
	Cash		$10,200
	(To record the purchase of 8% bond from Company U)

Table (1)

• Investment in available-for-sale securities is an asset. It is increased. Therefore, debit the investment in available-for-sale securities account.
• Interest income is decreasing here, because Company H paid the accrued interest to purchase the bond. Therefore, it is debited.
• Cash is an asset and decreased. Therefore, credit the cash account.

Record the sale of Company O’s 200 share for $30 per share on May 17.

Step 1: Determine the cash received from sale of 200 shares.

$\begin{array}{c}\text{Cash = Number of shares sold }\times \text{Price of share}\\ \text{=200shares }\times \$30\\ =\$6,000\end{array}$

Step 2: Determine the purchase price of 200 shares of Company O.

$\begin{array}{c}\text{Purchase price 200shares= Number of shares sold }\times \left(\frac{\text{Purchase price of 700shares}}{\text{700shares}}\right)\\ \text{=200shares}\times \left(\frac{\$23,100}{700}\right)\\ =200\times \$33\\ =\$6,600\end{array}$

Step 3: Record the entry.

Date	Account Title and Explanation	Debit	Credit
May 17, 2016	Cash	$6,000
	Loss on sale of Available-for-sale securities (Balancing figure)	$600
	Investment in Available-for-sale securities		$6,600
	(To record the realized loss on sale of 200 shares of Company O)

Table (2)

• Cash is an asset and increased. Therefore, debit the cash account.
• Loss on sale of available-for-sale securities is a loss. It decreases the equity. Therefore, it is debited.
• Investment in available-for-sale securities is an asset. It is decreased here due to sale. Therefore, credit the investment in available-for-sale securities account.

On May 17, 2016, reverse the cumulative unrealized loss for 200 shares that had accumulated at the end of December 31, 2015.

Company O’s 700 shares is purchased for $23,100, whose fair value as at December 31, 2015 is recorded as $21,700. Hence, the difference of $1,400$\left(\$23,100-\$21,700\right)$ loss would have been recorded as unrealized holding loss and the same amount might have been credited as allowance. Now, the Company O’s 200shares has been sold on May 17, 2016, and realized loss as on May 17 also recorded. Hence, the previously recorded unrealized loss and allowance of $\left[\frac{\$1,400}{700\text{shares}}\times 200\text{shares }\right]\text{= \$400}$ should be reversed as follows:

Date	Account Title and Explanation	Debit	Credit
May 17, 2016	Allowance for change in fair value of investment	$400
	Unrealized holding gain/loss: Available-for-sale securities		$400
	(To record the allowance adjustment and reverse the unrealized loss on holding the Securities)

Table (3)

Record the receipt of semiannual interest on Company U’s bond on June 30, 2016.

Step 1: Calculate the amount of interest income.

$\begin{array}{c}\text{Interest income = Face value of bond }\times \text{Interest rate }\times \frac{6\text{months}}{\text{12months}}\\ =\$10,000\times 8\%\times \frac{6}{12}\\ =\$400\end{array}$

Step 2: Record the entry.

Date	Account Title and Explanation	Debit	Credit
June 30, 2016	Cash	$400
	Interest income		$400
	(To record the receipt of semi-annual interest on Company U's bond)

Table (4)

• Cash is an asset and increased. Therefore, debit the cash account.
• Interest income is revenue; it increases the equity. Therefore, it is credited.

Record the sale of Company I’s 100 share for $24 per share on October 12.

Step 1: Determine the cash received from sale of 100 shares.

$\begin{array}{c}\text{Cash = Number of shares sold }\times \text{Price of share}\\ \text{=100shares }\times \$24\\ =\$2,400\end{array}$

Step 2: Determine the purchase price of 100 shares of Company I.

$\begin{array}{c}\text{Purchase price 100shares= Number of shares sold }\times \left(\frac{\text{Purchase price of 400shares}}{\text{400shares}}\right)\\ \text{=100shares}\times \left(\frac{\$8,400}{400}\right)\\ =100\times \$21\\ =\$2,100\end{array}$

Step 3: Record the entry.

Date	Account Title and Explanation	Debit	Credit
October 12, 2016	Cash	$2,400
	Gain on sale of Available-for-sale           securities (Balancing figure)		$300
	Investment in Trading Securities		$2,100
	(To record the realized gain on sale of 100 shares of Company I)

Table (5)

• Cash is an asset and increased. Therefore, debit the cash account.
• Gain on sale of available-for-sale securities is an income.  It increases the equity. Therefore, it is credited.
• Investment in available-for-sale securities is an asset. It is decreased here due to sale. Therefore, credit the investment in available-for-sale securities account.

On October 12, 2016, reverse the cumulative unrealized gain for 100 shares that had accumulated at the end of December 31, 2015.

Company I’s 400 shares is purchased for $8,400, whose fair value as at December 31, 2015 is recorded as $9,400. Hence, the difference of $1,000$\left(\$9,400-\$8,400\right)$ gain would have been recorded as unrealized holding gain and the same amount might have been debited as allowance. Now, the Company I’s 100shares has been sold on October 12, 2016, and realized gain as on October 12 also recorded. Hence, the previously recorded unrealized gain and allowance of $\left[\frac{\$1,000}{400\text{shares}}\times 100\text{shares }\right]\text{= \$250}$ should be reversed as follows:

Date	Account Title and Explanation	Debit	Credit
October 12, 2016	Unrealized holding gain/loss: Available-for-sale securities	$250
	Allowance for change in fair value of      investment		$250
	(To reverse the allowance and  the unrealized gain on holding the Securities)

Table (6)

Record the semiannual interest income received from Company U’s bond, and dividend income received for Company I and Company O on December 31, 2016.

Step 1: Determine the amount of interest income earned from Company O.

$\begin{array}{c}\text{Interest income = Face value of bond}\times \text{Interest rate }\times \frac{\text{6months}}{12\text{months}}\\ =\$10,000\times 8\%\times \frac{6}{12}\\ =\$400\end{array}$

Step 2: Determine the amount of dividend income recieived from Company I.

$\begin{array}{c}\text{Dividend income from Company I =}\left[\begin{array}{l}\text{ Outstanding number of shares}\\ \text{held as on December 31,2016}\times \\ \text{Dividend received per share}\end{array}\right]\\ =300\text{shares}\times \$1\\ =\$300\end{array}$

Step 3: Determine the amount of dividend income recieived from Company O.

$\begin{array}{c}\text{Dividend income from Company O =}\left[\begin{array}{l}\text{ Outstanding number of shares}\\ \text{held as on December 31,2016}\times \\ \text{Dividend received per share}\end{array}\right]\\ =500\text{shares}\times \$1.50\\ =\$750\end{array}$

Step 4: Determine the total amount of dividend income recieived from both the Company.

$\begin{array}{c}\text{Dividend income = }\left[\begin{array}{l}\text{Dividend income from Company I+}\\ \text{Dividend income from Company O }\end{array}\right]\\ =\$300+\$750\\ =\$1,050\end{array}$

Step 5: Record the entry.

Date	Account Title and Explanation	Debit	Credit
December 31, 2016	Cash (Balancing figure)	$1,450
	Interest income		$400
	Dividend income		$1,050
	(To record the receipt of semi-annual interest on Company U's bond and dividend income from Company I and Company O)

Table (7)

Determine the fair value of the investment as at December 31, 2016.

$\begin{array}{c}\text{Fair value of Company I's share}=\left[\begin{array}{l}\text{Outstanding number of shares held}\\ \times \text{Market price on December 31}\end{array}\right]\\ \text{=300shares }\times \$25\text{per share}\\ \text{=\$7,500}\end{array}$

$\begin{array}{c}\text{Fair value of Company O's share}=\left[\begin{array}{l}\text{Outstanding number of shares held}\\ \times \text{Market price on December 31}\end{array}\right]\\ \text{=500shares }\times \$31\text{per share}\\ \text{=\$15,500}\end{array}$

Determine the net amount of unrealized gain or loss on available-for-sale securities.

Investment	Cost (a)	Fair value at December 31, 2016 (b)	Cumulative change in fair value
300 shares of Company I	$6,300	$7,500	$1,200
500 shares of Company O	$16,500	$15,500	($1,000)
$10,000 face value of Company U's 8% bond	$10,000	$10,100	$100
Total	$32,800	$33,100	$300

Table (8)

Determine the amount of allowance to be adjusted to have $300 debit balance in allowance account at the end of the year 2016, using T-account.

Credit balance in allowance account on January 1, 2016 is $400$\left(\text{Fair value of investment as on December 31, 2015, \$31,100}-\text{Cost \$31,500}\right)$.

Table (9)

Record the adjusting entry at the end of the year 2016.

Date	Account Title and Explanation	Debit	Credit
December 31, 2016	Allowance for change in fair value of investment	$550
	Unrealized holding gain/loss: Available-for-      sale securities		$500
	(To record the allowance adjustment and the gain unrealized loss on holding the Securities)

Table (10)

• Unrealized holding gain increases the equity. Therefore, it is credited.
• Allowance is a contra asset. It is decreased. Therefore, it is debited.

To determine

Show how Company H would report its available-for-sale securities at its income statement for the year ended December 31, 2016.

Explanation of Solution

Income statement: The financial statement which reports revenues and expenses from business operations and the result of those operations as net income or net loss for a particular time period is referred to as income statement.

Show how Company H would report its available-for-sale securities at its income statement for the year ended December 31, 2016.

Company H
Income Statement (Partial)
For The Year Ended December 31, 2016
Particulars	Amount
Interest income	$600
Dividend income	$1,050
Loss on sale of available-for-sale securities	-$600
Gain on sale of available-for-sale securities	$300

Table (11)

To determine

Show how Company H would report its available-for-sale securities at its balance sheet at December 31, 2016.

Explanation of Solution

Balance sheet: Balance Sheet is one of the financial statements that summarize the assets, the liabilities, and the Shareholder’s equity of a company at a given date. It is also known as the statement of financial status of the business.

Show how Company H would report its available-for-sale securities at its balance sheet at December 31, 2016.

Company H
Balance sheet Statement (Partial)
As at December 31, 2016
Assets	Amount
Current assets:
Investment in available-for-sale securities (at cost)	$6,300
Add: Allowance for change in fair value of investment	$1,200
Investment in available-for-sale securities (at fair value)	$7,500
Noncurrent assets:
Investment in available-for-sale securities (at cost)	$26,500
Less: Allowance for change in fair value of investment	-$900
Investment in available-for-sale securities (at fair value)	$25,600
Shareholders' equity:
Accumulated other comprehensive income
Unrealized holding gain: Available-for-sale       securities	$300

Table (12)

To determine

Determine the amount of income would be recognized by Company H, if the unrealized holding gains and losses on available-for-sale securities are included income.

Explanation of Solution

If GAAP (Generally Accepted Accounting Principles) requires to include unrealized holding gains and losses on available-for-sale securities in income, then Company H would recognize $700 as unrealized holding gain in income statement.

Note:

$700 arrived from the difference between -$400 and +$300. -$400 is an unrealized loss of the portfolio as on December 31, 2015.