Source: Textbook Ch. 12, pp. 662–669
Tags: investments, debt securities, equity securities, trading securities, fair value, FV adjustment, unrealised gain, unrealised loss, marking to market, cost method, balance sheet classification, ACCTG 472, intermediate accounting, Chapter 12
Difficulty: Intermediate | Prerequisites: Accounting equation (A = L + SE), income statement and balance sheet basics (Ch. 4)
Big picture: Companies do not simply earn revenue and pay expenses; they also park idle cash in the debt and equity of other firms. How an investment is classified, measured, and reported depends on the investor's intent and its level of influence over the investee. This first section covers where capital comes from, the ownership thresholds that determine accounting treatment, and the full accounting cycle for trading securities (TS). If you are comfortable with basic journal entries and the distinction between net income and other comprehensive income, you are ready for this material.
When a company holds less than 20% of another company's outstanding stock, the investment is classified as held-to-maturity, trading, or available-for-sale. Trading securities live on the balance sheet at fair value, and every unrealised gain or loss runs straight through net income. The FV adjustment account is the valuation bridge between original cost and current market price.
Investor
The company or individual purchasing shares of stock or bonds. The investment appears as an asset on the investor's books.
Investee
The company whose stock or bonds are being purchased. The investee has a corresponding liability (if debt) or shareholders' equity entry (if equity).
Debt investment
Investing in another company's bonds or short-term notes (e.g. commercial paper). The investor earns interest revenue.
Equity investment
Investing in another company's stock. The investor earns dividend revenue and may realise a gain or loss on sale.
Trading securities (TS)
Debt or equity securities bought with the intent to sell them within hours or days. Think of it as: the investments a bank or mutual fund flips quickly for short-term profit. Classified as a current asset on the balance sheet.
Available-for-sale securities (AFS)
Debt or equity securities not actively traded but available to be sold when conditions are favourable. In simple terms, this is the default bucket: if the investment is not HTM or TS, it falls here.
Held-to-maturity (HTM)
Debt securities the investor intends and is able to hold until maturity. Covered in detail in Chapter 14.
Fair value (FV)
The price at which an asset would change hands between a willing buyer and a willing seller in an orderly market. In simple terms, this means the current market price of the investment.
FV adjustment account
A valuation (contra or adjunct) account that sits alongside the investment account on the balance sheet. Its balance equals the total difference between cost and current fair value across all investments in that category. Think of it as: the running tab of how much the portfolio has moved from what was originally paid.
Unrealised gain or loss
A gain or loss that exists on paper because an investment's fair value has changed, but the investment has not been sold. The gain or loss is only "realised" when the investment is actually sold.
Net Unrealised G/L, Income Statement (for TS)
The income-statement account debited or credited when trading securities are marked to market. It flows into net income and then closes to retained earnings.
Marking to market
The process of adjusting an investment's carrying value on the balance sheet to its current fair value at the balance sheet date. Also called "mark-to-market."
Every company finances its assets through some combination of debt (liabilities) and shareholders' equity. The accounting equation captures this:
ASSETS = LIABILITIES + SHAREHOLDERS' EQUITY
Debt (liabilities) includes loans and notes payable (short-term or long-term), bond issues, and commercial paper (short-term unsecured debt).
Shareholders' equity includes common stock, additional paid-in capital, and retained earnings.
The flip side matters here: the borrower issues the debt, but the lender invests in the debt. The company receiving funds issues stock, but the buyer invests in the stock. Chapter 12 is about that investor's perspective.
To earn a return on idle cash, whether short-term or long-term.
To establish a business affiliation, for instance by investing in a subsidiary company in a related industry. A supplier may buy into a customer's stock to gain some control over the relationship.
The percentage of an investee's outstanding common stock that the investor owns determines the degree of influence and, therefore, the accounting method:
Below 20% ownership: The investor lacks significant influence. No voting rights in practice. The investment is reported under the cost method, classified as HTM, TS, or AFS.
20% to 50% ownership: The investor has significant influence. The investor holds a large enough voting block that decisions would usually go its way. The investment is reported under the equity method.
Above 50% ownership: The investor has control. Majority of votes. The investor must consolidate the investee's financial statements with its own. (Consolidation is not covered in ACCTG 472.)
When the investor lacks significant influence, investments are slotted into one of three categories:
Held-to-maturity (HTM): Debt securities only. The investor intends and is able to hold them until they mature. Changes in fair value are ignored. (Covered with Chapter 14 material.)
Trading securities (TS): Debt or equity securities bought and sold frequently, within hours or days. Typical of financial institutions. Changes in fair value are reported in net income.
Available-for-sale (AFS): Everything that does not fit the other two categories. Changes in fair value are reported in other comprehensive income (OCI).
The critical difference between the three categories is how the third accounting event, recognising changes in fair value, is handled. Purchase, revenue recognition, and sale are treated the same across categories.
For any investment where the investor lacks significant influence, there are four accounting events:
Purchasing the investment
Recognising investment revenue (interest for bonds, dividends for stock)
Recognising changes in fair value
Sale of the investment
TS are initially recorded at cost, including broker fees. Every cost incurred to acquire the securities is capitalised.
Example (textbook p. 662): Purchase of Arjent, Inc. stock for $1,500,000.
Debit | Credit | |
|---|---|---|
Investment in Arjent Stock | 1,500,000 | |
Cash | 1,500,000 |
One asset (cash) decreases; another asset (the investment) increases by the same amount.
When the investee pays dividends, the investor records dividend revenue.
Debit | Credit | |
|---|---|---|
Cash | 75,000 | |
Investment Revenue | 75,000 |
Assets go up (cash received) and shareholders' equity goes up (revenue increases retained earnings).
TS are recognised at fair value on the balance sheet. Because stock prices change daily, current FV gives better information than historical cost.
The unrealised gain or loss is recognised in the income statement as part of net income. It is called "unrealised" because the company has not actually sold the investment; it only exists on paper.
How the FV adjustment works:
Calculate the difference between cost and current FV for each trading investment.
Sum all differences. This total is the balance that should be in the FV adjustment account.
The FV adjustment account is a valuation account (like accumulated depreciation for PP&E). It nets against the investment accounts on the balance sheet.
The journal entry debits or credits the FV adjustment account to bring it to the correct balance.
The other half of the entry is Net Unrealised G/L, reported in the income statement.
Example, no prior FV adjustment balance:
Arjent stock cost $1,500,000. At year-end, FV is $1,450,000. The decrease is $50,000.
Debit | Credit | |
|---|---|---|
Net Unrealised G/L (IS) | 50,000 | |
FV Adjustment | 50,000 |
Net investments on the balance sheet: $1,500,000 minus $50,000 = $1,450,000 (the fair value).
Example, prior-year FV adjustment already exists:
Suppose two stocks are on the books at the start of the year: Stock 1 at cost $500,000 and Stock 2 at cost $300,000, with an existing FV adjustment credit balance of $2,000 (total book value $798,000).
At year-end, Stock 1 is worth $505,000 (up $5,000) and Stock 2 is worth $290,000 (down $10,000). The net difference from cost is now a $5,000 credit. The FV adjustment account already has a $2,000 credit, so the additional credit needed is $3,000.
Debit | Credit | |
|---|---|---|
Net Unrealised G/L (IS) | 3,000 | |
FV Adjustment | 3,000 |
The overall unrealised loss is $5,000, but $2,000 was already recognised in the prior year. Only the incremental $3,000 hits this year's income statement.
Total book value at year-end: $500,000 + $300,000 minus $5,000 = $795,000.
The sale is identical to selling any other asset:
Record the cash received.
Remove the investment account (at original cost).
The difference is the realised gain or loss.
Example (p. 664): Arjent stock (cost $1,500,000) sold for $1,446,000.
Debit | Credit | |
|---|---|---|
Cash | 1,446,000 | |
Loss on Sale | 54,000 | |
Investment in Arjent Stock | 1,500,000 |
Reversing the prior unrealised loss:
Recall that a $50,000 unrealised loss was already recognised in the income statement and is now embedded in retained earnings. To avoid double-counting, the FV adjustment must be reversed:
Debit | Credit | |
|---|---|---|
FV Adjustment | 50,000 | |
Net Unrealised G/L (IS) | 50,000 |
The net effect on the income statement: the $54,000 realised loss minus the $50,000 reversal = $4,000 additional charge. The total loss over the life of the investment ($54,000) is correctly recognised across the two periods.
If other trading securities remain in the portfolio, the year-end FV adjustment automatically takes care of reversing any previously recognised unrealised gains or losses on the sold securities.
Purchase: Dr. Investment in [Stock Name] ... Cost + broker fees Cr. Cash ... Cost + broker fees
Dividend revenue: Dr. Cash ... Dividend received Cr. Investment Revenue ... Dividend received
FV adjustment (unrealised loss): Dr. Net Unrealised G/L (IS) ... Amount Cr. FV Adjustment ... Amount
FV adjustment (unrealised gain): Dr. FV Adjustment ... Amount Cr. Net Unrealised G/L (IS) ... Amount
Sale (realised loss): Dr. Cash ... Sale proceeds Dr. Loss on Sale ... Plug Cr. Investment in [Stock Name] ... Original cost
Sale (realised gain): Dr. Cash ... Sale proceeds Cr. Investment in [Stock Name] ... Original cost Cr. Gain on Sale ... Plug
Reversal of FV adjustment on sale: Dr. FV Adjustment ... Prior credit balance Cr. Net Unrealised G/L (IS) ... Same amount
(Reverse the debits/credits if the prior balance was a debit.)
FV adjustment balance formula: Required balance = Sum of (FV minus Cost) for all TS currently held Journal entry amount = Required balance minus Existing balance in FV Adjustment account
Students often think the FV adjustment journal entry records the change in fair value during the current year. It does not. The entry adjusts the FV adjustment account to the total difference between cost and current FV. If there is already a balance in the account from a prior period, you only record the incremental amount needed to reach the correct balance.
Students often confuse unrealised and realised gains/losses. An unrealised gain or loss is a paper change in value while the investment is still held. A realised gain or loss occurs only when the investment is actually sold. Both can appear on the same income statement in the same year.
Students sometimes think that trading securities are only equity (stock). They can also be debt (bonds), although the course focuses on equity TS.
Students sometimes forget to reverse the FV adjustment when a trading security is sold. If the unrealised loss was already in retained earnings via the income statement, failing to reverse it means the total loss is double-counted. The year-end FV adjustment for the remaining portfolio handles this automatically, but if the sold security is the only one in the portfolio, a separate reversal entry is needed.
The ownership-threshold table (below 20%, 20–50%, above 50%) is heavily tested. Know which method applies at each level and why.
Expect questions that give you the cost, the year-end FV, and a prior FV adjustment balance, then ask for the journal entry. The trap is recording the full difference rather than the incremental adjustment.
On the balance sheet, trading securities always appear at fair value. If a question asks "what value is shown on the BS for the investment?" the answer is the current FV, not the original cost.
The distinction between where unrealised G/L is reported (net income for TS, OCI for AFS) is a near-certain exam question.
Sale-of-TS questions often test whether you understand the reversal of the prior unrealised G/L and how the net effect on the income statement works across periods.
True or false: Trading securities are reported at original cost on the balance sheet.
Fill in the blank: Unrealised gains and losses on trading securities are reported in ____.
True or false: If an investor owns 15% of an investee's outstanding common stock, the investor has significant influence over the investee.
Fill in the blank: The FV adjustment account balance should always equal the total ____ between cost and current fair value for all securities in that category.
True or false: When a trading security is sold, the realised gain or loss equals the difference between the sale price and the current fair value.
Answers: 1. False (they are reported at fair value). 2. Net income. 3. False (below 20% means no significant influence). 4. Difference. 5. False (it is the difference between the sale price and the original cost).
Q: Company A purchased 5% of Company B's stock for $100,000 and classifies the shares as trading securities. At year-end the fair value of the shares is $110,000. What value will be shown on Company A's year-end balance sheet for its investment in Company B?
A: $110,000. Trading securities are always reported at fair value on the balance sheet, regardless of original cost.
Q: An investor holds two trading securities. Stock X was purchased for $500,000 (now worth $505,000) and Stock Y was purchased for $300,000 (now worth $290,000). The FV adjustment account has a prior credit balance of $2,000. What is the journal entry at year-end?
A: The required FV adjustment balance is ($5,000 gain minus $10,000 loss) = $5,000 credit. The account already has $2,000 credit, so an additional $3,000 credit is needed. Entry: Dr. Net Unrealised G/L (IS) $3,000, Cr. FV Adjustment $3,000.
Q: A trading security that cost $1,500,000 was previously written down via FV adjustment by $50,000. It is now sold for $1,446,000. What is the total net effect on the income statement across all periods?
A: The total loss is $54,000 (cost of $1,500,000 minus sale price of $1,446,000). In the sale year, the income statement shows a $54,000 realised loss and a $50,000 reversal of the prior unrealised loss, for a net current-year charge of $4,000. Combined with the $50,000 unrealised loss from the prior year, the total across both periods is $54,000.
Q: What is the key difference in how unrealised gains and losses are reported for trading securities versus available-for-sale securities?
A: For trading securities, unrealised G/L is reported in net income (on the income statement). For available-for-sale securities, unrealised G/L is reported in other comprehensive income (OCI), which bypasses net income and closes to accumulated other comprehensive income (AOCI) in shareholders' equity.
Q: A company holds an investment classified as a trading security. At year-end, the investment has increased in value by $20,000. The company has not sold the investment. Must the company report any gain? If so, where?
A: Yes. The $20,000 unrealised gain must be reported in net income, even though the investment has not been sold. Trading securities are marked to market at every balance sheet date, with changes flowing through the income statement.
This material connects directly to Chapter 4 (Comprehensive Income), which introduced the distinction between net income and other comprehensive income. The AFS treatment covered in Part 2 of these notes relies on that distinction.
The fair value hierarchy (Levels 1, 2, 3) reappears in Chapter 14 (Bonds and Long-Term Notes) and wherever GAAP requires fair value measurement.
The equity method (Part 3 of these notes) builds on the ownership thresholds introduced here and connects to consolidation concepts covered in advanced accounting courses.
Investments in debt and equity, trading securities, available-for-sale securities, held-to-maturity, fair value adjustment, FV adjustment account, unrealised gain, unrealised loss, realised gain, realised loss, marking to market, mark-to-market, cost method, below 20% ownership, significant influence, balance sheet classification, current asset, GAAP investments, net income, other comprehensive income, OCI, AOCI, valuation account, broker fees, investment revenue, dividend revenue, interest revenue, Chapter 12, ACCTG 472, intermediate financial accounting