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APPENDIX E
Appendix E
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Held-to-Maturity Securities
Since equity securities representing ownership interests have no maturity date, the held-to-maturity classification applies only to debt securities. Debt securities should be classified as held-to-maturity securities if the investor has a positive intent and the ability to hold the securities until the maturity date. Held-to-maturity securities are reported on the balance sheet at amortized historical cost.1
Trading Securities
Both debt and equity securities can be classified as trading securities. Trading securities are bought and sold for the purpose of generating profits on the short-term appreciation of stock or bond prices. They are usually traded within three months of when they are acquired. Trading securities are reported on the investors balance sheet at their fair value on the investors fiscal closing date.
Available-for-Sale Securities
All marketable securities that are not classified as held-to-maturity or trading securities must be classified as available-for-sale securities. These securities are also reported on the investors balance sheet at fair value as of the investors fiscal closing date. Two of the three classifications, therefore, must be reported at fair value, which is a clear exception to the historical cost concept. Other exceptions to the use of historical cost measures for asset valuation are discussed in later sections of this appendix.
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Appendix E
outflow reported on the statement of cash flows, as shown in the following statements model:
Event No.
Type Cash
Liab.
Equity
Rev.
Exp.
Net Inc.
Cash Flow
1 1 1
5 5 5
NA NA NA
1 1 1
NA NA NA
NA NA NA
2 2 2
NA NA NA
5 5 5
NA NA NA
IA OA IA
EVENT 2 Recognition of Investment Revenue Arapaho earned $1,600 of cash investment revenue. Investment revenue is reported the same way regardless of whether the investment securities are classified as held to maturity, trading, or available for sale. Investment revenue comes in two forms. Earnings from equity investments are called dividends. Revenue from debt securities is called interest. Both forms have the same impact on the financial statements. Recognizing the investment revenue increases both assets and stockholders equity. Revenue and net income increase. The cash inflow from investment revenue is reported in the operating activities section of the statement of cash flows regardless of how the investment securities are classified.
Event No.
Assets Cash
5 5 5
Liab.
Rev.
Exp.
Net Inc.
Cash Flow
1,600
NA
1,600
1,600
NA
1,600
1,600 OA
EVENT 3 Sale of Investment Securities Arapaho sold securities that cost $2,000 for $2,600 cash. This event results in recognizing a $600 realized (actual) gain that increases both total assets and stockholders equity. The asset cash increases by $2,600 and the asset investment securities decreases by $2,000, resulting in a $600 increase in total assets. The $600 realized gain is reported on the income statement, increasing net income and retained earnings. The $600 gain does not appear on the statement of cash flows. Instead, the entire $2,600 cash inflow is reported in one section of the statement of cash flows. Cash inflows from the sale of held-to-maturity and available-for-sale securities are reported as investing activities. Cash flows involving trading securities are reported as operating activities. These effects are shown below.
Event No.
Type Cash
Liab.
Equity
Rev. or Gain
Exp. or Loss
Net Inc.
Cash Flow
3 3 3
5 5 5
NA NA NA
1 1 1
2 2 2
NA NA NA
5 5 5
IA OA IA
Appendix E
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EVENT 4 Market Value Adjustment Arapaho recognized a $700 unrealized gain. After Event 3, the historical cost of Arapahos portfolio of remaining investment securities is $7,000 ($9,000 purchased less $2,000 sold). Assume that at Arapahos fiscal closing date, these securities have a fair value of $7,700, giving Arapaho a $700 unrealized gain on its investment. This type of gain (sometimes called a paper profit) is classified as unrealized because the securities have not been sold. The treatment of unrealized gains or losses in the financial statements depends on whether the securities are classified as held to maturity, trading, or available for sale. Unrealized gains or losses on securities classified as held to maturity are not recognized in the financial statements; they have no effect on the balance sheet, income statement, and statement of cash flows. Even so, many companies choose to disclose the market value of the securities as part of the narrative description or in the footnotes that accompany the statements. Whether or not the market value is disclosed, held-to-maturity securities are reported on the balance sheet at amortized cost. Investments classified as trading securities are reported in the financial statements at fair value. Unrealized gains or losses on trading securities are recognized in net income even though the securities have not been sold. In Arapahos case, the $700 gain increases the carrying value of the investment securities. The gain increases net income, which in turn increases retained earnings. Unrealized gains and losses have no effect on cash flows. Investments classified as available-for-sale securities are also reported in the financial statements at fair value. However, an important distinction exists with respect to how the unrealized gains and losses affect the financial statements. Even though unrealized gains or losses on available-for-sale securities are included in the assets on the balance sheet, they are not recognized in determining net income.2 On Arapahos balance sheet, the $700 gain increases the carrying value of the investment securities. A corresponding increase is reported in a separate equity account called Unrealized Gain or Loss on Available-for-Sale Securities. The statement of cash flows is not affected by recognizing unrealized gains and losses on available-for-sale securities. The effects of these alternative treatments of unrealized gains and losses on Arapahos financial statements are shown here:
Event No.
Type
5 5 5 5 5
Liab.
1 Ret. Earn.
Rev. or Gain
Exp. or Loss
Net Inc.
Cash Flow
4 4 4
NA 700 700
NA NA NA
1 1 1
NA 700 NA
NA 700 NA
2 2 2
NA NA NA
5 5 5
NA 700 NA
NA NA NA
FINANCIAL STATEMENTS
As the preceding discussion implies, the financial statements of Arapaho Company are affected by not only the business events relating to its security transactions but also the accounting treatment used to report those events. In other words, the same economic events are reflected differently in the financial statements depending on whether the
Statement of Financial Accounting Standards No. 130 permits companies to report unrealized gains and losses on available-for-sale securities as additions to or subtractions from net income with the result being titled comprehensive income. Alternatively, the unrealized gains and losses can be reported on a separate statement or as part of the statement of changes in stockholders equity.
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Balance Sheets
Held Assets Cash Investment securities, at cost (market value $7,700) Investment securities, at market (cost $7,000) Total assets Stockholders equity Common stock Retained earnings Unrealized gain on investment securities Total stockholders equity $ 5,200 7,000 $12,200 $10,000 2,200 $12,200 Trading $ 5,200 7,700 $12,900 $10,000 2,900 $12,900 Available $ 5,200 7,700 $12,900 $10,000 2,200 700 $12,900
*The $10,000 capital acquisition is assumed to have occurred prior to the start of the accounting period.
securities are classified as held to maturity, trading, or available for sale. Exhibit E.1 displays the financial statements for Arapaho under each investment classification alternative. The net income reported under the trading securities alternative is $700 higher than that reported under the held-to-maturity and available-for-sale alternatives because unrealized gains and losses on trading securities are recognized on the income statement. Similarly, total assets and total stockholders equity are $700 higher under the trading and available-for-sale alternatives than they are under the held-to-maturity category because the $700 unrealized gain is recognized on the balance sheet for those two classifications. The gain is not reported on the income statement for available-for-sale securities; it is reported on the balance sheet in a special equity account called Unrealized
Appendix E
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EXHIBIT E.2
Recognition of Unrealized Gains and Losses on the Income Statement No Yes No Cash Flow from Purchase or Sale of Securities Classified As Investing activity Operating activity Investing activity
Types of Revenue Recognized Interest Interest and dividends Interest and dividends
Gain on Investment Securities. The statements of cash flows report purchases and sales of trading securities as operating activities while purchases and sales of available-for-sale and held-to-maturity securities are investing activities. Exhibit E.2 summarizes the reporting differences among the three classifications of investment securities.
EXERCISES
Exercise E1 Identifying asset values for financial statements
Required
Indicate whether each of the following assets should be valued at fair market value (FMV), lower of cost or market (LCM), or historical cost (HC) on the balance sheet. For certain assets, historical cost may be called amortized cost (AC.)
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Appendix E
Asset Supplies Land Trading securities Cash Held-to-maturity securities Buildings Available-for-sale securities Ofce equipment Inventory
FMV
LCM
HC/AC
Required
a. Record a 1, 2, or NA in a horizontal statements model to show how the purchase of the securities affects the financial statements, assuming that the securities are classified as (1) held to maturity, (2) trading, or (3) available for sale. In the Cash Flow column, indicate whether the event is an operating activity (OA), investing activity (IA), or financing activity (FA). Record only the effects of the purchase event.
Event No. 1 2 3
Cash
Inv. Sec.
Liab.
Equity
Rev.
Exp.
Net Inc.
Cash Flow
b. Determine the amount of net income that would be reported on the 2009 income statement, assuming that the marketable securities are classified as (1) held to maturity, (2) trading, or (3) available for sale.
Required
a. Record the four events in a statements model like the following one. Use a separate model for each classification: (1) held to maturity, (2) trading, and (3) available for sale. The first event for the first classification is shown as an example.
Held to Maturity
Event No. 1 Unreal. Gain. NA Rev. or Gains NA Exp. or Loss NA
Cash (100,000)
5 5
Liab. NA
1 1
Ret. Earn. NA
1 1
2 2
5 5
Net Inc. NA
Appendix E
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b. What is the amount of net income under each of the three classifications? c. What is the change in cash from operating activities under each of the three classifications? d. Are the answers to Requirements b and c different for each of the classifications? Why or why not?
Required
Use a vertical statements model to prepare income statements, balance sheets, and statements of cash flow for Wright, Inc., assuming the securities were (a) held to maturity, (b) trading, and (c) available for sale.
Required
Use a vertical model to prepare a 2009 income statement, balance sheet, and statement of cash flows, assuming that the marketable investment securities were classified as (a) held to maturity, (b) trading, and (c) available for sale. (Hint: Record the events in T-accounts prior to preparing the financial statements.)
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Appendix E
Required
a. Show the effect of each event on the elements of the financial statements using a horizontal statements model like the following one. Use 1 for increase, 2 for decrease, and NA for not affected. In the Cash Flow column, indicate whether the item is an operating activity (OA), investing activity (IA), or financing activity (FA). The first transaction is entered as an example.
Event No. 1 Rev. or Gain NA Exp. or Loss NA
Assets 1
Liab. NA
Equity 1
Net Inc. NA
Cash Flow 1 FA
b. Explain why there is or is not a difference in the way Events 8 and 9 affect the financial statements model.