Trading Securities: Videos & Practice Problems

Trading securities are short-term investments that companies actively buy and sell, expecting to generate income primarily through dividends and changes in fair value. Fair value refers to the market price of these investments, and any fluctuations in this price result in realized or unrealized gains or losses. Realized gains or losses occur when the securities are sold, while unrealized gains or losses reflect changes in value before the sale.

On the balance sheet, trading securities are classified as current assets due to the intention of selling them in the near term. Initially, these investments are recorded at cost, which is the total amount spent to acquire them. For example, if a company purchases 500 shares of stock at $60 per share, the total cost would be calculated as:

Cost = Number of Shares × Price per Share = 500 × 60 = $30,000.

This amount is recorded as an asset in the journal entry. The subsequent measurement of trading securities is at fair value, meaning that any unrealized gains or losses will be reflected on the income statement, even if the securities have not yet been sold.

For the journal entry upon purchasing the trading security, the company would debit the investment account to reflect the increase in assets and credit the cash account to show the decrease in cash. The journal entry would look like this:

Debit: Investment in Trading Securities  $30,000Credit: Cash                          $30,000

This entry indicates that the company has exchanged cash for an investment, maintaining the overall total assets but changing the composition of those assets. The investment account increases by $30,000, while cash decreases by the same amount.

When a company receives dividends from its investments, it recognizes this as dividend revenue, which contributes to its overall financial performance. For instance, consider XYZ Company, which declared and paid a dividend of $1 per share on December 10th, Year 1. If the company had previously purchased 500 shares, the total dividend revenue would amount to:

Dividend Revenue = Number of Shares × Dividend per Share = 500 \times 1 = $500.

This $500 is received in cash, leading to a journal entry where cash is debited for $500, reflecting an increase in cash assets. Simultaneously, dividend revenue is credited for the same amount, indicating an increase in revenue. The journal entry can be summarized as follows:

Debit: Cash $500Credit: Dividend Revenue $500

It is important to note that dividend revenue is categorized differently from operating revenue. For a company like a t-shirt manufacturer, the primary revenue from selling t-shirts would be reported at the top of the income statement, while dividend revenue would appear later, typically under non-operating revenues. This distinction is crucial as it highlights that the company is not primarily focused on investment income, but rather this revenue is a secondary benefit from excess cash investments.

In summary, the receipt of dividend revenue increases both cash and equity by $500, contributing positively to the company's financial health, albeit outside its core business operations.

Understanding unrealized gains and losses is crucial for accurately reporting the value of investments, particularly trading securities. When an investment is held, its value must be adjusted to reflect fair value on reporting dates, such as the end of the fiscal year. For instance, if an investment was purchased in November and the balance sheet is prepared on December 31, the investment's value must be updated to its current market price.

The key distinction between trading securities and available-for-sale securities lies in how unrealized gains and losses are reported. For trading securities, any unrealized gains or losses are recorded on the income statement. This means that if the market price of an investment increases since its purchase, an unrealized gain is recognized. Conversely, if the market price decreases, an unrealized loss is recorded. These gains and losses are termed "unrealized" because they reflect changes in value while the investment is still held, rather than realized gains or losses that occur upon selling the investment.

To illustrate, consider an example where XYZ Company’s stock is valued at $65 per share on December 31, after being purchased at $60 per share. If 500 shares were bought, the initial investment totals $30,000. The current market value of the investment is calculated as follows:

Current Value = Number of Shares × Market Price = 500 shares × $65/share = $32,500.

The unrealized gain is determined by the difference between the current value and the original investment:

Unrealized Gain = Current Value - Original Investment = $32,500 - $30,000 = $2,500.

To adjust the investment's value on the balance sheet, a journal entry is made. The investment account is debited to reflect the increase in value, while the unrealized gain is credited to the income statement. The journal entry would be:

Debit: Investment in Trading Securities $2,500

Credit: Unrealized Gain on Income Statement $2,500

This adjustment increases both the asset value and equity, as the unrealized gain contributes to the overall income reported. It is important to note that this process of revaluation will occur regularly, aligning with the release of financial statements, ensuring that the investment's value is accurately reflected in the financial records.

In accounting for trading securities, it is essential to accurately track the investment's fair value over time, as this affects both the balance sheet and the income statement. Initially, when trading securities are purchased, they are recorded at cost. For example, if an investment is made for $30,000, this amount is debited to the investment account, reflecting the asset's value.

As the market value of the investment fluctuates, adjustments must be made to reflect unrealized gains or losses. If, at the end of the first year, the fair value of the investment increases to $32,500, an unrealized gain is recorded. This is done by debiting the investment account and crediting the unrealized gain or loss account, which impacts the income statement.

Moving into the second year, if the market value of the investment drops to $50 per share, it is crucial to reassess the investment's value. For instance, if 500 shares are held, the new fair value would be calculated as follows:

Investment Value = Number of Shares × Market Price per Share

Investment Value = 500 \times 50 = 25,000

Since the investment was previously recorded at $32,500, a decrease of $7,500 must be recognized. This adjustment is made by crediting the investment account and debiting the unrealized loss account, which again affects the income statement. The journal entry would look like this:

Debit: Unrealized Loss $7,500

Credit: Investment in Trading Securities $7,500

This entry reflects the unrealized loss, which reduces the asset's value on the balance sheet and decreases equity due to the loss reported on the income statement. By the end of the second year, the investment account will accurately reflect the new fair value of $25,000, ensuring that financial statements provide a true representation of the company's financial position.

Overall, maintaining accurate records of fair value changes is critical, especially when multiple periods are involved. Each adjustment must be based on the most recent fair value assessment, ensuring that the financial statements remain reliable and informative.

When an investment is sold, it results in a realized gain or loss, which is recorded on the income statement. The distinction between realized and unrealized gains or losses is crucial, particularly for trading securities and available-for-sale securities. Realized gains or losses occur when the investment is sold, and they reflect the difference between the selling price and the last recorded valuation of the investment.

To determine whether there is a realized gain or loss, one must compare the selling price of the investment to its last valuation on the books. If the selling price exceeds the last valuation, a realized gain is recorded; conversely, if the selling price is lower, a realized loss is recorded. For example, if a company sells its investment in XYZ stock at a market value of $70 per share, and the last recorded value was $50 per share, the calculation would be as follows:

Assuming the company holds 500 shares, the total selling price would be:

Selling\ Price = 500\ shares \times 70\ dollars/share = 35,000\ dollars

Given that the last valuation was:

Last\ Valuation = 500\ shares \times 50\ dollars/share = 25,000\ dollars

The realized gain can be calculated as:

Realized\ Gain = Selling\ Price - Last\ Valuation = 35,000\ dollars - 25,000\ dollars = 10,000\ dollars

This realized gain of $10,000 is recorded on the income statement as "Gain on Sale of Investment." The journal entries for this transaction would include a debit to cash for the amount received, a credit to the investment account for its book value, and a credit to the gain on sale of investment. Specifically:

Debit\ Cash = 35,000\ dollars

Credit\ Investment = 25,000\ dollars

Credit\ Gain\ on\ Sale\ of\ Investment = 10,000\ dollars

In terms of financial impact, the cash received increases the company's assets, while the removal of the investment reduces assets. The net effect is an increase in total assets and equity by the amount of the realized gain. This gain is classified as a non-operating income, appearing after operating income on the income statement, reflecting the company's investment activities.

Understanding these concepts is essential for accurately reporting investment transactions and their effects on financial statements.