Issues raised about Investment Securities you
have just started work for Warren Co. as part of the controller’s group
involved in current financial reporting problems. Jane Hens haw, controller for
Warren, is interested in your accounting background because the company has
experienced a series of financial reporting surprises over the last few years.
Recently, the controller has learned from the company’s auditors that there is
authoritative literature that may apply to its investment in securities. She
assumes that you are familiar with this pronouncement and asks how the
following situations should be reported in the financial statements.
Situation 1
Trading securities in the current assets
section have a fair value that is $4,200 lower than cost.
Situation 2
A trading security whose fair value is
currently less than cost is transferred to the available-for-sale category.
Situation 3
An available-for-sale security whose fair
value is currently less than cost is classified as noncurrent but is to be
reclassified as current.
Situation 4
A company’s portfolio of available-for-sale
securities consists of the common stock of one company. At the end of the prior
year the fair value of the security was 50% of original cost, and this
reduction in market value was reported as an other than temporary impairment.
However, at the end of the current year the fair value of the security had
appreciated to twice the original cost.
Situation 5
The company has purchased some convertible
debentures that it plans to hold for less than a year. The fair value of the
convertible debentures is $7,700 below its cost.
What is the effect upon carrying value and
earnings for each of the situations above? Assume that these situations are
unrelated.
Situation 1
GAAP requires that securities which are classified as trading securities be
reported on the balance sheet at their fair value amount. Any changes in the
fair value of trading securities from one period to another are included in
earnings. Therefore, the $4,200 decrease will be reported on the income
statement as an unrealized holding loss.
Situation 2.
The security should be reported in the available-for-sale category at the
current fair value. The transfer of the security affects earnings because the
unrealized loss at the date of transfer is recognized in the income statement.
Situation 3.
The reclassification does not affect earnings and the available-for-sale
security will continue to be reported at its fair value.
Situation 4.
When a reduction in the fair value of a security is considered to be an
impairment, the new cost basis of the security is its fair value. The security
is written down to the fair value amount and the loss is included in earnings.
In this case, the fair value of the security at the end of the prior year is
the new cost basis. However, since the security is classified as available-for-sale,
the fair value at the end of the current year is reported on the balance sheet.
Therefore, the increase in fair value will not affect earnings but instead is
reported as other comprehensive income and as a separate component of
stockholders’ equity.
Situation 5.
The securities would be classified as available-for-sale securities since
management’s intention is neither to hold the securities for the entire term
nor to sell the securities in the near future (less than 3 months).
Available-for-sale securities are reported on the balance sheet at the fair
value. The unrealized holding loss of $7,700 is excluded from earnings and
instead is reported as other comprehensive income and as a separate component
of stockholders’ equity.
