Chapter 12, Problem 12.5P

Various transactions related to trading securities

• LO12-1, LO12-3

The following selected transactions relate to investment activities of Ornamental Insulation Corporation during 2018. The company buys debt securities, intending to profit from short-term differences in price and maintaining them in an active trading portfolio. Ornamental’s fiscal year ends on December 31. No investments were held by Ornamental on December 31, 2017.

Mar. 31	Acquired 8% Distribution Transformers Corporation bonds costing $400,000 at face value.
Sep. 1	Acquired $900,000 of American Instruments’ 10% bonds at face value.
Sep. 30	Received semiannual interest payment on the Distribution Transformers bonds.
Oct. 2	Sold the Distribution Transformers bonds for $425,000.
Nov. 1	Purchased $1,400,000 of M&D Corporation 6% bonds at face value.
Dec. 31	Recorded any necessary adjusting entry(s) relating to the investments. The market prices of the investments are:
American Instruments bonds	$ 850,000
M&D Corporation bonds	$1,460,000
(Hint: Interest must be accrued.)

Required:

1. Prepare the appropriate journal entry for each transaction or event during 2018, as well as any adjusting entries necessary at year end.

2. Indicate any amounts that Ornamental Insulation would report in its 2018 income statement, 2018 statement of comprehensive income, and 12/31/2018 balance sheet as a result of these investments.

(Note: This problem is a variation of P 12–5, modified to categorize the investments as securities available-for-sale.)

To determine

Investment: The act of allocating money to buy a monetary asset, in order to generate wealth in the future is referred to as investment.

Debt securities: The financial instruments which are bought by investors, or corporations, or mutual funds, are referred to as debt securities. The companies issue debt securities to raise capital for the purposes of purchasing assets, or paying debts.

Trading securities: These are short-term investments in debt and equity securities with an intention of trading and earning profits due to changes in market prices.

Fair value: Fair value is the price at which, both seller and buyer agree to exchange the asset. So, fair value is the selling price to the seller and the purchase price for the buyer.

Journal: Journal is the method of recording monetary business transactions in chronological order. It records the debit and credit aspects of each transaction to abide by the double-entry system.

Rules of Debit and Credit:

Following rules are followed for debiting and crediting different accounts while they occur in business transactions:

• Debit, all increase in assets, expenses and dividends, all decrease in liabilities, revenues and stockholders’ equities.
• Credit, all increase in liabilities, revenues, and stockholders’ equities, all decrease in assets, expenses.

To Journalize: Each transaction or event during 2018.

Explanation of Solution

Prepare the journal entry to record the investment made by Company O.

Date	Account Title	Post ref.	Debit ($)	Credit ($)
03.31.18	Investment in  bonds of Company DT		$400,000
	Cash			$400,000
	(To record the investment made in Company DT)

 Table (1)

• Investments is being made, this increases the assets; hence debit the investment.
• Cash is being paid, cash is an asset which is being reduced; hence credit the cash account.

Prepare the journal entry to record the investment made by Company O.

Date	Account Title	Post ref.	Debit ($)	Credit ($)
09.01.18	Investment in  bonds of Company AI		$900,000
	Cash			$900,000
	(To record the investment made in Company AI)

 Table (2)

• Investments is being made, this increases the assets; hence debit the investment.
• Cash is being paid, cash is an asset which is being reduced; hence credit the cash account.

Prepare the journal entry to record the semiannual interest received by Company O.

Date	Account Title	Post ref.	Debit ($)	Credit ($)
09.30.18	Cash		$16,000
	Interest Revenue  (1)			$16,000
	(To record the interest received)

Table (3)

• Cash is received, cash is an asset which is being increased; hence debit the cash account.
• Interest revenue is a gain, which increases the stockholder's equity; hence credit the interest revenue account.

Prepare the adjustment journal entry to record the fair value of bonds of Company DT.

Date	Account Title	Post ref.	Debit ($)	Credit ($)
10.02.18	Fair value adjustment		$25,000
	Unrealized holding gain—NI (2)			$25,000
	(To record the gain on adjustment)

Table (4)

• Fair Value Adjustment is a contra-asset account which serves the purpose of valuation allowance account. The account is adjusted to update the fair value as on October 02, 2018.
• Unrealized Holding Gain–NI is an adjustment account used to report gain or loss on adjusting cost of investment at fair market value. Since gain has occurred and gains increase stockholders’ equity value, stockholders’ equity value is credited.

Working Note:

Compute the unrealized gain as on October 02, 2018, by adjusting the cost of $400,000 to the fair value of $425,000.

Details	Amount ($)
Fair value adjustment balance as on March 31, 2018	$400,000
Adjustment needed to update fair value (2)	$25,000
Fair value adjustment balance needed on October 02,2018	$425,000

Table (5)

(2)

Prepare the journal entry to record the sale of bonds of Company DT, by Company O.

Date	Account Title	Post ref.	Debit ($)	Credit ($)
10.2.18	Cash		$425,000
	Investment in  bonds of Company DT			$400,000
	Fair value adjustment			$25,000
	(To record the sale of the bonds of Company DT )

Table (6)

• Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
• Fair Value Adjustment is a contra-asset account which serves the purpose of valuation allowance account. The account is adjusted to update the fair value.
• Investment in Bonds is an asset account. Since stock investments are sold, asset value decreased, and a decrease in asset is credited.

Prepare the journal entry to record the investment made by Company O.

Date	Account Title	Post ref.	Debit ($)	Credit ($)
11.01.18	Investment in  bonds		$1,400,000
	Cash			$1,400,000
	(To record the investment made in Company MD)

 Table (7)

• Investments is being made, this increases the assets; hence debit the investment.
• Cash is being paid, cash is an asset which is being reduced; hence credit the cash account.

Adjusting entries:  Adjusting entries are the journal entries which are recorded at the end of the accounting period to correct or adjust the revenue and expense accounts, to concede with the accrual principle of accounting.

Prepare the journal entry to record the accrued interest as on December 31, 2018.

Date	Account Title	Post ref.	Debit ($)	Credit ($)
12.31.18	Interest receivable		$30,000
	Investment revenue   (3)			$30,000
	(To record the accrued interest of Company  AI)
12.31.18	Interest receivable		$14,000
	Investment revenue   (4)			$14,000
	(To record the accrued interest of Company  MD )

Table (8)

Working Note:

Calculate the interest revenue value for the bonds of Company AI.

$\begin{array}{c}\text{Interest Revenue =}\left(\begin{array}{l}\text{Face amount of bonds}\times \\ \text{Stated interest rate}\times \\ \text{Interest time period}\end{array}\right)\\ \text{=\$900,000 × }\frac{10}{\text{100}}\times \frac{4}{12}\\ \text{=\$90,000}\times \frac{4}{12}\\ \text{=\$30,000}\end{array}$ (3)

Calculate the interest revenue value for the bonds of Company MD.

$\begin{array}{c}\text{Interest Revenue =}\left(\begin{array}{l}\text{Face amount of bonds}\times \\ \text{Stated interest rate}\times \\ \text{Interest time period}\end{array}\right)\\ \text{=\$1,400,000 × }\frac{6}{\text{100}}\times \frac{2}{12}\\ \text{=}\frac{\text{\$1,400,000}}{100}\\ \text{=\$14,000}\end{array}$ (4)

Available-for-sale (AFS) securities: These are short-term or long-term investments in debt and equity securities with an intention of holding the investment for some strategic purposes like meeting liquidity needs, or manage interest risk.

Available-for-Sale Securities	Cost	Fair Value	Accumulated Unrealized Gains /  Loss
Bonds of Company MD	$1,400,000	$1,460,000	$60,000
Bonds of Company AI	$900,000	$850,000	(-)  $50,000
Total as on Dec. 31, 2018	$2,300,000	$2,310,000	(-)  $10,000

Table (9)

Prepare the journal entry to record the value of bonds available with Company O as on December 31, 2018.

Date	Account Title	Post ref.	Debit ($)	Credit ($)
12.31.18	Fair value adjustment		$10,000
	Unrealized holding gain—NI			$10,000
	(To record the gain on adjustment)

Table (10)

• Fair Value Adjustment is a contra-asset account which serves the purpose of valuation allowance account. The account is adjusted to update the fair value as on October 02, 2018.
• Unrealized Holding Gain–NI is an adjustment account used to report gain or loss on adjusting cost of investment at fair market value. Since gain has occurred and gains increase stockholders’ equity value, stockholders’ equity value is credited.

To determine

To Prepare: The income statement, statement of comprehensive income, and balance sheet of Company O as on December 31, 2018.

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.

Company O
Income Statement
For the year ended December 31 , 2018
Particulars	Amount ($)	Amount ($)
Revenues
Investment revenue	$60,000
Unrealized holding gain on investments	$10,000
Gain on sale of investments	$25,000
Net income		$95,000

Table (11)

The net income of Company O is $95,000.

Comprehensive income: The total of net income and other comprehensive income (OCI) is referred to as comprehensive income. OCI includes all financial items which result in changes in the stockholders’ equity, other than stock investments and dividends. Comprehensive income should be reported on income statement, and statement of comprehensive income.

Company O
Statement of Comprehensive Income
For the year ended December 31 , 2018
Particulars	Amount ($)	Amount ($)
Net income	$95,000
Other Comprehensive Income	$0
Comprehensive Income		$95,000

Table (12)

The Comprehensive Income of Company O is $95,000.

Balance sheet: This financial statement reports a company’s resources (assets) and claims of creditors (liabilities) and stockholders (stockholders’ equity) over those resources. The resources of the company are assets which include money contributed by stockholders and creditors. Hence, the main elements of the balance sheet are assets, liabilities, and stockholders’ equity.

Company O
Balance Sheet
December 31 , 2018
Particulars	Amount ($)	Amount ($)
Assets
Current Assets
Interest Receivable	$44,000
Trading securities	$2,300,000
Fair value adjustment	$10,000
Total current assets		$2,354,000
Liabilities and Stockholders’ Equity
Owner's equity
Retained earnings	$95,000
Total liabilities and stockholders’ equity		$95,000

Table (12)

The balance sheet of Company O shows the assets total as $2,354,000 and the stockholder's equity total as $95,000.