Question

(Financial Statement Effect of Securities) Presented below are three unrelated situations involving equity securities.

Situation 1: A debt security, whose fair value is currently less than cost, is classified as available-for-sale but is to be reclassifiedas trading.

Situation 2: A noncurrent held-to-maturity portfolio with an aggregate fair value in excess of cost includes one particular debtsecurity whose fair value has declined to less than one-half of the original cost. The decline in value is considered to be permanent.

Situation 3: The portfolio of trading debt securities has a cost in excess of fair value of \(13,500. The available-for-sale debt portfoliohas a fair value in excess of cost of \)28,600.

Instructions

What is the effect upon carrying value and earnings for each of the situations above?

Short answer

Trading securities decrease the company’s net income, and available for sale securities increase the company’s net income.

Step-by-step solution

Step 1:Reclassification of securities

Situation 1 does not affect the company’s carrying value and earnings because these are already recognised in available-for-securities.

Effect of held-to-maturity securities

Situation 2 does not affect the company’s carrying value and earnings because the given security is held-to-maturity security. In these types of securities, the amount is considered only at the time of the security’s maturity.

Adjustment of unrealized holding gain or loss

Situation 3 affect the carrying value and the earnings. Trading securities’ fair value is less than the cost value representing the unrealised loss that decreases the company's net income. Available-for-securities fair value is more than the cost representing unrealised gain that increases the company’s net income.