Hello. I'm Professor Bryan Bruchee. Welcome back. This is part two of our look at marketable securities. We left off the last video with the example of a couple of companies that had bought the stock of a third company. That investment had gone up in value at their balance sheet date, and then came back down and they sold it. Were going to start this video building off of that example where we look at an alternative reality, where we buy the same investment except now the price drops at the balance sheet date, and then comes back up and we sell it. Sounds exciting to me, so let's get started. Now to get some more practice at this and to see what happens if you end up getting an unrealized loss, we're going to do an alternate reality version of the final part of the example. So, we're going to go back to the mark to market on the balance sheet date. But instead of the TK stock going up to 103, in our alternate reality, at the quarter end, the investment of TK stock is now $97. So for the journal entry, we have to credit marketable securities by three. So remember, we originally bought the marketable securities at 100, it's the balance sheet date, they're now worth $97. How do we get the asset account from $100 down to $97? We credit the account by 3. So the debit here is going to be a loss on investment, which will show up in the income statement, that's the plus E, and then eventually work its way to stock holder's equity through retained earnings. So under the trading securities method, we book this loss on the income statement. Myer has the same investment, also drops to $97. They also do the credit to marketable securities to mark the balance sheet to the market value, go from a $100 down to $97. But remember under AFS, their unrealized losses going to go under AOCI. So we bring up our AOCI account. And that debit stores up the loss until we need it when we sell the security. Now notice this is just like retained earnings where you could actually have a balance on the debit or credit side. So AOCI had retained earnings, you could have balances on the credit side or the debit side depending whether it's accumulated other comprehensive income, or in this case it's really accumulated other comprehensive loss because it's a loss on investment. Bottom line is, this loss of 3 by passes net income for available for sale for Meyer, whereas it's recognized in the income statement for Bott. Now let's sell the investment. So after quarter end, Bott sells the TK stock for $101. So we receive cash, $101, we take off the marketable securities at their last balance sheet date value, which is $97. Here we need a plug that's a credit. So this is going to show up as a gain on investment, a 4. That gain of 4 is going to show up on the income statement, that's the plus R, and then eventually work its way to stockholder's equity. For Meyer Company, they also sell their stock at $101 after the quarter end. They also get cash of $101, and credit marketable securities for 97. So the debit to the cash, credit to marketable securities is the same across the two methods. What differs of course, is that we had unrealized losses stored up in AOCI, which now we have to pull out. So if we pull up the T account, we can see that we had unrealized losses stored up in AOCI, we had these unrealized losses hanging out in the attic until we needed them. Now we need them because we sold a stock so the way that we clear out this account is with a credit entry. So the credit entry undoes the debit, then we plug, we plug a gain on investment. This gain on investment is realized, so it goes on the income statement. 3 retained earnings in the stockholder's equity, and the gain equals 1, which is the same as it was in the last case. And that's because, the realized gain is based on the original cost for AFS securities. So it's the same we bought for $100, sold for $101, we get a gain of 1. What's different here is, for trading securities for Bott, the gain is based on the last balance sheet value. The last balance sheet value is 97 so we get a gain of 4 in this case. >> What does the IRS think of these two methods? When I sell stock and get a gain, I pay taxes on the gain. Are the taxes lower for the AFS method here? >> Ha ha! When have you ever made a gain an investment? You should be more interested in what happens with losses! Loser! >> Did you just call me a loser? >> Well, no, no, no, boys. Settle down, settle down. We don't want to get into anything ugly here. Let's focus back on the tax question. So as it turns out, the IRS taxes only realized gains. So you're only taxed on a gain or loss when you sell the stock. So Bott and Myer will actually pay identical taxes because they have identical realized gains. So these unrealized gains are relevant for tax purposes. They're going to create something called deferred taxes, which we'll talk about in a couple weeks. So I think we really need a summary slide at this point to try to tie all of these stuff together. So in the original example, Bott bought a marketable security at 100. We wrote it up to 103 at the quarter end, that went on the balance sheet, and then we eventually sold it for 101. On the income statement, in the first quarter we show a gain of 3, the difference between the quarter end value and what we bought it for. And then the next quarter, we show it a loss of minus 2. The difference between 103 and 101. Overall, the total gains showed on the income statement across the two periods was plus 1, which equals the realized gain. The difference between what we bought it for, 100, and what we sold it for, 101. For Meyer Company, it had the same pattern for marketable securities. They bought at 100, wrote it up to 103, that showed up on the balance sheet, and sold it for 101. But, when they wrote it up to 103, we put that unrealized gain of 3 in the AOCI. When they sold it we took that out, which got us a gain of 1 on the income statement. And so notice that realized gain is the same as for Bott over the life of the investment. The difference is for AFS it all shows up at the time you sell it. In our alternate reality example, we bought at 100. It went down in 97, we reflected that on the balance sheet. Came back up to 101, and we sold it. For Bott, those unrealized gains and losses show up. So the unrealized loss of minus 3 would go in the first quarter. Leads to a realized gain of 4. Net the two out, and it's still a gain of 1 over the entire life of the security. For Meyer, same pattern, 100 down to 97, which shows up on the balance sheet, goes back up to 101 when we sell it. We use AOCI to store up that unrealized loss of 3, take it out when we sell it. We get the realized gain of 1, that shows up on our income statement only when we sell it. So it costs all of these scenarios, the total affect on the income statement is the same. It's the difference between what we bought it for, and we eventually sold it for. What the training securities method does though is it puts volatility in the income statement because we market to market every period, whereas under AFS, all that volatility is stored up in AOCI, so that all we show up on the income statement is the realized gain at the time that we sell it. Kay, now we're going to talk quickly about marketable securities where it's debt securities. So when you're buying the bonds of another company. So debt investments can be accounted for as trading an available for sale. So using the same methods that we've seen so far. Or, they can be done under a third method called held-to-maturity. So under held-to-maturity, or HTM, the firm has to have both the ability and the intent to hold the debt investment until it matures. So if it's a five year bond that you buy, you have the intent and the ability to hold it for five years until the bond matures. We do not have to market to market under this method, and we're going to recognize interest revenue as we get it each period. >> Really, there are two methods for equity investments, and three for debt investments. Why can't equity investments be considered held to maturity? >> The simple answer is that equity does not mature. So when we're talking about these debt securities, oftentimes they have a fixed maturity. So you get paid back in five years, or ten years, or 30 years, whereas equity, there's no kind of fixed maturity at which point you get paid back. So when the first view was coming up with these methods, there was a demand for a third method, where firms said, look, sometimes we buy five year bonds. We intend to hold the bond for five years, collect interest, and then principal at the end. So, who cares about this fair value stuff? And the FASB said, okay, as long as you're willing to hold the bond for five years, we'll create a third category where you don't have to mark things to market. Let's quickly take a look at the journal entries for the held-to-maturity method. So at acquisition, it would be the same journal entry that we made under the two methods. We pay cash, we credit cash. Debit marketable securities to reflect the asset, the investment that we have. We'll say it's a 100 in this case again. When we receive interest, we're going to debit cash for the interest that we receive. Credit interest revenue, that will go on the income statement. Note here, it has to be interest instead of dividends. Shares of stock pay dividends, but a bond investment, you're going to get interest revenue. At the end of the quarter, the bond that we own may have changed in value, we don't do anything to recognize that. We don't market to market, so there's never any entry to update it to fair value. Then when we sell it, let's say we get $103 cash. We debit cash $103, we credit marketable securities at their original cost 100, because that's what they're on the balance sheet at. And then we plug a gain on investment of 3, that's the realized gain. Or if it was a loss, let's say we only got $97 of cash. We debit and cash $97, credit marketable securities for that original 100. Plug a loss on investment of 3, which is the realized loss. And both that gain and that loss will show up on the income statement. So the last thing that I want to talk about is, how these show up on the statement of cash flows. So if you decide to classify your investment as a trading security, and then it's going to be considered an operating activity. It's going to be considered part of your core operations, which makes sense because most of the companies that choose this are financial institutions and that's part of their business. So in that case, we're going to add decreases or subtract increases in the balance sheet account, marketable securities, in the cash and operations section. The way to think about it is it's going to work just like accounts receivable and inventory work on the cash flow statement. If we choose available for sale or held to maturity, those are going to be investing activities. So, cash and purchases, cash from sales are going to be in the cash flow from investing activities section. So it's going to not be part of the core business and operations but be considered part of investing activities. We have to add back realized losses or subtract realized gains in the cash room operations sections, because those will affect that income, but we want the cash flow to be reflected in investing. So, we have to pull them out to, it's treated just like property plant equipment. All the transactions that we did for property plant equipment, and how this showed up in the cash flow statement, will also work like that for available-for-sale and for held-to-maturity. >> So, you would do the hokey pokey method with AFS and with HTM? >> Can you do the hokey pokey again for us? >> Yes, for AFS and HTM securities, you would do the hokey pokey method on the cashless statement. But, no, I'm not going to do the hokey pokey for you again. You can go back to week three and re-watch those videos if you want to see that mess. Wow, if I'm too tired to do the hokey pokey, then it's clear that I've been talking about marketable securities for way too long. So let's go ahead and wrap this up, and I will be back in the next video to go over an example of footnote disclosures related to marketable securities. We will see what kind of things we can learn from those disclosures. I'll see you then. >> See you next video.
