OCW041: Debt for Sale

Accounting for Sale of Debt

How debt sales are recorded depends on whether the debt is classified as “held-to-maturity,” “a trading security,” or “available-for-sale”.

Learning Objectives

Summarize how to record the sale of a held-to-maturity, trading security and available for sale debt

Key Takeaways

Key Points

  • Because of fluctuations in market value, held-to- maturity debt is not periodically adjusted while owned. Recording the sale is simply a matter of recording how much cash was received and recording any gain or loss from the transaction.
  • The book value of trading security debt changes based on its market value. Any increase or decrease in the value of the debt is recorded as an unrealized gain or loss in a company’s income statement. Any gain or loss from the sale is based on the current book value of the debt.
  • The book value of available-for-sale debt changes based on market value. Any increase/decrease in the value of the debt is recorded as an unrealized gain/loss in equity. When debt is sold, the company should recognize all unrecognized gain/loss, and the gain/loss based on the current book value.

Key Terms

  • trading securities: any financial instrument an investor acquires and intends to resell in the short-term
  • available-for-sale: securities that do not qualify as “held-to-maturity” or as a “trading security”
  • Held-to-maturity: any security that an investor intends to retain until its term expires

Under FASB 115, a part of US GAAP (Generally Accepted Accounting Principles), a company must classify all of the debt securities it owns into one of three categories. If the company intends to hold the debt until it matures, it must be classified as a “held-to-maturity” security. If the company acquires the debt with the intent to resell it in the short-term, then it must be listed as a “trading security. ” If the debt is acquired without the intent to resell it in the short-term, nor the intent to hold it to maturity, it should be classified as “available-for-sale”. Each of these three classifications is treated differently for accounting purposes, both prior to sale and during the sale.

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A bond certificate: A bond certificate issued via the South Carolina Consolidation Act of 1873. How the sale of a bond is recorded on a company’s books depends on how the debt is initially classified by the acquiring investor. Debt securities can be classified as “held-to-maturity,” a “trading security,” or “available-for-sale. “

Held-to-Maturity

When debt is acquired and is intended to be held until maturity, it is recorded first by debiting a “Debt Investment Account,” and then by crediting “Cash” for the amount the debt was purchased. For example, if a company purchased $1000 in debt securities, the transaction would be recorded like this:

Investments – Corporate Debt: $1000

Cash: $1000.

While the market value of the debt may vary over time, the company does not need to adjust the value of the debt on its books. Once the company sells the bond, it must report any gains or losses on the sale of the debt. So, in the example above, if the company sold the debt for $1200, it would need to make the following journal entry.

Investments: $1000

Net Gain on Sale: $200

Cash: $1200

If the company sold the debt for $800, it would need to make the following journal entry:

Investments: $1000

Cash: $800

Net Loss on Sale: $200

Trading Securities

If a company acquires debt that it intends to sell in the short-term, it must still record the sale. If a company acquired debt for $1000, and this debt is classified as a trading security, the company would still need to make the first journal entry in the aforementioned manner.That being said, the value of the debt on the owner’s books must be adjusted to match the market value of the debt. For example, if the market value of the debt declined $200 from its original value to $800, a company would need to make the following journal entry:

Unrealized loss on trading security: $200

Investments: $200

The unrealized loss would be included on the company’s income statement for the period it was recorded. If immediately after the accounting period, the company sold the debt for $800, it would need to make the following journal entry:

Cash: $800

Investments: $800

Because both the loss and the decrease in the debt asset ‘s value were already recorded in the prior accounting period, the company would not have to make any additional adjustments.

Available-for-Sale

If a company acquires debt that is available-for-sale, it would still need to make a first journal entry in the same way that it would if the debt was “held-to-maturity” or a “trading security. ” It would also need to adjust the value of its debt asset in relation to its current market value. Using the same example above, assume a debt asset was acquired for $1000 but declined in value by $200. In the case of an available-for-sale asset, the following journal entry should be made in the following accounts:

(Equity) Unrealized loss on security investment: $200

(Asset) Investments: $200

Unlike trading securities, the unrealized gain is recorded in the equity section of the balance sheet and does not effect the current year income statement at all. This is because, unlike trading securities, the loss from an available-for-sale security is not expected to be realized in the near future. Returning to the example, assume that the debt asset is sold immediately after the end of the accounting period where it first recognized the unrealized loss. The asset is sold for $800. In such a case, the following entries would be appropriate:

(Asset) Cash: $800

(Income Statement) Loss on Investment: $200

(Asset) Investments: $800

(Equity) Unrealized loss on security investment: $200

The result of the journal entry is that the unrealized loss is realized, so the company’s profit for the period is decreased by $200. The debt asset, as well as the unrealized loss, is removed from the company’s books.

Accounting for Sale of Stock

How the stock sale is accounted for depends on the type of stock sold.

Learning Objectives

Summarize how to account for the sale of common stock, preferred stock and treasury stock

Key Takeaways

Key Points

  • For common stock at par value, debit cash and credit common stock. For common stock sold above par, debit cash, credit common stock, and credit additional paid in capital.
  • For preferred stock, debit cash and credit preferred stock.
  • For sales of treasury stock, debit cash and credit treasury stock.

Key Terms

  • preferred: Preferred stock.
  • par value: The amount or value listed on a bill, note, stamp, etc.; the stated value or amount.

Accounting for the Sale of Stock

Often times companies offer their stock for sale as a way to generate cash. How the stock sale is accounted for depends on the type of stock sold. Most stock sales involve common stock or preferred stock.

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Sale of Stock.: Often times companies offer their stock for sale as a way to generate cash. How the stock sale is accounted for depends on the type of stock sold. Most stock sales involve common stock or preferred stock.

Common Stock-sold at par value

Journal

entry

Debit cash

Credit common stock

If the common stock is sold above par value the journal entry is slightly different.

Debit cash

Credit common stock

Credit additonal paid in capital (to account for the difference between par value and sell value)

Preferred Stock

The sale of preferred stock is similarly treated, but a separate accounts should be established to record preferred stock and any additional paid in capital for preferred stock sold at above par value.

Journal entry

Debit cash

Credit preferred stock

Credit additional paid in capital preferred stock (if needed)

Treasury stock

Treasury stock is issued stock that the company has bought back from its shareholders. Since a corporation can’t be its own shareholder, the “bought back” stocks are not considered assets of the corporation. Treasury stock also doesn’t have the right to vote, receive dividends or receive liquidation value.

If the company plans to re issue the shares in the future, it would hold them in treasury and report the reduction in stockholder’s equity on the balance sheet.

There are several reasons a company may purchase treasury stock, it may need it for employee compensation plans, to buy another company or to reduce the number of outstanding shares.

Journal entry

Debit treasury stock

Credit cash

When treasury stock is sold the accounts used to record the transaction will vary depending on whether the stock sold above or below the cost of purchase.

Sold above purchase cost

Debt cash

Credit treasury stock

Credit additional paid in capital (the difference between sale price and purchase price)

Assessing Fair Value

Companies must calculate the fair market value for these available for sale securities at the end of each subsequent accounting period.

Learning Objectives

Explain why a company calculates the fair market value of available for sale securities

Key Takeaways

Key Points

  • The difference between the purchase price and the current fair market value results in a an unrealized gain or loss.
  • Realized gains and losses are included in income; unrealized amounts are included in income (trading investments) or in other comprehensive income (available-for-sale investments).
  • Unrealized holding gains (unrealized because asset is not sold yet)-increase in fair value of an asset while held.
  • Realized holding gain (realized through sale) increase in fair value of an asset while held.

Key Terms

  • unrealized: Not realized; possible to obtain, yet not obtained.

Fair Value Method

Often companies use excess cash to purchase stocks and bonds from other companies. If a company purchases stocks or bonds with the intent to sell these items at a future date when they need cash, these are referred to as “Available-for-sale securities”.

A company initially records the “available for sale securities” at cost. While holding onto the securities the company must calculate the fair market value for these securities at the end of each subsequent accounting period.

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Debt: A company initially records the “available for sale securities” at cost. While holding onto the securities the company must calculate the fair market value for these securities at the end of each subsequent accounting period.

The difference between the purchase price and the current fair market value results in an unrealized gain or loss. The unrealized gain or loss affects the company’s accumulated other comprehensive income, a component of stockholders’ equity.

Realized gains and losses are included in income; unrealized amounts are included in income (trading investments) or in other comprehensive income (available-for-sale investments).

Unrealized holding gains (unrealized because asset is not sold yet)-increase in fair value of an asset while held.

Realized holding gain (realized through sale) increase in fair value of an asset while held.

Using the fair value method, available for sale investment with unrealized gains and losses included in other comprehensive income should have:

  • The original investment is recorded at its investment cost.
  • Transaction costs, such as brokerage fees, included in acquisition cost and capitalized, or immediately expensed.
  • Interest or dividends declared are recorded as investment income.
  • Interest income includes amortization of any premium or discount inherent in the initial purchase price
  • At the end of each reporting period, the investments are revalued to fair value (market
  • value), whether this is higher or lower than the existing balance in the investment account.
  • Unrealized holding gains, defined as the difference between the existing balance in the
  • investment account (the new fair value) and the old fair value, are recorded in other comprehensive income.
  • The investment is reported at fair value on the balance sheet.

Using the fair value method, available for sale investment with unrealized gains and losses recognized in net income should have:

  • The original investment is recorded at its investment cost. This is fair value on the purchase date.
  • Transaction costs, such as brokerage fees, may be included in acquisition cost and capitalized, or immediately expensed.
  • Interest or dividends declared are recorded as investment income.
  • At the end of each reporting period, the investments are revalued to fair value, whether
  • this is higher or lower than the existing balance in the investment account.
  • Holding gains, defined as the difference between the existing balance in the investment
  • account (the new fair value) and the old fair value, are recorded in net income.
  • The investment is reported at fair value on the balance sheet.


Source: Accounting