WEBVTT

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- [Instructor] In this video,

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I'm gonna show you how to account

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for unrealized gains or losses

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on available for sale debt investments.

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So available for sale debt investments

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are marked-to-market on the balance sheet.

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So that means they're gonna
be presented at fair value.

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So we have to make changes
at the end of each period

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to make sure that they're at fair value.

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And any unrealized gains or losses

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are gonna go through other
comprehensive income.

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They're not going to
go through net income,

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they're not gonna show up
in the income statement.

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No changes, no realized gains or losses

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are gonna hit the income statement

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unless we were to actually sell

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the available for sale debt investments.

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So let me walk you through an example

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and kind of show you how this works.

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So let's say that we had this
Babu's Chocolate Factory.

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They issued these bonds.

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And the bonds, the
issue price was $92,221.

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And so from the investors' point of view,

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they're gonna debit debt investment

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and they probably call it
debt investment hyphen AFS,

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available for sale debt
investment for 92,221.

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They're gonna credit cash for 92,221.

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And then I've got a little
effective interest table

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that I put together here.

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Now, at the end of the first year,

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they're gonna need to make
an adjusting journal entry

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because they've received interest, right?

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So the investor has been
paid interest by Babu, right?

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So you're gonna debit cash,

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you're gonna debit debt investment.

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You're basically amortizing
the discount and so forth.

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We've talked about those things,

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so I won't get into all that.

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We have another video on it.

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What I wanna introduce here

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is that what if at the end of year one,

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the end of year one
here, we say that, okay,

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we look and we see that the fair value,

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the fair value of the bond is now $95,000.

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So the fair value of the bond is $95,000.

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So you might be thinking, why,

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why would the fair value be different

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than the carrying value?

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Because we can see at the end of year one,

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we can see the carrying value
of the bond is at 93,521.

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So why would the fair value be different?

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Well, it could be the case that maybe

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between when we issued the bonds

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and the end of the first year,

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maybe interest rates have gone down.

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Interest rates have gone down.

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So now our bonds are more
valuable relative to other bonds.

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So for whatever reason, we look,

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we see the fair value is now 95,000

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and we see that the carrying value

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is lower than the fair value, right?

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So the fair value at the end of year one

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is greater than the carrying value.

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So we're gonna need to make
an adjusting journal entry.

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And so it seems kinda counterintuitive,

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you would think you would just debit

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debt investment directly

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and then just increase
the asset account directly

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and then credit OCI, but
it doesn't work like that.

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We could create this silly account

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called fair value adjustment.

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I know it just adds
complexity, I apologize,

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but fair value adjustment

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hyphen available for sale securities.

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Okay, so what we're
gonna do, we debit this

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and this is going to be added,

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if we were to think
about our balance sheet,

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if we were to look at our balance sheet,

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so let me,

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so here's our balance sheet

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and then we've got our assets.

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Okay, so we would see
available for sale security.

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Okay, and we would have,

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if we just have the carrying value,

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it would be 93,521.

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But then we're gonna add
the fair value adjustment.

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We're gonna add that 1,479.

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Okay, and if you add them together,

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the net amount is 95,000,

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which is the fair value.

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Okay, so we have marked this to market.

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That's what we're doing.

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When we're debiting this fair
value adjustment account,

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we are marking this to market.

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Now we've got a debit, we need a credit.

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So what do we credit? We
credit unrealized gain.

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And if it had been a loss,

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you know, obviously we'd be debiting a lot

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and then we'd be crediting
the fair value adjustment.

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But we have a gain here,

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so we're gonna credit the unrealized gain.

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But again, this is going to
OCI, other comprehensive income.

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If you don't know what that is,

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I've got another video on
other comprehensive income.

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Basically other comprehensive
income is an account

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that's ultimately gonna get closed out

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to accumulate other comprehensive income

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on the balance sheet.

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But basically it increases equity.

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OCI increases equity, but
it bypasses net income.

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Bypasses net income.

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If this was accounted for
as a trading investment,

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okay, then it'd be unrealized gain,

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but it'd be dash NI

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because it would go to
net income instead of OCI.

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But this is available for sales security,

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so it bypasses the income statement.

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Okay, so equity increases,

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net income is not affected, okay?

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So our journal entry balances here.

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Now if and when we go and actually sell

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the available for sale security,

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then we could recognize a realized gain

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that would go and affect
net income, right?

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So with available for sale securities,

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it's not that you will never
ever affect net income,

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it's just that the
unrealized gains and losses

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bypass the income statement,
go to this OCI account.

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But then when you actually sell

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the available for sale security,

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then you're gonna have
a charge to net income

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a gain or a loss.

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And so that's why managers

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like available for sale securities

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'cause you can time when you sell

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the available for sale
security to get a little boost

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to your net income or so forth, right?

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So that's called earnings management

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and we'll talk about that some
more in the videos to come.