- [Instructor] In this video,
I'm gonna show you how to account
for unrealized gains or losses
on available for sale debt investments.
So available for sale debt investments
are marked-to-market on the balance sheet.
So that means they're gonna be presented at fair value.
So we have to make changes at the end of each period
to make sure that they're at fair value.
And any unrealized gains or losses
are gonna go through other comprehensive income.
They're not going to go through net income,
they're not gonna show up in the income statement.
No changes, no realized gains or losses
are gonna hit the income statement
unless we were to actually sell
the available for sale debt investments.
So let me walk you through an example
and kind of show you how this works.
So let's say that we had this Babu's Chocolate Factory.
They issued these bonds.
And the bonds, the issue price was $92,221.
And so from the investors' point of view,
they're gonna debit debt investment
and they probably call it debt investment hyphen AFS,
available for sale debt investment for 92,221.
They're gonna credit cash for 92,221.
And then I've got a little effective interest table
that I put together here.
Now, at the end of the first year,
they're gonna need to make an adjusting journal entry
because they've received interest, right?
So the investor has been paid interest by Babu, right?
So you're gonna debit cash,
you're gonna debit debt investment.
You're basically amortizing the discount and so forth.
We've talked about those things,
so I won't get into all that.
We have another video on it.
What I wanna introduce here
is that what if at the end of year one,
the end of year one here, we say that, okay,
we look and we see that the fair value,
the fair value of the bond is now $95,000.
So the fair value of the bond is $95,000.
So you might be thinking, why,
why would the fair value be different
than the carrying value?
Because we can see at the end of year one,
we can see the carrying value of the bond is at 93,521.
So why would the fair value be different?
Well, it could be the case that maybe
between when we issued the bonds
and the end of the first year,
maybe interest rates have gone down.
Interest rates have gone down.
So now our bonds are more valuable relative to other bonds.
So for whatever reason, we look,
we see the fair value is now 95,000
and we see that the carrying value
is lower than the fair value, right?
So the fair value at the end of year one
is greater than the carrying value.
So we're gonna need to make an adjusting journal entry.
And so it seems kinda counterintuitive,
you would think you would just debit
debt investment directly
and then just increase the asset account directly
and then credit OCI, but it doesn't work like that.
We could create this silly account
called fair value adjustment.
I know it just adds complexity, I apologize,
but fair value adjustment
hyphen available for sale securities.
Okay, so what we're gonna do, we debit this
and this is going to be added,
if we were to think about our balance sheet,
if we were to look at our balance sheet,
so let me,
so here's our balance sheet
and then we've got our assets.
Okay, so we would see available for sale security.
Okay, and we would have,
if we just have the carrying value,
it would be 93,521.
But then we're gonna add the fair value adjustment.
We're gonna add that 1,479.
Okay, and if you add them together,
the net amount is 95,000,
which is the fair value.
Okay, so we have marked this to market.
That's what we're doing.
When we're debiting this fair value adjustment account,
we are marking this to market.
Now we've got a debit, we need a credit.
So what do we credit? We credit unrealized gain.
And if it had been a loss,
you know, obviously we'd be debiting a lot
and then we'd be crediting the fair value adjustment.
But we have a gain here,
so we're gonna credit the unrealized gain.
But again, this is going to OCI, other comprehensive income.
If you don't know what that is,
I've got another video on other comprehensive income.
Basically other comprehensive income is an account
that's ultimately gonna get closed out
to accumulate other comprehensive income
on the balance sheet.
But basically it increases equity.
OCI increases equity, but it bypasses net income.
Bypasses net income.
If this was accounted for as a trading investment,
okay, then it'd be unrealized gain,
but it'd be dash NI
because it would go to net income instead of OCI.
But this is available for sales security,
so it bypasses the income statement.
Okay, so equity increases,
net income is not affected, okay?
So our journal entry balances here.
Now if and when we go and actually sell
the available for sale security,
then we could recognize a realized gain
that would go and affect net income, right?
So with available for sale securities,
it's not that you will never ever affect net income,
it's just that the unrealized gains and losses
bypass the income statement, go to this OCI account.
But then when you actually sell
the available for sale security,
then you're gonna have a charge to net income
a gain or a loss.
And so that's why managers
like available for sale securities
'cause you can time when you sell
the available for sale security to get a little boost
to your net income or so forth, right?
So that's called earnings management
and we'll talk about that some more in the videos to come.