Unrealized Gains and Losses on Available for Sale Debt Investments

- [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.