Chapter 15, Problem 2PA

Rios Financial Co. is a regional insurance company that began operations on January 1, Year 1. The following transactions relate to trading securities acquired by Rios Financial Co., which has a fiscal year ending on December 31:

Instructions

1. 1. Journalize the entries to record these transactions.
2. 2. Prepare the investment-related current asset balance sheet presentation for Rios Financial Co. on December 31, Year 2.
3. 3. How are unrealized gains or losses on trading investments presented in the financial statements of Rios Financial Co.?

To determine

Journalize the stock investment transactions in the books of Company RF.

Explanation of Solution

Trading securities: These are short-term investments in debt and equity securities with an intention of trading and earning profits due to changes in market prices.

Journal entry: Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Debit and credit rules:

• Debit an increase in asset account, increase in expense account, decrease in liability account, and decrease in stockholders’ equity accounts.
• Credit decrease in asset account, increase in revenue account, increase in liability account, and increase in stockholders’ equity accounts.

Prepare journal entry for the purchase of 7,500 shares of Company C, at $50 per share, and a brokerage commission of $75.

Date		Account Titles and Explanations	Post. Ref.	Debit ($)	Credit ($)
Year 1
February	1	Investments–Company C Stock		375,075
		Cash			375,075
		(To record purchase of shares for cash)

Table (1)

• Investments–Company R Stock is an asset account. Since stock investments are purchased, asset value increased, and an increase in asset is debited.
• Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Working Notes:

Compute amount of cash paid to purchase Company C’s stock.

$\begin{array}{c}\text{Cash paid = }\left\{\begin{array}{l}\left(\begin{array}{l}\text{Number of shares purchased× }\\ \text{Price per share}\end{array}\right)\text{+}\\ \text{Brokerage commission}\end{array}\right\}\\ \text{= }\left(\text{7,500 shares ×\$50}\right)+\$75\\ \text{= \$375,075}\end{array}$

Prepare journal entry for the purchase of 3,000 shares of Company H, at $42 per share, and a brokerage commission of $90.

Date		Account Titles and Explanations	Post. Ref.	Debit ($)	Credit ($)
Year 1
May	1	Investments–Company H Stock		126,090
		Cash			126,090
		(To record purchase of shares for cash)

Table (2)

• Investments–Company H Stock is an asset account. Since stock investments are purchased, asset value increased, and an increase in asset is debited.
• Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Working Notes:

Compute amount of cash paid to purchase Company H’s stock.

$\begin{array}{c}\text{Cash paid = }\left\{\begin{array}{l}\left(\begin{array}{l}\text{Number of shares purchased× }\\ \text{Price per share}\end{array}\right)\text{+}\\ \text{Brokerage commission}\end{array}\right\}\\ \text{= }\left(\text{3,000 shares ×\$42}\right)+\$90\\ \text{= \$126,090}\end{array}$

Prepare journal entry for sale of 4,500 shares of Company C, at $46, with a brokerage of $110.

Date		Account Titles and Explanations	Post. Ref.	Debit ($)	Credit ($)
Year 1
July	1	Cash		206,890
		Loss on Sale of Investments		18,155
		Investments–Company C Stock			225,045
		(To record sale of shares)

Table (3)

• Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
• Loss on Sale of Investments is a loss or expense account. Since losses decrease equity, equity value is decreased, and a decrease in equity is debited.
• Investments–Company C Stock is an asset account. Since stock investments are sold, asset value decreased, and a decrease in asset is credited.

Working Notes:

Calculate the realized gain (loss) on sale of stock.

Step 1: Compute cash received from sale proceeds.

$\begin{array}{c}\text{Cash received = }\left\{\begin{array}{l}\left(\begin{array}{l}\text{Number of shares sold× }\\ \text{Sale price per share}\end{array}\right)–\\ \text{Brokerage commission}\end{array}\right\}\\ \text{= }\left(\text{4,500 shares ×\$46}\right)–\$110\\ \text{= \$206,890}\end{array}$

Step 2: Compute cost of stock investment sold.

$\begin{array}{c}\begin{array}{l}\text{Cost of stock }\\ \text{investment sold}\end{array}\}\text{ = Number of shares sold × Price per share}\\ \text{= Number of shares sold ×}\frac{\text{Cost of 7,500 shares}}{\text{Number of shares}}\\ \text{= 4,500 shares ×}\frac{\text{\$375,075}}{\text{7,500 shares}}\\ \text{= \$225,045}\end{array}$

Step 3: Compute realized gain (loss) on sale of stock.

$\begin{array}{c}\begin{array}{l}\text{Realized gain }\left(\text{loss}\right)\\ \text{on investments}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Cash received –}\\ \text{Cost of stock investment }\end{array}\right\}\\ \text{= \$206,890–\$225,045}\\ \text{= \$}\left(18,155\right)\end{array}$

Note: Refer to Steps 1 and 2 for value and computation of cash received and cost of stock investment sold.

Prepare journal entry for the dividend received from Company C for 3,000 shares.

Date		Account Titles and Explanations	Post. Ref.	Debit ($)	Credit ($)
Year 1
July	31	Cash		1,500
		Dividend Revenue			1,500
		(To record receipt of dividend revenue)

Table (4)

• Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
• Dividend Revenue is a revenue account. Since revenues increase equity, equity value is increased, and an increase in equity is credited.

Working Notes:

Compute amount of dividend received on Company C’s stock.

$\begin{array}{c}\text{Dividend received = }\left\{\begin{array}{l}\text{Number of shares × }\\ \text{Dividend per share}\end{array}\right\}\\ \text{= }\left(\text{7,500–4,500}\right)\text{ shares ×\$0}\text{.50}\\ \text{= \$1,500}\end{array}$

Prepare adjusting entry for valuation of trading securities transaction.

Table (5)

• Unrealized Loss on Trading Investments is an adjustment account used to report gain or loss on adjusting cost of investment at fair market value. Since loss has occurred and losses reduce stockholders’ equity value, and a decrease in stockholders’ equity value is debited.
• Valuation Allowance for Trading Investments is a contra-asset account. The account is credited because the market price was decreased (loss) to $276,120 from the cost of $261,000.

Working Notes:

Compute the unrealized gain (loss) as on December 31.

Step 1: Compute the fair value of the portfolio of the trading investment.

Security	Number of Shares	$\times$	Fair Market Value	=	Fair Market Value of Investment
Company C	3,000 shares	$\times$	$47	=	$141,000
Company H	3,000 shares	$\times$	40	=	120,000
Total					$261,000

Table (6)

Step 2: Compute the cost per share of Company C.

$\begin{array}{c}\text{Cost per share = }\frac{\text{Cost of 7,500 shares}}{\text{Number of shares}}\\ \text{= }\frac{\text{\$375,075}}{\text{7,500 shares}}\\ \text{= \$50}\text{.01}\end{array}$

Step 3: Compute the cost per share of Company H.

$\begin{array}{c}\text{Cost per share = }\frac{\text{Cost of 3,000 shares}}{\text{Number of shares}}\\ \text{= }\frac{\text{\$126,090}}{\text{3,000 shares}}\\ \text{= \$42}\text{.03}\end{array}$

Step 4: Compute the cost of the portfolio of the trading investment, as on December 31.

Security	Number of Shares	$\times$	Cost per Share	=	Cost of Investment
Company C	3,000 shares	$\times$	$50.01	=	$150,030
Company H	3,000 shares	$\times$	42.03	=	126,090
Total					$276,120

Table (7)

Note: Refer to Steps 3 and 4 for cost per share of Company C and Company H.

Step 5: Compute the unrealized gain (loss) as on December 31.

Details	Amount ($)
Trading investments at fair value, December 31 (From Table-6)	$261,000
Less: Trading investments at cost, December 31 (From Table-7)	(276,120)
Unrealized loss on trading investments	$(15,120)

Table (8)

Prepare journal entry for the purchase of 5,000 shares of Company F, at $25 per share, and a brokerage commission of $100.

Date		Account Titles and Explanations	Post. Ref.	Debit ($)	Credit ($)
Year 2
April	1	Investments–Company F Stock		125,100
		Cash			125,100
		(To record purchase of shares for cash)

Table (9)

• Investments–Company F Stock is an asset account. Since stock investments are purchased, asset value increased, and an increase in asset is debited.
• Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Working Notes:

Compute amount of cash paid to purchase Company F’s stock.

$\begin{array}{c}\text{Cash paid = }\left\{\begin{array}{l}\left(\begin{array}{l}\text{Number of shares purchased× }\\ \text{Price per share}\end{array}\right)\text{+}\\ \text{Brokerage commission}\end{array}\right\}\\ \text{= }\left(\text{5,000 shares ×\$25}\right)+\$100\\ \text{= \$125,100}\end{array}$

Prepare journal entry for the dividend received from Company C for 3,000 shares.

Date		Account Titles and Explanations	Post. Ref.	Debit ($)	Credit ($)
Year 2
July	31	Cash		1,560
		Dividend Revenue			1,560
		(To record receipt of dividend revenue)

Table (10)

• Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
• Dividend Revenue is a revenue account. Since revenues increase equity, equity value is increased, and an increase in equity is credited.

Working Notes:

Compute amount of dividend received on Company C’s stock.

$\begin{array}{c}\text{Dividend received = }\left\{\begin{array}{l}\text{Number of shares × }\\ \text{Dividend per share}\end{array}\right\}\\ \text{= }\left(\text{7,500–4,500}\right)\text{ shares ×\$0}\text{.52}\\ \text{= \$1,560}\end{array}$

Prepare journal entry for sale of 1,000 shares of Company F at $28, with a brokerage of $110.

Date		Account Titles and Explanations	Post. Ref.	Debit ($)	Credit ($)
Year 2
October	14	Cash		27,890
		Gain on Sale of Investments			2,870
		Investments–Company F Stock			25,020
		(To record sale of shares)

Table (11)

• Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
• Gain on Sale of Investments is a revenue account. Since revenues increase equity, equity value is increased, and an increase in equity is credited.
• Investments–Corporation E Stock is an asset account. Since stock investments are sold, asset value decreased, and a decrease in asset is credited.

Working Notes:

Calculate the realized gain (loss) on sale of stock.

Step 1: Compute cash received from sale proceeds.

$\begin{array}{c}\text{Cash received = }\left\{\begin{array}{l}\left(\begin{array}{l}\text{Number of shares sold× }\\ \text{Sale price per share}\end{array}\right)–\\ \text{Brokerage commission}\end{array}\right\}\\ \text{= }\left(\text{1,000 shares ×\$28}\right)–\$110\\ \text{= \$27,890}\end{array}$

Step 2: Compute cost of stock investment sold.

$\begin{array}{c}\begin{array}{l}\text{Cost of stock }\\ \text{investment sold}\end{array}\}\text{ = Number of shares sold × Price per share}\\ \text{= Number of shares sold ×}\frac{\text{Cost of 5,000 shares}}{\text{Number of shares}}\\ \text{= 1,000 shares ×}\frac{\text{\$125,100}}{\text{5,000 shares}}\\ \text{= \$25,020}\end{array}$

Step 3: Compute realized gain (loss) on sale of stock.

$\begin{array}{c}\begin{array}{l}\text{Realized gain }\left(\text{loss}\right)\\ \text{on investments}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Cash received –}\\ \text{Cost of stock investment }\end{array}\right\}\\ \text{= \$27,890–\$25,020}\\ \text{= \$2,870}\end{array}$

Note: Refer to Steps 1 and 2 for value and computation of cash received and cost of stock investment sold.

Prepare adjusting entry for valuation of trading securities transaction.

Table (12)

• Valuation Allowance for Trading Investments is a contra-asset account. The account is debited because the market price was increased (gain).
• Unrealized Gain on Trading Investments is an adjustment account used to report gain or loss on adjusting cost of investment at fair market value. Since gain has occurred and gains increase stockholders’ equity value, and an increase in stockholders’ equity value is credited.

Working Notes:

Compute the unrealized gain (loss) as on December 31.

Details	Amount ($)
Unrealized gain as on December 31, Year 2	$43,800
Less: Unrealized loss as on December 31, Year 1 (From Table-8)	(15,120)
Unrealized loss on trading investments	$58,920

Table (13)

To determine

Indicate the presentation of trading investments on the current assets section of the balance sheet.

Explanation of Solution

Balance sheet presentation:

Company R
Balance Sheet (Partial)
December 31, Year 2
Assets
Current assets:
Trading investments (at cost)	$376,200
Add valuation allowance for trading investments	43,800
Trading investments (at fair value)		$420,000

Table (14)

To determine

Discuss the reporting of trading investments on the financial statements.

Explanation of Solution

Unrealized gain or loss is the result of change in trading investments cost and fair values, and reported as Other Revenues (Losses) on the income statement. The unrealized gain will be added to the net income and unrealized loss will be deducted from the net income. In the Year 1, Company R would report $15,120 of unrealized loss as Other Losses on the income statement. In the Year 2, Company R would report $58,920 of unrealized gain as Other Income on the income statement.