 This topic has 11 replies, 5 voices, and was last updated Oct1710:30 pm by DollarsToDonuts.

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Up::24
Hey all, I seem to be struggling with a concept I must have forgotten from level I. Let me start you out with the problem that has been troubling me:
On 1 January 2010, Alpha invested $240,000 in debt securities of Beta. The securities carry a coupon rate of 7% payable annually on par value of $200,000. On 31 December 2010, the fair value of the securities is $270,000. Given that the market interest rate in effect when the bonds were purchased was 5%, how would alpha account for the investment on 31 December 2010 if it designated it as available for sale?
So I read the question, saw that it was straight forward and dove in:
Income Statement: Interest income = $12,000
Balance Sheet: Reported at fair value = $270,000Easy enough. But then…
Shareholders’ Equity: Unrealized gain of $32,000
Why did they subtract amortized cost ($238,000) from fair value ($270,000)??? I thought unrealized gains were calculated as fair value – initial purchase price?

Up::4
I’m confused about this too. From my understanding in AFS you would put the bond on the balance sheet at fair value $240,000. Then Alpha receives a total of $14,000 in coupons. Of that $12,000 is interest and $2,000 is amortization of the premium.
When the bond is subsequently revalued at $270,000 to determine the unrealized gains to adjust to fair value is (270,000[fair value] 240,000[price paid]+ 2000[amortized premium])= $32,000
I might have repeated what people said earlier, but it helped me to understand it by typing it all out.

Up::4
Wait I’m totally confused. If the unrealized gain/loss isn’t calculated using the amortized cost basis, then why was an unrealized gain of $32,000 reported in equity??
According to here, http://financialexamhelp123.com/investmentsinfinancialassets/,
“Unrealized gain/loss=Fair market value â€“carrying value
where carrying value is the purchase price (when reporting on the first balance sheet date after purchase) or the value reported on the previous balance sheet adjusted for any realized gain/loss (e.g., amortization) reported since the previous valuation. “

Up::3
The amortization of $2,000 is a realized loss for Alpha, that reduces the basis (carrying value) of Alpha’s investment. When we calculate the unrealized gain/loss for a given year, we always compare the fair value with the new basis rather than the initial price paid.


Up::3
Hi @dollarstodonuts – it’s not the unrealised gains/losses that are calculated using the amortised cost basis – it’s the realised gains!
The unrealised gain is because they have not sold the bond. Market interest rates have moved, causing a change in the fair value of the bond.

Up::3
@Dr_Pain28 yeah, it took me a long while to wrap my head around it. i’m glad this was of some help.
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Up::3
Hi @yoshie ! Sorry for the late response but that looks right to me. When lay it out in terms of the accounting formula I see:
Step 1
+14K (Cash Account)
+14K (Interest Income that flows to Retained Earnings)Assets and Equity go up by $14K, accounting equation balances (A = L + E).
Step 2
2K (Decrease in book value of bond, which is an asset to you)
2K (Decrease in interest income due to amortization of premium, reduces Retained Earnings)Assets and Equity again decrease by the same amount, thus leaving the accounting equation in balance.
That seems to make sense to me, unless someone else chimes in and corrects us both.

Up::2
Thanks you guys for responding. I really appreciate it.
I guess my breakdown came in at a more fundamental level, i.e. I didn’t realize that unrealized gains/losses were calculated using amortized cost basis. I think what confused me was the fact that AFS securities are reported at fair value, so I didn’t understand why amortized cost was even coming into play.
And yes, after revisiting older material, I was able to remind myself how to calculate amortized cost basis (thankfully hahah)
So I understand that the $2,000 is a realized loss for Alpha (as a result of having paid a premium for the debt). Is the unrealized gain $32,000 because if they were to realize the gain, it would effectively reverse that $2,000 realized loss, because they don’t fully eat the premium until maturity?

Up::2
Ok I think I finally have it.
January 1, 2010
Balance Sheet
Reported at purchase price of $240,000December 31, 2010
Balance Sheet
Reported at fair value of $270,000Income Statement
Interest Income of $12,000 (5% x $240,000)
Realized loss of $2,000 via amortization of premium, which is equal to the difference between the coupon received ($14,000) and interest income ($12,000)Shareholder’s Equity
Unrealized gain of $32,000, which is the fair value ($270,000) subtracted by the amortized cost ($238,000)So as it stands, Alpha has suffered a realized loss of $2,000 due to the amortization of the premium (which is a built in loss spread out over the life of the bond to recognize the fact that Alpha will only be paid par at maturity, and also due to the matching principle).
Now, if they were to sell the bond on December 31st…
Balance Sheet
Bond is removedIncome Statement
Realized gain of $32,000, which is the unrealized gain reversed from equity and now recognized on the income statement as a “reclassification adjustment”With the sale, Alpha has realized the gain of $32,000 sitting in equity. The previously realized loss of $2000 would be effectively reversed and Alpha would be $30,000 richer than when it bought the bond at $240,000.

Up::2
@DollarsToDoughnuts That was my thought process. I thought long and hard about your post and looked up a schwesser example for it. I think that you have it correct, and your explanation helped me grasp it better.

Up::1
@â€ŒDollarsToDonuts
“Income Statement
Interest Income of $12,000 (5% x $240,000)
Realized loss of $2,000 via amortization of premium, which is equal to the difference between the coupon received ($14,000) and interest income ($12,000)I assume we are saying the same thing, but can you confirm…
Double entry transactions:
Cash Account increase $14K
Interest Income Account Increase 14KBook Value of Debt Account – Amortization of Debt $2K
Interest Income Account – Decrease 2KSo you have a net interest income of 12K.
Is this correct?


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