Lower of cost or market (LCM)
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10 -9. Copyright © 2011. Marty J.Schmidt.
Please note this item is under revision today and some sections may be incomplete during this process. Please return tomorrow for the complete revision.
Lower of cost or market (LCM) is an accounting rule for valuing inventory and, under certain conditions, securities holdings. Under the lower of cost or market rule, the reported value of inventory or eligible securities at the end of an accounting period is the lower of either (a) cost or (b) value in the market.
This encyclopedia item further defines and illustrates the LCM rule with examples in the context of related terms, including:
• Lower of cost or market (LCM) | • Minority passive investments |
Sections below show how the lower of cost or market rule can be applied for inventory and sometimes for securities holdings Also shown are examples of accounting adjustments necessary when values change under the LCM rule.
Purpose of the Lower of Cost or Market (LCM) Value Rule
Applying the Lower of Cost or Market Rule
Reporting Inventory and the LCM Rule
Determining Inventory Value Under the LCM Rule
Accounting for Inventory LCM Changes
Reporting Securities and the LCM Rule
Cost or Market Rule to Securities
Determining Securities Cost and Market
Accounting For Changes in Securities Values
Purposes of the Lower of Cost or Market (LCM) Value Rule
The lower of cost or market rule serves several purposes consistent with international accounting standards and the Generally Accepted Accounting Principles (GAAP) of most countries.
1. Realistic, verifiable, and objective reporting.
Inventories and some securities holdings are carried on the company's balance sheet as current assets. The reported values of these assets thus contribute heavily to financial metrics for evaluating company performance and company financial position—metrics such as working capital, current ratio, and return on assets. These asset values should be stated realistically, that is, they should represent something close to actual cost, replacement cost, or current market value (as described below).
If assets are reported at values that are unrealistically high or low, are unrealistically high or unrealistically low, the result is a misleading and unreliable picture of company financial performance and financial position.
2. The matching concept: Revenues are matched with expenses that brought them.
The matching concept is an accounting principle. whereby expenses are recognized in the same accounting period as the revenues associated with them. The lower of cost or market rule can serve to implement the matching principle, by ensuring that expenses for, say, loss of inventory value, are reported in the same period as revenues associated with sales of that inventory.
3. The conservatism principle: Choose the option that results in lower net income and/or lower asset value.
The LCM rule is also used specifically to implement the accounting principle of conservatism. The conservatism principle (incorporated in GAAP in most countries) directs that in situations having two acceptable alternatives for reporting value of an item, accountants should choose the reporting method that results in lower net income and/or lower asset value.
The universal use of an objective LCM rule for choosing between competing alternatives means that those who read and use financial reports can expect to see always the more conservative appropriate values for inventories and securities.
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Applying the Lower of Cost or Market Rule
Most assets are initially valued at acquisition cost, but after that, in subsequent reporting periods, the appropriate method for re-valuing assets can vary substantially depending on:
- The classes of assets, e.g., inventory, assets, wasting assets, intangible assets, or property, plant and equipment, for instance.
- The purposes the asset is used for (e.g., whether securities are held for long term objectives or short term profits).
- The method of acquisition (e.g., from an open market, or by privately negotiated deal).
- The year of acquisition (before or after certain regulations were issued), tax laws.
- Reporting choices made by the company's accountants, company policy and practice, as well the country's generally accepted accounting principles. .
Examples in this encyclopedia entry illustrate general accounting principles involved in LCM, but they are not meant as a complete guide for all circumstances. With this reality in mind, it will be helpful to introduce several cost- and valuing-related terms involved in applying the LCM rule.
- Book value (or reported value) of an asset. The asset's balance sheet value, after all adjustment's for depreciation/amortization and/or mark to market accounting, or application of the lower of cost or market rule.
- Cost, or acquisition cost, or historical cost. The cost actually paid for acquiring the asset, including purchase price but also any other acquisition costs (such as brokerage fees, or shipping expenses). This cost remains fixed throughout the life of the asset. It is not adjusted upwards for inflation. Cost in this sense is one of the two figures compared when making the "cost vs. market" choice to apply the LCM rule.
- Replacement cost. The cost of replacing an asset, including acquisition costs. It is quite possible for replacement cost to be either less than the asset's current selling price in the market, or more than its current selling price. A retailer, for instance, might sell finished goods to consumers in the retail market, but obtain finished goods inventory from a wholesaler or directly from the manufacturer. In such cases, replacement cost would likely be less than market price. On the other hand, if the company has to purchase other inventory at the market price, that plus additional acquisition costs will put replacement cost above the market price.
- Market selling price: The price that buyers currently pay in the market for the inventory or securities. Those familiar with securities markets know that securities prices can fluctuate above or below historical cost over time. The same is true for the price of most kinds of inventory. When the inventory consists of commodities such as oil, for instance, price is likely to fluctuate widely over time, above or below purchase price.
- Net realizable value (NRV): The current market selling price of the asset, minus any costs for selling, disposing, otherwise getting rid of the asset.
- Market value: The figure used as "market" value to compare with "cost" when applying the LCM rule. For purposes of applying the LCM rule, Market will be taken as replacement cost (defined above), except that the LCM market value must fall between two limits:
- Upper limit for market (market ceiling): Net realizable value (NRV) is the upper limit for the LCM market value. If, say, replacement cost is higher than net realizable value, then LCM market value will be taken instead as the NRV.
- Lower limit for market (market floor): The lower limit for LCM market value is the net realizable value minus normal profit. When replacement cost is less than NRV minus normal profit, LCM market value is taken instead as the market floor, that is NRV minus normal.profit.
When replacement cost is between the market floor and market ceiling, market value is taken as replacement cost. Table 1 below summarizes rules for setting "Market" value for the LCM comparison with a "Cost" figure.
| Condition | Market Value = |
|---|---|
| Replacement cost < Market floor < Market ceiling | Market = Market floor |
| Market floor < Replacement cost < Market ceiling | Market = Replacement cost |
| Market floor < Market ceiling < Replacement cost | Market = Market ceiling |
| Table 1. Market value is taken as inventory replacement cost, except when replacement cost is either above the market ceiling (in which case market value is taken as the ceiling) or below the market floor (in which case market value is taken as the floor). | |
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Reporting Inventory Under the Lower of Cost or Market Rule
How are "cost" and "market" values determined for inventory in order to apply the lower of cost or market rule? How do accountants recognize changes in inventory value under the rule? These questions are addressed in the two following sections.
Determining Inventory Value Under the LCM Rule
Under the LCM rule, inventory value is determined and reported each reporting period. The specific prescribed accounting methods for doing so vary slightly from country to country and accountants applying the rule should be familiar with local policies and practices.
Regarding inventory values and reporting in the United States, accountants should be famiiar with US Government IRS Publication 946, "How to Depreciate Property," as well as statements from the Financial Accounting Standards Board (FASB) and APB Accounting Research Bulletins (ARBs). Chapter 4 of ARB No 43, its ammendment, FASB FAS 151, and subsequent ammendments. for example, are especially relevant for the LCM rule.
As an example, consider a situation with a single inventory account to be valued at the end of each period. Consider here, in Table 2, below, four successive fiscal year quarters with the following inventory data standing at the end of each quarter:
| INVENTORY DATA | End of FY Q1 | End of FY Q2 | End of FY Q3 | End of FY Q4 |
|---|---|---|---|---|
| COST FOR LCM COMPARISON | ||||
| 1. The cost (Historical cost) | $100,000 | $95,000 | $85,000 | $72,000 |
| FACTORS FOR DETERMINING THE MARKET | ||||
| 2. Replacement cost | $107,000 | $95,000 | $90,000 | $75,000 |
| 3. Selling price in the market | $120,000 | $90,000 | $86,000 | $80,000 |
| 4. Cost to sell or dispose | $2,100 | $2,000 | $1,900 | $1,800 |
| 5. Normal profit | $12,000 | $9,000 | $8,600 | $8,000 |
| 6. Mkt ceiling: Net realizable value (NRV) Row 3 – Row 4 | $117,900 | $88,000 | $84,100 | $78,200 |
| 7. Mkt floor: NRV – Normal profit Row 6 – Row 5 | $105,700 | $79,000 | $75,500 | $70,200 |
| MARKET FOR LCM COMPARISON | ||||
| 8. The Market | $107,000 Row 2 | $88,000 Row 6 | $84,100 Row 6 | $75,000 Row 2 |
| RESULT | ||||
| 9. LCM Reported inventory | $100,000 The Cost | $88,000 The Market | $84,500 The Market | $72,000 The Cost |
Table 2. At the end of each reporting period (fiscal year quarters), an accountant choose between "Market" or "Cost" as the appropriate reported value for inventory. uses the data provided here and the rules presented above and below, in order to | ||||
Data in Table 2 are used to apply the LCM rule, resulting in a reported inventory that is either "Cost" or "Market." Note that inventory levels can fluctuate from quarter end to quarter end, Also, the factors in Rows 2 through 8 of Table 2 can change from quarter to quarter.
At each quarter end, however, accountants determined the reported inventory value under lower cost or market as follows
End of Q1: Inventory Acquired, Valued at Cost
At the end of Q1, the replacement cost ($107,000, Row 1) is used as the Market value for LCM comparison (Row 8), because Replacement cost is between the Market ceiling ($117,900, Row 6) and the Market floor ($105,700, Row 7). That is,
- Market Floor < Replacement Cost < Market Ceiling, therefore Market = Replacement cost.
- Under LCM, Reported inventory value (Row 9) is taken as the $100,000 Cost (Row 1) because Cost is lower than Market value ($107,000, Row 8). That is, Cost < Market, therefore report Cost.
End of Q2. Inventory Re-Valued to Market
At the end of Q2, the Market value for LCM Comparison (Row 8) is taken as the Market ceiling, or NRV ($88,000, Row 6), because Replacement cost ($107,000) is greater than the Market ceiling. That is,
- Market Floor < Market Ceiling < Replacement Cost, therefore Market = Market Ceiling.
- Under LCM, Reported inventory value (Row 9) is taken as the $88,000 Market value because Market is less than Cost. That is, Market < Cost, therefore report Market.
End of Q3. Inventory Re-Valued Again to Market
At the end of Q2, the Market value for LCM Comparison (Row 8) is taken as the Market ceiling, or NRV ($84,100, Row 6), because replacement cost ($90,000) is greater than the Market ceiling. That is,
- Market Floor < Market Ceiling < Replacement Cost, therefore Market = Market Ceiling.
- Under LCM, Reported inventory value (Row 9) is taken as the $84,500 Market value because Market is less than Cost. That is, Market < Cost, therefore report Market.
End of Q4. Inventory Re-Valued to Cost
At the end of Q4, the replacement cost ($75,000, Row 1) is used as the Market value for LCM Comparison (Row 8), because Replacement cost is between the Market Ceiling ($78,200, Row 6) and the Market Floor ($70,200) That is,
- Market Floor < Replacement Cost < Market Ceiling, therefore Market = Replacement cost.
- Under LCM, Reported inventory value (Row 9) is taken as the $72,000 Cost (Row 1) because Cost is lower than the Market value ($75,000, Row 8). That is, Cost < Market, therefore report Cost.
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Accounting for Inventory LCM Changes
Inventory levels can change from reporting period to reporting period, as mentioned above, due to product sales, inventory replenishment, spoilage, obsolescence, and other factors. With a double entry accounting system (as used by the vast majority of businesses), bookkeepers and accountants recognize a change in inventory level from such factors with at least one pair of account transactions, which may involve accounts having to do with inventory, cash on hand, sales revenues, accounts receivable, cost of goods sold expenses, spoilage expense, and others.
For purposes of clarity and simplicity, however, transactions due to changes in inventory level of these kinds are omitted from the examples in this section. Instead, this section focuses just on additional transactions that recognize the change from reporting inventory at "Cost" to reporting "Market", or the reverse.
Consider again the four end-of-period inventory reports summarized above in Table 2. The same period-end Cost and Market figures are repeated below in Table 3, but this table also shows the reported balance in three accounts:
- An inventory account as reported on the balance sheet. This is a balance sheet asset account that carries (like other asset accounts) a debit (DR) balance. The reported value for this account results from applying the LCM rule.
- An allowance account for LCM. This account is a contra asset account—a balance sheet account—carrying a credit (CR) balance.
- An LCM Expense account—an income statement account—carrying a debit (DR) balance.
Date | Cost | Market | Reported inventory account DR balance | Allowance acct. reducing inventory to LCM CR balance | Loss expense acct. reducing inventory to LCM DR balance |
|---|---|---|---|---|---|
| End FY Q1 | $100,000 | $107,000 | $100,000 | $0 | $0 |
| End FY Q2 | $95,000 | $88,000 | $88,000 | $7,000 | $7,000 |
| End FY Q3 | $85,000 | $84,100 | $84,100 | $900 | $900 |
| End FY Q4 | $72,000 | $75,000 | $72,000 | $0 | $0 |
| Table 3. Account balances in three accounts at the end of four reporting periods, including periods in which inventory reported value is changed from "cost" to "market" (FY Q2) and then back to "cost" (FY Q4). Changes in several other accounts due to changes in inventory level are not shown here. | |||||
End of Q1: Inventory Acquired, Valued at Cost
From the time it was acquired through the end of Q1, this inventory has been valued at "cost," because cost had always been lower than "market."
- The Allowance account has $0 balance since no LCM adjustments have been made.
- Similarly, the Loss expense account has $0 balance for the same reason.
End of Q2. Inventory Re-Valued to Market
During Q2, Market value (as determined in the previous section) fell below Cost. The Cost value, moreover, stands $7,000 greater than the Market value. In applying the LCM rule to move to a reported value below cost, two adjusting transactions are applied to recognize the loss of value.
- The allowance account for reducing inventory to LCM must now show a credit balance of $7,000. A credit (CR) transaction of $7,000 to this contra asset account increases account balance to that level.
- The loss expense account for reducing inventory must now show a debit balance of $7,000. A $7,000 debit (DR) transaction to this expense account increases account balance to that level.
| Date | Account | Debit | Credit |
| 31-Jun-12 31-Jun-12 | 895 Loss expense reducing inventory to LCM 125 Allowance, reducing inventory to LCM | $7,000 | $7,000 |
End of Q3. Inventory Re-Valued Again to Market
At the end of Q3, both inventory market value and cost stood at lower levels than in the previous quarter. The reported inventory value will again be Market, because Market (as determined above) is still below cost, however the difference between Market and Cost is smaller than at the end of Q2.
- Market ($84,100) is now only 900 below the Cost figure ($85,000), and so the allowance account for reducing inventory to LCM must now show a credit balance of $900. A debit (DR) transaction of $6,100 to this contra asset account decreases the account CR balance to $900.
- The loss expense account for reducing inventory must now show a debit balance of $900. A credit (CR) transaction of $6,100 to this expense account decreases the account DR balance to that level.
| Date | Account | Debit | Credit |
| 30-Sept-12 30-Sept-12 | 124 Allowance, reducing inventory to LCM 895 Loss expense reducing inventory to LCM | $6,100 | $ 6,100 |
End of Q4. Inventory Re-Valued to Cost
At the end of Q4, the inventory Cost is again below Market, which means that Cost will again be the reported value. This requires that the two adjustment accounts be brought to back to 0 balance
- Because Cost is again below Market, the contra asset allowance account receives a $900 debit to bring its balance to $0.
- For the same reason, the loss expense account receives a $900 credit to bring its balance to $0.
| Date | Account | Debit | Credit |
| 31-Jun-2012 31-Jun-2012 | 124 Allowance, reducing inventory to LCM 895 Loss expense reducing inventory to LCM | $900 | $900 |
Examples in this and the previous section show valuation and reporting for a single inventory account. Note that the reporting accounting usually has freedom to choose between applying the LCM rule to the value of all inventory, to the values of different classes of inventory, or even item by item through the inventory. The latter approach is generally the most conservative of these approaches (is least likely to overstated income or asset values.
Impact of LCM Changes on Income Statement and Balance Sheet
The balance sheet is impacted when the contra asset allowance account carries a non-zero balance. The allowance account balance reduces the book value of reported inventory by the balance amount.
The income statement is impacted when the loss expense account carries a non zero balance. This expense (account balance), like other income statement expenses, is subtracted from net sales revenues to lower reported profits.
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Reporting Securities and the Lower of Cost or Market Rule
Securities held as company assets include both debt instruments (corporate bonds, government bonds, and treasuries, e.g.) and equity instruments (e.g., corporate stock shares). The term securities also includes derivative instruments such as options, futures, and swaps.
Just how these securities are valued and reported (whether or not the lower of cost or market rule applies) can depend on several factors, including the purpose for acquiring them and the length of time they will be held. Note that the valuing and reporting of securities is an area that includes controversies and room for choice by the reporting company's accountants.
For the accounting practice in the United states, see, for example US Financial Reporting Standard 25 (FRS 25) "Accounting for Investments," from the Council on Corporate Disclosure and Governance (CCDG). Accountants in the US should also be familiar with Financial Accounting Standards Board publication FAS 115 "Accounting for Certain Investments in Debt and Equity Securities" and its subsequent ammendments. This publication has been the moving force behind a strong trend in the US towards valuing marketable securities at Market ("mark to market" rule) instead of "lower of cost or market." In the US, in fact, the lower of cost or market rule is rarely used now for securities.
With these cautions in mind, the following summary summary of valuing methods should be viewed simply as a representative sample of methods that may be applied in a given situation.
Class of Securities Assets Holdings
Investments in Securities vs. Marketable Securities
Valuing and Accounting for Investments in Securities
Minority, Passive Investment
Minority, Active Investment
Majority, Active Investment
Valuing and Accounting for Marketable Securities
Trading Securities
Securities Available for Sale
Debt Held to Maturity
Derivative Instruments
Classes of Securities Assets Holdings
In order to understand the place of the lower of cost or market rule among these methods for valuing securities it will be help
In order to understand the place of the lower of cost or market rule among these methods for valuing securities it will be helpful to put LCM rule in context with other securities valuing methods. Accordingly, this entry describes valuing methods for a wide range of securities holdings, organized as follows:
| SECURITIES ASSETS | Kind of securities | Initially valued at... | Subsequent valuations at |
|---|---|---|---|
| Investments in Securities | |||
| Minority, passive investment | Equity | Cost | Market or Lower of cost or market |
| Minority, active investment | Equity | Cost | Equity method |
| Majority, active investment | Equity | Cost | Equity method |
| Marketable securities | |||
| Trading securities | Equity or debt | Cost | Market or Lower of cost or Market |
| Available for trading | Equity or debt | Cost | Market or Lower of cost or Market |
| Debt held to maturity | Debt | Cost | xxxxx |
| Derivative instruments | |||
| Derivatives with available market | Derivative | Cost | xxxxx |
| Derivatives, negotiated purchase | Derivative | Cost | xxxxx |
| Table 4. Representative valuing methods for different classes of securities assets. In some of these areas there is either controversy regarding the appropriate valuing method, or some room for flexibility and choose on the part of the reporting company. | |||
Investments in Securities vs Marketable Securities
For accounting purposes, the majority of debt and equity securities assets are classified either as investments in securities or marketable securities. Securities assets are considered marketable securities if two conditions apply
- There is an active, accessible market for the securities. This means the securities can be considered liquid assets with a market value that is reliably assessed.
- The company may sell the securities when it needs the cash or there is a financial advantage for doing so..
If either condition does not apply, it is assumed that the securities were acquired for long term objectives and they are reported as long term assets. Equity securities held for long term objectives which do not meet both of the above criteria are called Investment in Securities assets, not marketable securities.
Investments in Securities: Minority Passive Investments
When Company A owns less than 50% of the voting stock in Company B, and when Company A does not attempt or intend to attempt to use its minority ownership to influence or control actions or decisions company B, A may be said to have a minority passive investment interest in B. In fact, However, the "minority passive" designation is usually applied only when one company owns 20% or less of another company's stock: there is a presumption that 20% ownership or greater implies an "active" interest.
The minority passive owner initially records the investment at acquisition cost. In many countries other than the United States, minority passive securities holdings are valued and reported under the lower of cost or marketing rule. In the US, however, the rule may or may not be applicable, depending on local policies and practices. In some US locales, subsequent values will be reported at Market value, regard,less of whether Market is above or below cost. In any case, for reporting minority passive investment securities in subsequent periods....
- Any dividends received from the minority passive investment are recorded and reported as revenues.
- The securities assets are reported (a) Market, or (b) Lower of cost or market. Adjustments to a new value from the previous period end value can be accounted for with two equal, offsetting adjustment transactions such as those illustrated above for inventory valuing.
- A debit to a "Loss expense" account will impact reported profits on the income statement.
- A credit to a contra asset "allowance account" will impact book value of the asset.
- If the assets have been sold during the accounting period, the adjustment accounts are brought zero and a gain or loss is measured with respect to acquisition costs, bringing the appropriate tax consequences.
Investments in Securitie: Minority Active Investments
The classification minority active investments usually applies to companies owning between 20% and 50% of the voting stock in another company, which do attempt to use this ownership to influence or control that company. In such cases, Company A is said to have a minority active investment interest in B.
Even though Company A does not have majority ownership of B, A can still attempt to exert influence by acting in concert with other minority owners to form a majority voting block (e.g, enlisting other shareholders in a proxy fight). Or, minority owners may exert influence simply by threatening to acquire enough additional stock to give them majority ownership (i.e., threaten takeover).
When Company A takes an Active investments interest in influencing or controlling Company B, even though it has a minority ownership, A must use the equity method of accounting for valuing and reporting is securities assets (Company B stock shares). As with the passive investment situation, active owners first record minority ownership stock at cost.
Equity securities held as minority active investment are initially valued at Cost. At the end of reporting periods, however, the equity method of valuation is applied:
- Each period, the investing firm recognized revenue equal to its proportionate share of the firm. The investing company's (Company A's) proportional share of the associate company's net income increases the investment and a net loss decreases the investment.
- On Company A's income statement, the proportional share of Company B's net income or net loss is reported as a single line item.
- When company B pays dividends, A's proportional share of dividends are not considered revenue, but rather a return of capital. A's investment is decreased by the amount of dividends paid.
- Dividends reduce the asset and are not revenue but rather a return of capital.
Investments in Securities: Majority Active Investments
When company A owns more than 50% of Company B, A is in a position to exercise absolute control over B. In such cases, A is said to be the parent company, and B is its subsidiary. In such cases:
Company A and Company B can be separate legal entities, but for financial accounting purposes (at least in the US), they are required to file combined financial statements (called consolidated financial statements).
Because one economic entity can control several legal entities and because there is a risk that income might be manipulated by economic transactions between the legal entities,U.S. GAAP requires that the financial statements of legally separate entities be combined under one controlling economic entity and that one set of financial statements called the consolidated financial statements be produced.
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Classes of Marketable Securities
Securities holdings for which (a) there is an accessible, active market, and (b) the company intends to sell or may sell when it is advantageous to do so, meet the two criteria for marketable securities.
When marketable securities are first acquired they are valued in the same way that most classes of assets are initially valued--at acquisition cost. Acquisition cost for securities includes purchase price, of course, but also other costs related to the acquisition such as brokerage commissions.
For subsequent reporting periods, however, the reported value of marketable securities may be subject to the lower of cost or market rule, or they may be subject to the mark to market rule, depending on on local policies and practice.
Marketable securities are classified as:
- Trading securities
Securities assumed to be held for relatively short term gains. It is assumed that securities in this class will be actively traded. - Securities available for sale
Securities which may or may not be held for long term gains. Marketable securities in this class are typically acquired and held for a while to meet a specific cash need (e.g., to retire bonds the company has issued that will be coming due). - Debt held to maturity
Debt securities (e.g., bonds) which the company has both the intent and ability to hold to maturity, and firm has both the positive intent & to hold to maturity. - Derivative Instruments
Options, swaps, or futures, held by the company either as insurance or intended as profit making investments in their own right. - If there is an open, accessible market for the derivatives, they may be called marketable securities.
- Derivatives which are acquired through private negotiated contract, which are not traded on an open market, are not classified as marketable securities.
Marketable Securities: Trading Securities
Trading securities may be either equity or debt securities, assumed to be held for short-term gains. Trading security portfolios are typically characterized by frequent, active buying and selling for the purpose of making profit. As a result, trading securities are carried on the balance sheet as current assets. The vast majority of trading securities are held by financial institutions.
Trading securities are first recorded in a balance sheet assets account valued at acquisition cost. For a $100,000 acquisition of equity securities purchased with cash, and to be held as trading securities, the acquisition transactions would be as follows. Note that the acquisition occurred in the middle of a reporting period, Q4 FY 2012.
- A $100,000 debit (addition to) a current assets account for marketable securities.
- A $100,000 credit (decrease) to a current assets account for cash on hand.
| Date | Account | Debit | Credit |
| 15-Nov12 15-Nov-12 | 895 Marketable securities 125 Cash on hand | $100,000 | $100,000 |
- If, for example, market value increases by $5,000 by end of the quarterly reporting period, and if the accounting policy is mark to market, the change in value will be recognized with two more transactions. At the end of, Q4:
- A $5,000 debit (addition to) a current assets account for marketable securities.
- A $5,000 credit (increase) to an income statement revenue account for unrealized holding gain.
| Date | Account | Debit | Credit |
| 31-Dec-12 31-Dec-12 | 895 Marketable securities 125 Unrealized holding gain | $5,000 | $5,000 |
- If, instead of increasing in value, the market value for these securities had decreased, the adjusting transactions would have included a credit (decrease) to Marketable securities and a debit (decrease) to unrealized holding gain.
- Net gains and losses for trading securities impact income statement income for the period they are reported, even if the gains or losses are not yet realized in that period, because there is a presumption that they will in fact be realized in the short term.
- If the securites are sold during Q1 for $120,000, they will have brought a net gain of $20,000 over their original acquistion cost.of $100,000. Of this gain, however, $5,000 have already been closed to income as unrealized gains (above). Three more transactions are required to recognize the sale:
- A $120,000 debit (increase) to a cash account, recognizing receipt of funds for the sale.
- A $105,000 credit (decrease) to marketable securities. This was the last reported value for the securities that are no longer held.
- A $15,000 credit (increase) to a Realized gain account.
| Date | Account | Debit | Credit |
| 31-Mar-12 31-Mar-12 31-Mar-12 | 101 Cash on hand 125 Marketable securities 333 Realized gain on securities | $120,000 | $105,000 $15,000 |
The realized gain of $15,000 appears as income on the income statement for this period.
Marketable Securities: Securities Available for Sale
Securities classified "available" for sale are neither trading securities nor securities held to maturity. They may include equity securities or debt securities. The owning company intends to sell them, but not necessarily in the short term. If they are debt securities (e.g., bonds), the company does not necessarily intend to hold them until maturity. Non financial companies typically buy and hold securities available for sale to meet a known future cash need, such as replacing factory equipment, or paying off the company's own bond issue that will come due in a few years.
Securities available for sale are valued at acquisition cost when they are first acquired. For instance a company buys securities once they are acquired for longer-term return, unrealized gains or losses that result from adjustments to market value do not pass through the income statement but stay on the balance sheet as an equity account.
Consider a situation similar to that in the previous section, but now assume that $100,000 in marketable securities will be bought and held for at least five years. Acquisition might, for instance come in the middle of Q4 FY 2012. Securities available for sale, just like trading securities, are initially valued at acquisition cost. If these were purchased with cash, two transactions would be called for at acquisition:
- A $100,000 debit (addition to) a current assets account for marketable securities
- A $100,000 credit (decrease) to a current assets account for cash on hand.
| Date | Account | Debit | Credit |
| 15-Nov12 15-Nov-12 | 895 Marketable securities 125 Cash on hand | $100,000 | $100,000 |
- If, for example, market value increases by $5,000 by end of the quarterly reporting period, and if the accounting policy is mark to market, the change in value will be recognized with two more transactions. At the end of, Q4:
- A $5,000 debit (addition to) a current assets account for marketable securities.
- A $5,000 credit (increase) to an income statement revenue account for unrealized holding gain.
| Date | Account | Debit | Credit |
| 31-Dec-12 31-Dec-12 | 895 Marketable securities 125 Unrealized holding gain | $5,000 | $5,000 |
- This unrealized holding gain for securities available for sale does not contribute to income on the income statement for the period it is posted, but appears in the equity section of the balance sheet. This contrasts with the situation for trading securities, above, whose unrealized gains or losses do impact income.
- If market value had gone down instead of up by the end of Q4, the change would have been recognized with (a) a credit (decrease) transaction to the marketable securities account and (b) a credit (increase) to an account for unrealized loss. The unrealized loss on securities availble for sale would bypass the income statement and directly impact a balance sheet equity account.
- Gains or losses for securities available for sale finally do impact income when they are sold. For this example, assume that three years later, at the end of Q3 2015, the securities are again valued at $105,000, but then at the end of Q4 2015, they are sold for $120,000. This represents a gain (profit) of $20,000 over the acquisition cost of $100,000 more than 3 years ago, recognized with the following transactions:
Date Account Debit Credit 31-Dec-15
31-Dec-15
31-Dec-15
31-Dec-15101 Cash on hand
125 Marketable securities
xxx Unrealized holding gain
xxx Realized holding gain$120,000
$20,000
$105,000
$5,000
Marketable Securities: Debt Held to Maturity
Marketable Securities: Debt Held to Maturity
Debt securities for which a firm has both the positive intent & ability to hold to maturity.
Shown on the balance sheet at the amortized acquisition cost.
Amortized acquisition cost means that the securities are amortized like a mortgage or bond.
The acquisition cost is assumed to be the present value.
The maturity value and maturity date are known from the bond certificate.
An internal rate of return can be calculated using PV techniques.
Valueing and Accounting for Derivative Instruments
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