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What is the Lower Of Cost Or Market LCM Rule?

The LCM rule enables objective, verifiable reporting. It also helps implement the matching concept and the conservatism principle.

In the interest accurate accounting, businesses must sometimes report publicly that certain assets greater or less value than during a reporting period. In this context, the Lower of Cost or Market Rule (LCM) is a GAAP-compliant method for valuing inventory and, under certain conditions, securities holdings. The rule prescribes how owners can recognize publicly and officially that specific assets have a new book value.

Define Lower of Cost or Market LCM Rule

The Lower of Cost or Market Rule is a GAAP-compliant method for revising the book value of certain assets, after asset values change.

Under the LCM rule, owners report the new book value of inventories or securities as the lesser of either (a) historical cost or (b) market value.


Explaining LCM Rule in Context

Sections below explain and illustrate the LCM rule in context with similar concepts, focusing on three themes

  • First, Lower of Cost or Market rule purpose and role in achieving verifiable, conservative, and accurate reporting.
  • Second, how to value and report inventory using LCM.
  • Third, how to use LCM to re-value and report securities holdings.

Contents

Lower of Cost or Market Rule

Purposes of Lower of Cost or Market Rule
LCM Supports Four Accounting Principles

The lower of cost or market rule serves several purposes consistent with international accounting standards. These principles appear almost universally in Generally Accepted Accounting Principles (GAAP) for most countries.

1. Realistic, Verifiable, and Objective Reporting.

Inventories and some securities holdings contribute to Balance Sheet values for Current Assets. Current assets figures, in turn, play a central role in several important metrics for evaluating company performance and financial position. Asset values, therefore, impact "metrics" such as Working Capital, Current Ratio, and Return on Assets.

A fundamental principle in GAAP is that owners should report asset values that are realistic. Asset values, therefore, should reflect actual cost, replacement cost or current market value. Owners who state unrealistic values risk presenting a misleading picture of company financial performance and financial position.

 2. The Matching Concept.

The matching concept is an accounting principle, whereby owners recognize revenues in the same accounting period they report the expenses that brought them. The lower of cost or market rule can help apply the matching principle in several ways. Using the LCM rule, for instance, owners can report expenses for, say, loss of inventory value in the same period they report revenues from sales of that inventory.

3. The Conservatism Principle.

GAAP in most countries incorporates the Conservatism Principle. This principle applies when there are acceptable alternative methods for reporting the value of an item. The rule directs owners to choose the method that results in lower net income or lower asset value.

The universal use of an objective LCM rule for choosing between alternative valuing methods means the following: Those who read financial reports can always expect to see the more conservative values for inventories and securities.

How Do You Apply the LCM Rule?
Different Rules for Different Asset Classes

Most assets enter the accounting system with a value equal to acquisition cost. GAAP prescribes many different methods for adjusting asset values in subsequent reporting periods. Which approach is preferred—or required—for any given asset? The answer can vary substantially, depending on several factors including the following.

  • Asset Class
    Classes including inventory, assets, wasting assets, intangible assets,  and property, plant and equipment assets, for instance, require different valuing methods.
  • Asset Purpose or Usage
    Valuation method may depend on whether owners hold securities for long-term objectives or short-term profits.
  • Acquisition Method
    Business firms value securities they buy on the open market differently from securities they acquire through deals they negotiate privately.
  • Year of Acquisition
    Valuation method may depend on whether purchase came before or after specific regulations and tax laws.
  • Reporting Choices from Company Policy and Practice
    When valuing inventory, for instance, companies are usually free to choose between LIFO and FIFO methods.
  • The Country's Generally Accepted Accounting Principles.
    GAAP rules for valuing assets, income, and tax liabilities, can differ from country to country. Standards for assessing and taxing capital gains, for instance, vary significantly among nations.

Examples in this article illustrate a few accounting principles in view with the LCM rule. Note especially, however, the article does not cover all situations. Before discussing the principles, consider first several costing and valuing terms relevant to the LCM rule.

Book Value  (or Reported Value) of an Asset

Book value is the asset's Balance sheet value after making all adjustments. These include adjustments for depreciation, amortization, "Mark to Market" accounting, and the Lower of Cost or Market rule.

Cost, Acquisition Cost, and Historical Cost

Cost, Acquisition Cost, Historical Cost. These three terms are interchangeable when referring to initial asset value. Here,"Cost" is what owners in fact pay for acquiring the asset. This cost includes purchase price, of course, but also any other acquisition costs such as brokerage fees or shipping costs.

This definition for "cost" also means there are no adjustments due to inflation, no matter how long asset ownership life lasts. Initial cost in this sense appears in the "cost vs. market" choice under the LCM rule.

Replacement Cost

This value is the cost of replacing an asset. Replacement can be either less or more than the asset's current selling price in the market. Consider for instance a merchant, selling goods in the retail market, while obtaining goods inventory from a wholesaler. In such cases, replacement cost is probably less than "market price." On the other hand, if a company must purchase inventory at market prices, that plus additional acquisition costs put replacement cost above the market price.

Market Selling Price

Market selling price is the price buyers currently pay in the market for inventory or securities. Those familiar with securities markets know that securities prices over time can fluctuate above or below historical prices. And, the same is true for the price of most kinds of inventory. When this stock consists of commodities such as oil, for instance, the price will probably fluctuate widely over time, above and below the purchase price.

Net Realizable Value (NRV):

Net realizable value is the current market selling price of the asset, minus any costs for selling, disposing of, or otherwise getting rid of the asset.

Market Value

This value is the Market Value figure to compare with "cost" when applying the LCM rule. For LCM purposes, market value equates to replacement cost, except that the LCM market value must fall between two limits: 

1. Upper Limit for Market: Market Ceiling

Net realizable value (NRV) is the upper limit for the market value. If, say, the replacement cost is higher than NRV, then LCM market value will be taken instead as the NRV.

2. Lower Limit for Market: Market Floor

The lower limit for market value is the net realizable value minus ordinary profit. When replacement cost is less than NRV minus "ordinary profit," "LCM market value" is taken instead as the market floor, that is NRV minus ordinary profit.

Rules for Setting Market Value

In the LCM market vs. cost comparison, the cost figure remains constant, no matter how long the ownership life of the inventory or securities. Market value, of course, can change with each reporting period. With the definitions established above, the LCM rule operates as follows. The "market" value for the comparison can, in fact, turn out to be any one of three values.

  • Firstly, Market Floor
    When replacement cost is lower than the market floor, market value from the LCM rule is the Market Floor.
  • Secondly, Replacement Cost
    When replacement cost falls between the market floor and market ceiling, the market value from the LCM rule is Replacement Cost.
  • Thirdly, Market Ceiling
    When replacement cost is higher than the market ceiling, the market value from the LCM rule is the Market Ceiling.

Table 1 below shows these rules in algebraic form. And, Table 2 below illustrates the LCM rule with a numerical example.

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
Table1. Market value equals inventory replacement cost, except under two conditions. Firstly, when replacement cost is above the market ceiling, market value is taken as the ceiling. Secondly, when replacement cost is below the market floor, market value is taken as the floor.

How Do You Value Inventories With the LCM Rule?
Example Transactions

How do you set "market" value for inventory, to apply the Lower of cost or market rule? And, how do accountants recognize changes in inventory value under the LCM rule? The following sections address these questions with examples.

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.

For reporting inventory values in the United States, accountants should be familiar with US Government IRS Publication 946,"How to Depreciate Property." They should also periodically review the Financial Accounting Standards Board (FASB) and APB Accounting Research Bulletin(ARBs), statements and updates. Chapter 4 of ARB 43, amendment FASB FAS 151, and subsequent amendments are especially relevant for the LCM rule.

Example Inventory Re-Valuation

As an example, consider a business with a single inventory account to value at the end of each period. Table 2, below, shows how inventory data stand at the end for four successive fiscal year quarters.

  INVENTORY DATA
End of
First Quarter
End of
Second Quarter
End of
Third Quarter
End of Fourth Quarter
COST FOR LCM COMPARISON
 
1. The cost (Historical cost)$100,000$95,000$85,000$72,000
FACTORS 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. Market ceiling: Net realizable value (NRV)
           Row 3 – Row 4
$117,900$88,000$84,100$78,200
7. Market 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
Second Row
$88,000
Sixth
Row
$84,100
Sixth Row
$75,000
Seventh
Row
RESULT
 
9. LCM Reported inventory
$100,000
Cost
$88,000
Market
$84,500
Market
$72,000
Cost

Table2.  At the end of each reporting period (fiscal year quarters), an accountant chooses between "Market" or "Cost" as the appropriate value to report for inventory.

Data in Table 2 enable owners to apply the LCM rule and report inventory value as either Cost or Market. Note that inventory levels can fluctuate from quarter to quarter. Also, the factors sitting in Rows 2 through 8 of Table 2 can change from quarter to quarter.

As each quarter ends, however, accountants find inventory value to report under the LCM rule as follows.

End of Q1: Acquiring Inventory, Value at Cost

At the end of Q1, the company reports a replacement Cost ($107,000, Row 1) as the Market value for LCM comparison (Row 8). At the end of Q1, the company reports a replacement cost ($107,000, Row 1) as the Market value for LCM comparison (Row 8). This value applies 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.
  • Cost < Market
    Under LCM, inventory value for reporting (Row 9) is $100,000 Cost (Row 1) because Cost is lower than Market value ($107,000, Row 8).

    Therefore, report Cost.

End of Q2. Inventory Re-Values to Market

At the end of Q2, the Market value for LCM Comparison (Row 8) turns out to be the Market ceiling, or NRV ($88,000, Row 6). This value is appropriate because Replacement cost ($107,000) is greater than the Market ceiling. That is:

  • Market < Cost
    Market Floor < Market Ceiling < Replacement Cost
    Therefore Market = Market Ceiling.
  • Under LCM, inventory value (Row 9) is the $88,000 Market value. This value applies because Market is less than Cost.

    Therefore, report Market.

End of Q3. Inventory Re-Values Again to Market

At the end of Q2, the Market value for LCM Comparison (Row 8) turns out to be the Market ceiling, or NRV ($88,000, Row 6). This value applies because Replacement cost ($107,000) is greater than the Market ceiling. That is:

  • Market Floor < Market Ceiling < Replacement Cost
    Therefore Market = Market Ceiling.
  • Market < Cost
    Under LCM, Reported inventory value (Row 9) is taken as $84,500 Market value because Market is less than Cost. T

    Therefore, report Market.

End of Q4. Inventory Re-Values 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
  • Cost < Market
    Under LCM, Reported inventory value (Row 9) is taken as the $72,000 Cost (Row1) because Cost is lower than the Market value ($75,000, Row 8).

    Therefore, report Cost.  

Reporting Inventory Changes Under LCM
Examples Re-valuing Inventory

Inventory levels can change from reporting period to reporting period, 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. Note especially, these may involve accounts for inventory, cash on hand, sales revenues, accounts receivable, cost of goods sold expenses, or spoilage expense.

For purposes of clarity and simplicity, however, examples in this section omit transactions due to changes in inventory level. Instead, this section focuses only on inventory values changing from "Cost" to "Market" or the reverse.

Example: Re-Valuing Inventory

Consider again the four end-of-period inventory reports above, in Table 2. Table 3 below repeats the same period-end Cost and Market figures. Also, however, this table shows the balance to report for three accounts:

  • (1) Inventory Account. This account is a Balance sheet asset account that carries (like other asset accounts) a debit (DR) balance. The balance value for this account results from applying the LCM rule.
  • (2) Allowance Account for LCM. This account is a contra asset accoun—a Balance sheet account—that carries a credit (CR) balance.
  • (3) LCM Expense Account. Like other expense accounts, this is an Income statement account that takes a debit (DR) balance.

Date

Cost

Market
(1)
Inventory
account
DR balance
(2)
Allowance account reducing inventory to LCM
CR balance
(3)
Expense account 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 value reports change from "Cost" to "Market" (FY Q2) and then back to "Cost" (FY Q4). This example does not show changes in other accounts due to inventory level changes.

End of Q1: Acquiring Inventory, Value at Cost

From acquisition through the end of Q1, inventory value was Cost. This value applies because Cost was always lower than Market.

  • The Allowance account has $0 balance because there were no LCM adjustments yet.
  • And, the Loss expense account has $0 balance for the same reason.

End of Q2. Inventory Re-Values to Market

During Q2, Market value (from the previous section) fell below cost. The cost value, moreover, is $7,000 greater than Market value. In applying the LCM rule to report a value below cost, accountants apply two adjusting transactions 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 the 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 the account balance to that level.
  • The firm reports Q2 inventory value
These transactions may appear in the journal as follows:

DateAccountDebit
Credit
31-Jun-YY
31-Jun-YY
  895 Loss expense reducing inventory to LCM
  125     Allowance, reducing inventory to LCM
$7,000 
$7,000

For Q2, the firm reports inventory value as Cost.

End of Q3. Inventory Re-Values Again to Market

At the end of  Q3, both inventory market value and cost were below their previous quarter levels. The inventory value to report will again be Market because this value is still below "cost." However, the difference between Market and Cost is smaller than it was at the end of Q2. 

  •  Market ($84,100) is now only 900 below the Cost figure ($85,000). Therefore, 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.
These transactions may appear in the journal as follows:

  Date  Account Debit
 Credit
30-Sept-YY
30-Sept-YY
  124 Allowance, reducing inventory to LCM 
  895     Loss expense reducing inventory to LCM
$6,100 
$6,100

For Q3, the firm reports inventory value as Market.

End of Q4. Inventory Re-Values to Cost

At the end of Q4, the Inventory Cost is again below market, which means that the owner once more reports the cost value. This report requires that both adjustment accounts return 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 AccountDebit
Credit
31-Jun-YY
31-Jun-YY
  124 Allowance, reducing inventory to LCM
  895     Loss expense reducing inventory to LCM
$900 
$900

For Q4, the firm reports inventory value as Cost.

Examples in this and the previous section show valuation and reporting for a single inventory account. Note that the reporting accountant usually has the freedom to choose between

  • Applying the LCM rule to the value of all inventory
  • Using LCM to value of different inventory classes
  • Applying the rule item by item through the stock

The latter is generally the most conservative of these approaches. That is, the latter approach is least likely to overstate income or asset values. 

LCM Changes Impact the Income Statement and Balance Sheet

The Balance sheet impacts occur when the contra asset allowance account has a non-zero balance. The allowance account balance reduces the book value of inventory by the balance amount.

Income statement impacts occur 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.   

Valuing and Reporting Securities Under LCM

Securities that companies hold as assets include both debt instruments (corporate bonds, government bonds, and treasuries, for example) and equity instruments (such as corporate stock shares). The term "securities" also covers derivative instruments such as options, futures, and swaps.

Precisely how firms value and report securities can depend on several factors. These include the purpose of acquiring them and the length of time they will hold them. Note that the valuing and reporting of securities is an area of controversy. This area has ample room for judgment and choice by 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 amendments. 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 LCM RULE is rarely used now for securities.

Summary of Securities Valuing Methods

With these cautions in mind, use the following links to sample valuing methods that may apply in different situations.


Which Securities Are Eligible for LCM Treatment?

Table 4 below shows the LCM rule in context with other approaches for valuing securities. As a result, this section describes assessing methods for a wide range of securities holdings.

  SECURITIES ASSETSKind of securities Initial value at: Subsequent valuation at:
Investments in Securities 
"Minority, passive investment.'EquityCostMarket or Lower of cost or market
"Minority, active investment."EquityCostEquity method
"Majority, active investment."EquityCostEquity method
MARKETABLE SECURITIES 
Trading securitiesEquity or debtCostMarket or Lower of cost or Market
Available for tradingEquity or debtCostMarket or Lower of cost or market
Debt held to maturityDebtCost 
Derivative instruments 
Derivatives with available
market
DerivativeCost 
 Derivatives, negotiated
 purchase
DerivativeCost 
Table 4. Representative valuing methods for different classes of securities assets. In some areas, there is either controversy regarding the appropriate valuing approach or some room for flexibility and choice on the part of the reporting company.  

Investment Securities vs. Marketable Securities

For accounting purposes, most debt and equity securities assets qualifyt either as investments in securities or marketable securities. Securities assets are considered marketable securities if two conditions apply:

  1. There is an active, accessible market for the "securities." In other words, these securities can are "liquid assets" with a measurable market value. 
  2. 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, regulators assume that the securities serve for long-term objectives and the firm must report them as long-term assets. Equity securities held for the long-term which do not meet both of the above criteria are Investments 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 try to use its minority ownership to influence or control actions or decisions of company B, A may be said to have a minority passive investment interest in B. In fact, However, the only time the "minority-passive" designation usually applies is 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, firms value and report minority passive securities holdings under the Lower of cost or Market rule. For the US, however, the rule may or may not apply, depending on local policies and practices. In some US locales, firms report the following values at Market value, regardless of whether Market is above or below cost. In any case, for reports on minority passive investment securities in subsequent periods, the following guidance applies:

  • Firms record and report incoming dividends from the "minority passive investment" as revenues.
  • The firm reports these securities assets at (a) Market or (b) Lower of cost or market. Firms account for adjustments to a new value from the previous period end value, with two equal, offsetting adjustment transactions such as those in the example above for inventory valuing.

    A debit to a "Loss expense" account will impact profit figures on the Income statement.

    A credit to a contra asset "allowance account" will impact book value of the asset.

  • If the firm sold these assets during the accounting period, accountants bring the adjustment accounts to zero and measure gain or loss referring to acquisition costs, bringing the appropriate tax consequences.

Investments in Securities: 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, Company A can still attempt to exert influence by acting in concert with other minority owners to form a majority voting block (for example, enlisting other shareholders in a proxy fight). Or, minority owners may exert influence by merely 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 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 Investments

Firms that report "minority active investment" equity securities holdings, usually initially value them at Cost. At the end of following reporting periods, however, owners apply the equity valuation method to adjust amounts if necessary.

  • 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, A reports the proportional share of Company B's net income as a single line item.
  • When company B pays dividends, A's does not consider its proportional share of as revenue, but rather a return of capital. A's investment decreases by the amount of dividend payment.
  • Dividends reduce the asset and are not revenue but rather a return on 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.

Because one economic entity can control several legal bodies and there is a risk that commercial transactions between the legal entities might manipulate income. To ensure that such operations are transparent, U.S. GAAP requires the following: Financial statements of the legally separate entities must be combined and reported as parts of a Consolidated Financial Statement for the governing economic body.

Consequently, Company A and Company B can be separate legal entities, but for Financial Accounting purposes (at least in the US), they must report together through one consolidated financial statements.

What Are the Major Classes of Marketable Securities?
How Are Trading Securities Valued?

Securities holdings qualify as marketable securities if they meet two criteria.

  • Firstly, there must be an accessible, active market for these securities.
  • Secondly, the company intends to sell these holdings when it is advantageous to do so.

When the owner first acquires marketable securities, the Balance sheet values of these securities are equal to acquisition cost. (Most asset categories, in fact, use acquisition cost for initial value). Acquisition cost for securities includes purchase price, of course, but also other purchase-related costs, such as brokerage commissions.

For late reporting periods, however, the owner reports a value for marketable securities that may be subject to the lower of cost or market rule. Or, they may instead be subject to the "mark to market" rule, depending on local policies and practice.

Marketable securities belong to several classes:

  • Trading Securities
    Securities presumably held for relatively short-term gains. Owners usually trade securities in this class actively.
  • Securities Available for Sale
    These are securities which the owner may or may not hold for long-term gains. It is usual to hold marketable securities in this class for a while, to meet a specific cash need(e.g., to retire company-issued bonds that will be coming due).
  • Debt Held to Maturity
    These are debt securities, such as bonds, which the owner intends to hold to maturity.
  • Derivative Instruments
    These are options, swaps, or futures, which the owner holds either as insurance or expecting they will turn into profitable investments in their own right. If there is an open, accessible market for the derivatives, they may qualify as marketable securities.

If instead, the owner acquires derivatives through private contract negotiations, they do not qualify as marketable securities.

Marketable Securities: Valuing Trading Securities

Trading securities may be either equity securities or debt securities. Presumably, investors hold these securities for short-term gains. As a result, owners use trading security portfolios for active buying and selling, hoping to earn profits. Because investors typically hold them for the short-term, trading securities appear on the Balance sheet as Current assets. The vast majority of trading securities belong to financial institutions.

Owners first record trading securities in a Balance sheet assets account, valued at cost. For example, consider a $100,000 equity securities cash purchase. If the owner intends to hold these securities as trading securities, the purchase transactions are as follows. Note that the acquisition occurs in the middle of a reporting period, Q4 FY2012.

  • A $100,000 debit (addition) to a current assets account, Marketable securities.
  • A $100,000 credit (decrease) to a current assets account, Cash on hand.
Date Account   Debit
Credit
15-Nov-YY
15-Nov-YY
 895  Marketable securities                   
  125     Cash on hand                              
   $100,000 
$100,000

Trading Securities After Market Value Changes

If, for example, market value increases by $5,000 by the end of the quarterly period, and if the accounting policy is "mark to market," accountants recognize the change in value with two account entries. At the end of, Q4:

  • A $5,000 debit (addition) to a Balance sheet current assets account for Marketable securities.
  • A $5,000 credit (increase) to the Income statement revenue account for unrealized holding gain.
DateAccountDebit
Credit
31-Dec-YY
31-Dec-YY
  895  Marketable securities
  125     Unrealized holding gain
$5,000
$5,000

If instead the market value of these securities decreases, the adjusting transactions include a "credit transaction" (reduction) to Marketable securities and a debit (decrease) to Unrealized holding gain.

Trading Securities Impact On the Income Statement

Net gains and losses for trading securities impact "Income statement earnings" for the period the firm reports them, even if the firm does not realize the gains or losses in that period. Regulators presume that the firm will "realize" them in the short-term.  

If the owner sells these securities during Q1 for $120,000, that brings a net gain of $20,000 over their original cost of $100,000. Of this gain, however, $5,000 have already been closed to income as unrealized gains (above). A $120,000 debit (increase) to a cash account, recognizing receipt of funds from the sale.

  • A $105,000 credit (decrease) to marketable securities. This amount was the last value for the securities the owner is no longer holding. 
  • A  $15,000 credit (increase) to a Realized gain account.
Date AccountDebit
Credit
31-Mar-YY
31-Mar-YY
31-Mar-YY
  101  Cash on hand
  125     Marketable securities
  333     Realized gain on securities
$120,000 
$105,000
$15,000

The company realizes a gain of $15,000, which appears as income on the Income statement.

 

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