Financial Assets - Unrealized Gains/Losses

Hello all,

Just need some confirmation of some information regarding financial assets. Is the unrealized gain/loss of a financial asset (available for sale, held for trading) for any given period calculated as:

Fair Market Value - Amortized Cost

I made the mistake in a practice question of calculating the unrealized gain/loss of an available-for-sale security by using:

End of Period Fair Value - Beginning of Period Fair Value

Only to see in the solution that they used:

End of Period Fair Value - End of Period Amortized Cost.

----- Here is the problem -----

Company A invests in debt securities of company B as follows:

January 1, 2011

Purchase price: $350,000 (par value = $300,000, coupon = 8%, ytm = 6%)

December 31, 2011

Amortized Cost = $347,000 >>> $350,000 - [($24,000 coupon - $21,000 interest income)]

Fair Value = $390,000

January 1, 2012

Sells securities for $395,000

What gain is recognized on the income statement for 2012 if the securities had been deemed available for sale?

My wrong answer:

selling price ($395,000) - fair value ($390,000) + incorrect unrealized gain/loss ($390,000-$350,000) = $45,000

Right answer:

selling price ($395,000) - fair value ($390,000) + correct unrealized gain/loss ($390,000-$347,000) = $48,000

The key is that you have to report the security at fair market value; thus, you have to capture the entire gain or loss somehow. If some of it is realized (e.g., through amortization), then only the remainder is unrealized.

Thank you for responding S2000magician!

I don’t think I’m fully grasping what is going on here. What is confusing me most is that I don’t understand why amortized cost is coming into play when we are dealing with an AFS security, which I thought we carried at fair market value.

I hate to ask, but could you maybe give an example of your explanation?

Ok, I think I finally understand what you mean that you have to capture the entire gain or loss somehow.

The amortization of $3,000 in 2011 is a realized loss for company A. So in order to capture the entire gain, the unrealized gain must equal $48,000 to effectively reverse that $3,000 loss.

Is that correct??


(Sorry for not getting back to answer sooner; I’ve been tied up for the last couple of days.)

Not a problem at all! You are seriously a lifesaver; as always, many thanks good sir!

Just to follow-up on that one, do we use the same procedure for the FV through P&L securities (i.e. that the unrealized gain or loss is the difference between FV and amortized cost)? Except from the fact that the unrealized G&L are directly reported to net income.