Trading Securities

Trading securities are investments in the form of debt or equity that the management of the company wants to actively purchase and sell to make profit in the short term with securities they believe are going to increase in price, these securities can be found on the balance sheet at the fair value on the balance sheet date.

If the management of a company invests a certain amount of money in debt or equity (meaning in a particular bond or a stock) for a short period. The purpose of doing this is to buy and sell that particular bond or the stock within a short while to make money. Trading securities include equity mutual funds and exchange-traded funds.

1. Trading securities are debt or equity assets that a company's management actively seeks to buy and sells to profit in the near term on securities they anticipate will gain in price. These securities can be found on the balance sheet at the fair value as of the balance sheet date.
2. The fact that these securities are exchanged frequently—sometimes even daily—on the open market makes them the fastest-moving securities. The company's management is directly in charge of these securities, managing them to determine whether they will increase earnings for the present period.
3. These investments are regarded as the company's current assets for the time being because the company will presumably sell them. Securities' market values fluctuate every day. Because of this, the securities must be displayed at fair value.

The trading securities are those financial instruments that the company purchases and holds for short term and then sell off with the intention of earning profits. In this way the companies take advantange of the fluctuations in prices of those securities in the financial market and makes profit for short term, thus, capitalizing on market opportunities. Investment in trading securities are reported in the balance sheets of the company in the form of assets.

There are three classifications of securities as per accounting - trading securities, held to maturity securities, and available for sale securities.

We will understand more about the securities that are trading in detail. Trading securities in the balance sheet are the fastest moving securities among all three. The reason these securities are the fastest moving is that these securities are traded regularly (even daily) in the open market. And these securities are managed directly by the management of the company to see whether these securities can bring in more profits for the current period or not.

They are reported at the fair market value in the balance sheet of the companies. But any change in the value of investment in trading securities is to be accounted for in the income statement. However, the accounting treatment of these securities can change depending on the rules and accounting standards followed in different countries.

Let us study the various types of securities that are traded by entities. Some commonly traded securities are bonds, stocks, exchange traded funds or derivatives.

• Stocks - The stocks are the shares of companies that are bought and sold in the stock exchange. The companies listed in the stock exchange, issue the shares to the general public who invest in such stocks, thus getting a part of the company ownership. This type of trading securities on balance sheet is a way in which companies raise capital for meeting their operational expenses. The management is not under the obligation to pay back the raised amount but in return, the investors are entitled to certain rights in the management decisions. Investors use these stocks to take advantage of price fluctuations and earn profits or make long term investments in them.
• Bonds – Bonds are the debt instruments issued by companies or the government and municipalities. It is a form of borrowing made by the bond issuers from the investors. Due to this, the issuer is obliged to pay back the amount to the investor within a period of time, known as maturity date, along with interest which are known as coupon payment. There are different kinds of bonds available in the market which the investors purchase as per their risk appetite, investment horizon and objective. It is important to check the credit rating of the issuer before investment.
• Derivatives – They are financial instruments whose value depends on another underlying asset. Derivatives are of various types like forwards, futures, options or swaps and are widely used for hedging, speculation or getting the exposure to a particular market or asset without directly having their ownership. Thading in them offer some benefits like capitalizing on market fluctuation, risk management or increase in market liquidity. However, there is the element of counterparty risk and possibility of large losses, ddue to which there are some strict rules and regulations in the contracts.
• Exchange traded funds – They are the funds are those that include a portfolio of assets, which may include stocks, bonds or commodities. This type of trading securities on balance sheet is traded like individual stocks in the stock exchange. The advantage is that thy have low broker commissions and low expense ratio than individually buying stocks. They are commonly used to track some particular investment strategies.

As per the accounting system of trading securities accounting, such securities are placed in the balance sheet of a company at a fair value. It is done so that the economic benefit (or loss) can be shown on the financial statements of a company during that period.

After that, at the end of each accounting period, which may be each quarter or every year a comparison is made between the fair market value of the security and their original price. If there is any change, then the change in valuation is recorded in the profit and loss statement. If the difference gives a positive amount, that is the market value is more than the original cost, there is an unrealized gain. Else, it is known as unrealized loss. They remain urealized till they are sold of by the entity.

Since the company will most probably sell off the investments, these investments are considered as the current assets of the company for the period.

The market value of securities changes every day. That’s why the securities must be shown at the fair value.

But the question remains what would we do till the time the investments are not sold? The treatment of trading securities accounting for this is to create a temporary account to which we can transfer the unrealized gain or loss. And whenever the selling is done, we can write off the temporary account and transfer the amount to the income statement.

Let us understand the concept with the help of a suitable example.

• United Co. has kept aside $100,000 for short-term investment purposes. This amount won’t be used for any operational purpose or working capital. This money would purely be used for making a quick gain on the short-term investment.
• The management of United Co. has seen that Grow & Lead Corporation has been doing extremely well for the last couple of years. And United Co. decided to invest the entire amount into the stocks of the Grow & Lead Corporation. The market price of each stock of Grow & Lead Corporation was $5 per stock.
• In the first year of investment, Grow & Lead Corporation has paid out a cash dividend of $0.50 per share. At the end of the year, the value of shared purchased by United Co. reached $125,000.
• Later in the next year, when the shares were sold, the amount received was $120,000.
• How would we report these transactions assuming that the management of United Co. had invested $100,000 for trading securities?
• First of all, we will treat each one transaction separately and would see how each transaction would get reflected in the books of United Co.
• The first transaction was to invest $100,000 in trading securities of Grow & Lead Corporation. At $5 per share, United Co. had bought 20,000 shares. And the following would be the entry in the books of accounts of United Co. -

This journal entry was passed so that we can create a current asset called “Investments in Trading Securities” and record it in the balance sheet of United Co. And cash is credited since United Co. has to let go of the other current asset “Cash” to invest in the securities.

The next transaction would be related to the cash dividend. Since Grow & Lead Corporation has declared a cash dividend of $0.50 per share, here’s the journal entry for that particular transaction -

We passed this entry to reflect the income received in the income statement. We have debited cash account because United Co. has been receiving cash in the form of the dividend. If the asset increases, we debit the asset. At the same time, we have credited divided revenue because when income increases, we credit the account. And the same dividend revenue can be reflected in the income statement of the books of accounts of United Co.

Finally, the major transaction of the above example of trading securities is the fair value at which the value of shares was recorded at the end of the year.

According to that, United Co. had gained $(125,000 - $100,000) = $25,000 as unrealized gain. Since the money is not received, we will record the following journal entry in the books of United Co. -

The next year, United Co. was able to sell the shares and gained $120,000 from the sale. Meaning the actual profit was $(120,000 - 100,000) = $20,000.

But in the previous year’s balance sheet, United Co. had shown $25,000 as the unrealized gain. So, here’s the final entry we need to pass for making things right -

By doing this, United Co. has made things right. The real gain was $20,000, and by passing the last entry, the investment in trading securities got closed, and United Co. had got a profit of $20,000.

From the above discussion, it’s clear that how a company can use a certain amount of money for short-term investments and can gain a lump sum amount at the end of the period.

Two things are most important here -

• First, at the end of the year, the balance sheet should reflect the fair value of the stocks or the bonds in which the amount is being invested physically or through online trading securities.
• Second, the reverse entry to effect the unrealized gain or loss.

The above are two different types of financial assets that entities hold in their investment portfolio. However, there some differences in both of them, as given below:

• The intention of the former is to trade to earn profits for short term but the aim of the latter is not necessarily for short term
• The former takes advantage of price fluctuation for short term for trading purpose, but the latter may be held for a long term with the intention to earn interest or dividend.
• The former is reported in the balance sheet at the fair market value and any subsequent change in it is, which may be a gain or loss, are reported in the profit and loss statement. But for the latter, even though the fair value is recorded in balance sheet, any chages are not recorded in income statement. The unrealized changes are recorded in the statement of changes in equity.
• The former which may be done physically or through online trading securities is frequently bought and sold, and they require constant monitoring and management. However, the latter is held for longer periods and their purchase or sale depends on market conditions and investment strategy.

Thus, we see that the main distinction is in the accounting treatment trading intention. It is necessary to understand both the concepts clearly so that companies can profitable invest in both and maximize investment value.

This article has been a guide to what is Trading Securities. We explain it with example, differences with available for sale securities, accounting and types. You may learn more about accounting from the following articles -

• Share Trading Account
• Trading Desk
• Marketable Securities Examples
• Outstanding Shares