Question

On December 29, 2005, BJ Co. sold an equity security investment that had been purchased on January 4, 2004. BJ owned no other marketable equity security. An unrealized loss was reported in the 2004 Income Statement. A realized gain was reported in the 2005 Income Statement. Was the equity security classified as available for sale, and did its 2004 market price decline exceed its 2005 market price recovery?2004 Market PriceDecline Exceeded 2005Available for Sale Market Price Recoverya Yes Yesb Yes Noc No Yesd No No

Answer 1

Answer:

AFS 2004 market price decline exceeded 2005 market price recovery

No No

The security cannot be classified as available-for-sale because the unrealized gains and losses are recognized in the Income Statement. Unrealized gains and losses on available-for-sale securities are recognized in owners' equity, not earnings.

The second part of the question is somewhat ambiguous. The 2004 price decline could exceed or be exceeded by the 2005 price recovery. The loss in the first year is not related in amount and does not constrain the realized gain in the second year.

The way to answer the question is to read the right column heading as implying that the earlier price decline must exceed the later price recovery. With that interpretation, the correct answer is no.

For example, assume a cost of $10 and a market value of $4 at the end of the first year. An unrealized loss of $6 is recognized in earnings. During the second year, the security is sold for $12. A realized gain of $8 is recognized-the increase in the market value from the end of the first year to the sale in the second year. Thus, the market decline in the first year did not exceed the recovery in year two. (It could have exceeded the recovery in year two but there is no requirement that it must.)

Explanation: