What are Trading Securities?
Trading securities are a class of investment in equity or bonds with the aim of actively trading them in the open market to earn short-term profits. In other words, Trading securities are the investment in stocks or debt instruments done by the company with an aim to earn near-term gains. Companies that invest in trading securities usually do not aim to hold them for a longer period and thus invest in such instruments only if they have a strong expectation of earning profits. These securities are considered to be risky investments and have the potential to give quite high capital gains. However, the downside of it might also be huge.
A company usually invests in trading securities in stocks or bonds which are issued by the companies in the purchasing company’s industry. This is a regular practice seen and is followed by the companies since they usually have more insight about their own industry than any other and they are well aware of the situations/changes happening and what effect they will have on a particular company.
How are Trading Securities Different from Investment in Stocks and Bonds in the Share Market?
A company may own stocks and bonds on its balance sheet but an accounting of trading securities is done quite differently. Trading securities are a different class of assets and are classified separately on the balance sheet of the company usually on the current asset side. Trading securities are used by the company usually for buying and selling the security to earn short-term profits rather than holding them for a longer period of time. The short term in the case of Trading Securities may vary from a few hours to a few days depending on the type of security and market movement.
Accounting Standards Followed for Trading Securities
Given below are the accounting standards mentioned:
1. For Balance Sheet
Trading Securities are usually classified on the current assets side of the balance sheet as “Investment in Trading securities” or “Trading Securities”. If the company has a net of the short position in the market, then trading might also be found on the current liability side of the balance sheet. Trading securities are reported at fair market value i.e. the value of security reported on the balance sheet of the company is as per the market price of the security on the date of the balance sheet. This method of accounting ensures that any change in the financial/economic condition from the date of purchase of stock/bond will be reflected in the books of the company.
2. For Profit and Loss Account
Since trading securities are reported at fair market value, they might increase or decrease the size of assets basis the change in prices of security from the date they were purchased to the date of reporting. Hence for creating a balance, the increase or decrease in the asset is booked as profit or loss in the profit and loss account of the company. Thus trading securities have an impact on Profit and loss accounts even if they are not sold till the date of the balance sheet. Any change in the price of trading from the date of purchase to the date of the balance sheet is reported in the profit and loss account of the company as unrealized profit/loss.
This is an important accounting practice as this helps the investor to understand the current state of the company’s financial health. For example, suppose a company takes a large exposure on a particular security at the end of the year with an aim to earn short-term profit by trading in the open market. However, due to an unexpected event, there is a huge slump in the market which affected the trading security adversely, and hence the company had a huge unrealized loss as of March 31. Thus this unrealized loss will bring the profit down significantly as the same will be booked as an unrealized loss in the Profit and loss account. Hence the investors will be aware of the downsides that may hit the company.
Please note that trading securities do not have any effect on the cash flow statement of the company since there is no actual profit or loss booked and hence no real cash flow is happening in or out of the company.
If a company ABC limited invests in trading securities and has a long position in XYZ stock. A company purchased 100 shares of XYZ at INR 100 on March 30, 2018. As of the date of the Balance sheet i.e. March 31, 2018, the company was still holding 100 shares of XYZ but the price of the share has moved to INR 110 per share. Thus, accounting entry for this transaction would be as follows:
- Under current assets, an entry of Trading will be done for INR 11,000 i.e. at the fair market value of stock
- In the profit and loss account, an entry of unrealized profit will be done for INR 1000 under non-cash earnings. Such income does have an impact on profit after tax of the company and thus on retained earnings or earning per share, but they do not have any impact on the cash flow statement since these are unrealized profit and hence are not real cash flow for the company
The inverse will be true in case the price of XYZ shares goes down. A current asset of ABC limited would shrink on account of a reduction in the price of a share and the unrealized loss will be booked in the profit and loss account of the company.
This has been a guide to Trading Securities. Here we discussed different accounting standards followed for trading securities with example. You may also learn more about accounting from the following articles –