Journal Entry for Purchase of Debt Securities
Overview
Debt securities are the type of financial instruments that the company may have on hand as a form of investment. The company may purchase debt securities for a variety of reasons, such as to earn returns on idle cash, to diversify the investment risk, or to use it as a contingency fund when needed, etc. In this case, the company needs to make the journal entry for the purchase of debt securities by recognizing it as an investment asset on the balance sheet.
Additionally, as the debt securities such as bonds, promissory notes, and commercial papers are usually sold in the security market with interests attached, the company also needs to record the interests that it receives at a later date from the purchased debt securities as extra revenues to the income statement.
Government bonds and corporate bonds are the common forms of debt securities that the company usually invests in to diversify the investment risks it has. This is because corporate bonds are usually issued by large and well-known companies while government bonds are backed by the government.
Journal entry for purchase of debt securities
Purchase of debt securities
The company can make the journal entry for the purchase of debt securities by debiting the debt securities account and crediting the cash account.
| Account | Debit | Credit |
|---|---|---|
| Debt securities | 000 | |
| Cash | 000 |
Debt securities account is an investment account on the balance sheet, in which it can be classified as a current asset or non-current asset based on the nature of the investment as well as how long the company intends to hold the investment for. Likewise, in this journal entry, there is no impact on the total assets on the balance sheet of the company as one asset increases, another asset decreases.
Interest received from debt securities
As the company usually receives the interest from the purchased debt securities such as bonds, promissory notes, or commercial papers, at a later date, it also needs to record the interest on the debt securities to the income statement for the period.
In this case, the company can make the journal entry for the interest received from debt securities by debiting the cash account and crediting the interest income account.
| Account | Debit | Credit |
|---|---|---|
| Cash | 000 | |
| Interest income | 000 |
In this journal entry, both total assets on the balance sheet and total revenues on the income statement increase by the same amount for the interest received from the purchased debt securities.
Receive principal back at maturity
When the company receives the principal of the debt securities it purchased at the maturity date, it can make the journal entry with the debit of the cash account and the credit of the debt securities account.
| Account | Debit | Credit |
|---|---|---|
| Cash | 000 | |
| Debt securities | 000 |
Purchase of debt securities example
For example, on January 1, the company ABC purchases $100,000 of debt securities as an investment to earn extra income as it still has some idle cash left. And these $100,000 debt securities have a maturity of nine months, in which they will mature on September 30.
The company ABC will receive both the principal and interest of 6% per annum on the maturity date. And the $100,000 of this investment is classified as a held-to-maturity security on the balance sheet of the company ABC.
In this case, the company ABC can make the journal entry for the $100,000 purchase of debt securities on January 1 as below:
January 1:
| Account | Debit | Credit |
|---|---|---|
| Held-to-maturity debt securities | 100,000 | |
| Cash | 100,000 |
In this journal entry, while the cash account decreases by $100,000, the held-to-maturity debt securities account increases in the same amount. Hence, there is zero impact on the total assets of the company ABC’s balance sheet.
Then, on September 30, when the company ABC receives receive both the principal and interest of $4,500 ($100,000 x 6% x 9/12), it can make the journal entry as below:
September 30:
| Account | Debit | Credit |
|---|---|---|
| Cash | 104,500 | |
| Interest income | 4,500 | |
| Held-to-maturity debt securities | 100,000 |
Sale of debt securities investments before maturity
As mentioned, the company may purchase debt securities to earn extra income while also using them as a contingency fund when needed. This is due to debt securities being actively traded in the security market makes it easy for the company to convert them to cash when needed.
In this case, the company can sell the debt securities that it has purchased back to the market before their maturity if there is an urgent need for cash. Of course, they may also sell the purchased debt securities back to the market before their maturity if there is a significant change in the market interest rate.
In either case, there is usually a gain or loss as a result of the sale of debt securities investments before maturity.
Gain on sale of debt securities investments
The company will have a gain on the sale of debt securities investments if the sale proceeds are more than the purchased price of the debt securities.
In this case, the company can make the journal entry for gain on the sale of debt securities investments by debiting the cash account and crediting the gain on sale of investments account and the debt securities account.
| Account | Debit | Credit |
|---|---|---|
| Cash | 000 | |
| Gain on sale of investments | 000 | |
| Debt securities | 000 |
Loss on sale of debt securities investments
On the other hand, the company will have a loss on the sale if the sale proceeds are less than the purchased price of the debt securities.
In this case, the company can make the journal entry for loss on sale of debt securities investments by debiting the cash account and the loss on sale of investments account and crediting the debt securities account.
| Account | Debit | Credit |
|---|---|---|
| Cash | 000 | |
| Loss on sale of investments | 000 | |
| Debt securities | 000 |
Sale of debt securities investments example
For example, on January 1, the company ABC purchase $500,000 of debt securities that have a 10-year maturity with an interest of 5% per annum. The interest of these debt securities is payable annually.
The company ABC does not intend to hold these debt securities until their maturity as it prepares to sell them back to the market immediately if it is in need of cash urgently or if there is a significant rise in the market rate. Hence, it classifies these debt securities as available-for-sale debt securities.
And on June 30 of the same year, the company ABC decide to sell the $500,000 of debt securities that it purchased on January 1, for only $498,000 as it need urgent cash for its business operation. This results in a $2,000 ($500,000 – $498,000) loss on the sale of debt securities investments that it purchased on January 1.
In this case, the company ABC can make the journal entry for the purchase of $500,000 debt securities on January 1 as below:
January 1:
| Account | Debit | Credit |
|---|---|---|
| Available-for-sale debt securities | 500,000 | |
| Cash | 500,000 |
And later, on June 30, the company ABC can make the journal entry for a $2,000 loss on sale of the debt securities investments by debiting the $2,000 to the loss on sale of investments account as below:
June 30:
| Account | Debit | Credit |
|---|---|---|
| Cash | 498,000 | |
| Loss on sale of investments | 2,000 | |
| Available-for-sale debt securities | 500,000 |
Note:
It may be useful to note that there are three categories of debt securities including held-to-maturity securities, available-for-sale securities, and trading securities. And while held-to-maturity debt securities are valued at the amortized cost, the trading debt securities and available-for-sale debt securities are treated the same as stock investments in which they are valued at fair value (e.g. market value).
Hence, trading debt securities and available-for-sale debt securities usually require the adjustment for unrealized gain or unrealized loss at the end of the accounting period, the same as stock investments.