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How to Prepare Journal Entries for Investment Income for Investments Measured at Fair Value

How to Prepare Journal Entries for Investment Income for Investments Measured at Fair Value

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Introduction

Purpose of the Article

Explain the Importance of Accurately Recording Investment Income

Accurately recording investment income is crucial for several reasons. It ensures that financial statements reflect the true financial position and performance of an entity, which is vital for making informed decisions by stakeholders, including investors, creditors, and management. Proper recording of investment income also ensures compliance with accounting standards and regulations, thereby avoiding potential legal and financial repercussions. Moreover, it provides transparency and consistency in financial reporting, fostering trust and credibility with external users of financial statements.

Overview of Investments Measured at Fair Value

Investments measured at fair value are financial assets that are reported at their current market value on the balance sheet. This category typically includes equity securities, debt securities, and derivative instruments. The fair value measurement approach aligns the asset’s carrying amount with its market value, offering a more realistic and timely reflection of an asset’s worth. This method captures both realized and unrealized gains and losses, providing a comprehensive view of the investment’s performance over time.

Scope

Focus on Journal Entries for Investment Income

This article focuses on the practical aspects of preparing journal entries for investment income, specifically for investments measured at fair value. It aims to provide clear and detailed guidance on how to record different types of investment income, including dividends, interest, and capital gains and losses. By understanding the correct journal entries, accountants and financial professionals can ensure that their financial records are accurate and comply with relevant accounting standards.

Brief Explanation of Fair Value Measurement

Fair value measurement is a financial reporting approach that determines the value of an asset based on current market conditions. According to accounting standards like GAAP and IFRS, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This method uses observable market data and other relevant information to arrive at an accurate valuation, ensuring that the financial statements provide a true and fair view of an entity’s financial position.

Understanding Fair Value Measurement

Definition of Fair Value

Explanation According to GAAP and IFRS

Fair value is a critical concept in financial reporting, defined similarly under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). According to GAAP, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Similarly, IFRS defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. Both frameworks emphasize using market-based measurements rather than entity-specific values, ensuring that the fair value reflects market participants’ assumptions and data available at the measurement date.

Types of Investments Measured at Fair Value

Equity Securities

Equity securities include shares of stock in a company that represent ownership interest. These are measured at fair value to reflect their current market price, which can fluctuate based on supply and demand, company performance, and broader market conditions. Common examples include common stocks and preferred stocks traded on public exchanges.

Debt Securities

Debt securities are financial instruments representing a creditor relationship with an entity, such as bonds or notes. These securities are measured at fair value to reflect their market value, which can change based on interest rates, credit ratings, and other market factors. Examples include corporate bonds, government bonds, and municipal bonds.

Derivative Instruments

Derivative instruments are financial contracts whose value is derived from an underlying asset, index, or rate. Common types of derivatives include futures, options, and swaps. These instruments are measured at fair value to accurately represent their market value, which can be influenced by changes in the underlying asset’s price, volatility, and other market conditions.

Methods for Measuring Fair Value

Market Approach

The market approach involves using prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. This method relies on observable inputs, such as quoted prices in active markets for identical assets or liabilities (Level 1 inputs) or observable inputs other than quoted prices (Level 2 inputs). It is considered the most direct and reliable method for measuring fair value when market data is available.

Income Approach

The income approach involves estimating the present value of future cash flows that an asset is expected to generate. This method uses discount rates to convert future amounts to their present value, considering the time value of money and the risks associated with the asset. The income approach is often used when market prices are not readily available, providing a way to measure fair value based on expected economic benefits.

Cost Approach

The cost approach involves determining the amount that would be required to replace the service capacity of an asset. This method considers the current cost of replacing the asset, adjusting for any physical deterioration and obsolescence. The cost approach is useful for measuring fair value when market and income approaches are not feasible, such as for specialized or unique assets without active markets.

Recognizing Investment Income

Types of Investment Income

Dividends

Dividends are distributions of a portion of a company’s earnings to its shareholders. They represent a return on investment for equity holders and are typically paid out in cash, though they can also be distributed as additional shares of stock (stock dividends). Dividends are declared by a company’s board of directors and are usually paid on a regular basis, such as quarterly or annually. Investors receive dividend income as a reward for their ownership in a company, and this income must be recognized in the financial statements.

Interest

Interest income is earned from investments in debt securities, such as bonds and notes. It represents the return on lending money to an issuer (e.g., a corporation or government) and is typically received at regular intervals, such as semi-annually or annually. The amount of interest income earned is based on the interest rate of the debt security and its principal amount. Recognizing interest income accurately is essential for reflecting the true earnings from debt investments.

Capital Gains and Losses

Capital gains and losses arise from the sale or exchange of investments. A capital gain occurs when an investment is sold for more than its purchase price, while a capital loss occurs when it is sold for less than its purchase price. These gains and losses can be classified as realized or unrealized. Realized gains and losses result from actual transactions, whereas unrealized gains and losses reflect changes in the value of investments that have not yet been sold. Both types of gains and losses are important for understanding the performance of an investment portfolio.

Criteria for Recognition

Realized vs. Unrealized Gains and Losses

Realized gains and losses are recognized when an investment is sold or exchanged. They reflect the actual profit or loss from the transaction and are recorded in the income statement. Unrealized gains and losses, on the other hand, represent changes in the fair value of investments that have not been sold. These are typically recorded in other comprehensive income (OCI) or directly in the income statement, depending on the classification of the investment. Recognizing both realized and unrealized gains and losses is essential for providing a complete picture of an investment’s performance and the entity’s financial position.

When to Recognize Dividends and Interest

Dividends are recognized as income when the shareholder’s right to receive the payment is established, which is typically on the declaration date or ex-dividend date, depending on the accounting policy. This ensures that dividend income is recorded in the period it is earned.

Interest income is recognized on an accrual basis, meaning it is recorded as it is earned, not necessarily when it is received. This involves calculating the interest income based on the effective interest rate method, which spreads the interest income over the life of the debt security. Recognizing interest income on an accrual basis ensures that financial statements accurately reflect the earnings from debt investments in the appropriate accounting periods.

Journal Entries for Investment Income

Basic Journal Entries for Dividends

When Dividends Are Declared and Received

When a company declares a dividend, it creates a liability for the amount to be paid to shareholders. The receipt of dividends is recorded as income for the investor.

Journal Entry When Dividends Are Declared:
When the dividend is declared by the company, the following journal entry is made to record the receivable:

  • Date: When the dividend is declared
  • Debit: Dividends Receivable (Asset)
  • Credit: Dividend Income (Revenue)

Example Entry:

Date Account Debit Credit 2024-07-01 Dividends Receivable $5,000 Dividend Income $5,000

Journal Entry When Dividends Are Received:
When the dividend payment is received, the following entry is made to record the cash receipt and clear the receivable:

  • Date: When the dividend is received
  • Debit: Cash (Asset)
  • Credit: Dividends Receivable (Asset)

Example Entry:

Date Account Debit Credit 2024-07-15 Cash $5,000 Dividends Receivable $5,000

Journal Entries for Interest Income

Accrual of Interest Income

Interest income is typically accrued over the period it is earned rather than when it is received. This ensures that the income is matched with the period in which it is earned.

Journal Entry for Accrual of Interest Income:

  • Date: End of the accounting period
  • Debit: Interest Receivable (Asset)
  • Credit: Interest Income (Revenue)

Example Entry:

Date Account Debit Credit 2024-06-30 Interest Receivable $1,000 Interest Income $1,000

Receipt of Interest Payments

When the interest payment is received, it is recorded as a reduction in the interest receivable.

Journal Entry for Receipt of Interest Payments:

  • Date: When the interest is received
  • Debit: Cash (Asset)
  • Credit: Interest Receivable (Asset)

Example Entry:

Date Account Debit Credit 2024-07-01 Cash $1,000 Interest Receivable $1,000

Journal Entries for Capital Gains and Losses

Recognition of Realized Gains and Losses

Realized gains and losses are recognized when an investment is sold. The gain or loss is calculated as the difference between the selling price and the carrying amount of the investment.

Journal Entry for Recognition of Realized Gains:

  • Date: When the investment is sold
  • Debit: Cash (Asset)
  • Credit: Investment (Asset)
  • Credit: Realized Gain on Investment (Revenue)

Example Entry:

Date Account Debit Credit 2024-07-01 Cash $12,000 Investment $10,000 Realized Gain on Investment $2,000

Journal Entry for Recognition of Realized Losses:

  • Date: When the investment is sold
  • Debit: Cash (Asset)
  • Debit: Realized Loss on Investment (Expense)
  • Credit: Investment (Asset)

Example Entry:

Date Account Debit Credit 2024-07-01 Cash $8,000 Realized Loss on Investment $2,000 Investment $10,000

Recognition of Unrealized Gains and Losses

Unrealized gains and losses are recognized based on the change in fair value of the investment and are typically recorded at the end of each reporting period.

Journal Entry for Recognition of Unrealized Gains:

  • Date: End of the reporting period
  • Debit: Investment (Asset)
  • Credit: Unrealized Gain on Investment (Revenue)

Example Entry:

Date Account Debit Credit 2024-06-30 Investment $3,000 Unrealized Gain on Investment $3,000

Journal Entry for Recognition of Unrealized Losses:

  • Date: End of the reporting period
  • Debit: Unrealized Loss on Investment (Expense)
  • Credit: Investment (Asset)

Example Entry:

Date Account Debit Credit 2024-06-30 Unrealized Loss on Investment $3,000 Investment $3,000

These journal entries ensure that investment income, whether from dividends, interest, or capital gains and losses, is accurately recorded in the financial statements, reflecting the true financial performance and position of the entity.

Adjustments for Fair Value Changes

Unrealized Gains and Losses

Reporting in the Income Statement or Other Comprehensive Income

Unrealized gains and losses arise from changes in the fair value of investments that have not yet been sold. The treatment of these gains and losses depends on the classification of the investment:

  1. Trading Securities: For investments classified as trading securities, unrealized gains and losses are reported in the income statement. This reflects the active management and frequent buying and selling of these investments to capture short-term market movements.
  2. Available-for-Sale Securities: For investments classified as available-for-sale (AFS) securities, unrealized gains and losses are reported in other comprehensive income (OCI). This approach separates these changes from the income statement, acknowledging that these investments are not intended for short-term profit.

Example Journal Entries for Trading Securities:

  • Date: End of the reporting period
  • Debit: Investment (Asset)
  • Credit: Unrealized Gain on Investment (Revenue) – for gains
  • Debit: Unrealized Loss on Investment (Expense)
  • Credit: Investment (Asset) – for losses

Example Entry for Unrealized Gain:

Date Account Debit Credit 2024-06-30 Investment $3,000 Unrealized Gain on Investment $3,000

Example Entry for Unrealized Loss:

Date Account Debit Credit 2024-06-30 Unrealized Loss on Investment $2,000 Investment $2,000

Example Journal Entries for Available-for-Sale Securities:

  • Date: End of the reporting period
  • Debit: Investment (Asset)
  • Credit: Unrealized Gain on Investment (OCI) – for gains
  • Debit: Unrealized Loss on Investment (OCI)
  • Credit: Investment (Asset) – for losses

Example Entry for Unrealized Gain:

Date Account Debit Credit 2024-06-30 Investment $3,000 Unrealized Gain on Investment (OCI) $3,000

Example Entry for Unrealized Loss:

Date Account Debit Credit 2024-06-30 Unrealized Loss on Investment (OCI) $2,000 Investment $2,000

Realized Gains and Losses

Reclassification from Unrealized to Realized

When an investment is sold, any unrealized gains or losses that were previously recorded must be reclassified to realized gains or losses. This reclassification reflects the transition from potential to actual gains or losses, based on the sale transaction.

Example Journal Entry for Reclassification:

  • Date: When the investment is sold
  • Debit: Unrealized Gain on Investment (OCI)
  • Credit: Realized Gain on Investment (Revenue) – for gains
  • Debit: Realized Loss on Investment (Expense)
  • Credit: Unrealized Loss on Investment (OCI) – for losses

Example Entry for Reclassification of Unrealized Gain:

Date Account Debit Credit 2024-07-01 Unrealized Gain on Investment (OCI) $3,000 Realized Gain on Investment (Revenue) $3,000

Example Entry for Reclassification of Unrealized Loss:

Date Account Debit Credit 2024-07-01 Realized Loss on Investment (Expense) $2,000 Unrealized Loss on Investment (OCI) $2,000

Example Journal Entries for Sale of Investment:

  • Date: When the investment is sold
  • Debit: Cash (Asset)
  • Credit: Investment (Asset)
  • Credit: Realized Gain on Investment (Revenue) – for gains
  • Debit: Realized Loss on Investment (Expense)

Example Entry for Sale Resulting in Realized Gain:

Date Account Debit Credit 2024-07-01 Cash $12,000 Investment $10,000 Realized Gain on Investment $2,000

Example Entry for Sale Resulting in Realized Loss:

Date Account Debit Credit 2024-07-01 Cash $8,000 Realized Loss on Investment $2,000 Investment $10,000

These journal entries ensure that fair value changes are accurately reflected in the financial statements, providing a clear and transparent view of an entity’s financial performance and position.

Practical Examples

Scenario-Based Examples

Example 1: Equity Securities

Initial Recognition

When an equity security is purchased, it is recorded at its fair value on the purchase date. Any transaction costs are typically expensed.

Journal Entry for Initial Recognition:

  • Date: When the equity security is purchased
  • Debit: Investment in Equity Securities (Asset)
  • Credit: Cash (Asset)

Example Entry:

Date Account Debit Credit 2024-01-01 Investment in Equity Securities $10,000 Cash $10,000

Receiving Dividends

When dividends are received from the equity security, they are recognized as dividend income.

Journal Entry for Receiving Dividends:

  • Date: When the dividend is declared
  • Debit: Dividends Receivable (Asset)
  • Credit: Dividend Income (Revenue)

Example Entry:

Date Account Debit Credit 2024-03-01 Dividends Receivable $500 Dividend Income $500

When the dividend payment is received:

  • Date: When the dividend is received
  • Debit: Cash (Asset)
  • Credit: Dividends Receivable (Asset)

Example Entry:

Date Account Debit Credit 2024-03-15 Cash $500 Dividends Receivable $500

Adjusting for Fair Value Changes

At the end of the reporting period, the equity security’s fair value is adjusted to reflect its current market price.

Journal Entry for Unrealized Gain:

  • Date: End of the reporting period
  • Debit: Investment in Equity Securities (Asset)
  • Credit: Unrealized Gain on Investment (Revenue)

Example Entry:

Date Account Debit Credit 2024-06-30 Investment in Equity Securities $1,000 Unrealized Gain on Investment $1,000

Journal Entry for Unrealized Loss:

  • Date: End of the reporting period
  • Debit: Unrealized Loss on Investment (Expense)
  • Credit: Investment in Equity Securities (Asset)

Example Entry:

Date Account Debit Credit 2024-06-30 Unrealized Loss on Investment $500 Investment in Equity Securities $500

Example 2: Debt Securities

Initial Recognition

When a debt security is purchased, it is recorded at its fair value, which includes any accrued interest.

Journal Entry for Initial Recognition:

  • Date: When the debt security is purchased
  • Debit: Investment in Debt Securities (Asset)
  • Credit: Cash (Asset)

Example Entry:

Date Account Debit Credit 2024-01-01 Investment in Debt Securities $20,000 Cash $20,000

Accruing Interest

Interest income on debt securities is accrued periodically.

Journal Entry for Accrual of Interest Income:

  • Date: End of the accounting period
  • Debit: Interest Receivable (Asset)
  • Credit: Interest Income (Revenue)

Example Entry:

Date Account Debit Credit 2024-06-30 Interest Receivable $800 Interest Income $800

Adjusting for Fair Value Changes

The fair value of the debt security is adjusted at the end of the reporting period.

Journal Entry for Unrealized Gain:

  • Date: End of the reporting period
  • Debit: Investment in Debt Securities (Asset)
  • Credit: Unrealized Gain on Investment (Revenue)

Example Entry:

Date Account Debit Credit 2024-06-30 Investment in Debt Securities $1,500 Unrealized Gain on Investment $1,500

Journal Entry for Unrealized Loss:

  • Date: End of the reporting period
  • Debit: Unrealized Loss on Investment (Expense)
  • Credit: Investment in Debt Securities (Asset)

Example Entry:

Date Account Debit Credit 2024-06-30 Unrealized Loss on Investment $1,000 Investment in Debt Securities $1,000

Example 3: Derivative Instruments

Initial Recognition

When a derivative instrument is entered into, it is recorded at its fair value on the inception date.

Journal Entry for Initial Recognition:

  • Date: When the derivative is purchased
  • Debit: Derivative Asset (Asset)
  • Credit: Cash (Asset)

Example Entry:

Date Account Debit Credit 2024-01-01 Derivative Asset $5,000 Cash $5,000

Adjusting for Fair Value Changes

The derivative’s fair value is adjusted to reflect its current market value at the end of each reporting period.

Journal Entry for Unrealized Gain:

  • Date: End of the reporting period
  • Debit: Derivative Asset (Asset)
  • Credit: Unrealized Gain on Derivative (Revenue)

Example Entry:

Date Account Debit Credit 2024-06-30 Derivative Asset $2,000 Unrealized Gain on Derivative $2,000

Journal Entry for Unrealized Loss:

  • Date: End of the reporting period
  • Debit: Unrealized Loss on Derivative (Expense)
  • Credit: Derivative Asset (Asset)

Example Entry:

Date Account Debit Credit 2024-06-30 Unrealized Loss on Derivative $1,500 Derivative Asset $1,500

Realizing Gains/Losses

When the derivative is settled, any unrealized gains or losses are reclassified to realized gains or losses.

Journal Entry for Realizing Gains:

  • Date: When the derivative is settled
  • Debit: Cash (Asset)
  • Credit: Derivative Asset (Asset)
  • Credit: Realized Gain on Derivative (Revenue)

Example Entry:

Date Account Debit Credit 2024-07-01 Cash $7,000 Derivative Asset $5,000 Realized Gain on Derivative $2,000

Journal Entry for Realizing Losses:

  • Date: When the derivative is settled
  • Debit: Cash (Asset)
  • Debit: Realized Loss on Derivative (Expense)
  • Credit: Derivative Asset (Asset)

Example Entry:

Date Account Debit Credit 2024-07-01 Cash $3,500 Realized Loss on Derivative $1,500 Derivative Asset $5,000

These practical examples illustrate how to record various transactions and adjustments related to equity securities, debt securities, and derivative instruments, ensuring accurate financial reporting and compliance with accounting standards.

Common Mistakes and Best Practices

Common Errors in Recording Investment Income

Misclassifying Realized and Unrealized Gains/Losses

One of the most common mistakes in recording investment income is the misclassification of realized and unrealized gains and losses. Realized gains and losses occur when an investment is sold, and they should be recorded in the income statement. Unrealized gains and losses, on the other hand, arise from changes in the fair value of investments that are still held. These should be recorded in other comprehensive income (OCI) or the income statement, depending on the investment classification. Misclassifying these gains and losses can lead to inaccurate financial statements and misinform stakeholders about the entity’s performance.

Incorrect Timing of Income Recognition

Another frequent error is the incorrect timing of income recognition. Dividends should be recognized when the shareholder’s right to receive the payment is established, not when the payment is received. Interest income should be accrued based on the effective interest rate method, spreading it over the period it is earned. Recognizing income at the wrong time can distort the financial statements, affecting the reported earnings and financial position of the entity.

Best Practices

Regularly Reviewing Fair Value Measurements

Regularly reviewing fair value measurements is essential to ensure that investments are accurately valued in the financial statements. This involves checking the market conditions, comparing prices from multiple sources, and considering any changes in the underlying assumptions. Regular reviews help in identifying any discrepancies or changes in the market value of investments, ensuring that the financial statements reflect the true value of the assets.

Ensuring Accurate and Timely Journal Entries

Accurate and timely journal entries are critical for maintaining reliable financial records. This includes recording all transactions related to investment income promptly and correctly. It is essential to follow the accounting standards and guidelines for recognizing and measuring investment income, ensuring that all entries are supported by adequate documentation. Timely entries help in providing up-to-date financial information for decision-making and compliance purposes.

Using Automation Tools for Consistency

Using automation tools can significantly enhance the accuracy and consistency of recording investment income. Automation tools can help in the automatic calculation and posting of journal entries, reducing the risk of manual errors. They can also provide real-time updates and reports, enabling better monitoring and management of investments. By leveraging technology, entities can streamline their accounting processes, ensure consistency in financial reporting, and improve overall efficiency.

Incorporating these best practices can help avoid common errors and enhance the reliability of financial statements, providing a clearer and more accurate picture of an entity’s financial performance and position.

Conclusion

Summary of Key Points

Importance of Accurate Journal Entries

Accurate journal entries are fundamental to maintaining reliable financial records. They ensure that all financial transactions are correctly recorded, reflecting the true financial performance and position of an entity. Proper journal entries help in complying with accounting standards and regulations, avoiding potential legal and financial repercussions. They also enhance the transparency and credibility of financial statements, fostering trust with stakeholders.

Key Steps in Recording Investment Income

Recording investment income involves several key steps:

  1. Initial Recognition: Record the purchase of investments at their fair value on the acquisition date.
  2. Income Recognition: Accurately recognize dividends when the right to receive payment is established and accrue interest income over the period it is earned.
  3. Fair Value Adjustments: Regularly adjust the carrying amounts of investments to reflect changes in their fair value.
  4. Realized Gains and Losses: Record realized gains and losses when investments are sold, ensuring proper reclassification from unrealized to realized.
  5. Timely and Accurate Journal Entries: Ensure all transactions are recorded promptly and accurately, supported by adequate documentation.

Following these steps ensures that investment income is accurately reflected in the financial statements, providing a clear view of an entity’s earnings and financial health.

Benefits of Understanding and Applying Fair Value Measurement

Understanding and applying fair value measurement offers several benefits:

  • Accurate Valuation: Fair value measurement provides a realistic and timely reflection of an asset’s worth, ensuring that financial statements represent the true market value of investments.
  • Transparency: It enhances the transparency of financial reporting by reflecting market participants’ assumptions and current market conditions.
  • Better Decision-Making: Accurate fair value measurements provide valuable insights into the performance and risks associated with investments, aiding better decision-making by management and stakeholders.
  • Compliance: Adhering to fair value measurement principles ensures compliance with accounting standards such as GAAP and IFRS, avoiding potential regulatory issues.

By understanding and applying fair value measurement, entities can improve the accuracy and reliability of their financial reporting, providing a clearer and more comprehensive view of their financial position and performance.

Additional Resources

Further Reading

Relevant Accounting Standards (GAAP, IFRS)

To gain a deeper understanding of how to prepare journal entries for investment income and the principles of fair value measurement, it’s essential to refer to the relevant accounting standards. These standards provide comprehensive guidelines and detailed requirements:

Articles and Books on Investment Accounting

For a broader perspective and practical insights, consider reading the following articles and books:

Tools and Software

Recommended Accounting Software

Using reliable accounting software can streamline the process of recording investment income and adjusting for fair value changes. Here are some highly recommended options:

  • QuickBooks: QuickBooks Online
  • A popular choice for small to medium-sized businesses, offering features for tracking investments and generating accurate financial reports.
  • Sage Intacct: Sage Intacct
  • An advanced accounting solution suitable for larger organizations, with robust investment tracking and fair value measurement capabilities.
  • Xero: Xero
  • An easy-to-use platform for small businesses, providing tools for managing investments and automating journal entries.

Tools for Fair Value Measurement and Investment Tracking

In addition to accounting software, specialized tools can assist in fair value measurement and tracking investments:

  • Bloomberg Terminal: Bloomberg Terminal
  • Offers comprehensive data and analytics for investment valuation, fair value measurement, and market analysis.
  • Thomson Reuters Eikon: Thomson Reuters Eikon
  • Provides real-time market data, valuation tools, and investment tracking features, ideal for financial professionals.
  • Morningstar Direct: Morningstar Direct
  • A powerful platform for investment research, portfolio management, and fair value analysis.

By leveraging these resources, tools, and software, you can enhance your understanding of investment accounting, ensure accurate financial reporting, and effectively manage your investment portfolios.

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