Professional literature of the accounting for marketable investments in debt securities isn’t easy to find. The only principle guidance that could be found, so far, is the Accounting Standard Codification (a.k.a the new U.S. GAAP by the FASB) codenamed ASC 320. The codification applies to both equity and debt instruments held as investments, and prescribe fair value accounting for all—except debt instruments being held to maturity.
The guidance stipulated that the amortized cost method be used, absent a substantial, other-than-temporary decline in value.
The same codification also requires that investments in debt securities be classified, upon acquisition, as belonging to one of three portfolios: (1) trading; (2) available-for-sale; or (3) held-to-maturity. What is trading debt securities? What is available-for-sale debt securities? What is held-to-maturity debt security? What would be happened if a debt security is transferred from one category to another? In short, what is the accounting for marketable investments in debt security? That is the topic I am going to discuss through this post which is based on the Accounting Standard Codification, the ASC 320-10-25 to be exact. Read on…
Accounting For Investments in Debt Securities in General
According to the ASC 320-10-25, investments in debt securities could be classified either to:
1. Trading Portfolios – Portfolios that are characterized by frequent purchase and sale activities, with the INTENTION of realizing profits from short-term price movements—which in the case of investments in debt instruments will largely be the result of changes in market interest rates. In some cases it may also be affected by market perceptions of credit risk. Some pause buy-and-sale activities do not necessarily a reason for not classifying portfolios to this group since the ‘intention’ is the prime criterion applied.
2. Available-for-sale Portfolios – Portfolios in this category is not intended for trading but it is available for sale. It means the holder did not intend to acquire the portfolios for getting profit from short term price movements, but also has no obligation to hold the portfolios for quiet long time.
3. Held-to-maturity Portfolios – Debt instruments can be so classified as held-to-maturity only if the reporting entity has both the positive intent and the ability to hold the securities for that length of time. A mere intent to hold an investment for an indefinite period is not adequate to permit such a classification. Well, this category is the most restrictive of the three. On the other hand, a variety of isolated causes may necessitate transferring an investment in a debt security from the held-to-maturity category without calling into question the investor’s general intention to hold other similarly classified investments to maturity. Sales of investments that were classified as held-to-maturity for other reasons, however, will raise doubts about the entity’s assertions regarding these and other similarly categorized securities.
Accounting for debt securities that are held for trading and those that are available for sale based on “fair value.” Increases or decreases in value are reflected by adjustments to the asset account, for balance sheet purposes. In this case, the adjustments are to be determined on an individual security basis.
Changes in the values of debt securities in the trading portfolio are recognized in net income immediately, while most changes in the values of debt securities in the available-for-sale category are reported in other comprehensive income rather than being included in net income.
Note: An exception is for declines that are deemed to be other than temporary, in which case the loss is recognized currently in net income. Once the investment is written down for a decline that is other than temporary, subsequent increases are reported only in changes to the contra equity account; increases cannot be accounted for as “recoveries” of previous declines.
Transfers Of Debt Securities Among Categories
Transfer of any given security between categories is accounted for at fair value. However:
- If the transfer is from the trading category, there is no further income statement effect since the fair value-based gains or losses have already been reported.
- If the transfer is to the trading category, the unrealized gain or loss is recognized immediately.
Depending on whether the transfer is from the ‘available-for-sale’ or the ‘held-to-maturity’ category, such unrealized gain or loss would have been included in the accumulated other comprehensive income account on the balance sheet, after having been reported as an element of other comprehensive income, or would not have been reported at all prior to the transfer:
- If the debt security is being transferred from held-to-maturity to the available-for-sale category, the unrealized gain or loss, not previously reflected in the investment account, will be added to the appropriate accumulated other comprehensive income account at the date of transfer and reported in other comprehensive income.
- If a security is being transferred from available-for-sale to held-to-maturity, the unrealized holding gain or loss previously accrued will continue to be maintained in the accumulated other comprehensive income account, but now will be amortized to income over the period until maturity as an adjustment of yield, using the effective interest method.
For purposes of the disclosures required by ASC 320, the fair value as of the date of transfer to the held-to-maturity classification, net of any subsequent amortization of the discrepancy between fair value and maturity or par value as of the transfer date, will be the new “cost”
Example Of Accounting For Debt Securities Involving Transfers
Lie Dharma Corporation purchases the following debt securities as investments in 2009:
Issue Face value Price paid
Locktones Chemical 8% due 2013 $200,000 $190,000
Pharmaton Pharmaceutical 9.90% due 2025 $500,000 $575,000
Colorado Mining 4% due 2011 $100,000 $ 65,000
Note: On the “Price Paid”, it is assumed that accrued interest is ignored in these amounts; the normal entries for interest accrual and receipt.
Management has informed us that Lie Dharma’s objectives differed among the various investments:
- The Locktones bonds are considered to be suitable as a long-term investment, with the intention that they will be held until maturity.
- The Colorado bonds are a speculation; the significant discount from par value was seen as very attractive, despite the low coupon rate. Management believes the bonds were depressed because mining stocks and bonds have been out of favor, but believes the economic recovery will lead to a surge in market value, at which point the bonds will be sold for a quick profit.
- The Pharmaton Pharmaceutical bonds are deemed a good investment, but with a maturity date sixteen years in the future, management is unable to commit to holding these to maturity.
Based on the foregoing, the appropriate accounting for the three investments in bonds would be as follows:
- Locktones Chemical 8% due 2013 – Account for these as held-to-maturity; maintain at historical cost, with discount ($10,000) to be amortized over term to maturity (assumed to be four years, for an amortization of $2,500 per year).
- Pharmaton Pharmaceutical 9.90% due 2025 – Account for these as available-for-sale, since neither the held-for-trading nor held-to maturity criteria apply. These are to be reported at fair value at each balance sheet date, with any unrealized gain or loss included in the additional/contra equity account, unless an “other than-temporary” decline occurs.
- Colorado Mining 4% due 2011 – As an admitted speculation, these are accounted for as part of the trading category, and also reported at fair value on the balance sheet. All adjustments to carrying value will be included in net income each year, irrespective of whether the fluctuations are deemed to be temporary.
Transfers between categories are to be accounted for at fair value at the date of the transfer. Consider the following events:
1. Lie Dharma management decides in 2010, when the Pharmaton bonds have a fair value of $604,500, that the bonds will be disposed of in the short term, hopefully when the price hits $605,000. The bonds are presently carried on the books at $580,000, which was the fair value at the time the year-end 2009 financial statements were being prepared. Based on this description of the decision, the bonds are to be transferred to the trading portfolio at a “cost” of $604,500. The journal entry to record this would be the following:
[Debit]. Investment in debt securities—held-for-trading = $604,500
[Credit]. Unrealized gain on holding debt securities as investment = $5,000
[Credit]. Investment in debt securities—available-for-sale = $580,000
[Credit]. Gain on holding debt securities = $29,500
The previously unrealized gain (reflected in the write-up of the investment from original cost, $575,000, to the fair value at year-end 2009, $580,000) is now “realized” for financial reporting purposes, as is the further rise in value from $580,000 to $604,500 at the time the portfolio transfer takes place.
2. Assume that at year-end 2009 the investment in the Pharmaton bonds is still held, and the fair value has declined to $602,000. Management’s intentions regarding this holding have not changed since the decision to transfer to held-for-trading. The year-end adjustment entry will be:
[Debit]. Loss on holding debt securities = $2,500
[Credit]. Investment in debt securities—held-for-trading = $2,500
The market decline is reflected in net income in 2009, since the bonds are in the held for trading portfolio.
3. Next, assume that in 2010, management determines that a major investment in plant renewal and expansion will likely be necessary by the year 2012, based on a detailed capital budget prepared. With this in mind, Lie Dharma Corporation determines that the holding of Pharmaton Pharmaceutical bonds would be an excellent vehicle to provide for these future cash needs, and accordingly concludes to hold these to maturity. At the time this decision is made, the fair value of the bonds is quoted at $603,000. The journal entry to record the transfer from ‘held-for-trading’ to ‘held-to-maturity’ is as follows:
[Debit]. Investment in debt securities—held-to-maturity = $603,000
[Credit]. Investment in debt securities held-for-trading = $602,000
[Credit]. Gain on holding debt securities = $1,000
The bonds are again transferred at fair value, which in this case gives rise to a $1,000 recognized gain.
4. In 2010 Lie Dharma management also made a decision about its investment in Locktones Chemical bonds. These bonds, which were originally designated as held-to-maturity, were accounted for at amortized historical cost. Assume the amortization in 2009 was $2,000 (because the bonds were not held for a full year), so that the book value of the investment at year-end 2009 was $192,000. In 2010, at a time when the value of these bonds was $198,000, management concluded that it was no longer certain that they would be held to maturity, and therefore transferred this holding to the available-for-sale portfolio. The journal entry to record this would be:
[Debit]. Investment in debt securities—available-for-sale = $198,000
[Credit]. Unrealized gain on holding debt securities as investment = $6,000
[Credit]. Investment in debt securities—held-to-maturity = $192,000
The transfer is at fair value, but since the bonds are being transferred into the ‘available-for-sale’ category (for which unrealized gains and losses are recorded in an additional or contra equity account), the gain at this date, $6,000, is not recognized in net income, but rather will be reported in other comprehensive income.
5. In 2011, for the same reason management determined to hold the Pharmaton Pharmaceuticals bonds to maturity, it also reverses its prior decision regarding the Locktones Chemical bond holding. It now professes an intention to hold these until their maturity, in 2013. At the date this decision is made, the Locktones bonds are quoted at $195,000. Assume that the value at year-end 2010 had been $198,000, so no adjustment was needed at that time to the carrying value of the investment. So, again the transfer will be recorded at fair value—with the following journal entry:
[Debit]. Investment in debt securities—held-to-maturity = $195,000
[Debit]. Unrealized gain on holding debt securities as investment = $3,000
[Credit]. Investment in debt securities—available-for-sale = $198,000
Keep in mind that, the unrealized gain previously recognized in an equity account is partially eliminated, since fair value at the date of this transfer is less than the previously recorded amount. The change in this equity account must be reported as other comprehensive income for the period in which this portfolio reclassification occurs. The remaining balance in the additional/contra equity account (whether a net debit or credit) is accounted for as additional premium or discount, and is amortized over the remaining term to maturity.
GAAP mandates that the effective yield method be used, but for this example, assume that the discount will be amortized over the remaining two years on the straight-line basis (if this difference from the effective yield method is not material, this would be an acceptable practice).
Thus, the actual discount as measured by the spread between the new carrying value, $195,000, and face value to be received at maturity, $200,000, plus the additional discount measured by the unrealized gain reported in the equity section of $3,000, gives a total discount amounting to $8,000 to be amortized over the remaining two years. This $8,000, when added to the $2,000 discount amortized in 2010 (when the bonds were in the original ‘held-to-maturity’ portfolio), equals $10,000, which is the discount between the face value, $200,000 and the price paid by Lie Dharma Corporation ($190,000).
Take a note that, the illustrated reclassification of the Locktones Chemical bonds from the ‘held-to-maturity’ to the ‘available-for-sale’ portfolios would, in most instances, have serious adverse consequences for Lie Dharma. Under the new U.S. GAAP codification (i.e. the ASC 320,) classification as ‘held-to-maturity’ can only occur when, at acquisition, management has both the intent and the ability to maintain the investment until maturity.
A sale prior to maturity is taken as an indication that its intent was not truly present, and accordingly, use of the held-to-maturity classification for any other investments will be precluded, unless the sale before maturity is precipitated by certain events.
Those events are:
- A major business acquisition or disposition necessitating portfolio changes to maintain the entity’s interest rate risk posture.
- A tax law change affecting the tax-exempt status of the investment holding.
- Evidence of a substantial deterioration in the issuer’s creditworthiness.
- For banks or thrifts, a change in regulatory capital requirements such that a significant downsizing is necessitated, including disposition of the bond portfolio.
- A significant increase in risk weighting (under bank and thrift capital rules) of the held-to-maturity investments, again necessitating dispositions of these investments
While a transfer from the held-to-maturity to the available-for-sale portfolios would not be a sale, it would be demonstrative of an intent or willingness to dispose of the investment, which would be equally suggestive of an earlier misrepresentation of management’s intent regarding those investments. While not prohibited, such transfers would be very rare and carry an accounting risk for the reporting entity.
Presentation In The Financial Statements
Trading securities must always be grouped with current assets in classified balance sheets, and held-to-maturity investments will be non-current (unless the maturity date is within one year).
Available-for sale securities may conceivable be classified as either current or non-current.
- If declines in value are deemed to meet ASC 320’s definition of “other than temporary,” then these are to be included in net income in the current period. However, subsequent recoveries cannot be recognized in net income.
- If available-for-sale investments are written down for such impairments that later reverse, the recovery is accounted for as an increase in fair value to be reflected in the other comprehensive income account, on the balance sheet only.
- If held-to-maturity investments are similarly written down and later recover some or all of the lost value, the fair value increase will not be reported in the balance sheet at all, although disclosure will generally be made in the notes.
For purposes of reporting in the statement of cash flows, all purchases and sales of trading securities must be included in the operations section, while those of available-for-sale and held-to-maturity investments are to be shown as part of investing activities. ASC 320 requires specific disclosures of the components of a reporting entity’s portfolios of investments. For available-for-sale securities and (separately) for held-to-maturity securities, classification by type of security is necessary.
Aggregate fair values, gross unrealized holding gains, and gross unrealized holding losses must also be disclosed, by major security type, as of the date of each balance sheet being presented.
For the available-for-sale and held-to-maturity portfolios, information about contractual maturities must be presented as of the date of the latest balance sheet presented and must be grouped into at least four categories: within one year; one to five years; five to ten years; and, over ten years. Both fair values and amortized cost of debt securities in each maturity category must be presented.
For each income statement presented, proceeds from the sales of available-for-sale securities, and the gross realized gains and losses resulting from those sales, also must be disclosed. The basis upon which the gains or losses were determined, must be disclosed. In addition, the notes must identify gross gains or losses included in net income resulting from transfers of securities from the available-for-sale to the trading portfolio, and the net change in unrealized gains or losses recognized by an adjustment of the contra equity account.
For sales or transfers from securities categorized as held-to-maturity, the amortized cost amounts, the related gains or losses realized or unrealized, and the circumstances surrounding the decision to sell or to reclassify the investment, are all to be disclosed in the notes to the financial statements for each period for which an income statement is being presented.