Accounting for investments in debt and equity securities. (2024)

Concerns have been expressed by regulators and others about therecognition and measurement of investments in debt securities byfinancial institutions. Such criticism intensified following the recentdifficulties experienced by savings and loan institutions and banks. Thecriticisms specifically expressed were--

* the unacceptable diversity in practice in accounting for investmentsin debt securities;

* fair value information about debt securities is more relevant thanhistorical cost information; and

* using historical cost information permitted the practice of "gainstrading."

It was contended that using fair or market value of debt securitieswould be more relevant to assess the solvency of financial institutions.

In response to such concerns, the Financial Accounting Standards Boardrecently devoted considerable attention to its project on financialinstruments. The first step in the process was the issuance of Statementof Financial Accounting Standards (SFAS) No. 107 Disclosures about FairValue of Financial Instruments. FASB's next step was the issuance ofSFAS No. 115 titled Accounting for Certain Investments in Debt andEquity Securities. This standard will supersede SFAS No. 12 Accountingfor Certain Marketable Equity Securities.

Equity and Debt Securities

Even though regulatory criticism was primarily targeted at accountingfor debt securities, fair value is equally relevant to debt and equitysecurities. Therefore, the FASB decided to include in the currentstandard accounting for investments in equity securities, but only thosehaving readily determinable fair values. Equity investments in closelyheld companies and partnerships are excluded from the scope of thestandard because they would not constitute equity securities withreadily determinable market values.

For debt securities, even if there are no quoted market prices, areasonable estimate of fair value can be calculated by using a varietyof pricing techniques such as discounted cash flow analysis, matrixpricing, option-adjusted spread models, and fundamental analysis.

Scope of the Statement

The FASB decided to limit the scope of the project in order to expeditethe resolution of some problems with current accounting practice. Sincethe Board was not able to identify a workable approach for includingliabilities, SFAS No. 115 addresses only issues related to accountingfor certain financial assets without changing the accounting for relatedliabilities. One consequence of a limited scope, however, was theBoard's decision not to require all investments in debt securities to bereported at fair value, with changes in fair value included in earnings.Thus, the FASB's approach can be viewed as a compromise.

The new standard will not change accounting for 1) investments in equitysecurities accounted for under the equity method or investments inconsolidated subsidiaries, and 2) entities such as brokers and dealersin securities, defined benefit pension plans, and investment companiesbecause the specialized accounting practices of such entities includeaccounting for substantially all investments in securities at market orfair value.

While the new standard would be equally applicable to public and non-public entities, not-for-profit organizations are exempted. The FASBdecided to address the issue of investments by not-for-profitorganizations in a separate project related to financial display by suchorganizations.

Three Categories

SFAS No. 115 requires that investments in securities be classified intoone of the following three categories:

* Held to maturity;

* Trading; or

* Available for sale.

For all three categories realized gains and losses, which arise whensecurities are disposed of, are included in the determination ofearnings. Further, dividend and interest income including amortizationof premium and discount is included in earnings for all threecategories. The differences in accounting treatment between thecategories of securities arise only with respect to unrealized gains andlosses. Each security must be classified into one of the threecategories at the time of the acquisition. Further, at each reportingdate the appropriateness of the classification must be reviewed.

Held-to-Maturity

The first category, held to maturity, consists of debt securities thatthe entity has "positive intent and ability" to hold to maturity. Forsecurities held to maturity, fair values may not be appropriate, since,absent default, amortized cost will be realized and any interimunrealized gains and losses will reverse. The FASB decided that suchsecurities are appropriately carried at amortized cost in the financialstatements. Therefore, for debt securities classified as held tomaturity, no unrealized gains and losses will be recognized in financialstatements.

The FASB deliberately decided to make the held-to-maturity categoryrestrictive. If the intent of management is to hold a security only foran "indefinite period," that would not constitute a security which canbe classified as held-to-maturity. Therefore, debt securities cannot beclassified as held-to-maturity if they might be sold in response tochanges in--

* market interest rates and related prepayment risk of the security;

* liquidity needs;

* availability and yield of alternative investments;

* funding sources and terms; and

* foreign currency risk.

Clearly, managerial intent plays a crucial role in classifying a debtsecurity as held-to-maturity. In establishing such intent, relevantfactors to examine include past experience of sales or transfers of suchsecurities. Certain dispositions of securities which are classified asheld-to-maturity would not be inconsistent with the intent to hold thesecurities to maturity, if they meet either of the following twocriteria:

1. The date of sale is so near the maturity date (within three months)that changes in market interest rates would not have a significantimpact on the value of the security; or

2. The sale occurs after a substantial portion (85%) of the principaloutstanding at acquisition has been collected.

In some situations, significant unforeseeable circ*mstances could causea change in intent with respect to some securities without affecting theentity's intent to hold other debt securities to maturity. Selling asecurity prior to maturity because of--

* a significant increase in credit risk of the security;

* a change in tax law eliminating the tax exempt status of theinterest on a security; or

* a major business combination or disposition that necessitates thesale or transfer of securities to maintain existing interest rate riskposition or credit risk policy would not be inconsistent withclassification in the held-to-maturity category.

It is important to emphasize that the first of the three situationsrequires considerable judgement. There are three other circ*mstances inwhich changes with respect to some held-to-maturity securities would notcall into question the intent with respect to other securities currentlyclassified as held-to-maturity. These relate primarily to situationsfaced by regulated financial institutions: changes in statutory orregulatory requirements about permissible investments, significantincreases in capital requirements, or significant increase in the riskweights used for risk-based capital purposes.

TABLE1

PORTFOLIOOFXYZCO.

TypeofNo.ofMarket

SecuritySecurityCostSecuritiesPrice

AEquity101,0006

BDebt101,0009

CDebt101,0008

Trading Securities and Securities Available for Sale

All other debt securities and all equity securities are classifiedeither as trading securities or as securities available for sale. Forsuch securities, the FASB decided that changes in fair value arerelevant to assess managerial decisions and actions in maximizingprofitable use of resources. Hence, the new standard requires that suchchanges in fair value be reflected in the financial statements. However,there are crucial differences in the accounting for trading securitiesand securities classified as available for sale.

Trading securities reflect active and frequent buying and selling, andare held for short periods of time with the objective of generatingprofits from short term differences in price. For trading securities,unrealized holding gains and losses are both recognized by includingthem in earnings. Unrealized holding gains and losses measure the totalchange in fair value--consisting of unpaid interest income earned orunpaid accrued dividend and the remaining change in fair value fromholding the security.

All other securities are classified as available for sale. Thus, allmarketable equity securities--except those categorized as tradingsecurities--which are now covered by SFAS No. 12, are classified asavailable for sale. This category also includes debt securities whichmight be sold prior to maturity to meet liquidity needs or as part of arisk management program.

For securities classified as available for sale, the new standardrequires that unrealized gains and losses be excluded from thedetermination of earnings, but reported separately and accumulated netof an income tax effect in a separate component of shareholders' equity.This represents a significant change from present practice formarketable equity securities classified as current assets. Under SFASNo. 12, unrealized losses for such securities and recoveries of suchlosses have to be recognized in the income statement for the period.

Another important change relates to unrealized holding gains. SFAS No.12 used the lower of cost or market approach on a portfolio wide basis,and prevented the recognition of unrealized holding gains except to theextent they represented recoveries of past unrealized holding losses.Under the new standard unrealized holding gains can be recognized as anet adjustment of shareholders' equity.

Cash flows from purchases and disposition of held-to-maturity andavailable-for-sale securities must be classified as cash flows frominvesting activities. Cash flows from transactions of trading securitiesmust be classified as cash flows from operating activities.

The impact of the new proposals on the income statement and balancesheet are illustrated in greater detail using two examples.

XYZ Company

Assume that the portfolio of XYZ Co. consists of the marketablesecurities at the end of an accounting period as shown in Table 1.

At the end of the period, accounting for the portfolio of securitieswould be as follows:

Current Accounting Practice. Assume equity security A is a currentasset. For this security, as per SFAS No. 12, the lower of cost ormarket rule would apply. The market value is $6,000. Since this is lessthan the cost of $10,000, an unrealized loss of $4,000 would berecognized in the income statement for the period. For debt securities,under present practice, no unrealized loss need be recognized.

Thus, for the entire portfolio the effect would be as follows:

* Income statement effect: A loss of $4,000 would be recognized.

* Balance sheet effect: Assuming a 34% marginal tax rate,shareholders' equity would be reduced by $2,640 (0.66 x $4,000).

Under SFAS 115. Assume that debt security C is classified as "held tomaturity." Thus, the reduction in value of that security will not berecognized. Assume further that debt security B is classified as"available for sale." In other words, none of the securities isclassified as "trading securities."

For equity security A, the unrealized holding loss is as before, $4,000.For debt security B, the net unrealized holding loss is $1,000.

Thus, for the entire portfolio the effect would be as follows:

* Income statement effect: There would be no impact on the incomestatement.

* Balance sheet effect: Assuming a 34% marginal tax rate as before,the reduction in shareholders' equity would now be $3,300 (0.66 x |4,000+ 1,000).

Thus, while the new standard would eliminate the losses to be recognizedon the income statement and thus lead to a higher net income (or, lowernet loss) than would currently be reported, the impact on theshareholders' equity is more negative than is currently the case.

KLM Company

Assume the portfolio of KLM Co. consists of the marketable securities atthe end of an accounting period as shown in Table 2.

At the end of the period, accounting for the portfolio of securitieswould be as follows:

Current Accounting Practice. Assume equity security D is a currentasset. For this security, as per SFAS No. 12, the lower of cost ormarket rule would apply. The market value is $12,000. Since this is morethan the cost of $10,000, there would not be an adjustment in thereported value of the portfolio. For debt securities, under currentpractice, no unrealized loss need be recognized.

Thus, for the entire portfolio the effect would be as follows:

* Income statement effect: No unrealized holding gain or loss isrecognized.

* Balance sheet effect: No impact.

Under SFAS 115. Assume that debt security F is classified as "held tomaturity." Thus, the reduction in value of that security will not berecognized. As before, assume further that all the other securities areclassified as "available for sale." In other words, none of thesecurities is classified as "trading securities."

For equity security D, the unrealized holding gain is $2,000. For debtsecurity E, the unrealized holding loss is $1,000. Thus, for the entireportfolio of securities available for sale, the net holding gain is$1,000.

For the entire portfolio, the effects would be as follows:

* Income statement effect: None of the unrealized losses or gainswould flow through the income statement.

* Balance sheet effect: assuming a 34% marginal tax rate as before,there would now be a net increase of $660 (0.66 x $1,000) inshareholders' equity.

Thus, the standard would lead to a higher value of reportedshareholders' equity being shown on the balance sheet than under currentaccounting practice.

Transfer Among Categories

Transfers among the three categories are accounted for at fair value. Ifa security is transferred into or from the trading category, anyunrealized holding gains and losses must be recognized in earnings. If adebt security is transferred from the held-to-maturity category to theavailable for sale category, unrealized holding gains and losses must berecognized in a separate component of shareholders' equity. For atransfer from the available for sale category to the held-to-maturitycategory, unrealized holding gains and losses will continue to bereported as a separate component of shareholders' equity, but should beamortized over the remaining life of the security (similar to theamortization of premium or discount).

TABLE2

PORTFOLIOOFKLMCO.

TypeofNo.ofMarket

SecuritySecurityCostSecuritiesPrice

DEquity101,00012

EDebt101,0009

FDebt101,0008

In all such situations, details about such transfers must be disclosedin the footnotes to the financial statements. Given the definitions ofheld-to-maturity and trading securities, transfers from the held-to-maturity category and transfers into or out of the trading category areexpected to be rare.

Impairment of Securities

While temporary declines in market value for securities classified asavailable for sale or held-to-maturity are not recognized in the incomestatement of the period, the new standard requires other-than-temporarydeclines to be recognized in earnings for the period. The written downcost basis cannot be changed for subsequent recoveries in fair value.

Subsequent increases and decreases in fair value should be included inthe separate component of equity.

Disclosures

Trading securities must be reported as current assets in classifiedbalance sheets. Individual securities held-to-maturity or available-for-sale should be reported as current or noncurrent, as appropriate underthe requirements of ARB No. 43. The individual amounts for the threecategories of securities need not be presented in the statement offinancial position, as long as the information is provided in the notes.

The notes should include information about aggregate fair value, grossunrealized holding gains, gross unrealized holding losses, and amortizedcost basis by major security types as of each reporting date. Thestandard specifies that for financial institutions, the following wouldconstitute major security types:

* Equity securities;

* Debt securities issued by the U.S. Treasury and other U.S.government corporations;

* Debt securities issued by states of the U.S. and politicalsubdivisions of the states;

* Debt securities issued by foreign governments;

* Corporate securities;

* Mortgage-backed securities; and

* Other debt securities.

In addition, all reporting entities are required to disclose informationabout the contractual maturities of securities classified as held-to-maturity or available for sale, for the most recent date for whichfinancial position is presented. The maturity groupings for financialinstitutions are specified as follows:

* Within one year;

* After 1 year through 5 years;

* After 5 years through 10 years; and

* After 10 years.

Securities not due at a single maturity date can be disclosed separatelyrather than be allocated over several maturity groupings.

The notes should also disclose revenues, gross realized gains and grossrealized losses from the sale of securities available for sale; grossgains and gross losses included in earnings from transfers ofsecurities; the change in net unrealized holding gain or loss that hasbeen included in earnings or in the separate component of shareholders'equity. Further, if there are any sales of or transfers from securitiesclassified as held-to-maturity details including the circ*mstancesleading to the decision to sell or transfer must be provided in thenotes.

Transition

The new statement is effective for fiscal years beginning after December15, 1993. Earlier application as of the beginning of the fiscal year ispermitted for fiscal years beginning after the statement was issued. Forfiscal years beginning prior to December 16, 1993, initial adoption asof the end of the fiscal year is permitted. Retroactive application ofthe statement is prohibited since the classification of securities atany point in time is dependent on managerial intent. The initial effectof applying this statement should be reported as the effect of a changein accounting principle (cumulative effect approach). However, theunrealized holding gain or loss, net of tax effect, for securitiesavailable for sale should be reported as an adjustment of the balance ofthe separate component of shareholders' equity.

Issue of Volatility

Why did the FASB require recognition of fair value in the balance sheetbut exclude the effect of changes in fair value in the income statementfor the period? Many have noted that requiring changes only in theaccounting for assets without a corresponding change in the accountingfor liabilities would have the potential for significant volatility inreported earnings. Such volatility would be unrepresentative of the wayinstitutions manage their business and would have significant impact onthe economy. For instance, it has been suggested that one consequence ofsuch a move would be that financial institutions will be reluctant toengage in long-term lending or invest in long-term instruments such aslong-term U.S. Treasury securities. This could seriously weaken theeconomy by raising the cost of capital for the Treasury, curtailingconsumer lending, and raising home mortgage rates.

In response to such concerns, the FASB chose a compromise option ofrequiring the recognition and measurement of changes in fair value butnot requiring that such changes be recognized in the income statementfor the period. This may not eliminate the problem completely, however,since changes in fair value can still have an adverse impact on the networth of financial institutions and lead to potential problems withcapital adequacy requirements.

The Future

The FASB noted that this standard is only an interim solution, since thestandard does not address all criticisms related to accounting forinvestments in securities. For example, the significant use ofmanagerial intent as a criterion to distinguish among the threecategories of securities can lead to comparability problems. Inaddition, the standard will not reduce the opportunities for selectivelymanaging earnings by engaging in "gains trading"--the practice ofselling those securities whose values have appreciated and therebyincluding realized gains in earnings and selectively excludingunrealized losses from earnings. Further, the standard's requirementthat unrealized gains and losses be recognized in earnings when they aretransferred between categories provides yet another opportunity tomanage earnings.

The FASB is currently engaged in a detailed project on the recognitionand measurement of financial instruments. That project addresses assetsas well as liabilities. Further, companies are required to disclosemarket values of financial instruments under SFAS No. 107 Disclosuresabout Fair Value of Financial Instruments. Some have suggested that theFASB ought to have waited and examined the results of applying SFAS No.107 in practice before addressing the issue of financial statementrecognition and measurement of securities. The FASB has stated that thenew standard is an interim solution given the current diversity inaccounting practice. The FASB expects that the use of fair valueaccounting for financial instruments will be reassessed at anappropriate future time, taking into consideration the experiences fromapplying SFAS Nos. 107 and 115.

Lawrence A. Ponemon, PhD, CPA, is an Associate Professor of Accountingat the State University of New York--Binghamton. K. Raghunandan, PhD, isan Assistant Professor of Accounting at Bentley College.