Accounting for investments in debt and equity securities.by Raghunandan, K.
Concerns have been expressed by regulators and others about the recognition and measurement of investments in debt securities by financial institutions. Such criticism intensified following the recent difficulties experienced by savings and loan institutions and banks. The criticisms specifically expressed were--
* the unacceptable diversity in practice in accounting for investments in debt securities;
* fair value information about debt securities is more relevant than historical cost information; and
* using historical cost information permitted the practice of "gains trading."
It was contended that using fair or market value of debt securities would be more relevant to assess the solvency of financial institutions.
In response to such concerns, the Financial Accounting Standards Board recently devoted considerable attention to its project on financial instruments. The first step in the process was the issuance of Statement of Financial Accounting Standards (SFAS) No. 107 Disclosures about Fair Value of Financial Instruments. FASB's next step was the issuance of SFAS No. 115 titled Accounting for Certain Investments in Debt and Equity Securities. This standard will supersede SFAS No. 12 Accounting for Certain Marketable Equity Securities.
Equity and Debt Securities
Even though regulatory criticism was primarily targeted at accounting for debt securities, fair value is equally relevant to debt and equity securities. Therefore, the FASB decided to include in the current standard accounting for investments in equity securities, but only those having readily determinable fair values. Equity investments in closely held companies and partnerships are excluded from the scope of the standard because they would not constitute equity securities with readily determinable market values.
For debt securities, even if there are no quoted market prices, a reasonable estimate of fair value can be calculated by using a variety of pricing techniques such as discounted cash flow analysis, matrix pricing, option-adjusted spread models, and fundamental analysis.
Scope of the Statement
The FASB decided to limit the scope of the project in order to expedite the resolution of some problems with current accounting practice. Since the Board was not able to identify a workable approach for including liabilities, SFAS No. 115 addresses only issues related to accounting for certain financial assets without changing the accounting for related liabilities. One consequence of a limited scope, however, was the Board's decision not to require all investments in debt securities to be reported 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 equity securities accounted for under the equity method or investments in consolidated subsidiaries, and 2) entities such as brokers and dealers in securities, defined benefit pension plans, and investment companies because the specialized accounting practices of such entities include accounting for substantially all investments in securities at market or fair value.
While the new standard would be equally applicable to public and non- public entities, not-for-profit organizations are exempted. The FASB decided to address the issue of investments by not-for-profit organizations in a separate project related to financial display by such organizations.
SFAS No. 115 requires that investments in securities be classified into one of the following three categories:
* Held to maturity;
* Trading; or
* Available for sale.
For all three categories realized gains and losses, which arise when securities are disposed of, are included in the determination of earnings. Further, dividend and interest income including amortization of premium and discount is included in earnings for all three categories. The differences in accounting treatment between the categories of securities arise only with respect to unrealized gains and losses. Each security must be classified into one of the three categories at the time of the acquisition. Further, at each reporting date the appropriateness of the classification must be reviewed.
The first category, held to maturity, consists of debt securities that the entity has "positive intent and ability" to hold to maturity. For securities held to maturity, fair values may not be appropriate, since, absent default, amortized cost will be realized and any interim unrealized gains and losses will reverse. The FASB decided that such securities are appropriately carried at amortized cost in the financial statements. Therefore, for debt securities classified as held to maturity, no unrealized gains and losses will be recognized in financial statements.
The FASB deliberately decided to make the held-to-maturity category restrictive. If the intent of management is to hold a security only for an "indefinite period," that would not constitute a security which can be classified as held-to-maturity. Therefore, debt securities cannot be classified as held-to-maturity if they might be sold in response to changes 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 debt security as held-to-maturity. In establishing such intent, relevant factors to examine include past experience of sales or transfers of such securities. Certain dispositions of securities which are classified as held-to-maturity would not be inconsistent with the intent to hold the securities to maturity, if they meet either of the following two criteria:
1. The date of sale is so near the maturity date (within three months) that changes in market interest rates would not have a significant impact on the value of the security; or
2. The sale occurs after a substantial portion (85%) of the principal outstanding at acquisition has been collected.
In some situations, significant unforeseeable circumstances could cause a change in intent with respect to some securities without affecting the entity's intent to hold other debt securities to maturity. Selling a security 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 the interest on a security; or
* a major business combination or disposition that necessitates the sale or transfer of securities to maintain existing interest rate risk position or credit risk policy would not be inconsistent with classification in the held-to-maturity category.
It is important to emphasize that the first of the three situations requires considerable judgement. There are three other circumstances in which changes with respect to some held-to-maturity securities would not call into question the intent with respect to other securities currently classified as held-to-maturity. These relate primarily to situations faced by regulated financial institutions: changes in statutory or regulatory requirements about permissible investments, significant increases in capital requirements, or significant increase in the risk weights used for risk-based capital purposes.
Trading Securities and Securities Available for Sale
All other debt securities and all equity securities are classified either as trading securities or as securities available for sale. For such securities, the FASB decided that changes in fair value are relevant to assess managerial decisions and actions in maximizing profitable use of resources. Hence, the new standard requires that such changes in fair value be reflected in the financial statements. However, there are crucial differences in the accounting for trading securities and securities classified as available for sale.
Trading securities reflect active and frequent buying and selling, and are held for short periods of time with the objective of generating profits from short term differences in price. For trading securities, unrealized holding gains and losses are both recognized by including them in earnings. Unrealized holding gains and losses measure the total change in fair value--consisting of unpaid interest income earned or unpaid accrued dividend and the remaining change in fair value from holding the security.
All other securities are classified as available for sale. Thus, all marketable equity securities--except those categorized as trading securities--which are now covered by SFAS No. 12, are classified as available for sale. This category also includes debt securities which might be sold prior to maturity to meet liquidity needs or as part of a risk management program.
For securities classified as available for sale, the new standard requires that unrealized gains and losses be excluded from the determination of earnings, but reported separately and accumulated net of an income tax effect in a separate component of shareholders' equity. This represents a significant change from present practice for marketable equity securities classified as current assets. Under SFAS No. 12, unrealized losses for such securities and recoveries of such losses 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 the extent they represented recoveries of past unrealized holding losses. Under the new standard unrealized holding gains can be recognized as a net adjustment of shareholders' equity.
Cash flows from purchases and disposition of held-to-maturity and available-for-sale securities must be classified as cash flows from investing activities. Cash flows from transactions of trading securities must be classified as cash flows from operating activities.
The impact of the new proposals on the income statement and balance sheet are illustrated in greater detail using two examples.
Assume that the portfolio of XYZ Co. consists of the marketable securities at the end of an accounting period as shown in Table 1.
At the end of the period, accounting for the portfolio of securities would be as follows:
Current Accounting Practice. Assume equity security A is a current asset. For this security, as per SFAS No. 12, the lower of cost or market rule would apply. The market value is $6,000. Since this is less than the cost of $10,000, an unrealized loss of $4,000 would be recognized 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 to maturity." Thus, the reduction in value of that security will not be recognized. Assume further that debt security B is classified as "available for sale." In other words, none of the securities is classified 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 income statement.
* 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 recognized on the income statement and thus lead to a higher net income (or, lower net loss) than would currently be reported, the impact on the shareholders' equity is more negative than is currently the case.
Assume the portfolio of KLM Co. consists of the marketable securities at the end of an accounting period as shown in Table 2.
At the end of the period, accounting for the portfolio of securities would be as follows:
Current Accounting Practice. Assume equity security D is a current asset. For this security, as per SFAS No. 12, the lower of cost or market rule would apply. The market value is $12,000. Since this is more than the cost of $10,000, there would not be an adjustment in the reported value of the portfolio. For debt securities, under current practice, 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 is recognized.
* Balance sheet effect: No impact.
Under SFAS 115. Assume that debt security F is classified as "held to maturity." Thus, the reduction in value of that security will not be recognized. As before, assume further that all the other securities are classified as "available for sale." In other words, none of the securities is classified as "trading securities."
For equity security D, the unrealized holding gain is $2,000. For debt security E, the unrealized holding loss is $1,000. Thus, for the entire portfolio 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 gains would 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) in shareholders' equity.
Thus, the standard would lead to a higher value of reported shareholders' equity being shown on the balance sheet than under current accounting practice.
Transfer Among Categories
Transfers among the three categories are accounted for at fair value. If a security is transferred into or from the trading category, any unrealized holding gains and losses must be recognized in earnings. If a debt security is transferred from the held-to-maturity category to the available for sale category, unrealized holding gains and losses must be recognized in a separate component of shareholders' equity. For a transfer from the available for sale category to the held-to-maturity category, unrealized holding gains and losses will continue to be reported as a separate component of shareholders' equity, but should be amortized over the remaining life of the security (similar to the amortization of premium or discount).
In all such situations, details about such transfers must be disclosed in the footnotes to the financial statements. Given the definitions of held-to-maturity and trading securities, transfers from the held-to- maturity category and transfers into or out of the trading category are expected to be rare.
Impairment of Securities
While temporary declines in market value for securities classified as available for sale or held-to-maturity are not recognized in the income statement of the period, the new standard requires other-than-temporary declines to be recognized in earnings for the period. The written down cost basis cannot be changed for subsequent recoveries in fair value.
Subsequent increases and decreases in fair value should be included in the separate component of equity.
Trading securities must be reported as current assets in classified balance sheets. Individual securities held-to-maturity or available-for- sale should be reported as current or noncurrent, as appropriate under the requirements of ARB No. 43. The individual amounts for the three categories of securities need not be presented in the statement of financial position, as long as the information is provided in the notes.
The notes should include information about aggregate fair value, gross unrealized holding gains, gross unrealized holding losses, and amortized cost basis by major security types as of each reporting date. The standard specifies that for financial institutions, the following would constitute 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 political subdivisions 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 information about the contractual maturities of securities classified as held-to- maturity or available for sale, for the most recent date for which financial position is presented. The maturity groupings for financial institutions 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 separately rather than be allocated over several maturity groupings.
The notes should also disclose revenues, gross realized gains and gross realized losses from the sale of securities available for sale; gross gains and gross losses included in earnings from transfers of securities; the change in net unrealized holding gain or loss that has been included in earnings or in the separate component of shareholders' equity. Further, if there are any sales of or transfers from securities classified as held-to-maturity details including the circumstances leading to the decision to sell or transfer must be provided in the notes.
The new statement is effective for fiscal years beginning after December 15, 1993. Earlier application as of the beginning of the fiscal year is permitted for fiscal years beginning after the statement was issued. For fiscal years beginning prior to December 16, 1993, initial adoption as of the end of the fiscal year is permitted. Retroactive application of the statement is prohibited since the classification of securities at any point in time is dependent on managerial intent. The initial effect of applying this statement should be reported as the effect of a change in accounting principle (cumulative effect approach). However, the unrealized holding gain or loss, net of tax effect, for securities available for sale should be reported as an adjustment of the balance of the separate component of shareholders' equity.
Issue of Volatility
Why did the FASB require recognition of fair value in the balance sheet but exclude the effect of changes in fair value in the income statement for the period? Many have noted that requiring changes only in the accounting for assets without a corresponding change in the accounting for liabilities would have the potential for significant volatility in reported earnings. Such volatility would be unrepresentative of the way institutions manage their business and would have significant impact on the economy. For instance, it has been suggested that one consequence of such a move would be that financial institutions will be reluctant to engage in long-term lending or invest in long-term instruments such as long-term U.S. Treasury securities. This could seriously weaken the economy by raising the cost of capital for the Treasury, curtailing consumer lending, and raising home mortgage rates.
In response to such concerns, the FASB chose a compromise option of requiring the recognition and measurement of changes in fair value but not requiring that such changes be recognized in the income statement for the period. This may not eliminate the problem completely, however, since changes in fair value can still have an adverse impact on the net worth of financial institutions and lead to potential problems with capital adequacy requirements.
The FASB noted that this standard is only an interim solution, since the standard does not address all criticisms related to accounting for investments in securities. For example, the significant use of managerial intent as a criterion to distinguish among the three categories of securities can lead to comparability problems. In addition, the standard will not reduce the opportunities for selectively managing earnings by engaging in "gains trading"--the practice of selling those securities whose values have appreciated and thereby including realized gains in earnings and selectively excluding unrealized losses from earnings. Further, the standard's requirement that unrealized gains and losses be recognized in earnings when they are transferred between categories provides yet another opportunity to manage earnings.
The FASB is currently engaged in a detailed project on the recognition and measurement of financial instruments. That project addresses assets as well as liabilities. Further, companies are required to disclose market values of financial instruments under SFAS No. 107 Disclosures about Fair Value of Financial Instruments. Some have suggested that the FASB ought to have waited and examined the results of applying SFAS No. 107 in practice before addressing the issue of financial statement recognition and measurement of securities. The FASB has stated that the new standard is an interim solution given the current diversity in accounting practice. The FASB expects that the use of fair value accounting for financial instruments will be reassessed at an appropriate future time, taking into consideration the experiences from applying SFAS Nos. 107 and 115.
Lawrence A. Ponemon, PhD, CPA, is an Associate Professor of Accounting at the State University of New York--Binghamton. K. Raghunandan, PhD, is an Assistant Professor of Accounting at Bentley College.
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2009 The New York State Society of CPAs. Legal Notices
Visit the new cpajournal.com.