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Disclaimer: The following essay is intended for informational purposes only and should not be construed as professional financial or accounting advice. Readers are encouraged to consult with qualified professionals or refer to official accounting standards and regulations for accurate guidance on investment accounting practices.
Micah Jeffery
March 9, 2024
Introduction
The Cambridge Dictionary defines an investment as “the act of putting money... into something to make a profit” (“Investment,” 2022). When a company wants to finance operations beyond its retained earnings, it must use financial instruments. These financial instruments, when purchased by another company or entity, are recorded as an investment. There are two types of investments: debt securities and equity securities. Debt securities come in the form of bonds, CDs, commercial paper, or other financial instruments that normally pay interest and do not represent ownership in the issuing company. Equity securities, on the other hand, represent shares in the issuing company (i.e. common stock, preferred stock, or capital stock). Equity securities do not earn interest, but rather a share of the company’s profits, which may or may not be distributed in the form of dividends. Both types of securities are classified as assets on the balance sheet but are accounted for differently elsewhere.
Accounting for Debt Securities
According to the Financial Accounting Standards Board (FASB), the body in charge of establishing U.S. GAAP, there are three classifications for debt securities: Trading securities, available-for-sale (AFS), and held-to-maturity (HTM) (FASB, 2009, ASC 320-10-25-1). When a company purchases a security that pays interest rather than grants ownership, the company must determine the classification. The security will generally be classified as a Trading security if the company intends to sell it within hours or days for a profit. It will be classified as HTM only if there is the intent and ability to hold it until maturity, the date at which all interest and principal must be paid. Finally, the classification of AFS is applied to any security that is not classified as either HTM or Trading. Regardless of the classification, “all investment securities are initially recorded at cost” (Spiceland et al., 2023, p. 641). Generally, the investment account is debited by the face amount and cash is credited by the amount paid.
According to the glossary of the Accounting Standards Codification (ASC), trading securities are “Securities that are bought and held principally for the purpose of selling them in the near term and therefore held for only a short period of time” (FASB, 2009, ASC-Glossary). Trading securities are normally classified as current assets and are reported at fair value. FASB’s ASC 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” (Stuart, 2020, p. 1; FASB, 2009, ASC 820-10-20; PwC, 2022). In other words, the fair value is the price that an asset can be sold based on reasonable estimates. When the fair value changes, an unrealized gain or loss occurs. Unrealized gains or losses to trading securities are used to adjust the investment account and are reported on the income statement in the period that said unrealized gains or losses occur. For the Statement of Cash Flow, while HTM and AFS securities are classified as investing activities, Trading activities can often be classified as operating activities (FASB, ASC 320-10-45-11; Spiceland et al., 2023, p. 650). Whether the cashflow is classified as from operating activities, instead of from financing activities, depends on if the trading is considered part of the entity’s normal operations. Because the unrealized gains or losses are accounted for in the income statement in the period within which they occur, there is no need to record the realized gains or losses upon the sale of the security.
A security should be classified as held-to-maturity (HTM) if, and only if, the reporting entity believes that it will not sell the security until maturity. Additionally, this standard is “distinct from the mere absence of an intent to sell” (FASB, 2009, ASC 320-20-25-3). The entity must positively anticipate holding the security to maturity. If the entity anticipates that it would sell the security in response to a change in market interest rates, foreign currency risk, or liquidity needs, then it should not classify the security as HTM (ASC 320-10-25-4). This requirement disqualifies convertible debt securities because “convertible debt securities generally bear a lower interest rate because the investor hopes to benefit from appreciation in value of the option embedded in the debt security” (ASC 320-10-25-5g). If the entity was positively planning to wait until maturity, then they would not opt for the lower interest rate that comes with convertible debt. Several valid reasons that may cause an entity to not hold the HTM security to maturity include a significant decline of the issuer’s credit rating, relevant changes to tax laws, major changes in the reporting entity, or changes in regulatory requirements. HTM securities are not recognized at fair value but rather are reported at amortized cost on the balance sheet. Unrealized gains or losses are not reported on the income statement or statement of comprehensive income but may need to be disclosed in the notes to the financial statements to provide transparency for investors (Spiceland et al., 2023, p. 645; Northan, 2024, p. 7). The amortized cost basis is the initial cost of the security adjusted for any “applicable accrued interest, accretion, or amortization of premium, discount, and net deferred fees or costs, collection of cash, write-offs, foreign exchange, and fair value hedge accounting adjustments” (Northan, 2024, p. 60). The adjustments each period will bring the carrying value closer to the face value (the amount to be repaid at maturity) of the security until maturity, when they will be equal. If the HTM security is rightfully held to maturity, then there will be no realized gains or losses because the carrying value ends up equal to the face value at the maturity date. If, on the other hand, the investment is sold before maturity, which generally should not be the case, then difference between the selling price and the carrying value is recognized as a realized gain or loss and is reported on the income statement for the period that the sale occurs.
Available-for-sale (AFS) securities, as already mentioned, are securities that are classified as neither Trading nor HTM. Securities that are classified as such are valued at fair value on the balance sheet. When the fair value changes, unrealized gains or losses occur. These gains or losses are not reported on the income statement, but rather are reported as other comprehensive income (OCI). OCI does not affect net income and is summarized in the statement of comprehensive income. On the balance sheet, OCI does not affect retained earnings but rather accumulated other comprehensive income (AOCI), an equity account that typically appears below retained earnings. The rationale for treating AFS’s unrealized gains as OCI is that since they are normally held for multiple reporting periods, the gains and losses over multiple periods will cancel each other out so, “including unrealized holding gains and losses in income each period would confuse investors by making income appear more volatile than it really is over the long run” (Spiceland et al., 2023, p. 651). At the sale of an AFS security, the OCI account is reversed, and the gain or loss is recorded as a realized gain or loss on the income statement.
Below is a chart that illustrates the difference between the three classifications of debt securities:
Accounting for Equity Securities
According to FASB, an equity security is “Any security representing an ownership interest in an entity” (FASB, 2009, ASC 321-10-20). Accounting for equity securities depends on the classification, and the classification depends on the extent of control or influence that the investing entity has over the investee. The investing entity can have no significant influence, significant influence, or control over the investee.
If the investor has no significant influence over the investee, it generally owns less than 20% of voting stock. Possessing 20% ownership leads to a presumption of influence, but that presumption threshold can be superseded if it is demonstrated that the entity has significant influence or if it does not (FASB, 2009, ASC 323-10-15-8). The investments, if their fair value is readily determinable, are accounted for using the fair value through net income method. The security has a readily determinable fair value if it is registered with the SEC, or if its price is publicly reported by NASDAQ or OTC Markets Group. For foreign market securities, it has a readily determinable fair value if “that foreign market is of a breadth and scope comparable to one of the U.S. markets” (ASC 321-10-21b). Finally, for mutual funds or similar securities, it has a readily determinable fair value if the fair value per share is published and used for current transactions. Accounting for the fair value through net income method is very similar to accounting for trading securities. This method recognized any changes in fair value as unrealized gains or losses which are included in the income statement for the period that the change occurred. Additionally, any dividends are recognized as revenue and reported on the income statement (ASC 321-10-35-6).
When the investing entity does not have significant influence, but the security also does not have a readily determinable fair value (as described in the previous paragraph), it can fall under the practicability exception. Under this exception, the “entity may elect to measure an equity security… at its cost minus impairment, if any” (FASB, 2009, 321-10-35-2). Using the cost method is not required, however. Such a security can be measured at fair value even if the cost method was previously used. Cost is simply the security’s purchase price, and an impairment is a reduction in the value of a security, which can be caused by deterioration in earnings, cash flows, or business prospects (Spiceland et al., 2023, p. 667; ASC 321-10-35-3). The methods for how impairments are calculated must be provided in the notes to the financial statements (Spiceland et al., 667). Each accounting period, the entity must reassess whether the security has a readily determinable fair value. If the security’s fair value becomes readily determinable, the entity must revert to valuing it using the fair value through net income method. The cost method, like the fair value through net income method, recognizes any dividends as revenue in the income statement.
If the investing entity holds 50% or less of ownership in the investee, and it is shown that there is significant influence, then the equity method is used to account for the related equity securities. Significant influence, again, is presumed with a 20% or more ownership of the investee, however, it is determined using a variety of factors including representation on the investees board of directors, influence over policies, shared management or technology, legal agreements to limit influence, evidence of the investee refusing influence, etc. (FASB, 2009, ASC 323-10-15-6&10). In the equity method, the securities are not measured at fair value on the balance sheet but rather at cost (or sometimes the initial fair value) plus the investor’s proportionate share of the investee’s proceeding earnings (ASC 323-10-35-4) available to common shareholders, that is, after deducting preferred stock dividends (ASC 323-10-35-16). If the investing entity owns 25% of another company, the investee will recognize 25% of that company’s net income as revenue available to shareholders in the investing entity’s income statement. Additionally, the carrying value of the security will increase by the amount of the investor’s share of the revenue available to common shareholders. The reason for increasing the carrying value is that if the investee turns a profit, their assets will increase, which warrants an increase in a claim on those assets. Unlike the previous methods, the equity method does not recognize dividends as revenue, since dividends are merely a distribution of earnings that shareholders already own. Since the investor recognized the earnings when the investee earned them, the investor cannot recognize them a second time at distribution. Furthermore, any dividends will decrease the carrying value of the investment as that amount is transferred to cash (or another asset). A noteworthy exception to the 20-50% rule is for Limited Partnership Investments which have a much lower threshold for using the equity method. The threshold is based on “more than minor influence” rather than significant influence which, according to an SEC Staff Announcement, is met with more than 3-5% ownership (Bennett, 2019; ASC 323-30-S99-1).
Generally, ownership of more than 50% of another entity indicates control of said entity. An investor may, however, possess control with less than 50% ownership by contract, court decree, or for other reasons (FASB, 2009, ASC 810-10-15-8). If the investing entity does have control, it is referred to as the parent company and the investee in referred to as the subsidiary. The parent company must combine their financials with the subsidiary’s financials into consolidated financial statements after excluding intra-entity transactions and balances (ASC 810-10-45-1). All the subsidiary’s assets and liabilities must be reported on the consolidated financial statement in addition to those of the parent company. The carrying value of the equity security is brought to zero, since the investment is accounted for with the additional assets and liabilities. “Revenues, expenses, gains, losses, net income or loss, and other comprehensive income shall be reported in the consolidated financial statements at the consolidated amounts” (ASC 810-10-45-19) after excluding intra-entity transactions. Any retained earnings or deficit from before the acquisition should also be excluded (ASC 810-10-45-2). Any dividends are excluded from the consolidated financial statements because they are transactions within a single economic entity.
Below is a chart that illustrates the difference between the four methods of accounting for equity securities:
Conclusion
In summary, investments can be debt securities or investment securities. Short-term debt securities that are traded frequently are Trading securities, are valued at fair value, and their unrealized gains are recognized as earnings in the period that they occur. Long-term debt securities are classified as HTM securities and are valued using amortized cost. Any debt securities that are neither Trading nor HTM are AFS and are valued at fair value, but with unrealized gains being excluded from net income until they are realized. Equity investments without a significant influence use the fair value through net income method, which is essentially the same as Trading securities. If the fair value is not readily available, then the security can be valued at cost less impairment, with dividends being recognized as revenue. If there is significant influence but no control, then the equity method should be employed, which uses cost plus the share of earnings and less dividends to determine the carrying value. Finally, if the equity security constitutes control, then the financial statements of the parent and the subsidiarity are consolidated after excluding intra-company transactions and balances.
References
References
Bennett, E. (2019, December 9). Remarks before the 2019 AICPA Conference on Current SEC and PCAOB Developments. https://www.sec.gov/news/speech/bennett-speech-2019-aicpa-conference
FASB (Financial Accounting Standards Board). (2009, July 1). Accounting standards codification. Retrieved from https://asc.fasb.org/
Investment. (2022). In Cambridge Dictionary. Cambridge University. https://dictionary.cambridge.org/us/dictionary/english/investment
Northan, M. (2024, February). Handbook: Investments. KPMG. https://frv.kpmg.us/content/dam/frv/en/pdfs/2024/handbook-investments-1.pdf
PwC. (2022, March 31). 4.2 Definition of fair value. Viewpoint.pwc.com. https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/fair_value_measureme/fair_value_measureme__9_US/chapter_4_concepts_u_US/42_definition_of_fai_US.html
Spiceland, D., Nelson, M., Thomas, W., & Winchel, J. (2023). Intermediate accounting. McGraw-Hill LLC.
Stuart, R. (2020). U.S. GAAP vs. IFRS: Fair value measurements. RSM. https://rsmus.com/pdf/us-gaap-vs-ifrs-fair-value-measurements.pdf
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