The accounting and financial reporting requirements for investments in debt and equity securities under US GAAP continues to be an area of focus and complexity for preparers and users of financial statements. This accounting topic applies to substantially all entities and investments often comprise a significant asset on the financial statements. The purpose of this article is to provide an overview of the current accounting and reporting requirements under US GAAP for investments in debt and equity securities.
Investments in Equity Securities
An equity security is any security representing an ownership interest in an entity, examples of which include common stock, preferred stock, other classes of stock, rights to acquire equity (e.g., warrants, call options, rights) or rights to sell equity (e.g., put options, forward sale contracts) at fixed or determinable prices.
The introduction of ASU 2016-01 introduced significant changes to the model of accounting for investments in equity securities whereby substantially all investments in equity securities are now required to be carried at fair value, with changes in fair value included as a component of earnings. Several exceptions to this measurement model exist, consisting primarily of investments required to be classified and accounted for under the equity method of accounting, investments requiring consolidation, investments that qualify for the net asset value (NAV) carrying value practical expedient, and equity investments that do not have a readily determinable fair value and thereby qualify for the measurement alternative. Under the measurement alternative, an entity may elect to carry the investments at cost, less any impairment. In addition, under the measurement alternative, the carrying value must be adjusted to reflect any orderly market transactions observed in the same or similar securities of the issuer, and such adjustments would result in a carrying value that is now measured at fair value in accordance with ASC 820.
Investments in equity securities with readily determinable fair values are generally classified as current in a classified balance sheet, even if an entity does not necessarily intend to dispose of the securities within a year, as such investments are available to be used in current operations. Equity investments are required to be presented as a separate line item on the balance sheet (or disclosed in the notes to the financial statements as to which line item includes equity investments). The fair value disclosure requirements included in ASC 820 apply to investments in equity securities carried at fair value. In addition, for all equity investments, entities are required to disclose the portion of unrealized gains and losses recognized during the period that relates to equity investments held at the reporting date for each period for which results of operations are presented.
Investments in Debt Securities
A debt security is defined as any security representing a creditor relationship with an entity, examples of which include corporate bonds, convertible debt, municipal bonds, U.S. Treasury securities, U.S. government agency securities, commercial paper, securitized debt instruments (including mortgage-backed securities), and certain preferred stock that by its terms must either be redeemed by the issuing entity or is redeemable at the option of the investor.
At acquisition, and at each reporting date thereafter, an entity must classify each acquired debt security into one of three categories as summarized below. The classification decision should consider the entity’s intent and all facts and circumstances of the entity when making the election.
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- Trading – debt securities bought and held primarily to be sold in the near term
- Held-to-Maturity – debt securities for which management has both the positive intent and ability to hold until the maturity of the security
- Available-for-Sale – the residual category for debt securities not classified as held-to-maturity or trading
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A summary of the three accounting models available for investments in debt securities is as follows:
A couple of items to highlight regarding the different classifications are as follows:
Trading securities are defined as those that are sold in the near term and held only for a short period of time. An entity is not precluded from classifying an investment as trading that it does not intend to sell in the near term; however, the entity should be prepared to maintain the trading classification until the security is sold, and transfers into or out of the trading category should be rare.
Held-to-maturity securities are carried at amortized cost, whereby amortized cost represents the cost to purchase the security, adjusted for the accretion or amortization of discounts or premiums paid below or above par value, and accrued interest.
While available-for-sale securities are carried at fair value on the balance sheet, unrealized gains and losses are included in accumulated other comprehensive income, net of tax effect, until realized whereby the realized gain or loss is then reclassified out of accumulated other comprehensive income and into earnings.
Debt securities classified as held-to-maturity and available-for-sale are evaluated for impairment at each reporting period whereby it is required to determine if a decline in fair value below the security’s cost basis is other than temporary. Determining whether an impairment is other than temporary requires significant judgment and all facts and circumstances must be considered. If an entity determines an other than temporary impairment (OTTI) has occurred, the accounting for the OTTI depends on whether the entity intends to sell (or not sell) the security prior to recovery of its amortized cost basis. When an entity intends to sell an impaired debt security or it is more likely than not that the entity will be required to sell the impaired debt security prior to recovery of its amortized cost basis, the entity recognized an OTTI loss in earnings equal to the difference between the debt security’s amortized cost basis and its fair value at the balance sheet date. When an entity does not intend to sell an impaired debt security and it is not more likely than not that it will be required to sell the impaired debt security prior to recover of the amortized cost basis, the entity recognized the OTTI amount representing the credit loss in net income and the amount related to all other factors in OCI, net of applicable taxes. This accounting treatment for impairments is the same for both available-for-sale and held-to-maturity classified securities.
There are many disclosure requirements related to investments in debt securities, a subset of which includes the following:
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- Entities are required to present the individual amounts for the three categories of debt investments either on the face of the balance sheet or in the notes to the financial statements.
- Cash flow activities are required to be presented separately for the three categories of debt investments. Cash flow activity from the purchase, sale, and maturity of held-to-maturity and available-for-sale securities are required to be presented on a gross basis. Cash flow activities related to trading securities are generally classified on a net basis.
- For securities classified as available-for-sale an entity must disclose the following summarized by major security type as of each balance sheet date presented:
- Amortized cost basis
- Aggregate fair value
- Total OTTI recognized in accumulated other comprehensive income
- Total gains for securities with net gains in accumulated other comprehensive income
- Total losses for securities with net losses in other comprehensive income
- Information about the contractual maturities of those securities as of the most recent balance sheet date presented
- For securities classified as held-to-maturity an entity must disclose the following summarized by major security type as of each balance sheet date presented:
- Amortized cost basis
- Aggregate fair value
- Gross unrealized holding gains
- Gross unrealized holding losses
- Net carrying amount
- Total OTTI recognized in accumulated other comprehensive income
- Gross gains and losses in accumulated other comprehensive income for any derivatives that hedged the forecasted acquisition of the held-to-maturity securities
- Information about the contractual maturities of those securities as of the date of the most recent statement of financial position presented.
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An example disclosure for a commercial entity that hold held-to-maturity and available-for-sale securities is as follows:
Entities are also required to disclose information related to investments in an unrealized loss position. As of each balance sheet date, an entity is required to disclose in tabular form, the following information aggregated by each major security type:
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- The aggregate related fair value of investments with unrealized losses
- The aggregate amount of unrealized losses (that is, the amount by which amortized cost basis exceeds fair value)
- These disclosures shall be segregated by those investments that have been in a continuous unrealized loss position for less than 12 months and those that have been in a continuous unrealized loss position for 12 months or longer.
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An example of the disclosure requirements related to investments in an unrealized loss position is as follows:
Next Steps
We hope this article has provided a helpful summary of the current accounting and financial reporting requirements for investments in debt and equity securities. To better understand how this accounting topic impacts your financial statements, reach out to a member of your Boulay client service team, or contact us at 952.893.9320 or learnmore@boulaygroup.com and ask about our accounting advisory services and our auditing and assurance services.
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