Chapter 9: Investment Securities
Types of Securities
Classification of Investment Securities
The management of the company must classify their investment securities into one of three categories based on their intent of how long they plan to keep the investment. Any of the securities mentioned above must be classified into one of these three categories.
- Trading: Securities that are intended to be sold within a short period of time are classified as trading securities. As the name suggests, securities classified as trading are often bought or sold frequently with the intention of achieving short-term investment objectives. For balance sheet presentation trading securities should be reported as current assets. Non-current classification is rarely used, however, the non-current classification can be used if the company intents to hold on to the security for at least one year or the operating cycle, whichever is longer. Gains or loses created from trading securities are reported in the cash flow from operations section of the statement of cash flows. They are also reported at fair value with all gains or loses being reported directly to the income statement.
- Available-for-sale: The available-for-sale classified is reserved for securities that will not be classified as trading or held-to-maturity based on classification rules. Securities in this category are reported at fair value with realized gains or loses being reported directly to the income statement. Unrealized gains and loses are reported in other comprehensive income. When a realized gain or lose is created, the cash flow impact will be reported in the investing section of the statement of cash flows. Similar to the trading category, securities in this category can be classified as current or non-current based on management's intent on when to sell the security or how the cash flow will be used (ie. if used to pay current liabilities or fund current operations then current. If it is for investment purposes then it should be classified as non-current).
- Held-to-Maturity: The held-to-maturity category is reserved only for bonds only. Equity securities can never be classified as held-to-maturity. A bond can only be classified in this category if the company has the intent and ability to hold the security until maturity. Both requirements must be met otherwise the bond should be classified in trading or available-for-sale. The bond is classified as current or non-current based on time to maturity of the bond. Cash flows from the bonds are reported in cash flows from investing activities on the statement of cash flows. Unrealized gains or loses are never recorded for the held-to-maturity category because this category is measured at amortized cost (purchase price with adjustments of discount or premium amortization over the life of the bond).
Fair Value and Impairments
The trading and available-for-sale securities are reported using the fair value method. The fair value of the securities is obtained by identifying the price at which a willing buyer and a willing seller engage to exchange the security. For equity common stock or bonds the active market is often a national stock exchange or bond market. The fair value of the security should be obtained at least annually or when circumstances indicate that the fair value of the security has rapidly changed from what it is being reported at.
After we have obtained the fair value for the security, we compare it to our reported value. Any difference between the two prices would be either an unrealized gain or loss. The treatment of unrealized gains or loses depends on the classification as either trading or held-to-maturity. A valuation account is used to report the changes in the fair value with the asset account being netted with the valuation account to show the fair value of the security at the valuation date.
- Unrealized gains or loses for trading securities: The unrealized gain or loss is recorded using a valuation allowance which has a direct impact on the income statement and net income. An unrealized loss on trading securities is recorded using the following entry:
- Unrealized gains or loses for available-for-sale securities:
If a security is sold then the gain or lose is realized and the realized gain or loss is reported on the income statement and impacts net income as well as the statement of cash flows. If an available-for-sale security is impaired then it has the same impact as a realized loss.