5.1 Classification and Valuation of Investments
6 min read•july 30, 2024
Investments are classified into three categories: trading, available-for-sale, and held-to-maturity. Each type has unique accounting treatments that impact financial statements differently. Understanding these classifications is crucial for accurate reporting and analysis.
Valuation methods for investments vary based on their classification. is used for trading and , while applies to . These methods affect how gains, losses, and income are reported on financial statements.
Investment Categories by Intent
Trading Securities
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- Bought and held primarily for sale in the near term to generate profits from short-term price differences
- Reported at fair value on the balance sheet (balance sheet example: " - $500,000")
- and losses are included in earnings, which can create volatility in the income statement (income statement example: "Unrealized Gain on Trading Securities - $25,000")
- and losses on the sale of trading securities are included in earnings when the securities are sold (income statement example: "Realized Gain on Sale of Trading Securities - $10,000")
Available-for-Sale Securities
- Investments not classified as either trading securities or held-to-maturity securities
- Reported at fair value on the balance sheet (balance sheet example: "Available-for-Sale Securities - $750,000")
- Unrealized holding gains and losses are reported as a component of , which affects but not (other comprehensive income example: "Unrealized Gain on Available-for-Sale Securities - $50,000")
- Realized gains and losses on the sale of available-for-sale securities are included in earnings when the securities are sold (income statement example: "Realized Gain on Sale of Available-for-Sale Securities - $15,000")
Held-to-Maturity Securities
- Debt securities that management has the positive intent and ability to hold to maturity
- Reported at amortized cost on the balance sheet (balance sheet example: "Held-to-Maturity Securities - $1,000,000")
- No adjustment for changes in fair value
- is recognized in the income statement using the effective interest method (income statement example: "Interest Income on Held-to-Maturity Securities - $60,000")
- Impairment losses are recognized in the income statement if the decline in fair value is considered other-than-temporary (income statement example: " on Held-to-Maturity Securities - $20,000")
Valuation Methods for Investments
Fair Value
- 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
- Used for trading securities and available-for-sale securities
- Unrealized holding gains and losses are included in earnings for trading securities and as a component of other comprehensive income for available-for-sale securities (example: if the fair value of a trading security increases from 120, an unrealized gain of $20 is recognized in earnings)
Amortized Cost
- The acquisition cost adjusted for the amortization of discount or premium
- Used for held-to-maturity securities
- Premiums and discounts on bonds should be amortized using the effective interest method (example: if a bond is purchased at a premium of $10,000 with a 5-year maturity, the premium is amortized over the life of the bond, reducing interest income each period)
- No adjustment for changes in fair value
- Impairment losses should be recognized if the fair value of an investment is less than its carrying amount and the decline is considered other-than-temporary (example: if the fair value of a held-to-maturity security drops from 80,000 and the decline is considered other-than-temporary, an impairment loss of $20,000 is recognized in the income statement)
Debt vs Equity Securities
Debt Securities
- Represent a creditor relationship with the issuer and include government bonds, corporate bonds, and other debt instruments
- Key characteristics include face value (the amount to be repaid at maturity), coupon rate (the interest rate paid on the face value), maturity date (the date when the face value is repaid), and credit risk (the risk of default by the issuer)
- Can be classified as trading, available-for-sale, or held-to-maturity, depending on management's intent and ability to hold the securities
- Interest income is recognized in the income statement, regardless of the investment classification (example: a corporate bond with a face value of 5,000)
Equity Securities
- Represent an ownership interest in an entity and include common stock, preferred stock, and other equity instruments
- Key characteristics include voting rights (the right to vote on corporate matters), dividend payments (a portion of the company's profits paid to shareholders), and potential for capital appreciation (an increase in the value of the shares)
- Can be classified as trading or available-for-sale, depending on management's intent
- is recognized in the income statement, regardless of the investment classification (example: if a company pays an annual dividend of 2,000 in dividend income)
Hybrid Securities
- Have characteristics of both debt and equity securities, such as convertible bonds (bonds that can be converted into a predetermined number of shares) and preferred stock with debt-like features (preferred stock that pays a fixed dividend and has a specified redemption date)
- Classification and valuation depend on the specific terms and features of the hybrid security (example: a convertible bond would be initially classified as a debt security and reported at amortized cost, but if converted into common stock, it would be reclassified as an equity security and reported at fair value)
Investment Classification Impact on Statements
Balance Sheet
- Trading securities and available-for-sale securities are reported at fair value (example: "Trading Securities - 750,000")
- Held-to-maturity securities are reported at amortized cost (example: "Held-to-Maturity Securities - $1,000,000")
- Unrealized holding gains and losses on available-for-sale securities are reported as a component of other comprehensive income, which affects shareholders' equity but not net income (example: "Accumulated Other Comprehensive Income - $50,000")
Income Statement
- Unrealized holding gains and losses on trading securities are included in earnings (example: "Unrealized Gain on Trading Securities - $25,000")
- Realized gains and losses on the sale of trading and available-for-sale securities are included in earnings when the securities are sold (example: "Realized Gain on Sale of Trading Securities - 15,000")
- Interest income and dividends from investments are recognized in the income statement, regardless of the investment classification (example: "Interest Income on Held-to-Maturity Securities - 20,000")
- Impairment losses on available-for-sale and held-to-maturity securities are recognized in the income statement if the decline in fair value is considered other-than-temporary (example: "Impairment Loss on Available-for-Sale Securities - 20,000")
Disclosures
- The notes to the financial statements should include information about the types of investments held, their classification, valuation methods, and related risks
- Disclosures should also include a reconciliation of the beginning and ending balances for each category of investments, showing purchases, sales, maturities, and other changes during the period (example: a table showing the changes in available-for-sale securities, with columns for "Beginning Balance," "Purchases," "Sales," "Maturities," "Unrealized Gains/Losses," and "Ending Balance")
- Additional disclosures may be required for investments with significant concentrations of credit risk, investments pledged as collateral, and investments in restricted or illiquid securities (example: a disclosure stating that "As of December 31, 20XX, the company held $100,000 of restricted securities that cannot be sold without prior approval from the issuer")
Key Terms to Review (21)
Amortized cost: Amortized cost refers to the method of accounting for the cost of an asset, whereby the initial cost is gradually reduced over time through systematic allocation of expenses. This approach is particularly relevant for financial instruments, as it allows entities to recognize interest income and impairment losses accurately, reflecting the ongoing value of their investments. By using amortized cost, companies can ensure that their financial statements provide a true and fair view of the value of their investments over time.
Available-for-sale securities: Available-for-sale securities are financial assets that a company intends to sell in the future but does not plan to hold until maturity. These securities are typically recorded at fair value on the balance sheet, with any unrealized gains or losses being reported in other comprehensive income rather than net income. This classification allows companies the flexibility to adjust their investment strategies based on market conditions without impacting their earnings immediately.
Dividend income: Dividend income is the money received by shareholders from a corporation's profits, typically distributed in the form of cash payments or additional shares of stock. This form of income is crucial for investors as it provides a return on their investment, especially in the context of equity securities. Understanding dividend income also involves recognizing how it influences an investor's cash flow and overall return on investment, and the implications for financial reporting and tax treatment.
Fair Value: Fair value is the estimated market value of an asset or liability, representing the price that would be received for selling an asset or paid to transfer a liability in an orderly transaction between market participants. This concept is essential in providing a transparent and consistent measurement basis for investments, helping investors and companies assess their financial standing in real time.
GAAP: GAAP, or Generally Accepted Accounting Principles, is a framework of accounting standards, principles, and procedures used in the preparation of financial statements. It ensures consistency and transparency in financial reporting, which is essential for stakeholders to make informed decisions based on comparable financial information across different organizations.
Held-to-maturity securities: Held-to-maturity securities are debt instruments that a company intends and has the ability to hold until their maturity date. These securities are classified as a long-term investment on the balance sheet and are recorded at amortized cost rather than fair value, meaning they are not subject to market fluctuations after acquisition. This classification allows companies to stabilize their financial statements by providing predictability in cash flows and interest income over time.
IFRS: International Financial Reporting Standards (IFRS) are a set of accounting standards developed by the International Accounting Standards Board (IASB) that aim to bring transparency, accountability, and efficiency to financial markets around the world. IFRS provides a common global language for business affairs, ensuring consistency in the financial reporting and making it easier for investors to compare financial statements from different countries.
Impairment Loss: Impairment loss refers to a permanent reduction in the carrying value of an asset, indicating that its market value has fallen below its book value and it cannot recover its original cost. This concept is critical as it affects the financial statements by recognizing losses when an asset's future cash flows are not expected to cover its carrying amount, influencing decisions related to investments and financial reporting.
Interest Income: Interest income is the revenue earned from investments that pay interest, such as bonds, loans, and savings accounts. This type of income is crucial for investors as it directly impacts their overall return on investment and financial strategies. Interest income reflects the profitability of holding certain types of assets and can influence decisions regarding asset classification and valuation.
Net Income: Net income is the total profit of a company after all expenses, taxes, and costs have been subtracted from total revenue. It serves as a key indicator of a company's profitability and financial health, providing insight into how efficiently a business is operating and whether it is generating enough revenue to cover its costs.
Other Comprehensive Income: Other comprehensive income (OCI) refers to revenues, expenses, gains, and losses that are excluded from net income on an entity's income statement. Instead of affecting the net income directly, OCI is reported separately in the equity section of the balance sheet, which affects the overall financial health of a company. This concept connects to various accounting topics, including the treatment of unrealized gains and losses on certain investments, the impact of tax allocation on comprehensive income, and the recognition of pension-related adjustments in defined benefit plans.
Purchase entry: A purchase entry is a recording in the accounting system that reflects the acquisition of goods or services for a business. This entry typically involves debiting an asset account, such as inventory, and crediting a liability account, like accounts payable, if the purchase was made on credit. Properly recording purchase entries is essential for maintaining accurate financial statements and ensuring effective tracking of assets and liabilities.
Realized gains: Realized gains refer to the profit that occurs when an investment is sold for more than its purchase price. This concept is crucial in the evaluation of investments, as it reflects the actual profit that investors make from their transactions, distinguishing between paper profits and real profits. Realized gains can impact an investor's tax liability and overall financial health, as they are recognized on financial statements and can affect net income.
Realized Losses: Realized losses occur when an investment is sold for less than its original purchase price, resulting in a financial loss that is officially recognized in the accounting records. These losses become significant for reporting purposes as they affect the net income and equity of an entity, making them crucial for accurate financial statements and investment performance evaluation.
Return on Investment: Return on investment (ROI) is a financial metric used to evaluate the profitability of an investment relative to its cost. It helps investors assess the efficiency of their investments and make informed decisions by comparing the expected returns against the costs incurred, which includes initial investments and ongoing expenses. Understanding ROI is crucial for classifying and valuing investments, as it provides a clear picture of how well an asset or project is performing financially.
Sale Entry: A sale entry is the accounting record made when a business sells goods or services, reflecting the transaction in the financial statements. This entry captures essential details such as the revenue generated, the cost of goods sold, and any related taxes, impacting the overall valuation of assets and liabilities. Properly recording sale entries is crucial for maintaining accurate financial records and ensuring compliance with accounting standards.
Shareholders' equity: Shareholders' equity represents the owners' claim on a company's assets after all liabilities have been deducted. It is a crucial part of a company's balance sheet and indicates the net worth of a company from the perspective of its shareholders. This equity can arise from various sources, including initial investments, retained earnings, and additional paid-in capital, reflecting how well a company is doing in generating profits and managing its finances.
Trading securities: Trading securities are financial instruments that are bought and held primarily for the purpose of selling them in the near term to generate profits from short-term price fluctuations. These securities are typically actively traded on a stock exchange, and their value is subject to frequent changes, reflecting market conditions. Companies classify these assets as current assets on their balance sheets due to their intention to sell them quickly, which connects directly to the broader concepts of investment classification and valuation.
Unrealized Holding Gains: Unrealized holding gains are increases in the value of an investment that an investor has not yet sold, meaning the profit is not yet realized in cash. These gains reflect the difference between the current market value of an investment and its original purchase price, but since the investment hasn’t been sold, these gains have no impact on cash flow. Understanding unrealized holding gains is crucial as they influence financial statements, especially in assessing the performance and valuation of investments over time.
Unrealized Losses: Unrealized losses are declines in the value of investments that have not yet been sold, meaning the loss exists only on paper. These losses can affect the financial statements of a company, particularly in relation to the classification and valuation of its investments. Although unrealized losses do not represent actual cash outflows, they provide important information regarding the market value of investments held by a company and can impact investor perception and future investment decisions.
Yield: Yield refers to the income generated from an investment, usually expressed as a percentage of the investment's cost or current market value. It serves as a measure of the return on investment, helping investors evaluate the profitability of various investment options and make informed decisions regarding asset allocation. Yield can vary based on the type of investment, market conditions, and the investor's objectives.