10.2 Available-for-sale securities
7 min read•august 20, 2024
are investments companies hold for an indefinite period. They're reported at on the balance sheet, with recorded in . This classification offers flexibility in managing investments.
AFS securities are initially recorded at cost and adjusted to fair value each reporting period. Unrealized gains and losses are kept separate from net income to avoid volatility. When sold or impaired, these gains or losses move from OCI to the income statement.
Definition of available-for-sale securities
- Debt or not classified as held-to-maturity or fall under the available-for-sale (AFS) category
- AFS securities are investments that a company intends to hold for an indefinite period but may sell in response to changes in market conditions or liquidity needs
- These securities are reported at fair value on the balance sheet, with unrealized gains and losses recorded in other (OCI)
Accounting for available-for-sale securities
Initial recognition of securities
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- AFS securities are initially recorded at their acquisition cost, which includes the purchase price and any transaction costs (brokerage fees)
- The entry to record the purchase of AFS securities is:
- Debit: Available-for-sale securities
- Credit: Cash
- For example, if a company purchases 100 shares of XYZ stock at 10 brokerage fee, the initial recognition would be:
- Debit: Available-for-sale securities $5,010
- Credit: Cash $5,010
Subsequent measurement of securities
- At the end of each reporting period, AFS securities are adjusted to their fair value
- Fair value is determined using quoted market prices for identical or similar securities (Level 1 inputs) or valuation techniques (Level 2 or 3 inputs)
- The entry to record the change in fair value is:
- Debit/Credit: Available-for-sale securities (to adjust to fair value)
- Debit/Credit: Unrealized gain/loss on AFS securities (OCI)
Unrealized holding gains vs losses
- or losses arise when the fair value of AFS securities changes from the previous reporting period
- Unrealized gains occur when the fair value increases, while unrealized losses occur when the fair value decreases
- These gains or losses are not recognized in net income but are instead recorded in other comprehensive income (OCI) until the securities are sold or impaired
Other comprehensive income treatment
- OCI is a separate component of shareholders' equity that captures gains and losses not included in net income
- Unrealized gains and losses on AFS securities are reported in OCI to avoid volatility in the income statement
- The accumulated balance of unrealized gains and losses in OCI is known as "" (AOCI)
- When AFS securities are sold or impaired, the unrealized gains or losses are reclassified from AOCI to net income
Impairment of available-for-sale securities
Indicators of impairment
- occurs when the fair value of an AFS security declines below its basis and the decline is considered other-than-temporary
- Indicators of impairment include:
- Significant financial difficulty of the issuer
- Breach of contract (missed interest or principal payments)
- Probability that the issuer will enter bankruptcy or financial reorganization
- Disappearance of an active market for the security
- If an impairment is deemed other-than-temporary, the unrealized loss is recognized in net income
Determining fair value
- Fair value is the price that would be received to sell the security in an orderly transaction between market participants
- For AFS securities with readily determinable fair values (quoted market prices), the fair value is easily obtained
- For securities without readily determinable fair values, valuation techniques (discounted cash flow analysis, comparable company analysis) are used to estimate fair value
Recognizing impairment losses
- If an AFS security is impaired and the impairment is deemed other-than-temporary, the unrealized loss is reclassified from OCI to net income
- The entry to record an other-than-temporary impairment is:
- Debit: Unrealized loss on AFS securities (income statement)
- Credit: Available-for-sale securities (to write down to fair value)
- The new cost basis of the AFS security becomes the fair value at the date of impairment, and any subsequent recoveries in fair value are not recognized in net income
Sale of available-for-sale securities
Calculating realized gain or loss
- When an AFS security is sold, the difference between the selling price and the security's carrying value (amortized cost) is recognized as a in net income
- The realized gain or loss is calculated as:
- Realized gain/loss = Selling price - Carrying value (amortized cost)
- For example, if a company sells an AFS security with a carrying value of 1,200, the realized gain would be:
- Realized gain = 1,000 = $200
Reclassifying unrealized gains or losses
- Upon sale, any unrealized gains or losses previously recorded in OCI must be reclassified to net income
- The entry to reclassify unrealized gains or losses is:
- Debit: Unrealized gain/loss on AFS securities (OCI)
- Credit: Realized gain/loss on sale of AFS securities (income statement)
- This reclassification ensures that the total gain or loss (realized and unrealized) is recognized in net income in the period of sale
Impact on financial statements
- The sale of AFS securities affects both the balance sheet and income statement
- On the balance sheet, the carrying value of AFS securities is reduced by the amount sold, and cash is increased by the selling price
- On the income statement, the realized gain or loss is reported as a component of net income, and any reclassified unrealized gains or losses are included in net income as well
Presentation of available-for-sale securities
Classification on balance sheet
- AFS securities are reported as a separate line item under the non-current assets section of the balance sheet
- They are typically classified as long-term investments unless management intends to sell them within the next 12 months
- If any portion of AFS securities is expected to be sold within the next 12 months, that portion is classified as a current asset
Disclosures in financial statement notes
- Companies are required to disclose information about their AFS securities in the notes to the financial statements
- Disclosures include:
- Description of the securities (issuer, type, maturity date)
- Amortized cost and fair value
- Unrealized gains and losses recognized in OCI
- Realized gains and losses recognized in net income
- Impairment losses recognized in net income
- Transfers between investment categories
- These disclosures provide transparency and help users of financial statements understand the nature and performance of a company's AFS securities
Transfers between investment categories
Accounting for transfers into AFS
- Securities can be transferred into the AFS category from the held-to-maturity or trading categories
- When a security is transferred into AFS from held-to-maturity, any unrealized gain or loss at the date of transfer is recorded in OCI
- The entry to record the transfer is:
- Debit: Available-for-sale securities (at fair value)
- Credit: Held-to-maturity securities (at amortized cost)
- Debit/Credit: Unrealized gain/loss on AFS securities (OCI)
Accounting for transfers out of AFS
- Securities can be transferred out of the AFS category into the held-to-maturity or trading categories
- When a security is transferred out of AFS, any unrealized gain or loss in OCI is reclassified to net income
- The entry to record the transfer is:
- Debit: Held-to-maturity or trading securities (at fair value)
- Credit: Available-for-sale securities (at fair value)
- Debit/Credit: Unrealized gain/loss on AFS securities (OCI)
- Debit/Credit: Realized gain/loss on transfer of AFS securities (income statement)
Comparison to other investment types
AFS vs held-to-maturity securities
- Held-to-maturity (HTM) securities are debt investments that a company intends to hold until maturity
- Unlike AFS securities, HTM securities are reported at amortized cost on the balance sheet, and unrealized gains and losses are not recognized
- HTM securities are less liquid than AFS securities because they are intended to be held until maturity
- If a company sells an HTM security before maturity, it may call into question its ability to hold other HTM securities to maturity
AFS vs trading securities
- Trading securities are investments that a company intends to sell in the near term for profit
- Like AFS securities, trading securities are reported at fair value on the balance sheet
- However, unrealized gains and losses on trading securities are recognized in net income, whereas unrealized gains and losses on AFS securities are recognized in OCI
- Trading securities are more liquid than AFS securities because they are actively bought and sold
Tax considerations for AFS securities
Taxable vs non-taxable interest
- from AFS securities can be either taxable or non-taxable, depending on the type of security
- Taxable interest income is earned on corporate bonds and other issued by taxable entities
- Non-taxable interest income is earned on municipal bonds and other debt securities issued by tax-exempt entities (state and local governments)
- Companies must track and report taxable and non-taxable interest income separately for tax purposes
Tax impact of gains and losses
- Realized gains and losses on the sale of AFS securities are subject to capital gains tax
- The tax rate applied to capital gains depends on the holding period of the security:
- Short-term capital gains (securities held for one year or less) are taxed at ordinary income rates
- Long-term capital gains (securities held for more than one year) are taxed at preferential rates
- Unrealized gains and losses recognized in OCI are not subject to tax until the securities are sold and the gains or losses are realized
- When an other-than-temporary impairment is recognized, the loss is deductible for tax purposes in the year of impairment
Key Terms to Review (23)
Accumulated Other Comprehensive Income: Accumulated other comprehensive income (AOCI) represents a component of shareholders' equity that includes gains and losses not yet realized and not included in net income. This can arise from various sources, such as changes in the fair value of available-for-sale securities, foreign currency translation adjustments, and pension plan adjustments. AOCI helps provide a more comprehensive view of a company's overall financial performance by capturing these unrealized effects, showing their potential impact on owners' equity over time.
Amortized Cost: Amortized cost is the accounting method used to gradually reduce the carrying value of an asset over time through periodic charges against earnings, reflecting its usage and economic benefits. This approach is commonly applied to financial instruments, where it ensures that the initial investment is adjusted for any principal repayments and interest earned, providing a more accurate financial picture. Understanding amortized cost is crucial for assessing current assets and liabilities, as well as distinguishing between different types of securities based on how they are measured and reported in financial statements.
ASC 320: ASC 320 is the Accounting Standards Codification section that addresses the accounting and reporting for investments in debt and equity securities. It outlines the classification of securities into three categories: held-to-maturity, trading, and available-for-sale, with specific rules on recognition, measurement, and reporting for each category. This framework is essential for understanding how to categorize securities and their implications for financial reporting.
Available-for-sale securities: Available-for-sale securities are financial assets that a company can sell in the future, but they are not classified as held-to-maturity or trading securities. These investments can include stocks and bonds that the company intends to hold for an indefinite period but may sell in response to changes in market conditions or liquidity needs. The classification affects how these securities are reported on financial statements, including the recognition of unrealized gains and losses.
Comprehensive income: Comprehensive income refers to the total change in equity of a company from all transactions and events, except those resulting from investments by owners and distributions to owners. This concept encompasses not only net income but also other items that are recognized directly in equity and not included in the traditional income statement, giving a fuller picture of a company's financial performance over a period. It connects closely with owners' equity, the elements of financial statements, and how available-for-sale securities are reported.
Debt Securities: Debt securities are financial instruments that represent a loan made by an investor to a borrower, typically corporate or governmental. They come with a promise to pay back the principal along with interest at specified intervals. Debt securities are crucial in investment activities, as they provide a way for investors to earn returns while also allowing organizations to raise capital for various purposes.
Disposal: Disposal refers to the process of selling, trading, or otherwise eliminating an asset from a company's financial records. This action is crucial for maintaining accurate financial statements and can impact a company's income statement and balance sheet. When an entity disposes of available-for-sale securities, it must recognize any gains or losses associated with the transaction, which influences overall earnings and equity.
Dividends: Dividends are payments made by a corporation to its shareholders, typically as a distribution of profits. They represent a return on investment for shareholders and can be issued in cash or additional shares of stock. The decision to pay dividends affects the company's retained earnings and owners' equity, reflecting the company's financial health and strategy regarding profit distribution.
Equity section: The equity section refers to the part of a company's balance sheet that represents the owners' residual interest in the assets after deducting liabilities. This section reflects the net worth of the company, including various components such as common stock, preferred stock, additional paid-in capital, retained earnings, and accumulated other comprehensive income. Understanding the equity section is essential for assessing a company's financial health and its ability to generate returns for shareholders.
Equity securities: Equity securities represent ownership interests in a company, typically in the form of stocks. They allow investors to gain a share of the company’s profits and may also grant voting rights. Equity securities are categorized primarily as either available-for-sale or trading, each with distinct accounting treatment and implications for financial reporting.
Fair Value: Fair value is the estimated price at which an asset or liability could be bought or sold in a current transaction between willing parties, reflecting current market conditions. It connects to the valuation of both long-term and intangible assets, as well as the recognition of changes in value due to impairment or disposition. Understanding fair value is essential for accurate financial reporting, as it affects the presentation of various assets and liabilities on financial statements.
IFRS 9: IFRS 9 is the International Financial Reporting Standard that addresses the classification, measurement, and impairment of financial instruments. It establishes principles for recognizing and measuring financial assets and liabilities, aiming to enhance transparency and comparability in financial statements. This standard is crucial for understanding how investing activities are reported, particularly when it comes to held-to-maturity and available-for-sale securities.
Impairment: Impairment refers to a permanent reduction in the value of an asset, indicating that its carrying amount exceeds its recoverable amount. This concept is crucial for recognizing losses on assets, ensuring that financial statements present an accurate view of a company's financial health. Impairment can affect various asset types, including notes receivable, acquisition costs, intangible assets, and available-for-sale securities, impacting both balance sheets and income statements.
Interest income: Interest income is the revenue earned by an entity from interest-bearing assets, such as cash equivalents, loans, or investments. This income is crucial for understanding the financial health of an organization, as it contributes to overall profitability and cash flow. It plays a significant role in financial reporting and impacts various accounting practices.
Mark-to-market accounting: Mark-to-market accounting is a method of valuing assets and liabilities at their current market prices, rather than their historical costs. This approach allows financial statements to reflect the real-time value of assets, providing a more accurate view of a company's financial position. It is particularly relevant for investments like available-for-sale securities, which can fluctuate in value based on market conditions.
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. OCI includes items such as unrealized gains and losses on available-for-sale securities, foreign currency translation adjustments, and certain pension plan adjustments, which are instead recorded in equity under accumulated other comprehensive income. This distinction helps investors understand the complete financial performance of a company beyond just its net income.
Purchase entry: A purchase entry is the accounting record made to document the acquisition of goods or securities by a company. This entry reflects the cost incurred to acquire the asset and impacts the financial statements, specifically the balance sheet and income statement. Purchase entries can vary based on the type of securities acquired, such as available-for-sale or trading securities, and how these are subsequently measured and reported in financial statements.
Realized gain or loss: A realized gain or loss occurs when an investment is sold for more or less than its original purchase price, resulting in a profit or loss being officially recorded. This concept is particularly important in the context of investment accounting, as it directly impacts the income statement and reflects the true financial outcome of investment transactions. Realized gains and losses help investors assess their investment performance and determine tax implications based on actual transactions.
Sale entry: A sale entry refers to the accounting process of recording a transaction where goods or services are sold to a customer. This process captures both the revenue generated from the sale and any related costs, impacting financial statements by increasing income and adjusting asset values. Understanding how sale entries function is essential for accurately tracking financial performance, especially in relation to different types of securities held by an entity.
Trading securities: Trading securities are financial instruments that a company buys with the intent of selling them in the short term to profit from price fluctuations. These securities are typically classified as current assets on the balance sheet, reflecting their expected quick turnover. The key aspect of trading securities is that they are actively managed and closely monitored, often leading to gains or losses recognized in the income statement.
Unrealized gains and losses: Unrealized gains and losses refer to the increases or decreases in the value of an asset that an investor has not yet sold. These adjustments reflect the current market value of assets held and can significantly impact the financial statements of a company, particularly affecting equity and reported earnings. Recognizing unrealized gains and losses helps provide a more accurate picture of a company's financial health, particularly in contexts involving investments like available-for-sale securities.
Unrealized Holding Gains: Unrealized holding gains refer to the increases in the value of an investment that have not yet been realized through sale. These gains are recorded in financial statements for available-for-sale securities, representing the difference between the current market value and the purchase price of the securities. Since these gains are not recognized in income until the securities are sold, they remain reported in equity, impacting financial ratios and overall financial health.
Unrealized holding losses: Unrealized holding losses refer to the declines in the value of available-for-sale securities that have not yet been sold. These losses arise when the market value of these securities drops below their cost basis, but since the securities are still held in the portfolio, they do not impact net income until realized. This concept is significant for understanding how fluctuations in the market can affect the reported value of an investment portfolio.