10.1 Held-to-maturity securities
7 min read•august 20, 2024
Held-to-maturity securities are debt investments companies intend to keep until they mature. These non-derivative financial assets have fixed payments and maturities, typically that pay regular interest and return principal at maturity.
To classify as held-to-maturity, companies must have both the intent and ability to hold until maturity. This limits sales or reclassifications, which are only allowed in rare circumstances. Initially recorded at fair value, these securities are subsequently measured at using the .
Definition of held-to-maturity securities
- Held-to-maturity securities are a category of debt investments that a company intends to hold until their maturity date
- These securities are non-derivative financial assets with fixed or determinable payments and fixed maturities
- Held-to-maturity securities are typically bonds or other debt instruments that pay regular interest and return the principal at maturity
Criteria for classification as held-to-maturity
Intent and ability to hold until maturity
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- To classify a debt security as held-to-maturity, the company must have both the intent and the ability to hold the investment until its maturity date
- Management must positively assert their intention to hold the securities to maturity
- The company must also have the financial capacity to hold the securities until maturity without being forced to sell them prematurely to meet liquidity needs
Restrictions on sales or reclassifications
- Once a debt security is classified as held-to-maturity, the company is restricted from selling or reclassifying the investment
- Sales or reclassifications of held-to-maturity securities are only permitted in rare circumstances, such as a significant deterioration in the issuer's creditworthiness or changes in tax laws
- Frequent sales or reclassifications of held-to-maturity securities may call into question the company's intent and ability to hold these investments to maturity
Initial measurement of held-to-maturity securities
Recording at fair value
- When a company acquires a held-to-maturity security, it initially records the investment at its fair value
- Fair value is the price that would be received to sell the security in an orderly transaction between market participants at the measurement date
- The fair value of a held-to-maturity security includes any transaction costs directly attributable to the acquisition of the investment
Treatment of transaction costs
- Transaction costs incurred to acquire held-to-maturity securities are capitalized and included in the initial carrying amount of the investment
- These transaction costs may include brokerage fees, commissions, or other costs directly related to the purchase of the security
- By capitalizing transaction costs, the company effectively amortizes them over the life of the held-to-maturity security using the effective interest method
Subsequent measurement of held-to-maturity securities
Amortized cost method
- After initial recognition, held-to-maturity securities are subsequently measured at amortized cost using the effective interest method
- Amortized cost is the amount at which the security was initially measured, adjusted for the accretion of any discount or amortization of any premium over the life of the investment
- The effective interest method allocates interest income over the life of the security, taking into account any discount or premium and transaction costs
Effective interest rate vs straight-line amortization
- The effective interest rate is the rate that exactly discounts the estimated future cash payments or receipts through the expected life of the held-to-maturity security to its net carrying amount
- The effective interest method results in a constant rate of return on the net carrying amount of the investment over its life
- In contrast, straight-line amortization allocates the discount or premium evenly over the life of the security, which may not accurately reflect the economic substance of the investment
Impairment of held-to-maturity securities
- Held-to-maturity securities are subject to impairment testing if there is objective evidence of a decline in value that is other than temporary
- Impairment may occur due to factors such as the issuer's financial difficulties, a breach of contract (e.g., default or delinquency in interest or principal payments), or a significant downgrade in the issuer's credit rating
- If an impairment is deemed other than temporary, the carrying amount of the held-to-maturity security is written down to its fair value, with the difference recognized as an impairment loss in the
Disclosure requirements for held-to-maturity securities
Amortized cost and fair value
- Companies are required to disclose the amortized cost and fair value of their held-to-maturity securities in the notes to the financial statements
- The amortized cost represents the carrying amount of the investment, while the fair value provides users with information about the current market value of the securities
- Disclosing both amortized cost and fair value allows financial statement users to assess the potential impact of changes in market interest rates on the value of the held-to-maturity portfolio
Unrealized holding gains and losses
- Unrealized holding gains and losses on held-to-maturity securities are not recognized in the income statement or
- These gains and losses represent the difference between the amortized cost and the fair value of the securities
- Although not recognized in the financial statements, companies are required to disclose the amount of unrealized holding gains and losses in the notes, providing transparency about the potential impact of market fluctuations on the value of the held-to-maturity portfolio
Comparison of held-to-maturity vs available-for-sale securities
Differences in accounting treatment
- Held-to-maturity securities are measured at amortized cost, while available-for-sale securities are measured at fair value
- Changes in the fair value of available-for-sale securities are recognized in other comprehensive income, while changes in the fair value of held-to-maturity securities are not recognized unless an impairment is deemed other than temporary
- Interest income from held-to-maturity securities is calculated using the effective interest method, while interest income from available-for-sale securities is calculated using the straight-line method
Impact on financial statements
- The of a debt security as held-to-maturity or available-for-sale has a significant impact on a company's financial statements
- Held-to-maturity securities provide a stable source of interest income and do not introduce volatility to the income statement or balance sheet due to changes in fair value
- Available-for-sale securities, on the other hand, can result in volatility in other comprehensive income and equity due to changes in fair value, but they offer more flexibility in terms of selling the securities before maturity
Reclassification of held-to-maturity securities
Rare circumstances allowing reclassification
- Reclassification of held-to-maturity securities is only permitted in rare circumstances, as it may call into question the company's intent and ability to hold the investments to maturity
- Examples of rare circumstances that may justify reclassification include a significant deterioration in the issuer's creditworthiness, a change in tax laws that eliminates or significantly reduces the tax-exempt status of interest on the security, or a major business combination or disposition that necessitates the sale of the securities
Accounting for reclassifications
- If a held-to-maturity security is reclassified as available-for-sale, the unrealized holding gain or loss at the date of reclassification is recognized in other comprehensive income
- If a held-to-maturity security is reclassified as trading, the unrealized holding gain or loss at the date of reclassification is recognized in the income statement
- Reclassifications from held-to-maturity to available-for-sale or trading are accounted for prospectively, meaning that the new classification and measurement principles are applied from the date of reclassification forward
Derecognition of held-to-maturity securities
Accounting for sales or disposals
- When a held-to-maturity security is sold or otherwise disposed of, the difference between the proceeds received and the carrying amount of the security is recognized as a realized gain or loss in the income statement
- The carrying amount of the security is the amortized cost at the date of sale or disposal, which includes any unamortized discount or premium and transaction costs
- Any accrued interest receivable on the security at the date of sale is also included in the calculation of the realized gain or loss
Realized gains and losses
- Realized gains and losses on the sale or disposal of held-to-maturity securities are reported in the income statement as part of the company's operating results
- Realized gains occur when the proceeds from the sale exceed the carrying amount of the security, while realized losses occur when the proceeds are less than the carrying amount
- The recognition of realized gains and losses in the income statement provides users with information about the actual economic impact of the sale or disposal of the held-to-maturity securities
Presentation of held-to-maturity securities on balance sheet
Classification as non-current assets
- Held-to-maturity securities are typically classified as non-current assets on the balance sheet, as they are expected to be held for more than one year from the balance sheet date
- The classification as non-current assets reflects the long-term nature of the investments and the company's intent to hold them until maturity
- In some cases, held-to-maturity securities with maturities of less than one year may be classified as current assets if they are expected to be realized within the company's normal operating cycle
Separate line item vs inclusion in investments
- Held-to-maturity securities are often presented as a separate line item on the balance sheet to distinguish them from other types of investments, such as available-for-sale securities or trading securities
- Presenting held-to-maturity securities as a separate line item provides users with clear information about the nature and amount of these investments
- Alternatively, held-to-maturity securities may be included in a broader "Investments" line item on the balance sheet, with the specific categories of investments disclosed in the notes to the financial statements
Key Terms to Review (18)
Accrual basis: Accrual basis is an accounting method where revenues and expenses are recorded when they are earned or incurred, regardless of when cash is actually received or paid. This approach provides a more accurate picture of a company's financial performance and position by matching income with the expenses incurred to generate that income. It emphasizes the timing of transactions and aligns with the principles of financial reporting.
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.
Balance Sheet: A balance sheet is a financial statement that presents a company's financial position at a specific point in time, detailing its assets, liabilities, and equity. This essential report helps stakeholders assess the company's net worth, liquidity, and overall financial health, making it crucial for understanding how investing activities impact the balance of assets and liabilities.
Bonds: Bonds are debt securities that represent a loan made by an investor to a borrower, typically corporate or governmental. When an entity issues a bond, it agrees to pay back the principal amount on a specified maturity date along with periodic interest payments, known as coupon payments, until maturity. This mechanism of borrowing and lending connects to essential financial concepts such as future value, present value, effective interest rates, and the classification of investments like held-to-maturity securities.
Cash basis: Cash basis is an accounting method where revenues and expenses are recorded only when cash is actually received or paid. This approach provides a straightforward view of cash flow, making it easy to track liquidity but can obscure the true financial performance of a business, especially when it comes to accounts receivable and payable.
Classification: Classification refers to the systematic arrangement of financial instruments into distinct categories based on their characteristics and intended use. This is crucial for understanding how these instruments are reported and valued in financial statements, allowing stakeholders to make informed decisions about investments and financial health.
Coupon rate: The coupon rate is the annual interest rate paid on a bond, expressed as a percentage of its face value. This rate is crucial as it determines the periodic interest payments that bondholders receive, making it a key feature in assessing the attractiveness and pricing of bonds in the market. It directly impacts cash flows and reflects the cost of borrowing for issuers, influencing investment decisions.
Credit loss: Credit loss refers to the financial loss that occurs when a borrower fails to repay a loan or fulfill contractual obligations. This term is essential for understanding the risks associated with lending and investing, especially in held-to-maturity securities, where the expectation is that the investor will receive regular interest payments and return of principal at maturity. If credit loss occurs, it can impact the overall financial position and profitability of an entity.
Debentures: Debentures are a type of debt instrument issued by companies or governments to raise capital, representing a loan made by an investor to the issuer. They are typically long-term securities that pay fixed interest over a specified period and are backed by the issuer's creditworthiness rather than physical assets. This means that debenture holders are creditors to the issuer and have a claim on its income and assets in the event of liquidation, although they stand behind secured creditors.
Effective Interest Method: The effective interest method is a way of calculating interest on financial instruments such as loans or bonds based on the actual amount of interest earned or incurred over time. This method reflects the time value of money and recognizes that the interest expense or revenue changes as the carrying amount of the asset or liability fluctuates. By applying this method, financial statements provide a more accurate representation of the financial health and performance related to interest-bearing instruments.
Fair Value Disclosure: Fair value disclosure refers to the requirement for entities to provide information about the fair value of their financial instruments and assets in their financial statements. This includes details on how fair values are determined and the associated risks, which helps users of the financial statements assess the reliability and relevance of the reported values.
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.
Income Statement: An income statement is a financial document that summarizes a company's revenues, expenses, and profits over a specific period. It provides insight into the company's operational performance, helping stakeholders assess how well the business is generating profit from its operations, managing costs, and ultimately determining net income.
Interest income recognition: Interest income recognition refers to the accounting process of recording interest earned on investments, such as bonds, as income in financial statements. This is especially important for held-to-maturity securities, where the investor intends to hold the security until it matures, allowing for a clear understanding of the income generated from these investments over time. Recognizing interest income accurately ensures that financial statements reflect the true performance and profitability of an investment portfolio.
Other-than-temporary impairment: Other-than-temporary impairment (OTTI) refers to a significant decline in the fair value of an investment in securities that is not expected to be recovered in the near term. This concept is crucial for accounting and financial reporting, as it impacts how certain securities are valued on the balance sheet and can affect earnings recognition. Recognizing OTTI may require companies to write down the value of their securities, which has implications for reported income and financial ratios.
Valuation: Valuation refers to the process of determining the current worth of an asset or a company. This process takes into account various factors, including market conditions, future earning potential, and risk assessments. Proper valuation is crucial for investors and businesses to make informed financial decisions, especially when it comes to buying, selling, or holding securities.
Yield to Maturity: Yield to maturity (YTM) is the total return expected on a bond if it is held until it matures. It considers the bond's current market price, par value, coupon interest rate, and the time remaining until maturity. This measure is crucial for investors as it helps compare the profitability of different bonds, especially in assessing held-to-maturity securities.