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Chapter12: Investments

Trading Securities

Some companies—primarily financial institutions—actively and frequently buy and sell securities, expecting to earn profits on short-term differences in price. Investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as trading securitiesequity or debt securities the investor (usually a financial institution) acquires principally for the purpose of selling in the near term. . The holding period for trading securities generally is measured in hours and days rather than months or years. These investments typically are reported among the investor's current assets. Relatively few investments are classified this way, because usually only banks and other financial operations invest in securities in the manner and for the purpose necessary to be categorized as trading securities. However, the FASB's decision to allow the fair value option could increase the prevalence of this classification.

   Just like other investments, trading securities initially are recorded at cost—that is, the total amount paid for the securities, including any brokerage fees. However, when a balance sheet is prepared in subsequent periods, this type of investment is written up or down to its fair value, or “marked to market.”

 

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Trading securities are actively managed in a trading account for the purpose of profiting from short-term price changes.

   Be sure to notice that fair value accounting is a departure from historical costs, which is the way most assets are reported in balance sheets. Why the difference? For these investments, fair value information is more relevant than for other assets intended primarily to be used in company operations, like buildings, land and equipment, or for investments to be held to maturity.5

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   For instance, consider an investment in debt. As interest rates rise or fall, the fair value of the investment will decrease or increase. Movements in fair values are less relevant if the investment is to be held to maturity; the investor receives the same contracted interest payments and principal at maturity, regardless of changes in fair value.

   However, if the debt investment is held for active trading, changes in market values, and thus market returns, provide an indication of management's success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable-rate securities, and whether to invest in long-term or short-term securities. For that reason, it makes sense to report unrealized holding gains and losses on trading securities in net income during a period that fair values change, even though those gains and losses haven't yet been realized through the sale of the securities.

 

Unrealized holding gains and losses for trading securities are included in net income in the period in which fair value changes.

   To see how we account for trading securities, let's modify the example we used for HTM securities. We'll assume that those debt investments are held in an active trading portfolio, with United intending to profit from short-term changes in price. In addition, let's add a couple of equity (stock) investments to highlight that, while the HTM approach applies only to debt securities, the TS approach applies to both debt and equity securities. The relevant facts are included in Illustration 12-2. Assuming all investments are classified as trading securities, the accounting would be as follows.

 

FINANCIAL
Reporting Case

Q2, p. 620

ILLUSTRATION 12-2

Accounting for Trading Securities and Securities Available-for-Sale

United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United's fiscal year-end is December 31. The following events during 2011 and 2012 pertain to the investment portfolio.

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PURCHASE INVESTMENTS.  The journal entry to record the purchase of the bond investment is the same as it is for HTM securities. The journal entries to record the equity investments are even simpler, just exchanging one asset (cash) for another (investment):

 

All investment securities are recorded initially at cost.

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RECOGNIZE INVESTMENT REVENUE.  The journal entry to record the receipt of bond interest is the same as it is for HTM securities, with the carrying value of the investment increasing due to amortization of $4,664 of discount. The journal entry to record the receipt of dividends related to the Arjent equity investment is straightforward. There is no entry for the Bendac equity investment, because Bendac doesn't pay dividends.

 

Dividend and interest income are included in net income.

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ADJUST TRADING SECURITY INVESTMENTS TO FAIR VALUE (2011).  Unlike HTM securities, trading securities are carried at fair value in the balance sheet, so their carrying value must be adjusted to fair value at the end of every reporting period. Rather than increasing or decreasing the investment account itself, we use a valuation allowance, fair value adjustment, to increase or decrease the carrying value of the investment. At the same time, we record an unrealized holding gain or loss that is included in net income in the period in which fair value changes (the gain or loss is unrealized because the securities haven't actually been sold). The next table summarizes the relevant facts for United's investments.

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Trading securities are adjusted to their fair value at each reporting date.

   United has an unrealized loss of $16,354. Note that, to determine the amount of unrealized holding gain or loss on the Masterwear bonds, United first identifies the bonds' amortized cost and then determines the amount necessary to adjust them to fair value:

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There is no discount to amortize for the equity investments, so for the Arjent and Bendac investments, their amortized cost is simply their initial cost. The journal entry to record the unrealized loss in United's fair value adjustment is

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6Sometimes companies don't bother with a separate fair value adjustment account and simply adjust the investment account to fair value. Also, sometimes companies set up separate fair value adjustment accounts for each investment.

7We title this account “Net unrealized holding gains and losses—I/S” to highlight that, for trading securities, unrealized holding gains and losses are included in the income statement (I/S) in the period in which they occur.

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ADDITIONAL CONSIDERATION

Don't Shoot the Messenger

Or, as written in The Economist, “Messenger, Shot: Accounting rules are under attack. Standard-setters should defend them. Politicians and banks should back off.”8 Using fair values that are hard to estimate is controversial. For example, during the recent financial crisis many financial-services companies had to recognize huge unrealized losses associated with their investments. Some blamed their losses on GAAP for requiring estimates of fair value that were driven by depressed current market prices, argued that those losses worsened the financial crisis, and lobbied for a move away from fair-value accounting. Others countered that these companies were using GAAP's requirement for fair value accounting as a “scapegoat” for their bad investment decisions. “Fair value accounting … does not create losses but rather reflects a firm's present condition,” says Georgene Palacky, director of the CFA's financial reporting group.”9

  

SELL TRADING SECURITY INVESTMENTS.  To record the gain or loss realized on the sale of the Masterwear and Arjent investments, United records the receipt of cash ($725,000 for Masterwear and $1,446,000 for Arjent), removes all balance sheet accounts that are directly associated with the investments, and calculates the difference to determine realized gain or loss.10

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Realized gain or loss for the difference between carrying value and the cash received from selling an AFS security is included in net income.

     For the Masterwear bonds, this journal entry is identical to what United used when recording the sale of held-to-maturity investments. However, United isn't done yet. Now that those investments are sold, United needs to remove the fair value adjustment from the balance sheet. Also, because United has recognized in this period's net income the entire gain or loss realized on sale of the investments, it must back out of this period's net income any unrealized gains and losses that were included in net income in prior periods. That way, this period's net income includes only the fair value changes arising since the last period, and United avoids double counting gains and losses (once when unrealized, and again when realized). United can accomplish all of this when it adjusts its investment portfolio to fair value at the end of the reporting period.

 

When trading securities are sold, unrealized gains or losses that were recorded previously are removed from the fair value adjustment and net income at the end of the accounting period.

ADJUST TRADING SECURITY INVESTMENTS TO FAIR VALUE (2012).  The following table summarizes the situation at the end of 2012:

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   The journal entry necessary to show the appropriate balance in the fair value adjustment at the end of 2012 is

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   This journal entry serves two purposes: it (a) accounts for changes in the fair value of investments that have not been sold (in this case, Bendac), and (b) removes from the fair value adjustment and net income any unrealized holding gains or losses that were recognized in prior periods and that are associated with investments that now have been sold (in this case, Masterwear and Arjent). We discuss those purposes in more detail when we show later in this chapter how these investments would be accounted for as available-for-sale securities.

FINANCIAL STATEMENT PRESENTATION.  We present trading securities in the financial statements as follows:

 

Income Statement and Comprehensive Income Statement: For trading securities, fair value changes are included on the income statement in the periods in which they occur, regardless of whether they are realized or unrealized. Investments in trading securities do not affect other comprehensive income.

 

Balance Sheet: Investments in trading securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders' equity.

 

Cash Flow Statement: Cash flows from buying and selling trading securities typically are classified as operating activities, because the financial institutions that routinely hold trading securities consider them as part of their normal operations. However, as discussed in more detail later, it may be appropriate to classify cash flows from buying and selling some trading securities as investing activities if they are not held for sale in the near term (which is particularly likely when an investment is classified as a trading security as a result of electing the fair value option).11

 
      

The Board concluded that fair value information is more relevant than amortized cost information, in part because it reflects the effects of a management decision to buy a financial asset at a specific time and then continue to hold it for an unspecified period of time.

      

   United's 2011 and 2012 financial statements will include the amounts shown in Illustration 12-3.




5Investments to be held to maturity, of course, include only debt securities.

8“Messenger, Shot,” The Economist, April 8, 2009.

9Sarah Johnson, “The Fair Value Blame Game,” CFO.com, March 19, 2008.

10For purposes of this example, we ignore any unpaid interest associated with the bonds. In practice, that amount would be added to the sales price of the bonds and included in investment revenue.

11FASB ASC 320: Investments (previously “The Fair Value Option for Financial Assets and Financial Liabilities,” Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, 2007, par. A42)). The relevant paragraphs from the original standard are not codified in the FASB Research System as they primarily provide a basis for conclusions.

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