Investment in debt securities | The Reynolds Center

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by Steven Orpurt August 1, 2016

This is part of a series of articles, Covering Financials, focused on financial accounting disclosures and how you as a journalist can interpret and report on them. The first four articles (see related links) introduce the concepts of financial accounting used in this article and in future ones. If you have a topic that interests you, post your request in the comments or email me at [email protected].

Investment accounting

Most entities maintain an investment portfolio that includes bonds, stocks and derivative securities. Entities maintain investments for a multitude of reasons, including investing additional cash until it is needed for expansion or used to pay dividends, bonuses, or buy back stocks. But issues exist with investments to the point where the FASB recently finalized a new update to the accounting standard, starting in 2018. Since investment accounting is more complicated than it probably should be, Let’s explore accounting for debt investments in this article and accounting for stocks. in next week’s article. I’ll highlight several of the issues that capital market participants recognize with accounting for debt investments that can help you generate article ideas.

Accounting for debt securities

When managers buy debt, they record debt as an asset at the price paid. They then classify the debt instrument in one of the three categories shown in the table. These three categories are important because the accounting differs between them.

HTM Classification

The different classifications and accountings exist because the FASB recognizes that entities buy debt for different reasons. When managers buy a debt security as an investment, they might intend to hold it until maturity, thereby receiving the bond’s maturity value; they might choose to actively trade it, hoping to generate trading gains; or hold it as an investment that is not actively traded but also should not be held to maturity. Based on their intent, managers classify debt securities into one of these three classification categories. The accounting then follows the classification. In practice, managers classify almost all debt investments in the HTM or AFS categories. They almost never use the trade classification for the reasons described below.

Managers buy debt securities for a variety of reasons, with the intention of holding them to maturity. Maybe they’re buying local government debt to help support schools, roads, and other infrastructure. Perhaps the managers of a large entity buy debt from small suppliers to help the small supplier acquire funds to build new manufacturing plants to increase capacity (which the large entity wishes to meet its own needs). of production). Holding to maturity is one of many financially sound investing strategies. There are many other reasons to hold bonds until maturity.

HTM accounting reflects the intention to hold to maturity. At maturity, managers receive the maturity amount of the debt and they know that amount when they buy the bond. Given the intent of the HTM, the FASB determined that there was no reason to record changes in the market value of the debt security while it was held, as changes in the market value will offset each other over time. time and, ultimately, the managers will receive the known maturity value of the bond. . Referring to the table, unrealized market gains or losses are therefore ignored for HTM bonds. Managers tend to like this accounting because the effect on bottom line is very predictable.

Technically, HTM accounting is an “amortized cost”. Here’s the idea: If an entity buys a bond today for $ 9,800 and the bond’s maturity value is $ 10,000, the difference of $ 200 is considered additional interest on top of the rate. coupon interest. This $ 200 is amortized (i.e., accrued) to increase interest income from the date of purchase to the maturity date. If the bond had been purchased for $ 10,300, the difference of $ 300 would be considered a deduction of interest from the coupon and the $ 300 amortized to reduce interest income from the date of purchase to the maturity date.

Commercial classification

Suppose an entity purchases a bond and intends to make short-term business gains. The FASB then considered that changes in the market price of the bond are important in measuring financial performance. Reflecting management’s intention, the FASB requires that bonds classified as trading securities be recorded on the balance sheet at fair value (and not at amortized cost like HTM bonds). Short-term bond price gains or losses are recognized in profit or loss, again reflecting the managers’ intention.

AFS Classification

Many entities buy bonds that they do not intend to hold to maturity, but neither are they actively trading. The managers classify these bonds as AFS securities. Again, the accounting reflects the intention of management. Since management does not hold the obligation to maturity, changes in the market price are recorded in income. But since management does not actively trade the bond, changes in the market price are recorded only in comprehensive income, not in net income. If the bond is ultimately sold, the gains and losses recorded in comprehensive income are reclassified to net income.

Accounting games with bond investment accounting

Very few managers classify bonds as trading securities. Why? Leaders know they will be judged on the basis of the bottom line. So it’s no surprise that managers want to control (manage) the bottom line. If you consider the accounting for trading securities, changes in the price of bonds are recorded in profit or loss. What if a negative market-wide event occurs on the last day of the year? Bond prices would fall and the loss would be recorded in profit or loss. This means that an event beyond management’s control could cost managers their bonuses, cause profits to fall outside managers’ expectations and could exceed otherwise positive operating profits. The managers are aware of this possibility and have decided almost unanimously not to trade in bonds (or shares). As anecdotal evidence, I remember that when these accounting principles were first implemented (well before the year 2000), the manufacturing entities all had trading portfolios. But a year after the new accounting was required, nearly all U.S. public entities had gotten rid of securities trading, presumably to avoid possible volatility in accounting bottom lines.

A more sinister game is to build a large AFS portfolio of bonds (and stocks) and then plan the sale to manage the net income. Suppose an entity’s profits on the last day of its fiscal year are just below expectations. The sale of AFS stocks that show market gains reclassifies the gains from comprehensive income to net income, allowing managers to say they have lived up to expectations. Does this behavior occur? Many managers and capital market participants believe this, although I have not seen a detailed and systematic academic research study on this behavior. There is academic evidence that points to this behavior. Here are the disclosures from Sony Corporation. What do you think?

Sony condensed income statement

Sony’s gain on the sale of titles is insignificant for 2011 and 2012, when Sony recorded significant losses. Sony executives were under pressure to improve operations and post a profit. At first glance, they did it in 2013. But apparently almost all of the profit came from managing the investments. Footnote details reveal that they sold investments to generate a gain of 41.781 billion yen (and positive net income). Is it a coincidence that gains from title sales generated a substantial percentage of Sony’s net income? This is a potential article in an investigative journal. Many similar examples exist.

Investments may not be readily available for paying dividends or investing in trades. If we explore Apple, Inc.’s quarterly balance sheet as of June 25, 2016, we see short-term marketable securities of $ 43.519 billion and long-term marketable securities of $ 169.764 billion for a total of $ 213.283 billion. . Total registered assets are only $ 305.602 billion, so, surprisingly, marketable securities are the most important assets on Apple’s balance sheet. If Apple used the funds to pay a dividend, it would have to repatriate the investments to the United States first and pay a repatriation tax. This tax could reach 33 percent, which is the US tax rate of 35 percent less the approximately two (2) percent rate Apple incurred on its non-US income. Two percent is not a typo. Apple negotiated this low rate with the Irish government years ago. The details were contained in Apple’s testimony to Congress in 2013 which is available to the public. It seems that Apple will continue to increase its investments for tax reasons. It would be interesting to observe how Apple behaved if the US government offered a “tax repatriation leave” that several members of the US Congress have discussed.

Next week, we’ll explore accounting for equity investments.

Figures and finances Photo via Ken Teegardin, CC BY-SA 2.0

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