5.1 Classification and Valuation of Investments

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. Fair value is used for trading and available-for-sale securities, while amortized cost applies to held-to-maturity securities. 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: "Trading Securities - $500,000")
• Unrealized holding gains and losses are included in earnings, which can create volatility in the income statement (income statement example: "Unrealized Gain on Trading Securities - $25,000")
• Realized gains 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 other comprehensive income, which affects shareholders' equity but not net income (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
• Interest income 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: "Impairment Loss 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 $100 to$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 $100,000 to$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 $100,000 and a 5$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
• Dividend income is recognized in the income statement, regardless of the investment classification (example: if a company pays an annual dividend of $2 per share and an investor holds 1,000 shares, the investor would receive$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 - $500,000" and "Available-for-Sale 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 - $10,000" and "Realized Gain on Sale of Available-for-Sale 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 - $60,000" and "Dividend Income -$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 - $30,000" and "Impairment Loss on Held-to-Maturity 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")