New standard: accounting for investments in debt & equity securities.Numerous criticisms exist with the current accounting practices for investments in debt and equity securities. For example, the authoritative literature provides little guidance on accounting for investments in marketable Marketable are securities that can be easily converted into cash. Such securities will generally have highly liquid markets allowing the security to be sold at a reasonable price very quickly. debt securities (MDS MDS, n See temporomandibular pain-dysfunction syndrome. MDS 1 Maternal deprivation syndrome, see there 2 Myelodysplastic syndrome, see there ), thus resulting in inconsistencies in practice. Some firms report their MDS at the lower of cost or market lower of cost or market A method for determining an asset's value such that either the original cost or the current replacement cost, whichever is lowest, is used for financial reporting purposes. (LOCOM LOCOM Lower of Cost or Market (inventory valuation method/rule) LOCOM Lake Oswego Communications (Oregon emergency dispatch) ) while other firms report them at cost. In addition, the LOCOM method, currently required for investments in marketable equity securities (MES (Manufacturing Execution Software) Software that provides real time access to plant activities that include equipment, labor, orders and inventory. An MES integrates the data with enterprise resource planning (ERP) systems so that management has complete control of , is criticized because it is a one-sided method. LOCOM recognizes declines in value below cost but ignores increases in value above cost. Opponents of LOCOM argue that increases in market value should also be recognized. The key reporting requirement should be providing relevant--not one-sided--information. The Financial Accounting Standards Board Financial Accounting Standards Board (FASB) Board composed of independent members who create and interpret Generally Accepted Accounting Principles (GAAP). (FASB FASB See: Financial Accounting Standards Board FASB See Financial Accounting Standards Board (FASB). ) has responded to these criticisms by issuing Statement of Financial Accounting Standards (SFAS SFAS Statement of Financial Accounting Standards SFAS Special Forces Assessment and Selection SFAS Student Financial Aid Services SFAS Sport Fishing Association of Singapore SFAS Safety Features Actuation System SFAS Statewide Fixed Assets System ) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This new standard will govern accounting for investments in MES and for most investments in debt securities. SFAS No. 115 supersedes SFAS No. 12, "Accounting for Certain Marketable Securities Marketable Securities Very liquid securities that can be converted into cash quickly at a reasonable price. Notes: Marketable securities are very liquid as they tend to have maturities less than one year, and the rate at which these securities can be bought or sold has ," and will significantly alter the method of accounting for investments. The new requirements become effective for fiscal years beginning after December 15, 1993. This article briefly reviews the current accounting procedures for investments in securities and presents the major changes set forth in SFAS No. 115. Review of Present Procedures for Equity Securities SFAS No. 12 prescribes the present procedures for accounting for MES, which are readily tradeable investments in preferred and common stock. SFAS No. 12 applies to passive investments, i.e., those in which the investor does not exert significant influence over the investee. Active investments--those in which the investor owns more than 20% of the investee's voting stock--are accounted for using the equity method as dictated dic·tate v. dic·tat·ed, dic·tat·ing, dic·tates v.tr. 1. To say or read aloud to be recorded or written by another: dictate a letter. 2. a. by Accounting Principles Board The Accounting Principles Board (APB) is the former authoritative body of the American Institute of Certified Public Accountants (AICPA). It was created by the American Institute of Certified Public Accountants in 1959 and issued pronouncements on accounting principles until 1973, (APB APB See Accounting Principles Board (APB). ) Opinion No. 18. The new standard will not affect the method of accounting for active investments but will greatly impact accounting for passive investments. Presently, passive investments in MES are accounted for using the LOCOM method. Before applying LOCOM, however, the MES must be divided between a current and a noncurrent portfolio. The classification as current or noncurrent depends upon management's intent to convert MES into cash within the operating cycle Operating cycle The average time between the acquisition of materials or services and the final cash realization from that acquisition. operating cycle . Current MES are those management intends to convert within the operating cycle. In applying LOCOM to the current portfolio, the aggregate market value and the aggregate cost of the portfolio are compared at year-end. If the aggregate market value has declined below the aggregate cost, this decline is recognized as an unrealized loss Unrealized Loss A loss that results from holding onto an asset rather than cashing it in and officially taking the loss. Notes: Let's say you own a stock that is down 50%, but you haven't sold it to realize the loss yet. This is said to be an unrealized loss. in the income statement and as an allowance to the investment account in the balance sheet. This aggregate comparison recurs each year with resulting adjustments to the allowance account. If the aggregate market value recovers in a later period, the allowance account will be reduced and a loss recovery will increase income. Loss recoveries, however, may be recognized only to the extent of previous losses (i.e., the portfolio may not be reported above cost). LOCOM is applied to the noncurrent portfolio in a manner similar to its application with the current portfolio. The primary difference lies in the treatment of the unrealized losses, which do not impact income for the noncurrent portfolio. Instead, the unrealized losses for the noncurrent portfolio are reported in a contra contra Member of a counterrevolutionary force that sought to overthrow Nicaragua's left-wing Sandinista government. The original contras had been National Guardsmen during the regime of Anastasio Somoza (see Somoza family). The U.S. stockholders' equity Stockholders' Equity The portion of the balance sheet that includes capital received from investors in exchange for stock (paid-in capital), donated capital, and retained earnings. This is equal to total assets minus liabilities, preferred stock and intangible assets. account on the balance sheet. The recorded values of the individual securities are not impacted by the LOCOM adjustments at year-end for either the current or noncurrent portfolios. On the other hand, if an individual security is transferred between the current and noncurrent classification when its market value is below cost, the cost basis is reduced and a realized loss Realized Loss A loss recognized when assets are sold for a price lower than the original purchase price. Notes: A portion of the realized loss may be applied against a capital gain or realized profit to reduce taxes. occurs. Even without a transfer between classifications, a realized loss and reduction in cost occur if a security's decline in value is deemed other than temporary. Review of Present Procedures for Debt Securities The investments in debt securities affected by the new standard are primarily MDS, which are readily tradeable investments in corporate bonds and government securities. Accounting for trade receivables Receivables An asset designation applicable to all debts, unsettled transactions or other monetary obligations owed to a company by its debtors or customers. Receivables are recorded by a company's accountants and reported on the balance sheet, and they and include all debts owed and loans will not be impacted by SFAS No. 115. Similar to MES, present accounting for MDS depends upon their classification as current or noncurrent, which hinges Hinges may refer to:
MDS classified as current are accounted for in one of two ways. One way is prescribed pre·scribe v. pre·scribed, pre·scrib·ing, pre·scribes v.tr. 1. To set down as a rule or guide; enjoin. See Synonyms at dictate. 2. To order the use of (a medicine or other treatment). in Accounting Research Bulletin No. 43, which states that marketable securities should be recorded and valued at cost. The second method used in practice is the LOCOM method as described above for MES classified as current. Even though SFAS No. 12 addresses accounting for MES only, many accountants opt for consistency between debt and equity securities by also applying SFAS No. 12's LOCOM procedures to MDS classified as current. ARB Opinion No. 21 presently governs accounting for MDS classified as noncurrent. A noncurrent investment is first recorded at cost, which may differ from its face value. Any difference between the investment's original cost and its face value is periodically amortized over the life of the investment as an adjustment to the investment's cost basis and to interest revenue. The effective interest method is the preferred amortization method. Accounting for MDS and MES Under the New Standard The primary focus of SFAS No. 115 is the expansion of fair value accounting to firms' investments in MDS and MES. Under SFAS No. 115, all of a firm's MES and the majority of its MDS will be reported at their market values each year. The resulting unrealized gains Unrealized Gain A profit that results from holding on to an asset rather than cashing it in and using the funds. Notes: Let's say you own a stock that has doubled, but you haven't sold it yet. This is said to be an unrealized gain. and losses from reporting these investments at their market values will appear either on the firms income statement or stockholders' equity section of the balance sheet. The proper placement of an unrealized gain or loss depends upon the classification of the investment. In attempting to expand the use of fair value accounting, the main issues addressed by SFAS No. 115 are the classification of investments in MDS and MES, reporting changes in the fair value of these investments, reporting transfers between classifications, and accounting for declines in value deemed to be other than temporary. Classification of Investments in MDS and MES The classification scheme set forth in SFAS No. 115 separates investments in MDS into three categories and separates investments in MES into two categories. The category in which a security is classified depends upon management's intent and in some instances the firm's ability to carry out that intent. The new categories set forth in SFAS No. 115 do not eliminate the current and noncurrent classifications presented on the balance sheet; rather, these new categories will be used solely for establishing the proper reporting of the fair values of the securities in each category. Securities in the new categories set forth in SFAS No. 115 will be reported on the balance sheet as either current or noncurrent assets Noncurrent asset Any asset that is expected to be held for the whole year, not sold or exchanged, such as real estate, machinery, or a patent. noncurrent asset based on the same criteria as presently used in applying SFAS No. 12. The first classification category in SFAS No. 115 is for securities held to maturity. Since MES do not have maturity dates, the held to maturity category applies to investments in MDS only. In order for a MDS to be classified as held to maturity, the firm must have positive intent and ability to hold the security to its maturity. If it is possible that the firm would sell the MDS prior to maturity in order to implement an asset-liability management strategy, then this possibility would negate ne·gate tr.v. ne·gat·ed, ne·gat·ing, ne·gates 1. To make ineffective or invalid; nullify. 2. To rule out; deny. See Synonyms at deny. 3. the firm's ability to hold the MDS to maturity. Therefore, the MDS would not be classified as held to maturity. Examples of asset-liability management strategies that might cause the MDS to be sold include changes in the debt's market rate risk, management of the firms income tax position, general liquidity needs and the need to increase regulatory capital (i.e., for financial institutions). The FASB intended to make the held to maturity classification quite restrictive since this group of MDS will continue to be shown on the balance sheet at amortized cost. For MDS included in the held to maturity category, there will be no reporting of unrealized gains or losses because fair values will not be used for this group of securities. For these MDS, the income statement will simply report the interest revenue earned in the current period, which includes the proper amount of discount or premium amortization. Any investment in MDS not classified as held to maturity and all investments in MES will be classified as either trading securities or securities available for sale. The trading securities category applies to securities being held for current resale resale n. selling again, particularly at retail. In many states a "resale license" or "resale number" is required so that the state can monitor the collection of sales tax on retail sales. RESALE. . Securities in this classification are usually held for short periods of time and are bought and sold by the firm with the expectation of making a profit on the transaction. The securities available for sale classification includes all securities not classified as either held to maturity or trading securities This category covers investments in MES and MDS that the firm intends to hold for an unspecified Adj. 1. unspecified - not stated explicitly or in detail; "threatened unspecified reprisals" specified - clearly and explicitly stated; "meals are at specified times" amount of time, but not until maturity in the case of MDS. Also classified as available for sale would be investments in MDS for which management intends to hold to maturity but the firm does not exhibit the ability to hold to maturity. For example, a firm's liquidity may have deteriorated to the point where it appears eminent Eminent may refer to:
Upon acquisition of an individual security, the firm should determine the appropriate classification into one of the three categories described above (i.e., held to maturity, available for sale or trading securities). This initial classification should be reexamined at each reporting date to determine whether it remains appropriate. If the present classification appears inappropriate, the security should be transferred to the appropriate category. One final classification issue is the proper reporting of investments in MDS and MES on a classified balance sheet. SFAS No. 115 will require trading securities to be classified as current assets Current Assets Appearing on a company's balance sheet, it represents cash, accounts receivable, inventory, marketable securities, prepaid expenses, and other assets that can be converted to cash within one year. . For held to maturity and available for sale securities, the current-noncurrent breakdown will be based on the same criteria as presently used in SFAS No. 12. Therefore, each security in these two categories will be classified as current or noncurrent based on management's intent to convert the security into cash within the operating cycle. Reporting Changes in Fair Value The proper method of reporting the change in the fair value of a security depends upon the classification of the security into one of the previously mentioned three categories. For a security classified as held to maturity, changes in the security's fair value are ignored for accounting purposes. Securities in the held to maturity classification are reported simply at amortized cost. Fair value is the proper reporting basis for securities classified as either trading securities or available for sale. If the fair value of a security in one of these categories changes during a reporting period, the firm must report an unrealized gain or loss. If the unrealized gain or loss applies to a security classified as a trading security, the gain or loss is reported on the current period's income statement. On the other hand, an unrealized gain or loss resulting from a change in the fair value of a security classified as available for sale is not included in the period's earnings. Unrealized gains and losses related to securities available for sale are reported as one net amount in a separate component of stockholders' equity. This manner of reporting applies regardless of the security's current vs. noncurrent classification on the balance sheet. The fair values of securities will be determined in most instances by examining quoted market prices in the financial press. These quoted market prices may not be available for a few MDS, but the FASB believes that reasonable estimates of fair value can still be obtained for these nonquoted securities. For example, one pricing technique recommended for estimating fair values for nonquoted MDS is discounted cash flow analysis. The reporting requirements prescribed by SFAS No. 115 differ markedly from existing standards and may seem confusing con·fuse v. con·fused, con·fus·ing, con·fus·es v.tr. 1. a. To cause to be unable to think with clarity or act with intelligence or understanding; throw off. b. . However, application of the new standard should not pose serious problems because its reporting requirements are quite specific, with the key issue being a security's classification as either a trading security, available for sale or held to maturity. Table 1 provides a brief summary of the current reporting requirements for marketable securities TABULAR tab·u·lar adj. 1. Having a plane surface; flat. 2. Organized as a table or list. 3. Calculated by means of a table. tabular resembling a table. DATA OMITTED and the forthcoming changes under SFAS No. 115. Reporting Transfers Between Categories and Impairments The classification of a security as either held to maturity, available for sale or trading security occurs at the time of acquisition and must be reexamined at each reporting date. If for any reason a security must be transferred between categories, the transfer is accounted for at the fair value of the security. The recording of unrealized gains and losses at the time of the transfer will vary depending upon which categories the transfer affects. For MDS or MES transferred from the trading security category, there will be no need to recognize the unrealized gain or loss because it will already have been recognized in earnings. This previous recognition should not be reversed. For MDS or MES transferred into the trading security category, any unrealized gains or losses at the time of transfer should be recognized in earnings for the current period. For a MDS transferred from the held to maturity category into the available for sale category or vice versa VICE VERSA. On the contrary; on opposite sides. , any unrealized gain or loss at the time of the transfer should be recognized in a separate component of stockholders' equity. If the transfer of MDS is from available for sale to held to maturity, the unrealized gain or loss recognized in stockholders' equity should be amortized over the remaining life of the debt as an adjustment to interest income. If there has been a decline in the fair value of a security classified as either held to maturity or available for sale, management must determine if the decline is considered to be other than temporary. If the decline is judged to be other than temporary, a realized loss occurs and the cost basis of the security is written down to its fair value. Any subsequent changes in fair value are reported as unrealized gains and losses in accordance Accordance is Bible Study Software for Macintosh developed by OakTree Software, Inc.[] As well as a standalone program, it is the base software packaged by Zondervan in their Bible Study suites for Macintosh. with the standards for reporting changes in fair value as discussed above. These subsequent changes in value will not impact the security's basis, unless another permanent impairment Impairment 1. A reduction in a company's stated capital. 2. The total capital that is less than the par value of the company's capital stock. Notes: 1. This is usually reduced because of poorly estimated losses or gains. 2. occurs. Conclusion SFAS No. 115 will significantly alter the reporting requirements for investments in marketable securities. The new standard focuses on reporting the fair values of these investments because the FASB believes that fair values are more relevant than present reporting practices. Reporting fair values will be a major departure from the historical cost model and will result in significant unrealized gains and losses being reported in the income statement and stockholders' equity section of the balance sheet. The FASB has taken a bold and admirable ad·mi·ra·ble adj. Deserving admiration. ad  mi·ra·ble·ness n.ad step which will hopefully improve financial reporting; all firms with investments in marketable securities will be affected. The effects of SFAS No. 115 will be felt as it becomes effective for fiscal years beginning after December 15, 1993. Stanley Stanley, town (1991 pop. 1,557), capital of the Falkland Islands, S Atlantic Ocean, on East Falkland island. It is the main port and trading center of the islands. The name is sometimes written as Port Stanley. J. Clark, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , PhD, is an assistant professor of accounting and Charles E. Jordan, EPA EPA eicosapentaenoic acid. EPA abbr. eicosapentaenoic acid EPA, n.pr See acid, eicosapentaenoic. EPA, n. , DBA, is an associate professor of accounting at the University of Southern Mississippi in Hattiesburg. |
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