Accounting for Investments (#286)
/In this podcast episode, we discuss the accounting for investments. Key points made are noted below.
Initial Accounting for an Investment
First of all, how do you initially account for any investment? When you buy a security, the initial cost of the investment is the purchase price, plus any brokerage fees, and service fees, and taxes paid. This becomes the initial carrying amount of the investment. On the back end, when you sell a security, the net proceeds are the selling price, minus any brokerage fees, service fees, and transfer taxes paid. The difference between these two figures is the gain or loss on the investment. If the accounting standards require that you adjust that initial carrying amount to the fair market value of a security, but you haven’t sold the security yet, then any gain or loss is considered to be unrealized. When you do eventually sell the security, then any associated gain or loss is said to be realized.
Classification of Trading Securities
A business may have debt securities that it acquired with the intent of selling them in the short term for a profit. These are classified as trading securities, and you have to adjust their carrying amount at the end of each reporting period to their fair values. If there’s a gain or loss on this adjustment, you record it in earnings.
Classification of Held-to-Maturity Investments
Next up, a business might have a debt security that it acquired with the intent of holding it all the way to maturity. It’s called a held-to-maturity investment, and there is no adjustment to fair value in each period. The reason is that it’s a debt instrument, like a bond, and you’re planning to hold it until maturity, when you get paid the face value of the instrument, so logically, there’s no need to worry about a gain or loss, because as of the maturity date, there won’t be one.
Classification of Available-for-Sale Investments
And finally, any other security that’s not classified as a trading security or a held-to-maturity investment is classified as available-for-sale. It’s not held strictly for short-term profits, but it’s also not expected to be held-to-maturity. If you have an unrealized gain or loss for this kind of security, it gets recorded in other comprehensive income, which is essentially a parking lot for gains and losses until the security is actually sold. When it is sold, the gain or loss is shifted out of other comprehensive income and into earnings.
Recordation of Equity Securities
Which brings us to the first change to the accounting standards for investments, which is that those three classifications now only apply to debt securities. Equity securities used to be classified as either trading investments or available-for-sale securities, but now they’re just treated as equity securities. You initially record these equity securities at their acquisition cost, and then adjust their carrying amount to their fair value. Any unrealized holding gains or losses are included in earnings. And here’s a new item: There’re lots of cases where you can’t determine the fair value for an equity security, such as shares in a privately-held company. When this is the case, you can now use what’s called the practical expedient of estimating fair value. This means estimating fair value at its cost minus any impairment, plus or minus any changes resulting from observable price changes in orderly transactions for a similar investment of the same issuer.
Now, let’s cut through that really long sentence to figure out how you actually value these shares. You start by initially recording whatever you paid for them. After that, you have to monitor the prices at which the issuer is selling similar securities or the prices at which these shares are being sold between third parties, and develop a guesstimate of a market value from there. I suppose that’s sort of guidance, but the real issue is that these types of shares are usually restricted, so they can’t be traded. And the issuer may only sell shares every five or ten years. So, realistically, the practical expedient sounds good, but there’s just not enough information out there to value shares that aren’t being traded on an exchange. In which case, you may end up just leaving them on the books at their initial acquisition cost.
Impairment Analysis
No matter what kind of investment you have, debt or equity, you still need to evaluate it for impairment, and take a write-down from its carrying amount down to its fair value if there is an impairment. There are a bunch of indicators of impairment. The issuer could have reported a significant deterioration in its earnings, or it just got hit with more restrictive regulations, or its industry could be going through a downturn, or it might have just reported that it can’t continue as a going concern. In short, you need to periodically investigate the financial circumstances of the issuer, to see if the related investment is still viable.
Accounting for Credit Losses
Which brings us to the other new accounting item relating to investments, which is credit losses. When a business has debt security investments that it’s classified as held-to-maturity, it may need to set up an allowance for credit losses. This is a reserve account that’s deducted from the carrying amount of those securities on the balance sheet. This means that you have to fund that reserve account by charging a credit loss expense in whatever amount is needed to top up the reserve account.
There’s no single mandated way to estimate the amount of this credit loss, though a probability of default method seems reasonable. Whatever you use for the analysis, just be consistent about using it, so that you can justify it to the auditors at the end of the year. And by the way, you don’t have to record a reserve at all, as long as your historical credit loss information, adjusted for current conditions and forecasts, shows a nonpayment risk of zero.
As long as you invest in high-grade debt securities where the default risk is minimal, you can probably get away without recording a reserve. But if your treasurer wants to invest in something riskier, then expect to do some analysis to arrive at a reserve amount. Consider talking to your auditors in advance of year-end about setting up this reserve. They may have some suggestions about how to calculate and document it.