A client buys a portfolio of corporate bonds with excess cash and records them in one account at cost. At year end the bond statements show fair values $60,000 below cost. The books show nothing, because nothing was sold. That is a misstatement under every classification except one, and which one depends on a decision the client probably never documented.
Debt securities carry a classification at acquisition, and that classification drives the measurement basis, where fair value changes land, and how credit losses are recorded. This guide covers the three categories, the credit loss models, transfers and worked entries, with the audit procedures that follow.
How are debt securities classified?
Each debt security is classified at acquisition into one of three categories, and the entity documents the choice.
Held-to-maturity (HTM). The entity must have the positive intent and the ability to hold the security to maturity. Not intending to sell is not enough. Securities that could be sold in response to changes in interest rates, prepayments, liquidity needs, alternative yields, funding sources or foreign currency risk cannot be HTM. Intent is typically supported by written representations, history, board or committee minutes, documented strategies, portfolio manager instructions, business plans and liquidity projections. HTM securities are measured at amortized cost, and classification is reassessed each reporting period.
Trading. Securities bought with the intent to sell within hours or days are trading. A security held longer can also be trading, based on the business purpose, strategy and history of trading activity. Trading securities are measured at fair value with unrealized gains and losses in net income.
Available-for-sale (AFS). AFS is the residual category: debt securities that are neither trading nor HTM. AFS securities are measured at fair value, with unrealized gains and losses reported in other comprehensive income (OCI), net of tax, except credit losses.
| HTM | AFS | Trading | |
|---|---|---|---|
| Balance sheet basis | Amortized cost | Fair value | Fair value |
| Fair value changes | Not recognized | OCI | Net income |
| Credit losses | Allowance under the current expected credit loss model | Allowance capped at the fair value shortfall | Not separately measured |
| Interest income, premium and discount amortization | Net income | Net income | Net income |
What does tainting mean for HTM?
Selling or transferring HTM securities outside the permitted exceptions calls the entity's intent into question for the whole HTM portfolio, and the remaining HTM securities may have to be reclassified to AFS. The exceptions include sales that follow a specified change in circumstances, such as significant credit deterioration, a change in tax law or a regulatory change; sales that are isolated, nonrecurring, unusual and not reasonably anticipated; sales so close to maturity that interest rate risk is substantially eliminated; and sales after a substantial portion of the original principal has been collected. Read the specific facts of any sale against the exceptions before concluding that the portfolio is not tainted.
How are credit losses measured?
HTM securities fall under the current expected credit loss model, the same one used for loans and receivables. The allowance covers expected losses over the life of the security. See /us/blog/cecl-asc-326-private-companies.
AFS securities have their own model, set by ASU 2016-13 in ASC 326-30. The sequence:
- A security is impaired only if its fair value is below amortized cost. If fair value is at or above amortized cost, there is no allowance.
- If the entity intends to sell the security, or more likely than not will be required to sell it before recovery of its amortized cost basis, any allowance is written off and the amortized cost is written down to fair value, with the incremental impairment in net income.
- Otherwise, the entity asks whether the decline resulted from a credit loss. It compares the present value of cash flows expected to be collected with the amortized cost.
- If a credit loss exists, an allowance is recorded, limited by the amount by which fair value is less than amortized cost.
- Impairment not recorded through the allowance goes to OCI, net of tax.
- Changes in the allowance are recorded in net income as credit loss expense or a reversal of it.
The cap in step 4 means the allowance can never exceed the fair value shortfall.
Worked entries
All figures are illustrations. A client buys a $100,000 bond at par.
Year-end fair value change by category
Fair value at year end is $98,000.
| Category | Account | Debit | Credit |
|---|---|---|---|
| Trading | Unrealized loss on securities (net income) | 2,000 | |
| Trading | Debt securities | 2,000 | |
| AFS | Unrealized loss (OCI) | 2,000 | |
| AFS | Debt securities, fair value adjustment | 2,000 | |
| HTM | No entry |
AFS credit loss with the cap
Fair value falls to $90,000, a $10,000 shortfall against amortized cost. The client does not intend to sell. Expected cash flows are $4,000 below amortized cost on a present value basis.
| Account | Debit | Credit |
|---|---|---|
| Credit loss expense | 4,000 | |
| Allowance for credit losses, AFS | 4,000 | |
| Unrealized loss (OCI) | 6,000 | |
| Debt securities, fair value adjustment | 6,000 |
Carrying amount is $90,000: amortized cost $100,000, less the $4,000 allowance, less $6,000 of unrealized loss. If the expected credit loss had been $12,000, the allowance would stop at $10,000, the fair value shortfall.
Sale of an AFS security
An AFS bond with a $100,000 cost is carried at $104,000 after marking to fair value, with $4,000 in accumulated OCI. It sells for $104,000.
| Account | Debit | Credit |
|---|---|---|
| Cash | 104,000 | |
| Accumulated OCI (unrealized gain) | 4,000 | |
| Debt securities (cost and fair value adjustment) | 104,000 | |
| Realized gain (net income) | 4,000 |
The gain moves from OCI to net income.
What happens on a transfer?
Transfers into or out of trading are expected to be rare.
- Into or out of trading is accounted for at fair value. A gain or loss already recognized in earnings is not reversed on the way out. An unrecognized gain or loss is recognized in earnings on the way in.
- HTM to AFS: the security moves to fair value, the unrealized gain or loss at the transfer date goes to OCI, and management considers whether the transfer calls into question intent and ability to hold the remaining HTM securities.
- AFS to HTM: the amount remaining in accumulated OCI stays in equity and is amortized over the remaining life as a yield adjustment, offsetting the premium or discount effect on interest income.
Audit angle
- Classification support. Obtain the documented classification at purchase, the investment policy, and board or committee minutes. For HTM, obtain a representation on intent and ability and test the liquidity projections.
- Sales and transfers. Read the activity for the year. A sale from HTM, or a repeat transfer, is a tainting question.
- Fair value. Agree fair values for AFS and trading to custodian statements or pricing sources and consider the hierarchy level. See /us/blog/asc-820-fair-value-measurement.
- Credit loss allowance. Test intent to sell, the cash flow estimate, and the cap against fair value. For HTM, test the pooling and the estimate.
- Premium and discount amortization. Recompute interest income.
- OCI. Agree the OCI rollforward to the investment schedule and test the reclassification on sales.
- Custody. Confirm holdings directly with the custodian.
Common misstatements: unrealized declines left off the books, AFS credit losses taken to OCI rather than an allowance, HTM classification kept after a tainting sale, and fair value changes on trading securities recorded in OCI.
Equity securities and equity-method investments are covered separately in /us/blog/investments-asc-321-equity-securities-asc-323-equity-method.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- PwC Viewpoint, Loans and investments guide, 3.3 Classification of debt securities: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/loans_and_investment/loans_and_investment_US/chapter_3_accounting__1_US/33_classification_of_US.html
- PwC Viewpoint, Loans and investments guide, 3.4 Accounting for debt securities: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/loans_and_investment/loans_and_investment_US/chapter_3_accounting__1_US/34_accounting_for_de_US.html
- PwC Viewpoint, Loans and investments guide, 3.5 Transfers of debt securities between classification categories: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/loans_and_investment/loans_and_investment_US/chapter_3_accounting__1_US/35_accounting_for_tr_US.html
- FASB, ASU 2016-13, Measurement of Credit Losses on Financial Instruments (ASC 326-30 AFS credit loss allowance limited by the fair value shortfall, intent-to-sell rule, HTM to AFS transfers to OCI): https://storage.fasb.org/ASU%202016-13.pdf
- Crowe, Transferring AFS debt securities to HTM (accumulated OCI amortized as a yield adjustment): https://www.crowe.com/insights/take-into-account/transferring-afs-debt-securities-to-htm
- Deloitte DART, Roadmap: Credit losses (CECL), 4.10 Transfers between classification categories: https://dart.deloitte.com/USDART/home/codification/assets/32x/asc326-10/roadmap-credit-losses-cecl/chapter-4-measurement-expected-credit-losses/4-10-transfers-between-classification-categories
- Wipfli, AOCI blues: ramifications of increased unrealized losses and accounting for AFS to HTM securities transfers: https://www.wipfli.com/insights/articles/fi-aa-aoci-ramifications-of-transferring-securities-from-afs-to-htm
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