SFAS No.115, Accounting for Certain Investments in Debt and Equity Securities, governs the accounting for short-term investments in marketable securities. This standard requires that a firm classify such investments as either trading securities or available-for-sale securities. Trading securities are intended to be held for brief periods of time to generate profits from short-term differences in price. For example, investment banks will often buy an entire stock issue from a corporation with the intent of almost immediately selling the stock to the public. The investment bank would classify the stock as a trading security.
Marketable equity securities not classified as trading securities are classified as available-for-sale. Nonfinancial organizations classify most of their investments in marketable equity securities as available-for-sale.Proper classification is important because the accounting treatment differs for the two categories. Because most corporations classify their securities as available-for-sale, this chapter emphasizes the accounting procedures for that classification.
Available-for-Sale Securities – Marketable equity securities classified as available-forsale should be accounted for at market value on the balance sheet date. The difference between a security’s historical cost and its market value is an unrealized gain or loss. The term unrealized indicates that the gain or loss has not been confirmed by an actual sale.
However, because the securities are highly marketable, the value change is virtually certain, and,accordingly, the gain or loss is a valid and useful measure of a change in wealth. Unrealized gains and losses on available-for-sale securities do not, however, appear on the income statement. Instead, these gains and losses appear in a special section of shareholders’ equity that is distinct from invested capital or retained earnings. Also note that the marketable securities account continues to reflect the historical cost of the securities. The adjustment to market value is made to a valuation account, often labeled allowance for unrealized gain/loss.
Trading Securities – Trading securities are also accounted for at market value. One major difference exists between the accounting for trading securities and that for securities classified as available-for-sale. Unrealized gains and losses on trading securities are included in net income,as opposed to being reflected in a special section of shareholders’equity. The FASB believes that,because trading securities are purchased to generate profits on short-term price changes, all unrealized gains and losses should be immediately reflected on the income statement.
Debt Securities – The accounting for debt securities is a bit more complex. If a firm intends to hold a debt security until its maturity date, the security is valued at historical cost. Debt securities not intended to be held until maturity appear on the balance sheet at market value. However, because debt securities classified as current assets will be liquidated within the next year, a large discrepancy between cost and market value is unlikely. Thus, in most cases, financial statement readers can view the marketable debt securities figure in the current asset section as a very close approximation to market value.