FASB 115: Accounting for Debt and Equity Securities
Understand the core principles of FASB 115, which established how a company's intent for its investments directly shaped their financial statement reporting.
Financial Accounting Standards Board (FASB) Statement No. 115 was established in 1993 to create a uniform approach for how companies report investments in debt and equity securities. Before this standard, varying accounting practices made it difficult to compare the financial health of different companies. FASB 115 provided a structured framework for classifying and measuring these assets, improving the reliability of financial statements.
The Three Original Security Classifications
FASB 115 required that upon acquisition, an entity must classify its debt and equity securities into one of three categories. This classification was based on the company’s intent at the time of purchase, not the characteristics of the security itself. The decision made at acquisition dictated the accounting treatment for the life of the investment.
Held-to-Maturity
The Held-to-Maturity (HTM) category was reserved for debt securities. To use this classification, the company had to have both the positive intent and the ability to hold the security until its maturity date. This meant the company did not plan to sell the security to manage risk or meet liquidity needs.
Trading Securities
Trading Securities (TS) included both debt and equity securities bought and held principally for the purpose of selling them in the near term. The objective was to generate profits from short-term fluctuations in market prices, which resulted in frequent buying and selling.
Available-for-Sale
The Available-for-Sale (AFS) category was the default classification for any debt or equity security not classified as HTM or Trading. This category was for investments that were not intended for active trading but might be sold before maturity to respond to market changes or liquidity needs.
Accounting Treatment Under FASB 115
The accounting treatment under FASB 115 was tied to a security’s classification. Upon purchase, all securities were initially recorded at their acquisition cost, which established a baseline value for subsequent measurements.
Securities classified as Held-to-Maturity were reported on the balance sheet at amortized cost. This method adjusts the initial cost over the bond’s life, so its carrying value moves toward its face value. Since the intent was to hold them to maturity, daily market price fluctuations were considered irrelevant and not reflected on the balance sheet.
In contrast, both Trading and Available-for-Sale securities were reported at fair value on the balance sheet at each reporting date. This practice, known as “mark-to-market,” ensures the balance sheet reflects the current market worth of these investments.
For Trading securities, unrealized holding gains and losses were included directly in the income statement. This meant any change in the market value of these securities immediately affected the company’s reported net income, reflecting the short-term nature of the investments.
For Available-for-Sale securities, unrealized gains and losses were reported in a separate component of shareholders’ equity called Other Comprehensive Income (OCI). The gain or loss was only moved from OCI to the income statement when the security was sold. This approach prevented market volatility from impacting net income until a gain or loss was realized.
Transition to Current GAAP
The principles from FASB 115 have been modified and integrated into the FASB Accounting Standards Codification (ASC) under Topic 320. While the core idea of classifying securities based on intent remains, subsequent updates have altered the rules, particularly for equity investments and impairment analysis.
ASU 2016-01: Equity Securities
A major shift occurred with ASU 2016-01, which eliminated the Available-for-Sale classification for equity investments. Under this guidance, most equity securities must be measured at fair value, with all changes in value reported directly in net income. This increases income statement volatility as market fluctuations flow directly through earnings.
The Measurement Alternative
For equity investments without a readily determinable fair value, ASU 2016-01 introduced a measurement alternative. This allows such investments to be held at cost, less any impairment. However, it requires an adjustment to fair value if an observable price change occurs for an identical or similar investment from the same issuer.
The CECL Model
Another evolution is the Current Expected Credit Losses (CECL) model under ASC 326, which changed how companies recognize impairment for debt securities. The CECL model requires entities to estimate and recognize lifetime expected credit losses for Held-to-Maturity debt securities in an allowance account. For AFS debt securities, credit-related losses are also recognized through an allowance, limited by the amount the security’s fair value is below its amortized cost.