Marketable Securities: Accounting and Tax Treatment

Marketable securities are financial instruments that can be bought and sold with ease on public exchanges. Companies utilize these assets to invest surplus cash on a temporary basis, aiming to generate returns while maintaining a high degree of liquidity. This provides a more productive alternative to holding cash, which generates no return, without committing funds to long-term, illiquid projects.

Types of Marketable Securities

Marketable securities are broadly divided into two main categories: equity and debt. Equity securities represent an ownership interest in a publicly traded company. The most common form is common stock, which gives the holder a claim on the company’s assets and earnings. The value of these securities can fluctuate based on the company’s performance and overall market sentiment.

Debt securities represent a loan made by an investor to an entity, such as a corporation or a government body. Corporate bonds are a frequent example, where a company borrows funds from the public and agrees to pay periodic interest and return the principal amount at a future date. Government-issued debt is also common, with U.S. Treasury bills (T-bills) being short-term instruments that mature in one year or less.

Other forms of debt securities include commercial paper and certificates of deposit (CDs). Commercial paper consists of short-term, unsecured promissory notes issued by companies, typically with a maturity period ranging from a few days to under a year. Certificates of deposit are time deposits offered by banks with a specified maturity date and interest rate, providing a predictable return.

Accounting Classification and Valuation

Under U.S. Generally Accepted Accounting Principles (GAAP), the accounting for debt securities is dictated by management’s intent for holding the investment. This intent leads to one of three classifications: Held-to-Maturity (HTM), Held-for-Trading (HFT), or Available-for-Sale (AFS). This classification is determined at the time of purchase.

Held-to-Maturity securities are debt instruments that the company has the positive intent and ability to hold until their scheduled maturity date. These investments are reported on the balance sheet at amortized cost, which is the initial purchase price adjusted for any premium or discount over the life of the bond.

Securities classified as Held-for-Trading are bought and held principally for the purpose of selling them in the near term to generate profits from short-term price differences. These securities are reported at fair value on the balance sheet. Fair value is the price that would be received to sell an asset in an orderly transaction between market participants.

The Available-for-Sale category is the default classification for debt securities not categorized as either HTM or HFT. Like trading securities, AFS securities are also reported at fair value. The difference lies in how the changes in that fair value are recognized in the financial statements.

The accounting for most equity securities is based on fair value. This means the market volatility of these stocks can directly impact a company’s reported net income.

Financial Statement Presentation

Marketable securities are listed as current assets on the balance sheet, reflecting their high liquidity and the expectation that they can be converted to cash within one year.

Changes in the value of these securities create unrealized gains and losses, which are recorded differently depending on the classification. For Held-for-Trading securities and most equity securities, unrealized gains or losses from changes in fair value are reported directly on the income statement, affecting the company’s net income.

For Available-for-Sale debt securities, the treatment of unrealized gains and losses is distinct. These changes in fair value bypass the income statement and are instead recorded in a separate component of shareholders’ equity called “other comprehensive income” (OCI). This prevents the volatility of these instruments from impacting reported earnings until the security is sold. In contrast, Held-to-Maturity securities do not generate unrealized gains or losses because they are carried at amortized cost.

Tax Treatment of Dispositions

Tax implications for marketable securities arise only when they are sold, an event known as a disposition. At the point of sale, any gain or loss is “realized,” which is different from the “unrealized” gains and losses recorded for accounting purposes. A realized gain occurs if the selling price is higher than the original purchase price, or cost basis, and this profit is subject to taxation.

If an investment is held for one year or less before being sold, the profit is considered a short-term capital gain. Short-term gains are taxed at the individual’s or corporation’s ordinary income tax rate. This tax consequence is reported to the taxpayer and the IRS on Form 1099-B.

If the security is held for more than one year, the profit qualifies as a long-term capital gain. Long-term capital gains are taxed at preferential rates, which are 0%, 15%, or 20% for individuals, depending on their overall taxable income. If a security is sold for less than its cost basis, a capital loss is realized, which can often be used to offset capital gains and reduce the overall tax burden.