What Are Held-for-Trading Securities?
Explore how the intent to trade securities for short-term profit dictates a specific accounting treatment that directly influences a company's reported earnings.
Held-for-trading securities are investments a company acquires to sell in the near future. The goal is not to receive interest or dividends but to profit from rapid changes in the security’s market price. This classification dictates how these assets are valued on financial statements and how the resulting gains or losses affect a company’s profitability.
Defining Held for Trading Securities
The classification of a security as “held-for-trading” depends on management’s intent at the time of purchase. For debt securities, the classification applies to investments bought with the goal of selling them within a short period to capitalize on price movements.
For equity securities, the accounting rules have evolved. Most equity investments must be measured at fair value, with all changes in value reported in net income. This treatment is very similar to that for trading securities, making the intent to trade less of a distinguishing factor than it is for debt.
An example is the portfolio of stocks and bonds managed by a financial institution’s trading desk to generate profits from market fluctuations. Another example is a corporation that trades commodity futures to speculate on price movements rather than to hedge costs.
Accounting and Financial Reporting
The accounting for held-for-trading securities is governed by the “mark-to-market” or “fair value” principle. When a security is acquired, it is recorded on the balance sheet at its purchase price. At the end of each financial reporting period, the company must adjust the security’s value to its current market price.
Any difference between the new fair value and the recorded value is an “unrealized gain or loss.” These unrealized gains and losses are reported directly on the company’s income statement in the period they occur, which can make earnings more volatile. For example, if a company buys a stock for $10,000 and its market value is $12,000 at the end of the quarter, the company reports a $2,000 unrealized gain on its income statement, even though it has not sold the stock.
On the balance sheet, held-for-trading securities are classified as current assets. The cash flows from buying and selling these securities are categorized as operating cash flows rather than investing cash flows.
Tax Treatment of Trading Securities
Tax rules for trading securities differ from financial accounting standards. For tax purposes, gains and losses are not recognized until the security is sold and the gain or loss is “realized.” This means the unrealized, mark-to-market adjustments that affect net income each quarter do not create a taxable event.
However, taxpayers who qualify as “traders” can make a “mark-to-market election” under Internal Revenue Code Section 475. This election allows the trader to recognize gains and losses on securities at the end of the year as if they had been sold at fair market value, reporting unrealized gains and losses for tax purposes annually.
Gains and losses under this election are treated as ordinary income or loss, not capital gains or losses. This contrasts with the treatment for an “investor,” whose capital losses are subject to limitations, such as a $3,000 annual deduction against ordinary income. For a trader, ordinary losses are not subject to capital loss limitations. The election must be made by the due date of the tax return for the prior year and applies to all subsequent years unless revoked with IRS consent.
Rules on Reclassification
The rules for reclassifying securities are strict for the held-for-trading category. Under U.S. Generally Accepted Accounting Principles (GAAP), transfers of any debt security into or out of the trading category are expected to be rare. This regulation exists to prevent companies from manipulating their reported earnings.
For example, a company could hide losses by moving a security that has dropped in value out of the trading category. Conversely, moving a security with a large unrealized gain into the trading category just before a sale could distort reported income.
Because of this potential for earnings management, accounting standards create a high barrier for such reclassifications. The decision to classify a debt security as trading is made at the time of acquisition and is intended to be lasting, reflecting the genuine short-term profit-seeking intent.