E. INVESTMENTS - 4. FINANCIAL ASSETS Debt Securities

Question 1

_{E. INVESTMENTS}

_{4. FINANCIAL ASSETS DEBT SECURITIES (HTM)}

Held to maturity (HTM) Treatment

Answer 1

Held to maturity (HTM) debt investments are reported at amortized cost.

• These are debt securities that the investor intends to “hold until maturity” of the investment.
• The fair value option can be elected for a held to maturity investment, and if so then fair value rules apply (see previous section).
• The investment is recorded at cost (includes brokerage or transfer fees if applicable). Unrealized gains and losses aren’t tracked or measured for HTM investments.
• Interest income is recognized in earnings (income statement).

Example:

ABC purchased a debt investment that it intends to hold until maturity. The cost of the investment is $100,000.

Journal entry to record investment:

HTM investment $100,000

Cash $100,000

If ABC receives $5,000 in interest income from the investment:

Cash $5,000

Interest income $5,000

HTM investments are evaluated for impairment at each balance sheet date.

If a decline in fair value is 1) below amortized cost and 2) the decline in value is considered other than temporary, the entity evaluates the investment according to the current expected credit loss model (CECL).

This model is based on historical experience and business outlook of the investee, market conditions in which the investee operates, and forecasts related to the investee to come up with all expected credit losses on an investment (essentially you’re evaluating the ability of the investee to repay the debt and come up with the amount the entity actually expects to receive on this debt investment).

The expected credit loss amount is then used to create a valuation allowance that is a contra account to the HTM investment.

• This amount is debited to “credit loss expense” on the income statement, and
• then credited to “allowance for credit loss”, the contra account which lowers the amortized cost amount on the balance sheet.

Example:

ABC evaluates its $100,000 HTM investment and expects a credit loss of $20,000.

The entry would be:

Credit loss expense $20,000

Allowance for credit loss $20,000

So this allowance lowers the value of the HTM investment on the balance sheet, even though it’s still being carried at its amortized cost, and it provides the net amount that the entity expects to actually collect on the debt investment.

At each balance sheet date these credit losses are re-evaluated, and previous losses can be reversed, but only up to the amount in the allowance account.

Question 2

_{E. INVESTMENTS}

_{<u>4. FINANCIAL ASSETS DEBT SECURITIES</u>}

Debt Securities

Available for Sale Securities

Answer 2

Available for Sale Securities

These are debt securities that are “available for sale”. These are reported at fair value on the balance sheet. If the fair value becomes greater than the carrying value, then there is an unrealized gain in OCI.

Example:

ABC purchased a bond from XYZ for $1,000 and classified it as an AFS security.

Journal entry at purchase:

AFS securities $1,000

Cash $1,000

At the balance sheet date if the fair value is now $1,250:

AFS securities $250

Unrealized holding gain (OCI) $250

When the amortized cost is greater than the fair value of the investment, there has been a decline in value of an AFS investment.

At this point there are two considerations:

First - What portion of the decline in value is because of general market conditions?

• These are unrealized losses in OCI.

Second - What portion of the decline in value is because of a decline in the credit worthiness of the investee?

• These are credit losses recognized in income and they create a valuation allowance or contra account to the AFS investment.

Example:

ABC determines that its $100,000 investment in XYZ’s debt securities is now worth $95,000. ABC attributes $3,000 to credit loss, and $2,000 to general market conditions.

The credit loss entry would be:

Credit loss expense $3,000

Credit loss allowance $3,000

The portion for general conditions would be:

Unrealized loss (OCI) $2,000

FV adjustment - AFS securities $2,000

These credit losses can be reversed if the situation changes, but only up to the amount in the credit loss allowance account.