Investments in financial assets are those in which the investor has no significant influence. Depending on the nature of the investment relationship, investments in financial assets can be accounted for in different ways.

• IFRS has three basic categories: 1) held-to-maturity, 2) fair value through profit or loss, and 3) available-for-sale.
• GAAP has four categories: 1) held-to-maturity, 2) held for trading, 3) available-for-sale, and 4) investments designated at fair value.

Held-to-Maturity

Characteristics: The investor has both a positive intent to hold the securities, and the ability to hold them to maturity.

The cost method is used. The cost method reports investments at cost, not at market value, plus (minus) unamortized premium (discount).

Balance Sheet:

• Initial value: fair value (IFRS) or cost (GAAP). In most cases they are identical.
• The securities are accounted for at amortized cost, not fair value.

Income Statement:

• Income is interest received -/+ amortization of premium (discount).
• When the investment is sold, a gain or loss is recognized. The gain (or loss) on the sale is the difference between the sales price and the amortized cost.

This classification is available to debt only.

Both IAS 7 and SFAS 115 require that the market value be disclosed in a footnote even though the cost basis is the value that is actually reported.

Held for Trading

Characteristics: Trading securities are used to generate profits from short-term differences in prices. The holding period is usually less than 3 months. We would expect the portfolio turnover of companies with trading securities to be high.

The market method is used.

• Balance Sheet: The securities are reported at fair market value. Any discount or premium is not amortized.
• Income Statement: Unrealized gains and losses are reported as part of net income and affect stockholders' equity via retained earnings. Interest and dividends are also included in income.

This classification is available to both debt and equity securities.

Available-for-Sale

Characteristics: Investments not classified in another category are included here. The investor might sell these securities, but does not intend to trade on short-term price fluctuations. That is, it does not expect to sell and repurchase the same securities frequently.

The market method is used.

• Balance Sheet: These investments are reported at fair value in the balance sheet.
• Income Statement: Differences between the fair value and amortized cost are reported as unrealized holding gains and losses (net of deferred income tax) as a separate component (comprehensive income) in shareholder's equity. Income includes realized gains or losses, interest and dividends.

IFRS and U.S. GAAP differ on the treatment of foreign exchange gains/losses for debt (not equity) securities.

• Under IFRS, foreign exchange gains/losses are recognized in the income statement (separate recognition of foreign exchange gains/losses).
• Under GAAP, they are included in other comprehensive income, just like other changes in the carrying amount.

Designated Fair Value

These instruments can be financial assets or liabilities. They can be initially reported at fair value. Unrealized gains / losses on such instruments are reported in the income statement.

Example

Assume that the investment portfolio at the end of the year consists of three securities with cost and market values as follows:

Assuming that the securities were all purchased during the year, there is an unrealized gain on the portfolio of $3,000 at year-end. The adjusting entry to reflect this under the two mark-to-market classifications (available for sale and trading) is as follows:

In both cases, the security fair value adjustment (positive or negative) is added to the cost of the securities to arrive at the carrying amount on the balance sheet, $24,000 at year-end. The difference between the two classifications is this:

• Available-for-sale: the unrealized gain is reported directly in stockholders' equity in other comprehensive income and does not affect current profitability.
• Trading: the unrealized gain is reported as a component of net income and affects stockholders' equity via retained earnings.

Assume that the Company A security is sold subsequent to year-end for $4,500 (the security appreciated in value subsequent to year-end). The accounting entry is,

The original cost of the security is maintained in the general ledger and is used to compute the loss on sale. Had the security been sold for $6,000, a gain of $1,000 would have resulted.

Now assume that the portfolio at the end of the next year is as follows:

The unrealized gain on the portfolio has declined to $2,000. Since the current balance of the unrealized gain account is $3,000, it must be reduced by $1,000 as follows:

Again, the reduction in market value would be recognized as a reduction of stockholders' equity under the available-for-sale classification and a reduction of income under the trading classification. In either classification, the company reports a realized loss on the sale of company stock of $500 and may have also reported investment income on any dividends received during the year. The only difference between the two classifications is in how they treat unrealized gains and losses.

Reclassification of Investments

Although a company determines the classification of the security upon purchase, it does have the ability to change classifications subsequently.

Issues:

• At what value is the security transferred?
• How are gains and losses accounted for?
• What is the effect of the gain/loss accounting on income and equity?

The security must be mark-to-market and all unrealized gains or losses recognized in income on the date the classification is changed.

IFRS generally allows reclassification between held-to-maturity securities and available-for-sale securities (the last 2 rows).

U.S. GAAP allows transfers of securities between all categories.

Although the classification rules are designed to curtail management's ability to manage earnings or smooth balance sheet volatility through reclassification, there are still some opportunities to accomplish exact that. One example is reclassifying securities that have had unrealized gains from available-for-sale to trading securities, so the company would report the unrealized gains as income.

For securities classified as available-for-sale, only realized gains and losses are recognized, so if the portfolio has securities with unrealized gains, management will have the ability to determine the amount and timing of gains, and this could have a distorting affect on the company's overall performance regardless of how the company's overall portfolio performed during the year.

Impairments

Occasionally, an investment's value will decline for reasons that are "other than temporary." This is called "impairment of value".

Under IFRS, if a security is deemed to be impaired:

• For a held-to-maturity security, its carrying value is reduced. The impairment loss can be reversed for subsequent increases in fair value.
• For an available-for-sale security its carrying value is reduced. The impairment loss on an equity security cannot be reversed, however.

Under U.S. GAAP, if the value is impaired, the recorded cost of the security is reduced to the impaired fair value, and the difference is included in the current period's income. The new cost basis (the impaired fair value) is not changed for subsequent recoveries in fair value.