New Standard: Accounting for Investments in Debt & Equity Securities
Clark, Stanley J., Jordan, Charles E., The National Public Accountant
Numerous criticisms exist with the current accounting practices for investments in debt and equity securities. For example, the authoritative literature provides little guidance on accounting for investments in marketable debt securities (MDS), thus resulting in inconsistencies in practice. Some firms report their MDS at the lower of cost or market (LOCOM) while other firms report them at cost. In addition, the LOCOM method, currently required for investments in marketable equity securities (MES, is criticized because it is a one-sided method. LOCOM recognizes declines in value below cost but ignores increases in value above cost. Opponents of LOCOM argue that increases in market value should also be recognized. The key reporting requirement should be providing relevant--not one-sided--information.
The Financial Accounting Standards Board (FASB) has responded to these criticisms by issuing Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This new standard will govern accounting for investments in MES and for most investments in debt securities. SFAS No. 115 supersedes SFAS No. 12, "Accounting for Certain Marketable Securities," and will significantly alter the method of accounting for investments. The new requirements become effective for fiscal years beginning after December 15, 1993. This article briefly reviews the current accounting procedures for investments in securities and presents the major changes set forth in SFAS No. 115.
Review of Present Procedures for Equity Securities
SFAS No. 12 prescribes the present procedures for accounting for MES, which are readily tradeable investments in preferred and common stock. SFAS No. 12 applies to passive investments, i.e., those in which the investor does not exert significant influence over the investee. Active investments--those in which the investor owns more than 20% of the investee's voting stock--are accounted for using the equity method as dictated by Accounting Principles Board (APB) Opinion No. 18. The new standard will not affect the method of accounting for active investments but will greatly impact accounting for passive investments.
Presently, passive investments in MES are accounted for using the LOCOM method. Before applying LOCOM, however, the MES must be divided between a current and a noncurrent portfolio. The classification as current or noncurrent depends upon management's intent to convert MES into cash within the operating cycle. Current MES are those management intends to convert within the operating cycle.
In applying LOCOM to the current portfolio, the aggregate market value and the aggregate cost of the portfolio are compared at year-end. If the aggregate market value has declined below the aggregate cost, this decline is recognized as an unrealized loss in the income statement and as an allowance to the investment account in the balance sheet. This aggregate comparison recurs each year with resulting adjustments to the allowance account. If the aggregate market value recovers in a later period, the allowance account will be reduced and a loss recovery will increase income. Loss recoveries, however, may be recognized only to the extent of previous losses (i.e., the portfolio may not be reported above cost).
LOCOM is applied to the noncurrent portfolio in a manner similar to its application with the current portfolio. The primary difference lies in the treatment of the unrealized losses, which do not impact income for the noncurrent portfolio. Instead, the unrealized losses for the noncurrent portfolio are reported in a contra stockholders' equity account on the balance sheet.
The recorded values of the individual securities are not impacted by the LOCOM adjustments at year-end for either the current or noncurrent portfolios. On the other hand, if an individual security is transferred between the current and noncurrent classification when its market value is below cost, the cost basis is reduced and a realized loss occurs. …