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Investments in debt and equity securities (before adoption of IFRS 9): Key differences between U.S. GAAP and IFRSs

In November 2009, the IASB issued IFRS 9, Financial Instruments, to replace the guidance on classifying and measuring financial assets in IAS 39, Financial Instruments: Recognition and Measurement. In October 2010, the IASB amended IFRS 9 to add requirements for classifying and measuring financial liabilities and for recognizing and derecognizing financial assets and financial liabilities. Entities have the option of adopting IFRS 9 (2009) without applying the provisions in IFRS 9 (2010). However, an entity adopting IFRS 9 (2010) must apply all the provisions in IFRS 9 (2009). The IASB voted in July 2013 to eliminate IFRS 9’s mandatory effective date and will instead set an effective date when it finalizes the remaining provisions of IFRS 9 (i.e., hedge accounting and impairment). Early application is permitted.

In this comparison, it is assumed that an entity is applying IAS 39 and has not yet adopted IFRS 9.

Under U.S. GAAP, ASC 320 is the primary source of guidance on the accounting for and reporting of certain investments in debt and marketable equity securities.

Under IFRSs, IAS 39 is the primary source of guidance on the recognition and measurement of financial assets and financial liabilities, including investments in debt and equity securities, for entities that have not adopted IFRS 9.

Note that ASC 320 applies to a narrower set of financial instruments than IAS 39. This comparison focuses specifically on differences between U.S. GAAP and IFRSs in the accounting for investments in debt and equity securities. It does not discuss the accounting for loan receivables and equity-method investments. The following five topics are summarized: scope, initial recognition, classification categories, subsequent measurement, and impairment.

The table below summarizes these differences and is followed by a detailed explanation of each difference.

Subject U.S. GAAP IFRSs
Scope: applicability to financial instruments that are not in security form ASC 320 applies only to an investment in debt or equity instruments that are securities. Investments in instruments that are not securities are outside its scope. Thus, ASC 320's scope is much narrower than that of IAS 39. IAS 39 provides guidance on the recognition and measurement of financial assets and financial liabilities. Accordingly, IAS 39's scope includes investments in financial assets that are not in security form, such as account and trade receivables, and is therefore much broader than ASC 320's scope.
Scope: applicability to, and measurement of, investments in equity instruments ASC 320 applies to investments in equity securities only if they have readily determinable fair values. Investments in equity securities without readily determinable fair values, including shares that carry a provision restricting sale or transfer for a period greater than one year, are accounted for under the cost method described in ASC 325-20 (unless the investor exercises significant influence over the investee, in which case the investment is accounted for by using the equity method of accounting in accordance with ASC 323-10). However, entities also have the option to account for investments in equity instruments at fair value with changes in fair value included in earnings in accordance with ASC 825. IAS 39 applies to all investments in equity instruments irrespective of whether they are securities or have readily determinable fair values (unless the investor exercises significant influence over the investee, in which case the investment is accounted for under the equity method of accounting under IAS 28, Investments in Associates). Restricted shares and unquoted equity securities are accounted for at fair value unless fair value cannot be reliably measured (a case that is expected to be rare). Investments in equity instruments that do not have a quoted price in an active market and whose fair value cannot be reliably measured are measured at cost.
Initial recognition: transaction costs incurred to acquire a security ASC 320 does not provide guidance on accounting for transaction costs incurred in acquiring an equity security. ASC 310 states that for investments in debt securities classified as held to maturity (HTM) or available for sale (AFS) under ASC 320, costs paid directly to the seller of the debt security plus any fees paid less fees received should be included in the debt security's initial investment. Under paragraph 43 of IAS 39, all transaction costs that are directly attributable to the acquisition of any financial asset must be included in the initial measurement of that asset unless it is subsequently measured at fair value with changes in fair value recognized through profit or loss (FVTPL) (e.g., financial assets held for trading or designated at FVTPL).
Initial recognition: trade-date versus settlement-date accounting ASC 320 does not provide guidance on whether a debt or equity security should be initially recognized on a trade-date or settlement-date basis. An entity's accounting often depends on the industry in which the entity operates. An entity may elect as an accounting policy to apply trade-date or settlement-date accounting to each category of financial asset defined in IAS 39 (i.e., AFS, HTM, loans and receivables, and FVTPL). However, trade-date or settlement-date accounting must be applied consistently to all financial assets in the same category.
Initial recognition: accounting for changes in value between the trade date and settlement date ASC 320 does not provide guidance on accounting for a change in value of a security between its trade date and settlement date. If a financial asset is initially recognized on its settlement date, any changes in fair value of the asset to be received that occur between the trade date and settlement date should be accounted for in the same way as changes in value that will be recognized once the asset is received.
Classification categories: HTM definition An investment that meets the definition of a debt security and that management has the intent and ability to hold to maturity is classified as HTM. An investment in a debt security that is not traded in an active market could be classified as HTM if it meets certain conditions. Investments in debt securities that are classified as HTM are accounted for at amortized cost. The HTM classification is not limited to investments in debt securities but applies to investments in debt instruments more generally, including instruments that are not securities. However, classifying an investment as HTM is prohibited if that investment is not quoted in an active market. Such an investment may instead be classified in the loans and receivables category. Note that both financial assets classified as loans and receivables and those classified as HTM are accounted for at amortized cost.
Classification categories: classification of a puttable security A debt security that is puttable by the holder may be classified as HTM if the holder has the positive intent and ability to hold that security to maturity. However, because the purchase price of the puttable security includes a premium for the put feature, an entity needs to consider the put feature carefully to determine whether it calls into question the holder's intent and ability to hold the security until maturity. A debt security that is puttable by the holder may not be classified as HTM, regardless of whether the holder has the positive intent and ability to hold the security until maturity.
Classification categories: required reclassification of HTM securities An entity is required to reassess the appropriateness of classifying its debt securities as HTM as of each reporting date. If an entity (1) no longer has the ability to hold securities to maturity, (2) sells or transfers one or more HTM debt securities before maturity for reasons that materially contradict the entity's stated intent to hold those securities until maturity, or (3) has a pattern of sales or transfers, the entity must reclassify its remaining HTM debt securities. In scenarios (2) and (3) above, an entity must reclassify its remaining HTM debt securities as AFS. Reclassification of all remaining HTM financial assets as AFS is required if an entity sells or reclassifies more than an insignificant amount of HTM financial assets for reasons other than those permitted under paragraph 9 of IAS 39.
Classification categories: tainting period for the HTM classification There is no specified period during which an entity may not classify debt securities as HTM after being forced to reclassify "tainted" HTM debt securities. However, the SEC staff has suggested a two-year "tainting" period for all securities after such a sale or transfer takes place. Paragraph 9 of IAS 39 specifies a two-year tainting period for all entities that sell or reclassify more than an insignificant amount of HTM financial assets before their maturity.
Classification categories: definition of a trading security A trading security is one that is bought and held principally for the purpose of selling in the near term. However, ASC 320-10-25-1 states that "an entity is not precluded from classifying [a] security as trading . . . simply because [it] does not intend to sell [the security] in the near term." In addition, an entity may elect to account for an investment in a debt or equity security at fair value with changes in value recognized in earnings in accordance with ASC 825. A financial asset is classified as held for trading if the investment (1) is acquired principally to sell in the near term, (2) is "part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking," or (3) is a derivative instrument. An investment may not be classified as held for trading if an entity does not intend to sell the investment in the near term. However, such an investment may qualify for designation at FVTPL if certain conditions are met.
Classification categories: transfers into or out of the trading classification ASC 320-10-35-12 indicates that a transfer of a financial instrument into or out of the trading category should be rare. Paragraph 50 of IAS 39 prohibits transfers of financial instruments into the FVTPL category after initial recognition. It permits transfers out of the FVTPL category in limited circumstances.
Subsequent measurement: interest income recognition Interest income is recognized on the basis of contractual cash flows, with certain exceptions depending on the specific characteristics of a debt security, such as whether the debt security (1) is part of a group of prepayable debt securities, (2) is a beneficial interest in securitized financial assets, or (3) has been other-than-temporarily impaired. The effective interest method is used to recognize interest income on investments in debt instruments on the basis of the estimated cash flows over the expected life of the instrument.
Subsequent measurement: recognition of a change in expected future cash flows Whether and how an entity recognizes a change in expected future cash flows of an investment in a debt security depends on the characteristics of the debt security and what effective interest method is being applied.

If a change in the expected future cash flows of an investment in a debt instrument occurs, the carrying value of the investment is recalculated on the basis of the present value of the revised estimated future cash flows of the debt investment, discounted at the original effective interest rate. The cumulative catch-up adjustment to the carrying value of the debt investment is recognized directly in earnings.

An exception exists for financial assets that are transferred out of the FVTPL classification and in which the estimated future cash flows have subsequently increased as a result of the greater recoverability of the cash receipts. In such circumstances, the entity should adjust the effective interest rate going forward rather than immediately adjust the carrying amount of the asset.
Subsequent measurement: recognition of foreign exchange gains and losses on AFS debt instruments The unrealized change in value of an investment in a debt security classified as AFS that is attributable to changes in foreign currency rates is generally included in accumulated other comprehensive income (AOCI) rather than in current-period earnings. Impairment losses on investments in debt securities are generally recognized in current-period earnings and may include foreign exchange gains or losses. The unrealized change in value of an investment in a debt instrument classified as AFS that is attributable to changes in foreign exchange rates is recognized in current-period earnings.
Impairment: other-than-temporary loss versus a loss event An impairment loss on an investment in a debt or equity security is recognized if the investment is considered other-than-temporarily impaired. Several sources provide guidance on when a security is considered other-than-temporarily impaired. A financial asset is considered impaired and an impairment loss is recognized only if there is objective evidence of impairment as a result of one or more events ("loss events") that have occurred after recognition of the asset.
Impairment: determination of impairment loss

If an investment in an equity security is determined to be other-than-temporarily impaired, the impairment loss to be recognized in earnings is calculated as the difference between the security's cost basis and the current fair value of the security on the date of impairment.

The determination of the amount of impairment loss to be recognized for a debt security, whether classified as AFS or HTM, depends on whether the entity (1) intends to sell the debt security, (2) has determined that it is more likely than not required to sell the debt security, or (3) expects to recover the entire amortized cost basis of the security.

If the entity has determined that it (1) intends to sell the debt security or (2) will be more likely than not required to sell the debt security before the recovery of its amortized cost basis, an impairment loss is recognized in earnings as the difference between the debt security's carrying value and the current fair value as of the date of impairment.

If the entity has determined that it (1) does not intend to sell and will not be more likely than not required to sell the debt security and (2) does not expect to recover the security's entire amortized cost basis, a credit loss is considered to have occurred. The impairment loss is bifurcated between a credit loss and a noncredit loss. The credit loss, which is measured as the difference between the debt security’s cost basis and the present value of expected future cash flows, is recognized in earnings, and the noncredit loss, which is measured as the remaining difference between the debt security’s cost basis and its current fair value, is recognized in other comprehensive income (OCI).

Once a loss event has occurred and an investment is considered impaired, the impairment loss recognized depends on the investment's balance sheet classification.

If an equity investment classified as AFS is impaired, the amount of impairment is calculated as the difference between the security’s cost basis and the current fair value of the security on the date of the impairment.

If an AFS debt security investment is considered impaired, the impairment loss recognized is calculated as the difference between the cost basis of the impaired security and its current fair value and would be recognized in profit or loss.

If an investment that is classified as HTM or as a loan or receivable is considered impaired, the impairment loss is measured as the difference between the asset's carrying amount and the present value of estimated future cash flows, discounted at the original effective interest rate. This amount would be recognized in profit or loss.
Impairment: reversing recognized impairments Once an other-than-temporary impairment (OTTI) is recognized and the cost basis of a security is written down through earnings, subsequent recoveries in the value of that security are not recognized in earnings. Entities are prohibited from reversing previously recognized impairment losses on equity investments. However, entities may reverse impairment losses previously recognized on investments in debt instruments classified as HTM, AFS, or loans and receivables through earnings by adjusting the carrying amount of the investment. The carrying amount of an HTM investment or a loan or receivable cannot exceed what the amortized cost of that investment would have been had the original impairment not been recognized.

Scope

Applicability to Financial Instruments That Are Not in Security Form

Under U.S. GAAP, ASC 320 applies only to investments in debt and marketable equity securities (i.e., equity securities that have readily determinable fair values). Investments in instruments that are not in security form are outside the scope of ASC 320.

As defined in ASC 320-10-20, a debt security is any "security representing a creditor relationship" and an equity security is any "security representing an ownership interest in an entity . . . or the right to acquire . . . or dispose of . . . an ownership interest." In addition, ASC 320-10-20 defines a security as follows:

A share, participation, or other interest in property or in an entity of the issuer or an obligation of the issuer that has all of the following characteristics:

a. It is either represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer.
b. It is of a type commonly dealt in on securities exchanges or markets or, when represented by an instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for investment.
c. It either is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations.

Because ASC 320 applies only to investments in debt and marketable equity securities, its scope is much narrower than IAS 39's scope. For example, a creditor relationship (e.g., an account or trade receivable) or an investment in an ownership interest (e.g., an investment in an uncertificated residual interest) that is not in security form is not within the scope of ASC 320.

Under IFRSs, IAS 39 applies to investments in financial assets regardless of whether a financial asset meets the definition of a security. Thus, more types of instruments are within IAS 39's scope than ASC 320's scope. For example, the creditor relationship and the ownership interest discussed above are within the scope of IAS 39 regardless of whether the financial instrument is in security form.

Applicability to, and Measurement of, Investments in Equity Instruments 1

Under U.S. GAAP, ASC 320 applies only to equity securities that have readily determinable fair values. ASC 320-10 states that an equity security is considered to have a readily determinable fair value if any of the following conditions apply:

a. The fair value of an equity security is readily determinable if sales prices or bid-and-asked quotations are currently available on a securities exchange registered with the U.S. Securities and Exchange Commission (SEC) or in the over-the-counter market, provided that those prices or quotations for the over-the-counter market are publicly reported by the National Association of Securities Dealers Automated Quotations systems or by Pink Sheets LLC. Restricted stock meets that definition if the restriction terminates within one year [and the other conditions above are also met].
b. The fair value of an equity security traded only in a foreign market is readily determinable if that foreign market is of a breadth and scope comparable to one of the U.S. markets referred to above.
c. The fair value of an investment in a mutual fund is readily determinable if the fair value per share (unit) is determined and published and is the basis for current transactions.

If an investment in an equity security does not have a readily determinable fair value, that investment is typically accounted for at cost subject to impairment testing under ASC 325-20 and ASC 320-10-35. Because restrictions on the transferability of an equity security may affect the determination of whether that security has a readily determinable fair value, restricted shares are not within the scope of ASC 320-10 and are therefore accounted for at cost less OTTIs if the restriction does not terminate within one year.

Under IFRSs, IAS 39 applies to investments in equity instruments regardless of whether the equity instrument has a readily determinable fair value. All equity instruments must be measured at fair value unless fair value cannot be reliably measured. Paragraph AG80 of IAS 39 states that fair value can be reliably measured if "(a) the variability in the range of reasonable fair value measurements is not significant . . . or (b) the probabilities of the various estimates within the range can be reasonably assessed and used when measuring fair value." If an equity investment does not have a quoted market price in an active market and its fair value cannot be reliably measured, that equity investment must be measured at cost subject to impairment testing in accordance with paragraph 46(c) of IAS 39.

Investments in equity securities that are not publicly traded and restricted shares for which the restriction does not terminate within one year are examples of securities that are generally outside the scope of ASC 320 (because they do not have readily determinable fair values) but would be within the scope of IAS 39.

Initial Recognition

Transaction Costs Incurred to Acquire a Security

Under U.S. GAAP, ASC 320 does not provide guidance on accounting for transaction costs that are associated with the acquisition of a debt or equity security. However, the guidance on accounting for transaction costs incurred in purchasing a loan or a group of loans under ASC 310-20-25-22 and ASC 310-20-35-15 applies to investments in debt securities that are classified as HTM or AFS pursuant to ASC 320.2 ASC 310-20-30-5 and ASC 310-20-35-15 state that the amount paid to the seller plus fees paid to the seller less any fees received are included as part of the initial measurement of the debt security and are recognized as an adjustment to the yield of the debt security over its remaining life. All other costs incurred as part of the acquisition are expensed immediately as incurred.

Under IFRSs, paragraph 43 of IAS 39 indicates that transaction costs that are directly attributable to the acquisition of a financial asset are included in the initial measurement of any acquired financial asset unless the asset is classified at FVTPL.

Trade-Date Versus Settlement-Date Accounting

Under U.S. GAAP, ASC 320 does not provide guidance on whether the acquisition of a debt or equity security should be recognized on a trade-date or settlement-date basis. Whether a particular entity applies trade-date or settlement-date accounting often depends on the industry in which the entity operates. For example, broker-dealers subject to ASC 940-320-25-1 must account for all regular-way securities transactions on a trade-date basis. In addition, the following accounting guidance indicates that trade-date accounting is required for regular-way security trades:

  • ASC 942-325-25-2, Financial Services — Depository and Lending.
  • ASC 946-320-25-1, Financial Services — Investment Companies.
  • ASC 960-325-25-1, Plan Accounting — Defined Benefit Pension Plans.
  • ASC 962-325-25-1, Plan Accounting — Defined Contribution Pension Plans.

However, ASC 815-10-15-141 and ASC 815-10-35-5 indicate that an entity should apply settlement-date accounting to the purchase of a nonderivative security that will be accounted for under ASC 320 if the purchase contract (1) is either a forward contract or a purchased option contract with no intrinsic value at acquisition, (2) requires physical settlement by delivery of the security, and (3) is not a derivative instrument within the scope of ASC 815.

Under IFRSs, IAS 39 indicates that an entity may elect as an accounting policy to apply trade-date or settlement-date accounting to each category of financial assets that is defined in paragraph 9 of IAS 39 (i.e., AFS, HTM, loans and receivables, and FVTPL). Specifically, paragraph 38 of IAS 39 stipulates that a "regular way purchase or sale of financial assets shall be recognised and derecognised, as applicable, using trade date accounting or settlement date accounting." Paragraph AG53 of IAS 39 further states: The method used is applied consistently for all purchases and sales of financial assets that belong to the same category of financial assets defined in paragraph 9. For this purpose assets that are held for trading form a separate category from assets designated at fair value through profit or loss.

For example, under IFRSs, an entity may elect to recognize financial assets that are classified as HTM and subsequently measured at amortized cost on a settlement-date basis but elect to recognize financial assets that are classified as trading on a trade-date basis.

Accounting for Changes in Value Between the Trade Date and Settlement Date

Under U.S. GAAP, as discussed above, ASC 320 does not provide guidance on whether an entity should follow trade-date or settlement-date accounting when recognizing the acquisition of a security, although certain other accounting pronouncements require trade-date or settlement-date accounting. Therefore, ASC 320 also does not provide guidance on accounting for the change in value of a security between its trade date and settlement date if the security is initially recognized on a settlement-date basis.

However, there is guidance on the purchase of a nonderivative security that will be accounted for under ASC 320 if the purchase contract (1) is either a forward contract or a purchased option contract with no intrinsic value at acquisition, (2) requires physical settlement by delivery of the security, and (3) is not a derivative instrument within the scope of ASC 815. ASC 815-10-25-17 and ASC 815-10-35-5 require such a contract to be accounted for similarly to how the underlying security will be accounted for once the contract is settled.

Under IFRSs, IAS 39 allows an entity to elect to apply trade-date or settlement-date accounting to each category of financial assets. An entity that elects to initially recognize a financial asset on its settlement date must still account for changes in value between the trade date and settlement date in accordance with how the entity will account for the financial asset once it is acquired. Specifically, paragraph AG56 of IAS 39 states, in part: When settlement date accounting is applied an entity accounts for any change in the fair value of the asset to be received during the period between the trade date and the settlement date in the same way as it accounts for the acquired asset. In other words, the change in value is not recognised for assets carried at cost or amortised cost; it is recognised in profit or loss for assets classified as financial assets at fair value through profit or loss; and it is recognised in other comprehensive income for assets classified as available for sale.

Classification Categories

Definition of Held to Maturity

Under U.S. GAAP, ASC 320-10-25-1(c) allows an entity to classify investments in debt securities as HTM and measure them at amortized cost only if "the reporting entity has the positive intent and ability to hold those securities to maturity." However, an entity may not classify a debt security as HTM if it "can contractually be prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment" in the debt security in accordance with ASC 320-10-25-5(a).

Under IFRSs, paragraph 9 of IAS 39 allows an entity to classify a financial asset as HTM measured at amortized cost if the entity has the positive intent and ability to hold that investment until maturity and the investment has (1) fixed or determinable payments and (2) a fixed maturity date. However, an investment cannot be classified as HTM under IAS 39 if that investment (1) is held for trading or (2) meets the definition of a loan or receivable in paragraph 9 of IAS 39. The definition of a loan or receivable under paragraph 9 includes investments in "non-derivative financial assets with fixed or determinable payments that are not quoted in an active market" (emphasis added).

Because the definition of loans and receivables includes investments that are not quoted in active markets and the definition of an HTM investment excludes loans and receivables, any investment that is not traded in an active market cannot be classified as HTM under IAS 39. Under U.S. GAAP, however, the requirements to classify an investment in a debt security as HTM do not take into account whether the debt security trades in an active market.

Note that while investments that do not trade in active markets are classified differently under IFRSs than they are under U.S. GAAP, investments classified as loans and receivables under IAS 39 are subsequently measured at amortized cost in the same way HTM securities are measured.

Classification of a Puttable Debt Security as Held to Maturity

Under ASC 320-10-25-18(d), a debt security that is puttable at the option of the holder can be classified as an HTM security if the holder has the positive intent and ability to hold it until maturity. The presence of the put feature does not automatically result in the holder's inability to assert a positive intent to hold the puttable security until maturity. However, an entity must carefully consider whether such an assertion is reasonable given that the holder presumably paid for the put feature.

Under IFRSs, paragraph AG19 of IAS 39 states:

A financial asset that is puttable [at the option of the holder] cannot be classified as a held-to-maturity investment because paying for a put feature in a financial asset [through a higher purchase price for the financial asset] is inconsistent with expressing an intention to hold the financial asset until maturity. [Emphasis added]

Required Reclassification of HTM Securities

Under U.S. GAAP, an entity is required to reassess the appropriateness of classifying its investments in debt securities as HTM as of each reporting date. If an entity no longer has the ability to hold its securities to maturity, the entity should reclassify its HTM securities. In addition, any time an entity sells or transfers one or more HTM debt securities before maturity, that sale or transfer may call into question management's intent to hold its remaining HTM securities until maturity. In accordance with ASC 320-10-35-9, the reclassification of all remaining HTM debt securities to the AFS classification is required if a sale or transfer "represents a material contradiction [to] the entity's stated intent to hold those securities to maturity or when a pattern of such sales [or transfers] has occurred." Sales or transfers of HTM securities may not call into question management’s intent to hold other securities to maturity if they occur under the conditions noted in ASC 320-10-25-6, ASC 320-10-25-9, or ASC 320-10-25-14. Examples of such conditions include (1) evidence of significant deterioration in the counterparty’s creditworthiness, (2) a major business combination or major disposition that necessitates the sale or transfer of HTM securities, and (3) events that are isolated, nonrecurring, or unusual for the reporting entity.

Under IFRSs, paragraph 52 of IAS 39 states that "[w]henever sales or [transfers] of more than an insignificant amount of held-to-maturity investments do not meet any of the conditions in paragraph 9, any remaining held-to-maturity investments shall be reclassified as available for sale" (emphasis added). Paragraph 9 of IAS 39 indicates that an entity is not precluded from continuing to use the HTM classification for the following sales or reclassifications: (1) those that are so close to maturity that changes in market interests rates would not significantly affect fair value, (2) those that occur after the entity has collected substantially all of the asset’s original principal, and (3) those that are attributable to an isolated, nonrecurring event that could not have been reasonably expected. Under IAS 39, whether reclassification is required depends on the significance of the amount of HTM financial assets sold or transferred. Paragraph 9 of IAS 39 further indicates that when determining what is considered more than an insignificant amount, an entity should consider the total amount of HTM investments.

Tainting Period for the HTM Classification

Under U.S. GAAP, ASC 320 does not provide guidance on the period during which an entity is no longer allowed to classify debt securities as HTM after a sale or transfer that materially contradicts an entity’s stated intent to hold HTM debt securities until maturity. ASC 320-10-35-7 states:

After securities are reclassified to available-for-sale in response to a taint, judgment is required in determining when circumstances have changed such that management can assert with a greater degree of credibility that it now has the intent and ability to hold debt securities to maturity.

However, SEC registrants should consider views expressed by the SEC staff in a speech given in 1996 at the AICPA Conference on Current SEC Developments. In this speech, an SEC staff member stated that "the taint period for sales or transfers of held-to-maturity securities that do not meet the limited exceptions of [ASC 320-10-25-6] should be two years."

Under IFRSs, paragraph 9 of IAS 39 states that an "entity shall not classify any financial assets as held to maturity if the entity has, during the current financial year or during the two preceding financial years, sold or reclassified more than an insignificant amount of held-to-maturity investments before maturity . . . other than sales or reclassifications" for a reason permitted under paragraph 9.

Definition of a Trading Security

Under U.S. GAAP, a security may be classified as trading if it is bought and held principally to sell in the near term. ASC 320-10-20 states, "Trading generally [involves] active and frequent buying and selling . . . with the objective of generating profits on short-term differences in price." However, as clarified in ASC 320-10-25-1(a), an entity is not precluded from classifying a security as trading "simply because the entity does not intend to sell it in the near term."

In addition, an entity may elect to account for its investments in debt or equity securities at fair value with changes in value recognized in earnings regardless of management’s intentions by electing the fair value option provided under ASC 825.

Under IFRSs, paragraph 9 of IAS 39 indicates that an investment in a financial asset may be classified as held for trading only if one of the following conditions is met:

  • The investment "is acquired . . . principally for the purpose of selling . . . in the near term."
  • The investment is "part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking."
  • The investment meets the definition of a derivative instrument.

Note, however, that an entity may designate its investment in a financial asset as at FVTPL if certain conditions are met.

Transfers Into or Out of the Trading Category

ASC 320-10-35-12 states that "given the nature of a trading security, transfers into or from the trading category . . . should be rare" (emphasis added). However, while such a transfer should be rare, it is not prohibited.

Under IFRSs, paragraph 50 of IAS 39 prohibits transfers into the FVTPL category while the financial asset is held. In limited circumstances such as the following, paragraphs 50, 50B, and 50D of IAS 39 permit transfers out of the FVTPL category for assets that an entity was initially required to classify as held for trading:

  • If the financial asset would have met the definition of loans and receivables, it may be reclassified out of the FVTPL category if the entity has the intent and ability to hold the financial asset for the foreseeable future or until maturity.
  • If the financial asset would not have met the definition of loans and receivables, it may be reclassified out of the FVTPL category only in rare circumstances.

Subsequent Measurement

Interest Income Recognition

Under U.S. GAAP, ASC 320 does not provide specific guidance on the method of recognizing interest income on an investment in a debt security. An entity typically recognizes interest income pursuant to ASC 310-20-35-18 and ASC 310-20-35-26 by applying the effective interest method on the basis of the contractual cash flows of the security. Prepayments of principal should not be anticipated. However, the following are several exceptions to this method of recognizing interest income:

  • If a debt security is part of a pool of prepayable financial assets and the timing and amount of prepayments are reasonably estimable, an entity is allowed to anticipate future principal prepayments when determining the appropriate effective interest rate to apply to the debt security under ASC 310-20-35-26.
  • If an investment in a debt security is purchased with evidence of credit deterioration, the interest method articulated in ASC 310-30-35-8 and 35-9, which is based on expected rather than contractual cash flows, must be applied.
  • If an investment in a debt security is a beneficial interest in securitized financial assets that (1) is not of high credit quality or (2) can be contractually prepaid or otherwise settled in such a way that the holder would not recover substantially all of its investment, the interest method articulated in ASC 325-40-35-4, which is based on estimated rather than contractual cash flows, must be applied.
  • If an investment in a debt security is considered other-than-temporarily impaired after acquisition, the interest method articulated in ASC 320-10-35-35, which is based on estimated rather than contractual cash flows, must be applied.
  • If an investment in a debt security is considered a structured note3 but does not contain an embedded derivative that must be separated under ASC 815, the interest method articulated in ASC 320-10-35-40, which is based on estimated rather than contractual cash flows, must be applied.

Under IFRSs, IAS 39 defines the effective interest rate of a financial asset or liability as "the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or . . . to the net carrying amount of the financial asset or financial liability" (emphasis added). Therefore, unlike the effective interest method described in ASC 310-20, the effective interest method in IAS 39 requires an entity to compute the effective interest rate on the basis of the estimated cash flows that are expected to be received over the expected life of an investment when all contractual terms (e.g., prepayment, call, and similar options, but excluding future credit losses) are taken into account. In the rare cases in which it is not possible to estimate reliably the cash flows or the expected life of the financial instrument, the contractual cash flows over the full contractual term should be used. As an exception, if a financial asset is acquired at a deep discount that reflects incurred credit losses, an entity includes those incurred losses in computing the effective interest rate (see paragraph AG5 of IAS 39).

Finally, unlike the effective interest method under U.S. GAAP, which can be applied in one of several ways depending on the characteristics of the debt security, the effective interest method under IAS 39 is applied to all investments that have fixed or determinable payments.

Recognition of a Change in Expected Future Cash Flows

Under U.S. GAAP, interest income typically is recognized on the basis of the contractual cash flows of the security, as discussed above. Under ASC 310-20-35-18(c), if the stated interest rate varies on the basis of future changes in an independent factor (e.g., LIBOR), the effective interest rate used to amortize fees and costs is "based either on the factor . . . that is in effect at the inception of the loan or on the factor as it changes over the life of the loan." For investments in debt securities for which recognition of interest income is based on estimated rather than contractual cash flows, there are several methods for recognizing changes in estimated cash flows, depending on the type of the security:

  • If an entity anticipates estimated prepayments when measuring interest income of an investment in a debt security that is part of a pool of prepayable financial assets in accordance with ASC 310-20-35-26, the entity must continually recalculate the appropriate effective yield as prepayment assumptions change. That is, if the estimated future cash flows of a debt security change, the effective yield of the debt security must be recalculated to take into account the new prepayment assumptions. The adjustment to the interest method under ASC 310-20 must be retrospectively applied to the debt security. That is, the carrying value of the debt security is adjusted to reflect what it should have been had the new effective yield been used since the acquisition of the debt security with a corresponding charge or credit to current-period earnings.
  • If an investment in a debt security is within the scope of ASC 310-30 because there is evidence of credit deterioration, an entity must prospectively recalculate the amount of accretable yield for the debt security if it is probable that there is a significant increase in cash flows previously expected to be collected or if actual cash flows are significantly greater than cash flows previously expected.
  • If an investment in a debt security is a beneficial interest in securitized financial assets that is within the scope of ASC 325-40, an entity must prospectively recalculate the amount of accretable yield of the debt security whenever it is probable that there is a favorable or adverse change in estimated cash flows from the cash flows previously projected.
  • If an investment in a debt security is within the scope of ASC 320-10-35 because it is other-than-temporarily impaired, an entity must prospectively recalculate the amount of accretable yield as if the debt security had been purchased on the measurement date of the OTTI, in a manner consistent with the method described in ASC 310-30.
  • If an investment in a debt security is a structured note within the scope of ASC 320-10-35-38, an entity must retrospectively recalculate the amount of accretable yield for the debt security on the basis of the current estimated future cash flows as of the reporting date. However, if the recalculated effective yield is negative, a zero percent effective yield is used instead.

Note that paragraph 97 of FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, discusses both the prospective and retrospective approaches of recognizing changes in estimated cash flows.

Under IFRSs, paragraphs AG7 and AG8 of IAS 39 provide guidance on when an entity should recalculate the effective interest rate during the life of an instrument. Paragraph AG7 acknowledges that reestimating expected future cash flows on a floating-rate instrument will alter the instrument's effective interest rate. However, the change in the effective interest rate of a variable-rate instrument will normally have no significant effect on the carrying value of the instrument (as long as it is initially recognized at par with minimal transaction costs). If an instrument has fixed cash flows but includes rights for the issuer or holder to prepay the instrument, or has variable cash flows linked to a rate other than a market interest rate, the effective interest rate determined at initial recognition is retained throughout the instrument's life. Paragraph AG8 of IAS 39 usually requires an entity to recalculate the carrying amount of the financial asset "by computing the present value of estimated future cash flows at the financial instrument's original effective interest rate." The resulting "catch-up" adjustment to the carrying amount of the financial asset must be recognized immediately in earnings.

This catch-up approach of recognizing changes in estimated cash flows is different from both the prospective and retrospective approaches used under U.S. GAAP; however, this approach is mentioned in paragraphs 97 and 98 of Concepts Statement 7. There is one exception to the cumulative catch-up approach. If a financial asset has been transferred out of the profit or loss category and there are subsequent increases in the estimated future cash flows as a result of an increased recoverability of the cash receipts, paragraph AG8 of IAS 39 requires the entity to adjust the effective interest rate rather than immediately adjust the carrying amount of the asset.

Recognition of Foreign Exchange Gains and Losses on AFS Debt Instruments

Under U.S. GAAP, unrealized changes in the value of an investment in a foreign-currency-denominated security classified as AFS that are attributable to changes in foreign exchange rates are included in AOCI. ASC 320-10-35-36 states that the "entire change in the fair value of foreign-currency-denominated [AFS] debt securities shall be reported in other comprehensive income." However, impairment losses are recognized in net income when the impairment is determined to be other than temporary. Such losses may include foreign exchange gains or losses.

Under IFRSs, paragraph 55 and AG83 of IAS 39 indicate that unrealized foreign exchange gains or losses on an AFS equity instrument should be recognized directly in OCI. Unlike U.S. GAAP, IFRSs indicate that foreign exchange gains or losses on an AFS debt instrument are recognized in current-period earnings. The amount recognized in current-period earnings that is attributable to foreign exchange gains and losses is determined by using the amortized cost basis even though the asset is measured at fair value.

Impairment

Other-Than-Temporary Loss Versus a Loss Event

Under U.S. GAAP, ASC 320-10-35 indicates that an entity recognizes an impairment loss on an AFS or HTM security if a decline in fair value below amortized cost is other than temporary.

Investors in equity securities should refer to the pertinent guidance on whether an impairment is other than temporary. For equity investments available for sale, that may include the guidance in ASC 320-10-35-33, which states that an entity that has decided to sell an impaired AFS equity security that it does not expect to fully recover in fair value before the expected time of sale would conclude that it is other-than-temporarily impaired. For cost-method investments, entities may refer to ASC 325-20-35-2 for limited guidance on determining whether equity investments are other-than-temporarily impaired. For AFS equity investments, an investor should also look to the guidance in Staff Accounting Bulletin (SAB) Topic 5.M, "Other Than Temporary Impairment of Certain Investments Equity Securities," as amended by SAB 111 and included in ASC 320-10-S99-1. SAB Topic 5.M highlights the following factors that, individually or in combination, may indicate that a decline in fair value for an equity security is other than temporary:

a. The length of the time and the extent to which the market value has been less than cost;
b. The financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology that may impair the earnings potential of the investment or the discontinuance of a segment of the business that may affect the future earnings potential; or
c. The intent and ability of the holder to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.

Under ASC 320-10-35, an impaired debt security is considered other-than-temporarily impaired if the entity (1) intends to sell the security as of the measurement date or (2) has determined that it is more likely than not that it would be required to sell the security before the recovery of its amortized cost. Further, if an entity has determined that (1) it does not intend to sell the security and (2) it is not more likely than not required to sell the security, an OTTI is considered to have occurred if the entity does not expect to recover the entire amortized cost basis of the debt security (i.e., a credit loss is considered to have occurred).

Unlike U.S. GAAP, IFRSs do not include the concept of OTTI. However, IAS 39 does require an entity to review financial assets for impairment, with the exception of those measured at FVTPL. Under IFRSs, paragraph 59 of IAS 39 indicates that a financial asset is considered impaired and an impairment loss is recognized "if, and only if, there is objective evidence of impairment as a result of one or more [triggering] events" (loss events). Paragraph 59 of IAS 39 provides various examples of objective evidence supporting the occurrence of a loss event, including the following:

a. significant financial difficulty of the issuer or obligor;
b. a breach of contract, such as a default or delinquency in interest or principal payments;
c. the lender, for economic or legal reasons relating to the borrower's financial difficulty, granting to the borrower a concession that the lender would not otherwise consider;
d. it becoming probable that the borrower will enter bankruptcy or other financial reorganisation;
e. the disappearance of an active market for that financial asset because of financial difficulties; or
f. observable data indicating that there is a measurable decrease in the estimated future cash flows from a group of financial assets since the initial recognition of those assets.

In addition to the above events, paragraph 61 of IAS 39 lists the following examples of objective evidence indicating that the cost of an investment in an equity instrument may not be recovered and that an impairment loss should be recognized:

  • A significant change "in the technological, market, economic or legal environment in which the issuer operates" that has an adverse effect.
  • A "significant or prolonged decline in the fair value of an investment in an equity instrument below its cost."

Determination of Impairment Loss

Under U.S. GAAP, ASC 320-10-35-34 indicates that if an equity investment is considered other-than-temporarily impaired, "an impairment loss shall be recognized in earnings equal to the entire difference between the investment's cost and its fair value at the balance sheet date . . . . The fair value of the investment would then become the new amortized cost basis of the investment." Therefore, an entity would "recycle" AOCI and losses to current-period earnings for fair value gains and losses recognized on equity investments classified as AFS. Similarly, the entire difference between a cost-method equity investment’s cost basis and fair value would be recognized in current-period earnings.

Investors in debt securities should look to the guidance in ASC 320-10-35-34B through 35-34E, which notes that the amount of impairment loss to be recognized in earnings depends on whether the entity (1) intends to sell or is more likely than not required to sell the debt security before recovery of its amortized cost or (2) expects not to recover the entire amortized cost basis of the security. If the entity intends to sell the debt security or has determined that it is more likely than not required to sell the debt security as of the measurement date before recovery of its amortized cost, an impairment loss equal to the difference between the security's cost basis and fair value must be recognized in earnings. If the entity has determined that it does not intend to sell and is not more likely than not required to sell the security, and does not expect to recover the entire amortized cost basis of the security, the OTTI loss is separated between (1) the amount representing the credit loss, which is recognized in earnings, and (2) the amount related to all other factors, which is recognized in OCI. A credit loss is measured by comparing the debt security's amortized cost basis and the entity’s best estimate of the present value of cash flows expected to be collected from the debt security. The remaining difference between the security’s amortized cost basis and fair value is the amount relating to all other factors that should be recognized in OCI.

Under IFRSs, once a loss event has occurred and an investment is considered impaired, the impairment loss recognized in profit or loss depends on the investment's balance sheet classification. If an investment that is classified as HTM or a loan or receivable is considered impaired, the impairment loss is calculated, in accordance with paragraph 63 of IAS 39, as the difference between (1) the present value of the investment's estimated future cash flows discounted at its original effective interest rate and (2) the investment's carrying value on the date of impairment. If an investment that is classified as AFS is considered impaired, the impairment loss recognized is calculated as the difference between the cost basis of the impaired security and its current fair value. However, an entity would not consider an impairment to have established a new cost basis for AFS equity securities; thus, when evaluating a previously impaired equity security to determine whether there has been a significant or prolonged decline in fair value, the entity uses the original cost at initial recognition and the entire period during which fair value is below that original cost. Under U.S. GAAP, an entity establishes a new cost basis for AFS equity securities that are other-than-temporarily impaired.

Reversing Recognized Impairments

Under U.S. GAAP, once an investment in a security is considered other-than-temporarily impaired, the new cost basis of the previously impaired security cannot be adjusted through earnings for subsequent recoveries in the value of the security. Under IFRSs, paragraph 65 of IAS 39 states that for investments classified as HTM, AFS, or loans and receivables, a previously recognized impairment loss may be reversed through earnings "[i]f, in a subsequent period, the amount of the impairment loss decreases and the decrease can be related objectively to an event occurring after the impairment was recognised" (e.g., an improvement in credit rating). A recovery of an impairment loss is reversed by crediting earnings and debiting the carrying amount of the investment. However, the carrying amount of an investment classified as HTM or as a loan or receivable cannot exceed what the amortized cost of that investment would have been had the original impairment not been recognized. Similarly to how they are treated under U.S. GAAP, impairments on investments in equity instruments that are classified as AFS cannot be reversed.

 

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1 Neither ASC 320 nor IAS 39 applies to investments that are either (1) accounted for under the equity method of accounting or (2) in consolidated subsidiaries. For more information, see paragraph 2(a) of IAS 39 and ASC 320-10-15-7.

2 ASC 310-20-15-4 clarifies that the guidance in ASC 310 also applies to purchased debt securities that are classified as HTM or AFS pursuant to ASC 320. However, ASC 310 does not apply to items carried at fair value with changes in fair value included in earnings such as trading securities.

3 ASC 320-10-20 defines a structured note as a "debt instrument whose cash flows are linked to the movement in one or more indexes, interest rates, foreign exchange rates, commodities prices, prepayment rates, or other market variables . . . . Contractual cash flows for principal, interest, or both [from structured notes] can vary in amount and timing throughout the life of the note based on nontraditional indexes or nontraditional uses of traditional interest rates or indexes." However, certain embedded derivatives in structured notes must be separated from their host contracts and accounted for separately as derivatives at fair value.

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