Question

Red Co. is planning to invest some of its excess cash in 5-year bonds issued by Black Co. and in 2% of ordinary shares of Blue Co. Both Black’s bonds and Blue’s shares are traded actively on securities market. Red Co. plans to hold the bonds until the maturity date and trade the shares in short term. Regarding the accounting for these investments, answer the following questions:

1. How should Red classify the bonds and the shares?

2. What is the accounting treatment for the Black bonds? And what is the accounting treatment for the bonds if Red has the following strategies?

a) an active trading strategy for the bonds or

   b) a plan to sell the bonds in the long run.

3. Identify and explain the different types of classifications for equity investments.

Answer 1

Q1. Red Co. should classify the bonds as Held To Maturity as it plans to hold the bonds until the maturity date. Red Co. should classify the shares as Held For Trading as it plans to trade the shares in short term.

Q2. What is the accounting treatment for the Black's bonds: Since the Black's bonds are Held To Maturity bonds, the investment will be classified as a long-term investment and recorded at the original cost of acquisition and amortized over the life of the investment on Red Co's financial statements. The amortized cost includes the initial acquisition cost plus any additional costs incurred to date on the investment. All changes in market value are ignored for held to maturity investments. Interest income will be reported in the income statement. Securities with maturities over one year are shown as long-term assets and only when their maturity time is one year or less, these are reported as current assets.

2a. The accounting treatment for the bonds if Red follows an active trading strategy for the bonds: The bonds will become held-for-trading securities. The initial cost of acquisition is the basis of held-for-trading investments which is equal to their fair value at the time of purchase. When the market value of these securities changes over time, any unrealized gains or losses have to be reported as earnings by the investor by reflecting them on the income statement. The gains or losses are calculated on the basis of comparing the fair market value of a held-for-trading security to its original cost. Increase or decrease in the fair value of held-for-trading securities is adjusted by debiting an increase or crediting a decrease in an account named "Securities Fair Value Adjustment (Trading)" Interest income will also be reported in the income statement.

2b) In this case, the bonds will become Available For Sales securities. Available-for-sale debt securities (AFS) are securities  purchased with the intention of holding them for a long period but selling them before their maturity. Unlike the gains or losses from held-for-trading investments being accounted for in income stateement, the gains or losses from AFS securities are not accounted for in net income, but shown in the Other Comprehensive Income (OCI) until these securities are sold. Therefore, unrealized gains and losses on AFS securities are not reflected on the income statement. Any increase in the value of an AFS security is adjusted by debiting the increase in the value of the security to the account of "Securities Fair Value Adjustment (AFS)" and crediting the amount to Other Comprehensive Income. Declines in value are debited to Other Comprehensive Income and crediting the amount to "Securities Fair Value Adjustment (AFS)".

3) The different types of classifications for equity investments are Available For Sales and held-for-trading. There is no Held To Maturity classification as the equity shares do not have a maturity date. The AFS equity securities(AFS) are shares purchased with the intention of holding them for a long period but selling them within a reasonable time such within one year. Held-for-trading equity shares are held for actively trading them or selling them within three months.