Community Bank Audit Group
Investments
June 3, 2014
by: Daniel F. Morrill, CPA
MEMBER OF PKF NORTH AMERICA, AN ASSOCIATION OF LEGALLY INDEPENDENT FIRMS
© 2013 Wolf & Company, P.C.
Overview of Accounting Guidance
Q: What is the primary accounting guidance that
relates to accounting for investments?
A: FASB ASC 320 (Accounting for Certain Investments
in Debt and Equity Securities)
FASB ASC 820-10 (Fair Value Measurements and
Disclosures – Overall)
Overview of Accounting Guidance
FASB ASC 320-10-25
–
Applies to all entities except for entities in specialized industries
which generally account for investments at fair value with
changes in value recognized in earnings / changes in net assets.
For example
•
Brokers and dealers in securities
•
Defined benefit pension plans
•
Investment companies
•
Not-for-profit entities (except for certain guidance on
impairment)
–
Applies to:
•
Investments in equity securities that have readily
determinable fair values
•
All investments in debt securities
Types of Investments
• Marketable Equity Securities = ownership interest in entity
Characteristics include:
– Ownership interest in an entity
– No maturity
– Returns on investment not always guaranteed
(dividends)
Examples of MES:
– Common stock
– Preferred stock
– Mutual funds
Types of Investments
• Debt Securities = creditor relationship with an entity
Characteristics include:
– Creditor relationship with an entity
– Specified period of existence (maturity)
– Generally pay interest
Examples of debt securities:
– US Treasury bills, notes and bonds
– US Government Agency securities
– US Government-sponsored entities (GSEs)
– Municipal securities (Muni’s)
– Corporate bonds
– Securitized debt instruments (MBS, CMO, etc.)
– Trust Preferred
Types of Investments
– US Treasury bills, notes and bonds
Issued by US Government
• Bills are short term (1 year or less), are sold at a discount from
face and do not pay interest
• Notes are issued with maturities of 2,3,5,7 and 10 years and
pay interest every 6 months
• Bonds mature in 30 years and pay interest every 6 months
Types of Investments
– US Government Agency securities
Direct arms of the US Government
• Backed by full faith and credit of US government
• Generally less liquid than treasury bonds so may have slightly
higher rate of interest
• Generally pay interest semi-annually
• Examples -GNMA, FHA, SBA
– US Government-sponsored entities (GSEs)
Privately owned, publicly chartered organizations created by acts
of Congress to support a specific purpose
• NOT backed by full faith and credit of US government
• Generally less liquid than treasury bonds so may have slightly
higher rate of interest
• Generally pay interest semi-annually
• Examples - FHLMC, FNMA, FHLB,FFCB, SLMA
Types of Investments
– Municipal securities (Muni’s)
Issued by a city or other local government, or their agencies
• Generally pay interest semi-annually
• Interest is often federal and state tax exempt
• Because of tax exempt status, usually at lower interest rate
than other types of bonds of comparable risk
Types of Investments
– Corporate bonds
Issued by a corporation to raise money to expand its business
• Generally have a higher risk of default than government bonds,
depending particularly on the corporation issuing the bond
• Because of the higher risk, interest rate is usually higher than
government debt
• Generally pay interest semi-annually
• Interest is usually taxable
• May or may not be listed on major exchanges – may have
liquidity risk (may not be a willing buyer at a fair price)
Types of Investments
– Securitized debt instruments (MBS, CMO, etc.)
• A pool of individual contractual debt instruments that has been
packaged together (such as residential mortgages, commercial
mortgages, credit card receivables)
• Generally amortized, meaning principal and interest is paid
back gradually over the term of the security (as opposed to
principal paid only at maturity)
• Many different ways to structure, can get very complex
Types of Investments
– Securitized debt instruments (MBS, CMO, etc.)
Can be issued by:
• Federal Agencies– backed by the faith of the US government
– GNMA - Government National Mortgage Association
– FHA – Federal Housing Administration
• Government Sponsored Enterprises – not backed by government.
Investors subject to some credit risk
– FNMA - Federal National Mortgage Association
– FHLMC - Federal Home Loan Mortgage Corporation
– FHLB – Federal Home Loan Bank
• Other – may be issued by large banks or corporations
Types of Investments
– Most common types of securitized debt instruments
• Mortgage-backed security (MBS) - Asset-backed security or
debt obligation that represents a claim on the cash flows from
mortgage loans through a process known as securitization.
• Collateralized Mortgage Obligation (CMO) - A mortgagebacked, investment-grade bond that separates mortgage pools
into different maturity classes. (Protects against prepayment
risk).
• Real Estate Mortgage Investment Conduits (REMICS) – A type
of special purpose vehicle used for the pooling of mortgage
loans and insurance of mortgage-backed securities.
• Collateralized debt obligations (CDO’s) - A type of structured
asset backed security (ABS) whose value and payments are
derived from a portfolio of fixed-income underlying assets.
Types of Investment
– Most common types of securitized debt instruments
(concluded)
• Stripped Mortgage Securities - MBS that pay investors principal
only (PO) or interest only (IO). Strips are created from MBS, or
they may be tranches in a CMO.
– Principal Only (PO)
Investors pay a deeply-discounted price for the PO and receive
principal payments from the underlying mortgages.
Interest Only (IO)
An IO strictly pays interest that is based on the amount of
outstanding principal. As the mortgages amortize and
prepayments reduce the principal balance, the IO's cash flow
declines.
Types of Investment
• Securitized Debt Instrument (Securitization)
– Securitization converts mortgages to mortgage-backed securities.
Types of Investments
•
Tranche - Pools of Mortgage loans grouped together by risk
characteristics and sold to investors.
Types of Investments
– Trust Preferred
• Hybrid security - characteristics of both debt and equity
securities
• Generally issued by bank holding companies
• Generally very long term (i.e. 30 years)
• Allows early redemption by issuer
• Makes periodic fixed or variable interest payments
• Matures at face value
Types of Investments
• Other – outside the scope of ASC 320
– FHLB stock, FRB stock, stock in corporate credit
unions
– Carried at cost
– Broken out separately on balance sheet if material
– Evaluated for impairment when conditions warrant
Investment Cycle
Purchase
Recognition
Amortization/Accretion
Mark to Market
Impairment
Transfer of Category
Contractual Interest
Holding
Period
Disposition
Sale
Call
Maturity
18
Investment Cycle
Individual
Investment
How do you
know that all of
these are
correct?
Investment
Subledger
General Ledger
Financial Statements
Operational
GAAP/Accounting
19
Investment Cycle
Purchase
Recognition
Amortization/Accretion
Mark to Market
Impairment
Transfer of Category
Contractual Interest
Holding
Period
Disposition
Sale
Call
Maturity
20
Purchases
Operational
Individual
Investment
• Authorization
• Approval
Sub-ledger
• Set-up
• Review
General
Ledger
GAAP
• Classification
• Date of recording
• Posting
• Reconciliation
21
Purchases
Operational
Individual
Investment
• Authorization
• Approval
Sub-ledger
• Set-up
• Review
General
Ledger
Mitigating the Risks
• Posting
• Reconciliation
22
Purchases
Classification of investments, at acquisition:
–
Requires that debt securities and equity securities be classified
into 1 of 3 categories:
•
Trading –
–
–
•
Held to Maturity (HTM)
–
–
•
Securities acquired with intent to sell within hours or days
Not precluded from classifying as trading a security if entity
plans to hold for longer period
Entity has positive intent and ability to hold to maturity
Equity securities have no maturity so cannot be HTM
Available for Sale (AFS)
–
Securities with readily determinable fair values that are not
classified as trading or HTM
Purchases
Financial Statement Impact of Classification
Trading:
Balance sheet:
Carried at fair value
Income statement: Changes in fair value flow through the income
statement
Held to Maturity (only debt securities):
Balance Sheet:
Carried at amortized cost
Income Statement: None
Available for Sale:
Balance Sheet:
Income Statement:
other
Carried at fair value
None (Changes in fair value flow through OCI –
comprehensive income)
Purchases
Restrictions on Classification of a Debt Security as Held-to-Maturity
•
320-10-25-3 Amortized cost is relevant only if a security is actually held to
maturity. Use of the held-to-maturity category is restrictive because the use of
amortized cost must be justified for each investment in a debt security. At
acquisition, an entity shall determine if it has the positive intent and ability to
hold a security to maturity, which is distinct from the mere absence of an intent
to sell. If management's intention to hold a debt security to maturity is uncertain,
it is not appropriate to carry that investment at amortized cost. In establishing
intent, an entity shall consider pertinent historical experience, such as sales and
transfers of debt securities classified as held-to-maturity. A pattern of sales or
transfers of those securities is inconsistent with an expressed current intent to
hold similar debt securities to maturity.
Purchases
• Recording Purchase
– Trade Date
• Date which the transaction was initiated
• Record date for GAAP
– Settlement Date
• Date which cash and investment are exchanged
• Common record date in practice
Journal Entries
Best practice
Trade Date
DR Investment
CR Due to Broker
In practice, recorded as follows:
Settlement Date
DR Due to Broker
CR Cash
Settlement Date
DR Investment
CR Cash
Investment Cycle
Recognition
Amortization/Accretion
Mark to Market
Impairment
Transfer of Category
Contractual Interest
Purchase
Holding
Period
Disposition
Sale
Call
Maturity
27
Amortization/Accretion
Operational
• Method
• Period of time
Individual
Investment
Sub-ledger
General
Ledger
GAAP
• Accuracy of system
calculation
• Posting
• Reconciliation
28
Amortization/Accretion
Operational
Mitigating the Risks
Individual
Investment
Sub-ledger
General
Ledger
• Accuracy of system
calculation
• Posting
• Reconciliation
29
Amortization/Accretion
• Premiums / Discounts
– Adjustments to purchase price of debt
securities based on market levels of
interest in relation to the interest on the
debt security being purchased
• Adjusted over the life of investment to
maturity through amortization /
accretion
– Amortization - Reduction of premiums paid
– Accretion - Reduction of discounts
received
If market rate is….
Discount
Premium
Amortization/Accretion
Premiums and discounts on bonds and MBS –
•
•
•
GAAP requires them to be amortized / accreted using the effective
interest method to the MATURITY (not call) date
Amortization of premium – decreases interest income
Accretion of discount – increases interest income
ASC 310-20-35-33 Assuming that an entity purchases an individual
callable bond at a premium, the premium may not be amortized to the
earliest call date. Under paragraph 310-20-35-26, an entity must have a
large number of similar loans in order to consider estimates of future
principal prepayments when applying the interest method.
Amortization/Accretion
PREMIUM:
Bond par value $1,000,000
Purchase price $1,100,000
Premium
$100,000
•
Journal entry at purchase:
Dr Investment (bond)
Dr Premium on bond
Cr Cash
$1,000,000
$ 100,000
$1,100,000
Amortization/Accretion
DISCOUNT:
Bond par value $1,000,000
Purchase price $ 900,000
Discount
$ 100,000
•
Journal entry at purchase:
Dr Investment (bond)
Cr Discount on bond
Cr Cash
$1,000,000
$ 100,000
$ 900,000
Amortization/Accretion
• Amortization / Accretion
– Effective interest method – GAAP
• Matches amortization / accretion with interest received for a consistent
yield over life of investment
– Other common methods – Non GAAP
• Straight line common practice but should not be materially different
from interest method
• Proportionate method for MBS
– Based on principal payments as proportion of purchased premium
• Journal Entries:
Amortization
Accretion
•DR. Interest income
•DR. Investment discount
•CR. Investment premium
•CR. Interest income
Amortization/Accretion
• Calculation exercises for premium/discount
Investment Cycle
Recognition
Amortization/Accretion
Mark to Market
Impairment
Transfer of Category
Contractual Interest
Purchase
Holding
Period
Disposition
Sale
Call
Maturity
36
Mark-to Market
Operational
• Appropriate measurement
technique
Individual
Investment
Sub-ledger
General
Ledger
GAAP
• File maintenance changes
• Review
• Posting
• Reconciliation
37
Mark-to Market
Operational
Mitigating the Risks
Individual
Investment
Sub-ledger
General
Ledger
• File maintenance changes
• Review
• Posting
• Reconciliation
38
Mark-to Market
•
AFS and Trading Reported at Fair Value
• Trading –
– Adjustments through Income Statement
• Available for Sale –
– Adjustments through other
comprehensive income (OCI) in equity
on BS
Mark-to Market
•
FV Adjustment
–
FV is calculated as:
•
•
–
Debt securities = par value x market price
Equity securities = number of shares x price per share
For Debt securities
•
FV adjustment is the difference between amortized cost and FV
Par Value
+/- Premium/Discount
Book Value/Amortized Cost
+/- FV Adjustment
Reported Value (Fair value)
The Investment Cycle
Debt Security
Marketable Equity
Security
Par Value
x Market Price
= Fair Value
No. of Shares
x Market Price
= Fair Value
- Amortized Cost
Fair Value Adjustment
- Historical Cost
Fair Value Adjustment
Mark-to Market
HTM
AFS
Trading
No Adjustments
•Gain
•Gain
•DR. Investment
•CR Deferred Tax
•CR OCI
•DR. Investment
•CR Gain on
Investment
•Loss
•Loss
•DR. OCI
•DR Deferred Tax
•CR Investment
•DR. Loss on
investment
•CR Investment
Investment Cycle
Recognition
Amortization/Accretion
Mark to Market
Impairment
Transfer of Category
Contractual Interest
Purchase
Holding
Period
Disposition
Sale
Call
Maturity
43
Impairment
Operational
Individual
Investment
• Authorization
• Approval
Sub-ledger
• File maintenance changes
• Review
General
Ledger
GAAP
• Appropriate accounting
• Posting
• Reconciliation
44
Impairment
Operational
Individual
Investment
• Authorization
• Approval
Sub-ledger
• File maintenance changes
• Review
General
Ledger
Mitigating the Risks
• Posting
• Reconciliation
45
Impairment
Other than temporary impairment (OTTI) evaluation:
•
STEP 1 = Determine whether an investment is
impaired:
Fair Value
–
Assess at the individual security level
•
–
Cost
If client holds multiple lots of same stock, must use
same level of detail as used by entity measuring
realized and unrealized gains.
If FV < cost, proceed to STEP 2
Impairment
Other than temporary impairment (OTTI) evaluation:
•
STEP 2 = Evaluate whether impairment is other
than temporary
–
If management intends to sell the security or will
likely be required to sell the security prior to
recovery, security is considered OTTI and must
be written down to fair value.
Impairment
–
Factors to consider whether decline is “other-thantemporary” include:
–
–
–
–
–
–
Length of time
Extent of loss – as a % of BV
Financial condition of issuer
Failure of issuer to make scheduled interest or principal payments
Downgrades to rating of security by a rating agency
Recoveries or additional declines after balance sheet date
– Debt securities – if present value of expected future cash
flows is less than amortized cost, must determine how
much of the loss is “credit” loss
Impairment
• Other than temporary Impairment - EQUITY
– Recording Write-down of Equity Security
• Write down to fair value at date determined to
be impaired
• Results in new cost basis of investment
– Journal Entry:
•DR Loss on Investment (IS)
•CR Investment (Asset)
Impairment
• Other than Temporary Impairment – Debt Security
– Credit Loss vs.. Non-Credit Loss
• If PV cash flows < amortized cost = Credit Loss recorded in IS;
anything else would be the “non-credit” loss recorded to OCI
– Recording Write-down of Debt Security
• Account as if the security had been purchased on the measurement
date of the OTTI (amortized cost basis = previous amortized cost basis
less the other-than-temporary impairment recognized in earnings).
• The other-than-temporary impairment recognized in other
comprehensive income for debt securities classified as held-to-maturity
shall be accreted over the remaining life of the debt security in a
prospective manner on the basis of the amount and timing of future
estimated cash flows.
DR Loss on Investment -IS(credit loss)
DR OCI (non credit loss)
CR Investment
Investment Cycle
Recognition
Amortization/Accretion
Mark to Market
Impairment
Transfer of Category
Contractual Interest
Purchase
Holding
Period
Disposition
Sale
Call
Maturity
51
Transfers between Categories
Operational
Individual
Investment
• Authorization
• Approval
Sub-ledger
• File maintenance changes
• Review
General
Ledger
GAAP
• Tainting
• Appropriate accounting
• Posting
• Reconciliation
52
Transfers between Categories
Operational
Individual
Investment
• Authorization
• Approval
Sub-ledger
• File maintenance changes
• Review
General
Ledger
GAAP
• Posting
• Reconciliation
53
Transfers between Categories
•
Transfers between Classifications
–
Accounting for Transfers
•
•
•
•
Trading to AFS
– Do not reverse income recognized
– FV at transfer is new cost basis
AFS to Trading
– Unrealized gain/loss moved from OCI to IS
– Continue to account like trading
HTM to AFS
– Unrealized gain/loss recognized in OCI
– Continue to treat like AFS
AFS to HTM
– Keep amounts in OCI and amortize to income using
interest method
– FV becomes cost basis with difference between par value
treated like premium/discount and amortized
– continue to treat like HTM
Investment Cycle
Recognition
Amortization/Accretion
Mark to Market
Impairment
Transfer of Category
Contractual Interest
Purchase
Holding
Period
Disposition
Sale
Call
Maturity
55
Contractual Interest
Operational
GAAP
Individual
Investment
Sub-ledger
General
Ledger
• Accuracy of system
calculation
• Posting
56
Contractual Interest
Operational
GAAP
Individual
Investment
Sub-ledger
General
Ledger
• Accuracy of system
calculation
• Posting
57
Investment Cycle
Recognition
Amortization/Accretion
Mark to Market
Impairment
Transfer of Category
Contractual Interest
Purchase
Holding
Period
Disposition
Sale
Call
Maturity
58
Sales
Operational
Individual
Investment
• Authorization
• Approval
Sub-ledger
• Removal
• Review
General
Ledger
GAAP
• Gain/loss recognition
• Tainting (HTM classification)
• Posting
• Reconciliation
59
Calls
Operational
• Gain/loss recognition
Individual
Investment
Sub-ledger
General
Ledger
GAAP
• Removal
• Review
• Posting
• Reconciliation
60
Maturities
Operational
GAAP
Individual
Investment
Sub-ledger
General
Ledger
• Removal
• Review
• Posting
• Reconciliation
61
Sales, Calls and Maturities
Operational
Individual
Investment
• Authorization
• Approval
Sub-ledger
• Removal
• Review
General
Ledger
Mitigating the Risk
• Gain/loss recognition
• Tainting (HTM classification)
• Posting
• Reconciliation
62
Sales, Calls and Maturities
Disposition of Investments
• Sales
– Like purchases, should be recorded on trade date
– Receive proceeds based on current fair value;
– Typically results in gain or loss included in non-interest
income (banks)
• Maturities
– Receive remaining par value based on terms of the
investment
– Only debt securities (equities have no maturity)
• Calls
– Issuer has right to buy back investment at it’s current par
value
– Remaining premiums/discounts recorded as gain/loss on IS
Sales, Calls and Maturities
• Recording Sale
– Proceeds – Amortized Cost = Gain/Loss on Investment
• Journal Entries:
Gain:
•DR. Cash
•CR. Investment
•CR. Gain on Investment
Loss:
•DR. Cash
•DR. Loss on investment
•CR. Investment
NOTE: For AFS – Need to reverse OCI adjustment. As part of the month
end adjusting entries, the fair value adjustment will reverse.
Unamortized premiums/discounts are part of the amortized cost of the
investment.
Sales, Calls and Maturities
•
Sale of HTM Security
–
Allowed under certain circumstances
•
In-substance maturity
–
•
•
–
w/in 3 months of maturity or 85% of principal has been
collected (most common)
Significant deterioration in issuer’s creditworthiness
Change in tax law that impacts tax-exempt status of
debt security
• Circumstances related to major business combination
• Change in statutory / regulatory requirements
• Increase in capital requirements
• Increase in risk weights of debt securities used for riskbased capital purposes
Taints portfolio if no justification for sale
Questions?
66
Thank You
Daniel F. Morrill, CPA
Principal, Professional Practice
413-726-6857
dmorrill@wolfandco.com
67