Explain how marketable securities are classified and measured
The idea
Debt securities the company intends and is able to hold to maturity are carried at amortised cost, so market fluctuations do not appear anywhere. Trading securities are carried at fair value with gains and losses in net income. Securities available for sale, or measured at fair value through other comprehensive income, are carried at fair value with unrealised gains and losses in equity rather than income. The same security in the same portfolio can therefore produce three different effects on reported earnings depending on how it was classified at acquisition, which rests on management's intent (US GAAP) or business model (IFRS).
A practice question
How are trading securities measured?
- At amortised costWhy not: That is the held-to-maturity treatment, where the interim market price is irrelevant because the holder intends to collect the contractual cash flows.
- At fair value, with gains and losses recognised in net income — correct
- At historical cost less impairmentWhy not: That basis applies to some non-financial assets. A security held to be sold shortly is marked to market.
Securities held to be sold in the near term are marked to market, and the change flows straight through earnings.
A harder one
Which classification leaves reported net income untouched by market movements while still carrying the asset at fair value?
- Held to maturityWhy not: It does insulate income, but it does not carry the asset at fair value — it uses amortised cost. Only half the description fits.
- TradingWhy not: The opposite: fair value on the balance sheet *and* every movement through earnings.
- Available for sale — correct
The same category is described elsewhere as fair value through other comprehensive income. The balance sheet shows the current price while the income statement is insulated, which is the combination that makes it attractive to preparers.
The hardest tier
Two insurers hold identical bond portfolios and report very different earnings volatility. What is the most likely cause?
- Different coupon ratesWhy not: The portfolios are stipulated to be identical, so the coupons are the same. Coupon income is also the stable part of the return, not the volatile part.
- Different classification of the same instruments — correct
- Different auditorsWhy not: Auditors assess whether the treatment is acceptable. They do not produce a different earnings path from the same holdings under the same standards.
Identical holdings can produce three different earnings paths, so a difference in volatility is evidence about the classification rather than about the investments.
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