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Accounting for debt securities held by corporates · PwC's accounting podcast

0:00
SPEAKER_01: Thought leadership from PWC's National Office.
0:07
SPEAKER_00: Welcome to PWC's Accounting Podcast.
0:10
SPEAKER_00: I'm Heather Horn.
0:11
SPEAKER_00: Today we kick off the last segment of our series covering the most popular topics from our most popular guides.
0:19
SPEAKER_00: This month's topic, Loans and Investments Guide.
0:22
SPEAKER_00: Our first episode is focused on accounting for debt securities for entities outside the financial services sector.
0:29
SPEAKER_02: From in the corporate space, a lot of the things you deal with are going to clearly fall in one bucket or another.
0:36
SPEAKER_02: You start with accounts receivable or a loan to a customer that's that's bilateral and documented separately, probably pretty clearly in the loan bucket.
0:47
SPEAKER_02: On the other hand, we see a lot of clients invest in very liquid debt securities like U.S.
0:53
SPEAKER_02: treasuries or corporate bonds that have a QCIP identifier.
0:58
SPEAKER_02: Those are almost always registered bonds and are gonna clearly be a security.
1:03
SPEAKER_02: So you start with start with that, assessing whether you have a security or not.
1:08
SPEAKER_02: If it's not a security, then it still gets a little more complicated because there are some things that are not securities that still need to be accounted for like a debt security.
1:26
SPEAKER_00: That was Brett Dooley, Deputy Chief Accountant in PwC's National Office, who's joined by Chris Judeau, also a partner in the national office.
1:34
SPEAKER_00: As we'll learn today, there's some complexities in accounting for debt securities that definitely deserve our focus and attention.
1:41
SPEAKER_00: Let's start the episode.
1:43
SPEAKER_00: Brett, Chris, welcome to the podcast.
1:45
SPEAKER_00: So nice to have you on today.
1:46
SPEAKER_00: And I'm excited to be kicking off a new series.
1:49
SPEAKER_00: Uh, again, for our regular listeners, you'll know this is our regular series on our most popular guides.
1:56
SPEAKER_00: And this month we're all about loans and investments.
1:58
SPEAKER_00: And uh we'll be covering some of the most popular or quote trending topics from the guide, although not sure accounting and trending aren't necessarily two words that normally go together.
2:09
SPEAKER_00: Um, but today's podcast is going to focus in talking about debt investments with a focus on approaching this from the perspective of a corporate entity.
2:18
SPEAKER_00: But maybe, Brett, before we get into that, you can um share with us of what we're going to talk about today.
2:25
SPEAKER_02: Yeah, I mean, I want to take a step back and think we're gonna talk about loans and investments all month.
2:30
SPEAKER_02: Um, and I thought we'd try to cover that landscape in a couple steps.
2:34
SPEAKER_02: Um, I thought the approach we take um today, and I think for the next one, is to think of loans and investments from the vantage point of a corporate entity.
2:43
SPEAKER_02: We often talk on these topics and we get into an amazing amount of nuance and detail.
2:50
SPEAKER_02: Um, we come, Chris and I both have a banking background, and and you know, the issues around loans and investments from a banking perspective can be super detailed and affect large portfolios and get into some you know fairly nuanced accounting.
3:05
SPEAKER_02: But in these episodes, we're gonna try to take a step back from that and think about these issues from the lens of a corporate entity because our corporate clients still have these issues.
3:15
SPEAKER_02: They tend to be different.
3:16
SPEAKER_02: Um they're not always necessarily easier.
3:18
SPEAKER_02: They're they are different.
3:19
SPEAKER_02: And so we're gonna try to hit a couple topics um that will focus on those corporate entities, and then we'll wrap up the month with a couple topics, credit losses and equity securities that really um run the gamut of across all of our clients, both uh financial services and non-financial services alike.
3:37
SPEAKER_00: All right, very helpful and looking forward to the discussion.
3:40
SPEAKER_00: And I know from coming from a background where I was working on corporate clients, I think they all dealt with all of these issues.
3:46
SPEAKER_00: So I think approaching it from that direction will be very helpful.
3:49
SPEAKER_00: Now, with that said, I think one of the challenges with this accounting is it's not that you can just go say, oh, let's point to one ASU or one ASC and say, here's the guidance on accounting uh for these debt securities.
4:03
SPEAKER_00: I also think, I know it's been some time ago, but this model has changed over time.
4:08
SPEAKER_00: And I think that also creates some complexity, particularly I think for corporate clients where, you know, it's maybe a regular quarterly or annual item, but it's not something they're dealing with necessarily every day.
4:21
SPEAKER_00: So with that said, then Brett, what guidance are we looking to when we're talking about the accounting here?
4:27
SPEAKER_02: Yeah.
4:27
SPEAKER_02: So, like you said, there's not one integrated model for loans and investments.
4:32
SPEAKER_02: And so we're gonna break it down uh into pieces.
4:36
SPEAKER_02: Um there are debt securities that under that are under ASC 320.
4:41
SPEAKER_02: There are equity securities that are gonna be under a different standard, 321.
4:46
SPEAKER_02: Uh, and then we have the loan receivable model that's under ASC 310.
4:51
SPEAKER_02: Even that three buckets, wait, I feel like we're always talking about three stocks.
4:55
SPEAKER_02: I know.
4:56
SPEAKER_00: I think, but then there's actually really 20 stocks.
4:59
SPEAKER_02: To get to the 20, like if you have an equity interest, you can't just look at 320.
5:04
SPEAKER_02: You have to think about consolidation or equity method.
5:07
SPEAKER_02: Uh and then even in loans uh and receivables, you have to think of embedded derivatives and when you account for a derivative separately.
5:15
SPEAKER_02: So we're gonna leave those complications aside.
5:17
SPEAKER_02: And even within those three models, the the accounting frameworks in each model is very different.
5:23
SPEAKER_02: You know, debt securities, we've got three classifications that we're gonna talk about.
5:28
SPEAKER_02: Loans and receivables has two, and equity securities, you know, are generally all at fair value, but there's really kind of two models within there as we see in practice.
5:37
SPEAKER_02: So, you know, given that we need to break down into these different categories, the first step in all of these discussions is scoping.
5:48
SPEAKER_02: And which one of these models am I in?
5:50
SPEAKER_02: You know, do I have a choice?
5:52
SPEAKER_02: Usually not, but there is sometimes some judgment in assessing which of the three models you're in.
5:59
SPEAKER_02: So this is the first step.
6:00
SPEAKER_02: You you're buying an investment, you have to think, what is this that I that I bought?
6:05
SPEAKER_02: Um and you need to think of that from an accounting perspective.
6:08
SPEAKER_02: Um, and I start with whether that thing you bought meets the definition of a security.
6:14
SPEAKER_02: That sounds like it should be an easy question, and and sometimes it is, um, but oftentimes it can involve some judgment because the definition in the accounting literature starts with um the universal commercial code at the time this was issued back from FAS 115 back in the mid-90s.
6:34
SPEAKER_02: Um, and it has a specific definition.
6:37
SPEAKER_02: And I won't go through that in detail now, but it's generally something that is in registered form, uh, that is like commonly dealt on securities exchanges, or is like divisible into a bunch of different classes or shares.
6:52
SPEAKER_02: As we see uh financial instruments have evolved over time, sometimes even a plain vanilla loan could have some of these characteristics.
7:02
SPEAKER_02: So it's important to understand what you have both from a legal perspective and assessing against this accounting definition.
7:09
SPEAKER_02: From in the corporate space, a lot of the things you deal with are going to clearly fall in one bucket or another.
7:15
SPEAKER_02: You start with accounts receivable or a loan to a customer that's that's bilateral and documented separately, probably pretty clearly in the loan bucket.
7:27
SPEAKER_02: On the other hand, we see a lot of clients invest in very liquid debt securities like U.S.
7:32
SPEAKER_02: treasuries or corporate bonds that have a QCIP identifier.
7:38
SPEAKER_02: Those are almost always registered bonds and are going to clearly be a security.
7:43
SPEAKER_02: So you start with start with that, assessing whether you have a security or not.
7:48
SPEAKER_02: If it's not a security, then it still gets a little more complicated because there are some things that are not securities that still need to be accounted for, like a debt security.
8:00
SPEAKER_02: And before your eyes glaze over and say, like, this is banking speak again, think of like securitizations that a lot of our corporate clients do where they retain an interest in those.
8:12
SPEAKER_02: Sometimes that retained interest, we call it a beneficial interest in a securitization, that often needs to be accounted for like a debt security.
8:21
SPEAKER_02: So we started with security.
8:23
SPEAKER_02: We think about is this from a securitization vehicle and assess that.
8:28
SPEAKER_00: Um maybe, Brett, can I pause you and ask a question before you keep going?
8:32
SPEAKER_00: So definitely a lot to think about there and a lot of different paths to take from, and I know we're going to get into a little more detail too, maybe on some of the judgments, because I guess my question is is this an area where we get a lot of questions?
8:45
SPEAKER_00: Or is it typically fairly clear, oh, you have a security or you don't have security, or is it get more complicated?
8:53
SPEAKER_02: It it can get more complicated.
8:54
SPEAKER_02: And I wouldn't say we get a lot of questions, but like I said, as financial instruments are evolving, the difference between a loan and a security, loans are becoming more and more liquid.
9:06
SPEAKER_02: They're becoming more and more tradable.
9:09
SPEAKER_02: Uh, you know, some securities, you know, they used to be all very liquid, but now we see a lot of like very illiquid securities because they can be very bespoke.
9:18
SPEAKER_02: And so I would say the lines between loans and securities have sometimes blurred and there are judgments.
9:25
SPEAKER_02: I would say that I don't know that we get many of those questions from non-financial entities, because, like I said, usually what we see in our corporates are you know fairly clear on one side or the other.
9:39
SPEAKER_00: Aaron Powell But it's I guess a good reminder that it's something you need to start with this step before you immediately jump into an accounting model.
9:46
SPEAKER_00: And I do know that there are sometimes more complicated questions.
9:49
SPEAKER_00: So any examples there that you would talk about?
9:53
SPEAKER_02: Yeah.
9:54
SPEAKER_02: One example that we could see in in the corporate space um deals with preferred stock.
9:59
SPEAKER_02: When I say preferred stock, you probably think immediately equity.
10:03
SPEAKER_02: It says stock in it.
10:05
SPEAKER_02: Um but there are certain preferred stock instruments that are accounted for like a debt security.
10:12
SPEAKER_02: Um think of a preferred stock that is mandatorily redeemable or is redeemable at the investor's option.
10:19
SPEAKER_02: Those need to be accounted for as a debt security.
10:21
SPEAKER_02: And I think that has some logic to it, because in both of those cases, whether it's mandatory or at the investor's option, there is going to be a maturity-like date to it.
10:32
SPEAKER_02: The investor control can control when it's going to get paid back, or there's a mandatory date.
10:37
SPEAKER_02: And so that's going to be treated like a debt security, even though it may be in legal form an equity.
10:43
SPEAKER_02: And interestingly, it doesn't have to be currently redeemable for it to be a debt security.
10:48
SPEAKER_02: I could have something that's redeemable at a time certain in the future, or you could have instruments that are contingently redeemable.
10:57
SPEAKER_02: And in those, you're going to have to wait for that contingent event to happen.
11:01
SPEAKER_02: And something could be an equity security for a period of time, and then you hit some contingency, say that uh preferred stock is redeemable upon an IPO.
11:12
SPEAKER_02: You know, you're going to wait for that IPO to happen, suddenly it becomes redeemable, and then it would become a debt security after that point.
11:19
SPEAKER_00: But I guess if it's contingent, then it wouldn't be until after the contingency is resolved.
11:24
SPEAKER_02: That's right.
11:24
SPEAKER_00: All right.
11:25
SPEAKER_00: And I know we have a whole at least one other podcast about this topic, because when you said that people would assume preferred stock means it's equity, I knew the answer was no because of past conversations that I've had with you and maybe John Haran or others.
11:40
SPEAKER_00: So it's very helpful.
11:41
SPEAKER_00: Okay.
11:42
SPEAKER_00: So with all of that level setting, you know, again, I think the key reminder there is don't presume anything.
11:48
SPEAKER_00: But once you've concluded that you do have a debt security, then we need to think about the accounting model.
11:52
SPEAKER_00: So, Chris, what comes next?
11:55
SPEAKER_03: Well, oftentimes um when a corporate entity invests in debt securities, one of the first things that come to mind is whether it actually is a cash equivalent, which maybe sound a little silly talking about cash uh when we're talking about securities.
12:10
SPEAKER_03: Um the definition of a of a uh cash equivalent is in a different accounting standard of cost than that's ASC 230.
12:20
SPEAKER_00: And confusingly, like basically the inverse of the Trevor Burrus There's two main criteria really.
12:28
SPEAKER_03: I mean, one is whether it's readily convertible to known amounts of cash, you know, the instrument that you've invested in, and whether it's so near maturity that there's an insignificant risk uh due to the change in value uh due to interest rates.
12:44
SPEAKER_03: The guidance has an explicit requirement when we're talking about the um the maturity, um so near maturity, and that's three months or less.
12:53
SPEAKER_03: That's where most companies tend to focus is on the maturity aspect.
12:58
SPEAKER_03: But it's equally important to think about whether or not the instrument is highly liquid.
13:02
SPEAKER_03: Um so the the the first criteria I mentioned, the the readily convertible to known amount of cash.
13:07
SPEAKER_03: Usually those are things that need to be traded on in an exchange or an established market.
13:13
SPEAKER_03: So if you think about the U.S.
13:15
SPEAKER_03: Treasury that was mentioned before, say a uh 90-day or less U.S.
13:19
SPEAKER_03: Treasury would qualify for a cash equivalent.
13:23
SPEAKER_03: Other instruments could be uh redeemable on demand without a significant penalty.
13:28
SPEAKER_03: Um so think of like a bank where a corporate may have uh money on account at a bank in a in a CD certificate of deposit, may perhaps could be uh greater than three months, but um if you go to redeem that instrument at the bank, most times you may only lose the interest that it would have accumulated, but you still get your your par back, your principal, you know, your deposit, if you will.
13:51
SPEAKER_03: So that's probably going to be defined as without a significant penalty, and it could be redeemable by the bank.
13:56
SPEAKER_03: So that could still qualify, even though the instrument itself may not be um a maturity of less than than three months.
14:04
SPEAKER_03: One instrument that typically is looked at as a cash equivalent or or could qualify is money market funds.
14:12
SPEAKER_03: Um there are some criteria though that you need to think about.
14:15
SPEAKER_03: And basically, if it's uh a 1940 Act uh money market fund, um that's okay.
14:21
SPEAKER_03: That that's that's good.
14:23
SPEAKER_03: And so therefore, if you have a money market fund that may not specifically be a 1940 Act registered fund, um, but it has all of the criteria that would otherwise have caused it to be uh registered, um, then that could still qualify.
14:37
SPEAKER_03: So, for example, the the fund would need to have a policy that um the weight average maturity of the debt instruments is 90 days or less, um, would need to have an ability to redeem on a daily basis, and the investment attributes would be consistent with those um required for an SEC registered money market fund.
14:59
SPEAKER_00: So, Chris, I know you gave the characteristics, but I think sometimes for our listeners, as soon as they hear 1940 Act and they think, I don't know, how am I supposed to know if my money market fund is uh 1940 Act registered or if it should be treated as one?
15:12
SPEAKER_00: So can you just reiterate there what companies should be thinking about to see if they should be following that model?
15:19
SPEAKER_03: Yeah, I mean, so 1940 Act is just simply the the act that the Securities and Exchange Commission um where they provided um, you know, in order to be a registered uh money market fund with the SEC, uh, it needs to meet all of the criteria that I just you know discussed with you.
15:37
SPEAKER_03: Um and so that's simply all that means when we say 1940 Act fund.
15:41
SPEAKER_03: It's a reg it's a money market fund registered with the SEC, and so therefore has to have all of those requirements.
15:48
SPEAKER_03: And so the comparison is, well, even if it's not, uh if the fund kind of mirrors you know being registered with the SEC as a money market account, um, and therefore it puts all of those things in as their policies, um, it could still qualify.
16:04
SPEAKER_00: All right, that's helpful.
16:05
SPEAKER_00: And I know this is a question that comes up um frequently, so I think that's a helpful clarification.
16:10
SPEAKER_03: Now it's important to know that it needs to be reassessed periodically.
16:15
SPEAKER_03: Um so for example, if there's uh a period of time where potentially a uh a redemption gate is up and so it's no longer uh redeemable on a daily basis, that could cause you to no longer qualify as cash equivalent, then you may have have a movement there.
16:29
SPEAKER_00: And I guess, Chris, maybe before we go on, I think what's interesting there is that we have the case where we're looking at the 90 days that if you originally buy something that's more than 90 days, you don't reassess.
16:41
SPEAKER_00: So can you just explain a little bit more about that?
16:44
SPEAKER_00: I was gonna mention that.
16:44
SPEAKER_00: Right.
16:44
SPEAKER_00: So I jumped into there.
16:46
SPEAKER_03: That's that's quite all right.
16:47
SPEAKER_03: Yeah, so so as you were mentioning, Heather, it's that assessment is done at the time that you acquire it.
16:54
SPEAKER_03: So you could uh you know acquire a uh a new security, um, like maybe like a commercial paper or U.S.
17:01
SPEAKER_03: Treasury that's that's being issued.
17:03
SPEAKER_03: Um, and you look at the maturity of that, and that's 90 days or less, or three months or less, I should really say, um, and that qualifies you know for the for this short-term aspect.
17:13
SPEAKER_03: Um, I could buy a uh uh one-year bond from you, but I'm buying it at a point in time where the remaining maturity is less than three months.
17:23
SPEAKER_03: So for me, as the purchaser of that, at the time I purchased it, the maturity is less than three months away.
17:29
SPEAKER_03: That could qualify.
17:30
SPEAKER_03: However, if I bought that same one-year bond at the original date of issuance, I can't wait until we get to the last three months and say, okay, now I have a cash equivalent because it's from the point in time that I acquire it.
17:42
SPEAKER_00: And actually, it would say from the point of view of the holder, that's probably a good thing because if you had to re-assess and like reclassify all your securities, you know, when they got to that last 90 days, that would be a lot of potentially extra accounting versus you just stick with the original classification.
18:01
SPEAKER_03: Right.
18:02
SPEAKER_03: Now, two things to keep in mind.
18:03
SPEAKER_00: Yeah.
18:04
SPEAKER_03: Um if it is a cash equivalent, if you account for it as a cash equivalent, um, that's more of a presentation between the balance sheet and the cash flow statement.
18:14
SPEAKER_03: You still have to uh do all of the debt security accounting um that we're gonna talk about in a few minutes.
18:21
SPEAKER_03: Um it's still a debt security, you still account for it as a debt security.
18:24
SPEAKER_03: It's just whether or not I call it after that fact, you know, cash or cash equivalent.
18:30
SPEAKER_03: Um the other thing is there's no mandatory must-be a cash equivalent, right?
18:34
SPEAKER_03: It's a it's a policy.
18:35
SPEAKER_03: Each company can establish a policy for what they define as a cash equivalent or what they consider cash equivalent.
18:43
SPEAKER_03: So it's not as if it it meets these criteria, you have to account for it as a cash equivalent.
18:48
SPEAKER_03: I could have a policy that says I'm never going to account for anything as a cash equivalent.
18:52
SPEAKER_03: It's just a security.
18:54
SPEAKER_03: However, um, if I do establish a policy that says, you know, I will acquire debt instruments and will be cash equivalents, that needs to be consistent.
19:03
SPEAKER_00: All right, that's very helpful clarification.
19:06
SPEAKER_00: Uh one question then for this readily convertible to cash question.
19:10
SPEAKER_00: We've mentioned US Treasuries several times.
19:13
SPEAKER_00: And then you also mentioned like acquiring a bond from me.
19:16
SPEAKER_00: So do you see where there's other core like where there's high quality corporate bonds?
19:21
SPEAKER_00: Because of course, if I was to Ashina, I'd be high quality.
19:23
SPEAKER_00: But no, that if it was um, do you see where high quality corporate bonds can also meet that criteria as cash equivalents are readily convertible to cash, or it's typically just the sort of US treasuries and the like?
19:36
SPEAKER_03: I think US treasuries are usually the ones that are given an example because it's pretty clear.
19:40
SPEAKER_03: But yeah, corporate bonds can be traded on a on a on exchange.
19:44
SPEAKER_03: Um and so they could be highly liquid.
19:47
SPEAKER_03: You look at it more from the perspective of can I readily convert it to a known amount of cash uh pretty quickly.
19:54
SPEAKER_03: And so if I can easily go and trade it tomorrow on an exchange somewhere, that should that should qualify.
20:00
SPEAKER_02: It'll depend on go ahead, Brian.
20:02
SPEAKER_02: I think that distinction is important.
20:03
SPEAKER_02: He he was talking about whether it's traded on an exchange and you were teeing it up as high credit quality.
20:09
SPEAKER_02: Yes, and there are things that are high credit quality, but that just aren't exchange traded.
20:14
SPEAKER_00: And I guess vice versa is true.
20:16
SPEAKER_00: Okay, so it's a very so I did miss that.
20:18
SPEAKER_00: So it's a very important point that it's really focused on if it's traded on exchange.
20:23
SPEAKER_00: All right.
20:23
SPEAKER_00: That's very helpful.
20:24
SPEAKER_00: So then now that we've concluded that we have a security, it's not a loan.
20:29
SPEAKER_00: And I guess sort of for this purpose, it doesn't matter if it's a cash equivalent or not, because you said you have to follow the same accounting.
20:35
SPEAKER_00: What are some of the accounting decisions you need to think about?
20:38
SPEAKER_03: Yeah, I think Brett uh mentioned before.
20:40
SPEAKER_03: So when I have decided I have a debt security, and like you said, what it doesn't matter if I'm gonna treat it as a cash equivalent or not, but I have a debt security.
20:50
SPEAKER_03: I need to account for it.
20:51
SPEAKER_03: The first thing that you want to do is you want to understand how is it classified.
20:56
SPEAKER_03: And there's three buckets of potential ways you can classify a debt security health to maturity, trading, or available for sale.
21:07
SPEAKER_03: Those are the three.
21:08
SPEAKER_03: And that's a decision point that's made at the time of acquisition.
21:12
SPEAKER_03: Transferring between the three is pretty rare and and usually not done, maybe in some limited instances.
21:21
SPEAKER_03: So um it's pretty important that you understand up front kind of what your intentions and abilities are and what makes sense to you, like what you plan to do with that security, um, that debt security, um, and and what you have the ability to do with it.
21:36
SPEAKER_03: So those three classifications actually have three different accounting models associated with it.
21:42
SPEAKER_03: So it's again, you know, it's important to make sure you get it right um from the beginning.
21:46
SPEAKER_03: Um so let's talk a little bit about health and maturity.
21:49
SPEAKER_03: This is intended to be a restrictive category because the accounting um for a health maturity security is you just account for it at amortized cost.
21:59
SPEAKER_03: Um As Brett mentioned, you you may have need to understand if there are any uh embedded derivatives or anything like that, but generally speaking it's it's accounted for at amortized cost.
22:10
SPEAKER_03: So it in order to qualify, you need the intent and the ability to hold to maturity.
22:15
SPEAKER_03: So if you think about oftentimes a corporate entity may use uh debt securities for liquidity purposes, um that would not mesh up with the intent and ability to hold to maturity.
22:28
SPEAKER_03: And so you know, you need to think about that.
22:30
SPEAKER_03: Like if it's going to be held for liquidity purposes, that's generally not going to qualify for a health to maturity uh security.
22:37
SPEAKER_03: And if you do wind up selling or transferring uh security from health to maturity, uh there's a concept of that may taint your portfolio, which would mean that all of my health to maturity securities would now have to come out of the health to maturity and you're somewhat put in health to maturity jail for a period of time.
22:56
SPEAKER_03: Um so it it could have a pretty large, large impact, um, which will be more evident when we get into the accounting for well, what are the other categories.
23:04
SPEAKER_03: So maybe the next one to talk about uh is is trading security, and that's kind of the complete opposite accounting uh for health to maturity.
23:11
SPEAKER_03: I mean, trading is you know intended to be short-term, you know, i.e., you know, days or or weeks um for the period of time that that you plan to hold it.
23:20
SPEAKER_03: However, the trading is not quite as restrictive um as health to maturity.
23:25
SPEAKER_03: So it's not as if you have to only hold it for you know days or weeks.
23:31
SPEAKER_03: You could hold it for a longer period of time and still consider it a trading security.
23:35
SPEAKER_03: But the accounting for a trading, uh, like I said, is kind of the complete opposite, where trading is you mark to market that security um to its fair value each period, and the changes in those fair value marks uh would go directly to your income statement, go directly to the earnings um as a mark-to-market gain or loss.
23:55
SPEAKER_03: So could create some volatility uh in your PL because of you know fluctuations in the market value uh as you go from period to period.
24:04
SPEAKER_03: There's no impairment um that you need to consider, which I should have mentioned for the health to maturity.
24:10
SPEAKER_03: Um, since it's at amortized cost, you know, our good friend Cecil uh comes into play.
24:16
SPEAKER_03: And uh you would need to think about whether there are um impairment losses or impairment uh credit loss impairment um that you would need to record for Cecil for the health and maturity.
24:26
SPEAKER_03: That's not uh an issue with trading because you're marking the full instrument to market through P ⁇ L already.
24:32
SPEAKER_00: So, Chris, for both of those two categories, and I think you may have said this for trading, do you have to use those categorizations?
24:39
SPEAKER_00: So, for example, if I have a security that I do have the intent and ability to hold to maturity, but you know, something always could happen, or maybe I'd rather just use one accounting model, or there could be different reasons.
24:54
SPEAKER_00: Do I have to use the health to maturity classification, or could I go to your third category that I know we haven't talked about yet, but the available for sale?
25:03
SPEAKER_03: Right.
25:03
SPEAKER_03: Yeah.
25:03
SPEAKER_03: No, there's there's nothing that says you have to account for something as health to maturity.
25:08
SPEAKER_03: Uh, there's nothing that says you have to account for something as trading.
25:12
SPEAKER_03: Um, those are kind of the decision points, if you will, that the company would need to make.
25:16
SPEAKER_03: Because if you don't either want to or you don't qualify for one of those two categories, the third category available for sale is kind of like the default or the catch-all, which is I don't know, I might hold it to maturity, I might sell it, I'm not quite sure.
25:31
SPEAKER_00: Yeah.
25:32
SPEAKER_03: Um, maybe I have a feeling, but to your point, you know, I don't necessarily want to deal with the potential issues that could come out if I was wrong.
25:41
SPEAKER_03: Yes, exactly.
25:42
SPEAKER_03: Yes.
25:43
SPEAKER_03: Um, or I don't want the PL volatility uh of trading.
25:47
SPEAKER_03: And you, you know, if you think about it, available for sale seems kind of like a midpoint between the two.
25:53
SPEAKER_03: Well, the accounting model is kind of a midpoint between the two as well.
25:56
SPEAKER_03: Um and so the accounting for available for sale is um like a trading security, I do market to market to fair value each period.
26:04
SPEAKER_03: However, um, unlike a trading security, that um valuation change does not go directly to my profit and loss, doesn't go to my income statement, it goes to a part of my equity on my balance sheet and and in my comprehensive income.
26:20
SPEAKER_03: And so it's other comprehensive income, OCI um and accumulated as AOCI accumulated other comprehensive income.
26:26
SPEAKER_03: So instead of directly to my PL, it goes to equity.
26:30
SPEAKER_03: But because I don't put it directly to my PL um like a held to maturity, I need to think about impairment.
26:38
SPEAKER_03: However, the impairment for available for sale is not Cecil.
26:42
SPEAKER_03: It's a it's a slightly different model.
26:44
SPEAKER_03: Um and that starts with um whether or not I'm in an unrealized gain or loss position in the first place, right?
26:50
SPEAKER_03: So if I bought a security at$100, today it's worth$101, I'm in an unrealized gain position, I don't have to even worry about the impairment because it, you know, the impairment is floored, if you will, at uh the value of the security.
27:05
SPEAKER_03: However, if I'm in an unrealized loss position and say it's$99, now I need to think, you know, hey, it's part of that one dollar is that credit.
27:14
SPEAKER_03: And if there's a credit component to the security, then I would need to record an impairment up to that uh credit piece, um, again, Florida at that you know, one dollar difference.
27:27
SPEAKER_03: And that would be kind of a movement from the OCI equity into my PL.
27:32
SPEAKER_03: Now there's one other requirement or thing to think about is well, if I had the intent to actually sell that security, um, or it's more likely than not that I would be required to sell that security.
27:44
SPEAKER_03: So sometimes that comes into play uh in a regulated entity.
27:47
SPEAKER_03: Um, other times it could be if I may have um potential going concern or liquidity issues, and so I may be required to sell that security for whatever reason, um then I need to take the full value of that unrealized loss as my impairment and not just simply the credit component.
28:03
SPEAKER_00: All right.
28:04
SPEAKER_00: So, Chris, I think that's a really helpful example.
28:06
SPEAKER_00: Let me ask a question though, just to maybe reinforce the point, hopefully reinforce the point.
28:12
SPEAKER_00: So if I had a security that I purchased, my purchase was$95, but the ultimate um maturity is 100.
28:20
SPEAKER_00: So I bought it at a discount.
28:22
SPEAKER_00: Then what happens is the fair value moves.
28:25
SPEAKER_00: So original cost is 95, maturity is 100, and then let's say it goes up to 97 and then it drops to 94.
28:32
SPEAKER_00: What would that counting be?
28:34
SPEAKER_03: Right.
28:34
SPEAKER_03: So the comparison point is the amortized cost.
28:38
SPEAKER_03: And so that generally is going to be the original purchase price.
28:43
SPEAKER_03: Uh, you may have you know amortized um because you're you're showing a a um a true interest income.
28:50
SPEAKER_03: And so, you know, you may up or down the the depending if it's uh discount or premium, um, and you may have had previous write-offs.
28:58
SPEAKER_03: Um, so it's kind of the current amortized cost of what the security is, as opposed to it's it's on the balance sheet at its fair value.
29:05
SPEAKER_03: Um but that's what we're using to compare to, right?
29:08
SPEAKER_03: So all right.
29:09
SPEAKER_00: So then for my purposes, let's assume my amortized cost is 95.
29:13
SPEAKER_00: Then if it goes up to 97, I don't have to do anything.
29:22
SPEAKER_03: All right, and then if it goes down to 94, then it would be a potential one dollar unrealized, or it is a one dollar unrealized loss, a potential impairment.
29:30
SPEAKER_00: Right, because you have to consider then the points about if this is related to credit or if I had the intent to sell, or more likely than not, would be required to sell.
29:41
SPEAKER_00: All right, that's very helpful.
29:43
SPEAKER_00: And I think the point about remembering that you're not automatically comparing to the purchase price is very important because I think there's an inclination to want to do that.
29:52
SPEAKER_00: All right, that's helpful.
29:53
SPEAKER_00: So definitely a lot to think about there and making sure that you get that classification right up front is obviously important.
30:01
SPEAKER_00: Brett, what are some of the considerations as companies are making this classification determination or you know, as they're dealing with these different securities?
30:10
SPEAKER_02: I think another thing I would raise is just valuation of these instruments.
30:14
SPEAKER_02: Chris talked about two of the models that where the accounting is dependent on the fair value, both trading and available for sale.
30:21
SPEAKER_02: Uh, even when you're dealing with held maturity securities, there are disclosures around fair value.
30:26
SPEAKER_02: And so understanding the valuation of these instruments, I think, is always um is always important.
30:32
SPEAKER_02: And for valuation, we're we're following the same definition of fair value that's laid out in ASC 820.
30:40
SPEAKER_02: And there's a lot of fair value disclosure requirements under that standard, uh, as you know.
30:44
SPEAKER_02: And fair value is just defined as the price that between a willing buyer and a willing seller, the price that would be received to sell an asset.
30:53
SPEAKER_02: We call it an exit price.
30:55
SPEAKER_02: Um I think this is an important when when we're thinking about fair value.
30:59
SPEAKER_02: Um, you're thinking about orderly transactions, not necessarily what it may be worth to the party currently holding the asset.
31:07
SPEAKER_02: You have to take yourself out of it and say, what is someone else going to be willing to pay me for that asset?
31:13
SPEAKER_02: I think another important area, especially in with non-financial services companies, is their valuation process.
31:21
SPEAKER_02: Um we see that valuation of financial instruments is not a core competency of that function.
31:27
SPEAKER_02: And so they and they outsource um some of this to third-party service providers.
31:33
SPEAKER_02: Um so I think it's important to think about what the controls are for valuation, because even if you're going to outsource to a third party, they're still your financial statements and you need to take responsibility for the judgments that are being made.
31:47
SPEAKER_02: In some cases, these these the valuation isn't very judgmental.
31:50
SPEAKER_02: They may be very liquid uh instruments that have a very clear exit price, but in other cases, there may be more judgment involved in the valuation.
31:59
SPEAKER_02: And so you need to make sure you have enough information around what that third-party service provider is recommending or giving to you to make sure that you can take responsibility for the valuation decisions made.
32:12
SPEAKER_02: I think another part of this uh valuation process that we get questions around are the disclosures that are required.
32:20
SPEAKER_02: One of the disclosures around fair value is what we call the hierarchy table.
32:24
SPEAKER_02: This is level one, level two, level three for frequent listeners.
32:28
SPEAKER_02: And it's really getting to the level or the amount of valuation certainty you have in an instrument.
32:35
SPEAKER_02: And with level one uh instruments are those that are uh priced directly off of an observed price.
32:42
SPEAKER_02: Level two instruments are those that have uh no significant unobservable inputs, but it's based on the modeled value.
32:50
SPEAKER_02: And then level three instruments are where one or more of the significant inputs is not observable.
32:56
SPEAKER_02: Those are going to be the most judgmental items to value.
33:01
SPEAKER_02: So when you're going through, especially if you're outsourcing this process, you need to understand how that third-party service provider is coming up with the values.
33:10
SPEAKER_02: Is it using exchange prices?
33:12
SPEAKER_02: Is it using models?
33:13
SPEAKER_02: Is it using instrument or inputs that are not observable?
33:17
SPEAKER_02: Again, sometimes this is going to be very clear.
33:19
SPEAKER_02: Like I talked about, you know, an on-the-run, like just issued U.S.
33:23
SPEAKER_02: Treasury may be very liquid.
33:25
SPEAKER_02: But in other cases, um, corporates may have instruments that are not that liquid, not that observable.
33:32
SPEAKER_02: Um, to your earlier point, they may still be high credit quality, but they just don't have a very clear price to them.
33:38
SPEAKER_02: So understanding the inputs and the process around that valuation for these leveling disclosures are important.
33:46
SPEAKER_02: One question that we have gotten from time to time is how to think about and how to level U.S.
33:52
SPEAKER_02: Treasury bonds.
33:53
SPEAKER_02: Um, even within U.S.
33:54
SPEAKER_02: Treasury bonds, there are bonds that are considered, quote, on the run, which are generally the most recent issuances.
34:00
SPEAKER_02: They trade very frequently and actively versus off-the-run instruments that still trade, but maybe not as frequently.
34:10
SPEAKER_02: And they're still high credit quality, but they just don't have that observable price.
34:14
SPEAKER_02: And what we find is a lot of on-the-run treasuries are often classified as level one, but maybe some off-the-run treasuries, even though again high credit quality may still be in level two.
34:25
SPEAKER_02: So understanding those nuances again in what you own and what the process is to value them is always important.
34:32
SPEAKER_00: Well, and I guess Brett, maybe this goes without saying, but then also that you need to consider each period, because something could move.
34:41
SPEAKER_00: Um, just given the example you just gave, you could move from a level one to a level two if maybe it stops trading as actively or otherwise.
34:48
SPEAKER_02: Absolutely.
34:49
SPEAKER_00: All right, that's very helpful.
34:50
SPEAKER_00: So then, Chris, maybe coming back to you, you know, now we have a debt security, we've done our classification, we've done our fair value, and you talked about the income statement and what happens there, but we didn't really talk about the balance sheet.
35:05
SPEAKER_00: So, well, income statement and statement of comprehensive income, to be clear.
35:09
SPEAKER_00: Um so as we think about then balance sheet or other presentation issues that companies should be considering.
35:15
SPEAKER_03: Yeah.
35:16
SPEAKER_03: So if you think about the balance sheet, you know, you're probably talking about like what uh financial statement line item on my balance sheet uh um would I put this in?
35:27
SPEAKER_03: Taking aside the cash equivalent discussion we had earlier, because that could change things up a little bit as well.
35:33
SPEAKER_03: Um and let's just talk, you know, straight uh debt securities and my my three categories: my help to maturity, valve for sale, um, and trading.
35:42
SPEAKER_03: Um the first thing that you want to do is you want to separate on the balance sheet securities from say simple loans and receivables.
35:50
SPEAKER_03: Um so securities should be presented separately uh from loans and receivables.
35:56
SPEAKER_03: Then when you get into your securities, as we mentioned, there's two basic models from a balance sheet perspective.
36:01
SPEAKER_03: They're either on the balance sheet at amortized cost or they're on the balance sheet at fair value, right?
36:06
SPEAKER_03: So the trading and available for sale would be at fair value, the health and maturity would be at amortized cost.
36:14
SPEAKER_03: Those things should be separated as well.
36:16
SPEAKER_03: You should separate on the balance sheet um those securities that are carried at um fair value separately from those that are carried at amortized cost.
36:26
SPEAKER_03: And really, when you get into the fair value, oftentimes you'll see the trading securities um separate from the available for sale as well, because those are still slightly different um accounting models.
36:38
SPEAKER_03: So you need to think about you know what the categorization is and kind of the accounting model and make sure you get the right line item.
36:45
SPEAKER_00: And I guess to be clear, at a minimum, separating the health maturity or the amortized cost from the fair value on the face of the balance sheet is important.
36:55
SPEAKER_00: Sometimes you see the further separation, but that is not a footnote disclosure, basically the separation between amortized cost and fair value, as well as the separation from loans and receivables.
37:06
SPEAKER_00: Right.
37:06
SPEAKER_00: Okay.
37:07
SPEAKER_00: That's an important point because I think often people like to just say, oh, I'll put that in the footnote.
37:12
SPEAKER_00: But in this case, that's not permitted.
37:13
SPEAKER_03: Yeah.
37:14
SPEAKER_03: Uh taking materiality maybe out of the out of the code.
37:17
SPEAKER_03: Okay, fair enough.
37:17
SPEAKER_00: That's uh everything we talk about on the podcast is always subject to materiality.
37:22
SPEAKER_00: Hopefully, our listeners know that.
37:23
SPEAKER_00: So and then Chris, how about then if you're thinking about a classified balance sheet, so you have current and long-term, then how do you fit your securities into that?
37:32
SPEAKER_03: Right.
37:33
SPEAKER_03: So the classified balance sheet, um, which is not something that I personally deal with a lot, come coming from the banking industry.
37:40
SPEAKER_00: But if you were coming from a corporate, you would be well familiar.
37:43
SPEAKER_03: I would.
37:43
SPEAKER_03: So I just just wanted to get that out.
37:45
SPEAKER_00: Yes.
37:46
SPEAKER_03: Right.
37:46
SPEAKER_03: So the classified balance sheet, uh, you know, as as you know, our our corporate listeners um are aware, separates your assets and liabilities into current versus non-current.
37:57
SPEAKER_03: And the general idea in that is um 12 months is current, you're greater than 12 months is non-current.
38:04
SPEAKER_03: So there's two basic ways when you're talking about securities and specifically debt securities, that's what we're talking about today, on how to decide uh what that 12-month, that short-term aspect is versus the non-current, the long-term aspect.
38:21
SPEAKER_03: Um, the first basic way of doing it is you simply look at the maturity of the instrument we're talking about.
38:26
SPEAKER_03: So um, if I have a you know six-month bond or a six-month uh you know treasury security, and and I'm gonna look at it based on the maturity, that's going to be short-term, that's going to be a current uh asset.
38:39
SPEAKER_03: If I have a two-year bond, um that's going to be longer term, that's going to be non-current.
38:45
SPEAKER_03: Um, that seems simple enough and straightforward and probably no different than the way I think about the rest of my assets and liabilities.
38:52
SPEAKER_03: There is a second way, which maybe is a little different than the typical way you think about classification between current and non-current, and that's well, really, I own these securities because they're kind of available as a temporary funding or a temporary investment of my excess funds that's still available for use in my current operations.
39:12
SPEAKER_03: And so if I take that view or that model in thinking about classification, then I would say, well, the securities that I have that are available for my current use in my operations, those are current.
39:25
SPEAKER_03: Um they're they're just where I took my cash and parked it temporarily.
39:29
SPEAKER_03: Um but if you think about the accounting models we talked about, that doesn't sound something that would be consistent with an intent and ability to hold to maturity, right?
39:36
SPEAKER_03: So that's a long way of saying held to maturity, unless the particular bond or debt security is maturing within 12 months, probably shouldn't be in your current category, regardless of which method you're using.
39:49
SPEAKER_00: All right.
39:49
SPEAKER_00: This is very helpful clarification there.
39:51
SPEAKER_00: And very interesting because you're right, it's different than the way you think about other things and the classification between current and non-current.
40:00
SPEAKER_00: So, with that said, then, Brett, I don't want to neglect the cash flow statement, which I know a statement that you spend a lot of time answering questions on.
40:08
SPEAKER_00: So, what should we be thinking about from a cash flow statement perspective with these securities?
40:13
SPEAKER_02: Yeah, a couple things to think about.
40:15
SPEAKER_02: I think in general, most times the cash flow presentation is fairly easy.
40:20
SPEAKER_02: Purchasing and selling debt instruments is almost always classified as an investing activity.
40:26
SPEAKER_02: I think there are certain types of entities where that activity is part of their core strategy to make short-term profits.
40:34
SPEAKER_02: We generally don't see that in non-financial services companies.
40:37
SPEAKER_02: And so for the listeners for this folks on corporates, I think generally thinking that these purchases and sales will be in investing is is uh probably a good assumption.
40:48
SPEAKER_02: Uh entities are required to report uh purchases, sales, and maturities of investments separately on the cash flow statement.
40:56
SPEAKER_02: So that's one topic that we often see come up.
40:59
SPEAKER_02: You know, can I net all of its activity or the standard is to require them to be shown separately?
41:06
SPEAKER_02: And then there are some cases where there's a question about how to present certain types of instruments.
41:12
SPEAKER_02: And this has come up uh most recently.
41:15
SPEAKER_02: We've talked about it a couple times uh when you're buying, say, a zero coupon bond uh that has, let's say you're gonna buy that bond for$950, and at maturity, you're gonna receive$1,000.
41:28
SPEAKER_02: It doesn't have any interest payments, and no, there's no interest cash flows.
41:32
SPEAKER_02: It's just that the stated principle is going to be higher than your than your purchase price.
41:38
SPEAKER_02: In that case, you know, when the investment is purchased for$950, I think um it's fairly clear that cash flow is investing, that's straightforward.
41:46
SPEAKER_02: But there's a question, what do I do with that$1,000 that I receive at maturity?
41:51
SPEAKER_02: Economically, I think a lot of people look at that and say, well, you've been paid$50 for essentially interest, even though it's not uh legally an interest cash flow.
42:01
SPEAKER_02: There's no explicit cash flow guidance around this topic.
42:04
SPEAKER_02: There is on the issuer of that instrument, but not for the investor.
42:08
SPEAKER_02: And so preparers need to think about what's the best and most appropriate classification.
42:13
SPEAKER_02: I think one reasonable approach that we've seen is to split that$1,000 and call 950 of it a return of principal, which would be an investing inflow, and then considering the$50 as an operating inflow for that interest component.
42:30
SPEAKER_00: All right.
42:31
SPEAKER_00: That's helpful.
42:32
SPEAKER_00: So, Chris, Brett, this is a great topic and definitely a lot to think about.
42:36
SPEAKER_00: Um, I think you guys have been on enough to know my final question, what that's gonna be.
42:42
SPEAKER_00: But it's just if you're talking to clients or engagement teams that are dealing with debt securities or you know, some of these different issues, what is a piece of advice that you would give to them?
42:54
SPEAKER_00: And Chris, I'll go to you first.
42:56
SPEAKER_03: Yeah, so we talked a lot a lot about like the classifications and the categories and intent and ability.
43:02
SPEAKER_03: So I think what I would caution people to think about is really take a long-term view, right?
43:08
SPEAKER_03: Like look at the life of whatever the instrument is.
43:11
SPEAKER_03: You know, don't take a short-term view because you really need to look forward as to you know what you're doing.
43:17
SPEAKER_03: And because, like I said before, if you're wrong, it could have accounting consequences to it.
43:22
SPEAKER_00: All right, very helpful.
43:23
SPEAKER_00: And Brad, how about from your perspective?
43:25
SPEAKER_02: I I think the focus on controls in the whole discussion is important.
43:28
SPEAKER_02: We talked about some valuation controls, but we also talked about situations uh at inception at the purchase date where you have to go through some evaluation.
43:39
SPEAKER_02: And especially for companies that aren't very um steeped in this literature or are new to some of these investments, it's important to understand and have the right control structure to understand what you're buying and and what that uh means for the different classification choices you have.
43:55
SPEAKER_00: All right, great reminder, and probably one we should be on every one of these podcasts.
43:59
SPEAKER_00: So thank you for bringing that up.
44:01
SPEAKER_00: All right, well, Chris, Brennett, as always such a pleasure to talk to you.
44:04
SPEAKER_00: Thanks so much for joining me today.
44:06
SPEAKER_03: Thank you.
44:06
SPEAKER_03: Thanks.
44:08
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44:30
SPEAKER_00: From Thought Leadership at PwC, I'm Heather Horn.
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