WHAT ARE MARKETABLE SECURITIES?

Marketable securities are unrestricted financial instruments which can be readily sold on a stock
exchange or bond exchange. Marketable securities are often classified into two groups:
a) Marketable equity securities
b) Marketable debt securities.

Marketable equity securities include shares of common stock and most preferred stock
which are traded on a stock exchange and for which there are quoted market prices.

Marketable debt securities include government bonds and corporate bonds which are
traded on a bond exchange and for which there are quoted market prices.

ACCOUNTING FOR INVESTMENT SECURITIES

Types of investment securities

A financial investment occurs when one entity provides assets or services to another entity in
exchange for a certificate known as a security. The entity that provides the assets and receives
the security certificate is called the investor. The entity that receives the assets or services and
gives the security certificate is called the investee. There are two primary types of investment
securities: debt securities and equity securities. An investor receives a debt security when assets
are loaned to the investee. In general, a debt security describes the investee’s obligation to return
the assets and to pay interest for the use of the assets. Common types of debt securities include
bonds, notes, certificates of deposit, and commercial paper.
An equity security is obtained when an investor acquires an ownership interest in the investee.
An equity security usually describes the rights of ownership, including the right to influence the
operations of the investee and to share in profits or losses that accrue from those operations. The
most common types of equity securities are common stock and preferred stock. In summary,
investment securities are certificates that describe the rights and privileges that investors receive
when they loan or give assets or services to investees.
Transactions between the investor and the investee constitute the primary securities market.
There is a secondary securities market in which investors exchange (buy and sell) investment
securities with other investors. Securities that regularly trade in established secondary markets
are called marketable securities. Investee companies are affected by secondary-market
transactions only to the extent that their obligations are transferred to a different party. For
example, assume that Tom (investor) loans assets to ABC Company (investee). Tom receives a
bond (investment security) from ABC that describes ABC’s obligation to return assets and pay
interest to TOM. This exchange represents a primary securities market transaction. Now assume
that in a secondary-market transaction Tom sells his investment security (bond) to Tina.
ABC Company is affected by this transaction only to the extent that the company’s obligation
transfers from TOM to Tina. In other words, ABC’s obligation to repay principal and interest
does not change. The only thing that changes is the party to whom ABC makes payments. An
investee’s financial statements are not affected when the securities it has issued to an investor
are traded in the secondary market.

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The fair value, also called market value, is the amount that the investor would receive if the
securities are sold in an orderly transaction. More specifically, the fair value is based on the
amount that would be collected (an exit value) from the sale of an asset as opposed to the cost
necessary to acquire a comparable asset. Whether securities are reported at fair value or
historical cost depends on whether the investor intends to sell or hold the securities. Generally
accepted accounting principles require companies to classify their investment securities
into one of three categories:

(1) held-to-maturity securities,

(2) Trading securities.
(3) available-for-sale securities.

Held-to-Maturity Securities
Since equity securities representing ownership interests have no maturity date, the held-to-
maturity classification applies only to debt securities. Debt securities should be classified as
held-to-maturity securities if the investor has a positive intent and the ability to hold the
securities until the maturity date. Held-to-maturity securities are reported on the balance sheet at
amortized historical cost.

Trading Securities
Both debt and equity securities can be classified as trading securities. Trading securities are
bought and sold for the purpose of generating profits on the short-term appreciation of stock or
bond prices. They are usually traded within three months of when they are acquired. Trading
securities are reported on the investor’s balance sheet at their fair value on the investor’s fiscal
closing date.

Available-for-Sale Securities
All marketable securities that are not classified as held-to-maturity or trading securities must be
classified as available-for-sale securities. These securities are also reported on the investor’s
balance sheet at fair value as of the investor’s fiscal closing date.
Two of the three classifications, therefore, must be reported at fair value, which is a clear
exception to the historical cost concept.

REPORTING EVENTS THAT AFFECT

INVESTMENT SECURITIES
The effects on the investor’s financial statements of four distinct accounting events involving
marketable investment securities are illustrated in the following section. The illustration assumes
that the investor, ABC Company, started the accounting period with cash of Kshs.10, 000 and
common stock of Kshs.10, 000.

EVENT 1 Investment Purchase

ABC Company paid Kshs.9, 000 cash to purchase marketable investment securities.
This event is an asset exchange. One asset (cash) decreases, and another asset (investment
securities) increases. The income statement is not affected. The Kshs.9, 000 cash outflow is
reported as either an operating activity or an investing activity, depending on how the securities

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are classified. Since trading securities are short term assets that are regularly traded for the
purpose of producing income, cash flows from the purchase or sale of trading securities are
reported in the operating activities section of the statement of cash flows. In contrast, cash flows
involving the purchase or sale of securities classified as held to maturity or available for sale are
reported in the investing activities section of the statement of cash flows. The only difference
among the three alternatives lies in the classification of the cash
Debt securities are frequently purchased for amounts that are more or less than their face value
(the amount of principal due at the maturity date). If the purchase price is above the face value,
the difference between the face value and the purchase price is called a premium. If the purchase
price is below the face value, the difference is called a discount. Premiums and discounts
increase or decrease the amount of interest revenue earned and affect the carrying value of the
bond investment reported on the balance sheet.

EVENT 2 Recognition of Investment Revenue

ABC Company earned Kshs.1, 600 of cash investment revenue.
Investment revenue is reported the same way regardless of whether the investment securities are
classified as held to maturity, trading, or available for sale. Investment revenue comes in two
forms. Earnings from equity investments are called dividends. Revenue from debt securities is
called interest. Both forms have the same impact on the financial statements. Recognizing the
investment revenue increases both assets and stockholders’ equity. Revenue and net income
increase. The cash inflow from investment revenue is reported in the operating activities section
of the statement of cash flows regardless of how the investment securities are classified.

EVENT 3 Sale of Investment Securities

ABC Company sold securities that cost Kshs.2, 000 for Kshs.2, 600 cash.
This event results in recognizing a Kshs.600 realized (actual) gain that increases both total assets
and stockholders’ equity. The asset cash increases by Kshs.2, 600 and the asset investment
securities decreases by Kshs.2, 000, resulting in a Kshs.600 increase in total assets. The
Kshs.600 realized gain is reported on the income statement, increasing net income and retained
earnings. The Kshs.600 gain does not appear on the statement of cash flows. Instead, the entire
Kshs.2, 600 cash inflow is reported in one section of the statement of cash flows. Cash inflows
from the sale of held-to-maturity and available-for-sale securities are reported as investing
activities. Cash flows involving trading securities are reported as operating activities.

EVENT 4 Market Value Adjustments

ABC Company recognized a Kshs.700 unrealized gain.
After Event 3, the historical cost of ABC’s portfolio of remaining investment securities is
Kshs.7, 000 (Kshs.9, 000 purchased less Kshs.2, 000 sold). Assume that at ABC’s fiscal closing
date, these securities have a fair value of Kshs.7, 700, giving ABC Company a Kshs.700
unrealized gain on its investment. This type of gain (sometimes called a paper profit) is
classified as unrealized because the securities have not been sold. The treatment of unrealized
gains or losses in the financial statements depends on whether the securities are classified as held
to maturity, trading, or available for sale. Unrealized gains or losses on securities classified as
held to maturity are not recognized in the financial statements; they have no effect on the balance
sheet, income statement, and statement of cash flows. Even so, many companies choose to

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disclose the market value of the securities as part of the narrative description or in the footnotes
that accompany the statements.
Whether or not the market value is disclosed, held-to-maturity securities are reported on the
balance sheet at amortized cost.
Investments classified as trading securities are reported in the financial statements at fair value.
Unrealized gains or losses on trading securities are recognized in net income even though the
securities have not been sold. In ABC’s case, the Kshs.700 gain increases the carrying value of
the investment securities. The gain increases net income, which in turn increases retained
earnings. Unrealized gains and losses have no effect on cash flows.
Investments classified as available-for-sale securities are also reported in the financial statements
at fair value. However, an important distinction exists with respect to how the unrealized gains
and losses affect the financial statements. Even though unrealized gains or losses on available-
for-sale securities are included in the assets on the balance sheet, they are not recognized in
determining net income. On ABC’s balance sheet, the Kshs.700 gain increases the carrying value
of the investment securities. A corresponding increase is reported in a separate equity account
called Unrealized Gain or Loss on Available-for-Sale Securities. The statement of cash flows is
not affected by recognizing unrealized gains and losses on available-for-sale securities.

FINANCIAL STATEMENTS
As the preceding discussion implies, the financial statements of ABC Company are affected by
not only the business events relating to its security transactions but also the accounting treatment
used to report those events.
Statement of Financial Accounting Standards No. 130 permits companies to report unrealized
gains and losses on available-for-sale securities as additions to or subtractions from net income
with the result being titled comprehensive income. Alternatively, the unrealized gains and losses
can be reported on a separate statement or as part of the statement of changes in stockholders’
equity.

Gain on Investment Securities. The statements of cash flows report purchases and sales of
trading securities as operating activities while purchases and sales of available-for-sale and held-
to-maturity securities are investing activities. If an investor owns 20 percent or more of an
investee’s equity securities, the investor is presumed able, unless there is evidence to the
contrary, to exercise significant influence over the investee company. Investors owning more
than 50 percent of the stock of an investee company are assumed to have control over the
investee. The previous discussion of accounting treatment for equity securities assumed the
investor did not significantly influence or control the investee. Alternative accounting rules apply
to securities owned by investors who exercise significant influence or control over an investee
company.
Accounting for equity investment securities differs depending on the level of the investor’s
ability to influence or control the operating, investing, and financing activities of the investee.
As previously demonstrated, investors who do not have significant influence (they own less than
20 percent of the stock of the investee) account for their investments in equity securities at fair
value. Investors exercising significant influence (they own 20 to 50 percent of the investee’s
stock) must account for their investments using the equity method. Be aware that investments
reported using the equity method represent a mea sure of the book value of the investee rather
than the cost or fair value of the equity securities owned.

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Investors who have a controlling interest (they own more than 50 percent of the investee’s stock)
in an investee company are required to issue consolidated financial statements. The company that
holds the controlling interest is referred to as the parent company, and the company that is
controlled is called the subsidiary company. Usually, the parent and subsidiary companies
maintain separate accounting records. However, a parent company is also required to report to
the public its accounting data along with that of its subsidiaries in a single set of combined
financial statements. These consolidated statements represent a separate accounting entity
composed of the parent and its subsidiaries. A parent company that owns one subsidiary will
produce three sets of financial statements: statements for the parent company, statements for the
subsidiary company, and statements for the consolidated entity.

EXERCISE- Effect of marketable investment securities transactions on financial statements

The following transactions pertain to KIBABII Imports for 2009:
1. Started business by acquiring Kshs.30, 000 cash from the issue of common stock.
2. Provided Kshs.90, 000 of services for cash.
3. Invested Kshs.35, 000 in marketable investment securities.
4. Paid Kshs.18, 000 of operating expense.
5. Received Kshs.500 of investment income from the securities.
6. Invested an additional Kshs.16, 000 in marketable investment securities.
7. Paid a Kshs.2, 000 cash dividend to the stockholders.
8. Sold investment securities that cost Kshs.8, 000 for Kshs.14, 000.
9. Received another Kshs.1, 000 in investment income.
10. Determined the market value of the investment securities at the end of the year was Kshs.42,
000.

Required
Use a vertical model to prepare a 2009 income statement, balance sheet, and statement of cash
flows, assuming that the marketable investment securities were classified as (a) held to maturity,
(b) Trading, and (c) available for sale. (Hint: Record the events in T-accounts prior to preparing
the financial statements.)