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Figure LI 2-1 in LI 2.2 is a flowchart to help determine whether an investment held by a for-profit reporting entity is within the scope of ASC 320 or is within the scope of other guidance.
Investments outside the scope of ASC 320 include investments that are derivative instruments, in their entirety, subject to the requirements of ASC 815. Similarly, derivative instruments that have been separated from a host contract are outside the scope of ASC 320. However, if an investment in the scope of ASC 320 contains an embedded derivative that is required to be separated, the host instrument remains within the scope of ASC 320.

3.2.1 Entities within the scope of ASC 320

ASC 320 is not applicable to entities that apply certain industry-specific guidance requiring substantially all debt securities to be measured at fair value with subsequent changes in fair value recognized in net income or in the change in net assets. Examples of these specialized industries include:
  • Brokers and dealers in securities
  • Defined benefit pension plans and other postretirement plans
  • Investment companies
  • Health and welfare plans accounted for under ASC 965
The following entities are not deemed to belong to specialized industries for the purposes of ASC 320 and so are included in the scope of ASC 320:
  • Cooperatives and mutual entities (such as credit unions and mutual insurance entities)
  • Trusts that do not report substantially all of their debt securities at fair value

3.2.2 Instruments within the scope of ASC 320

Entities within the scope of ASC 320 are required to apply its provisions to investments in all debt securities, including loans that meet the definition of a security.

Definition from ASC 320-10-20

Security: A share, participation, or other interest in property or in an entity of the issuer or an obligation of the issuer that has all of the following characteristics:
a.  It is either represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer.
b.  It is of a type commonly dealt in on securities exchanges or markets or, when represented by an instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for investment.
c.  It either is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations.

Trade receivables of commercial or industrial entities and loans receivable originated by banks or other financial institutions are common examples of instruments that may not meet the definition of a security in ASC 320-10-20. Therefore, these trade or loan receivable may not be within the scope of ASC 320.
The form of the instrument and the relevant jurisdiction should be considered when evaluating whether it meets the definition of a security under ASC 320. The definition in ASC 320 is based on the Uniform Commercial Code at the time the guidance was developed more than 20 years ago, but may not be consistent with the legal definition of a security today. As a result, the legal classification may not be conclusive for determining whether an instrument is in the scope of ASC 320.
Once a reporting entity determines that a debt instrument meets the definition of a security, it should then determine whether it is a debt or equity security.
ASC 320-10-20 defines a debt security.

Definition from ASC 320-10-20

Debt Security: Any security representing a creditor relationship with an entity. The term debt security also includes all of the following:
a.  Preferred stock that by its terms either must be redeemed by the issuing entity or is redeemable at the option of the investor
b.  A collateralized mortgage obligation (or other instrument) that is issued in equity form but is required to be accounted for as a nonequity instrument regardless of how that instrument is classified (that is, whether equity or debt) in the issuer’s statement of financial position
c.  U.S. Treasury securities
d.  U.S. government agency securities
e.  Municipal securities
f.  Corporate bonds
g.  Convertible debt
h.  Commercial paper
i.  All securitized debt instruments, such as collateralized mortgage obligations and real estate mortgage investment conduits
j.  Interest-only and principal-only strips.
The term debt security excludes all of the following:
a.  Option contracts
b.  Financial futures contracts
c.  Forward contracts
d.  Lease contracts
e.  Receivables that do not meet the definition of security and, so, are not debt securities (unless they have been securitized, in which case they would meet the definition of a security), for example:
1.  Trade accounts receivable arising from sales on credit by industrial or commercial entities
2.  Loans receivable arising from consumer, commercial, and real estate lending activities of financial institutions.

A reporting entity should determine whether an investment meets the definition of a debt security without regard to the determination made by the issuer. For example, a preferred security issued in the form of equity, that has no maturity date and is redeemable at the option of an investor should be accounted for as a debt security regardless of how that instrument is classified by the issuer (i.e., liability, mezzanine equity, or permanent equity).
Although the legal form of an instrument should be considered when determining whether an investment meets the definition of a debt security, form does not always determine whether a security should be accounted for as a debt or an equity security. Instruments that are legally equity may still meet the ASC 320 definition of a debt security. As noted above, preferred stock that must be redeemed by the issuer or is redeemable at the option of the holder through the unilateral right of the individual investor to demand repayment is a debt security under ASC 320.
Question LI 3-1 discusses whether an entity should account for its preferred share investment in another entity as an equity or debt security.
Question LI 3-1
Investor Corp owns 14% of the outstanding preferred shares of Issuer Corp. Issuer Corp has two classes of stock issued and outstanding: common and preferred. The preferred stock is not redeemable by Issuer Corp; however, after five years have passed, the preferred shareholders may, as a group, redeem the preferred stock for cash upon a two-thirds vote.

Should Investor Corp account for its preferred investment in Issuer Corp as an equity or debt security?
PwC response
Since Investor Corp only owns 14% of the preferred stock, it cannot trigger redemption of the preferred stock on its own (redemption requires a two-thirds vote by all holders). We believe the definition of a debt security includes instruments that the holder can choose to hold until maturity or demand repayment and ultimately receive payment from the issuer. Given that Investor Corp cannot unilaterally demand redemption of the preferred stock, it should account for its investment as an equity security. See LI 2 for additional information on accounting for equity securities.

Question LI 3-2 discusses whether bank certificates of deposit or guaranteed investment contracts are securities within the scope of ASC 320.
Question LI 3-2
Are bank certificates of deposit (CDs) or guaranteed investment contracts (GICs) securities within the scope of ASC 320?
PwC response
It depends. If a CD or GIC meets the definition of a debt security, it is within the scope of ASC 320. Depending on the type, form, and characteristics of the CD or GIC, it may meet the definition of a debt security. This is more likely to be the case with a negotiable jumbo CD. In addition, notes collateralized by insurance company-issued GICs or funding agreements are often issued from special purpose vehicles to investors. These notes frequently meet the definition of a debt security.

Question LI 3-3 discusses whether debt securities that are classified as cash equivalents are within the scope of ASC 320.
Question LI 3-3
Are debt securities that are classified as cash equivalents (e.g., US Treasury bills with an original maturity of less than three months) within the scope of ASC 320?
PwC response
Yes. Debt securities classified as cash equivalents are within the scope of ASC 320. Upon acquisition, they should be classified as trading, available-for-sale, or held-to-maturity securities and accounted for according to that designation (see LI 3.3 for information on the classification of debt securities). Since trading and available-for-sale securities are measured at fair value, they are subject to the relevant disclosure requirements for recurring fair value measurements in ASC 820. See FSP 6.5 for information on cash equivalents.

3.2.2.1 Beneficial interests and other instruments

Many securitization transactions involve the transfer of financial assets to a limited-purpose entity through one or multiple steps. Beneficial interests are formed when a special purpose entity issues various interests in security form (hence the term “securitization”) to third parties. The interests entitle the third parties to the cash flows generated by the securitization entity’s underlying financial assets. ASC 860 defines beneficial interests.

Definition from ASC 860-10-20

Beneficial Interests: Rights to receive all or portions of specified cash inflows received by a trust or other entity, including, but not limited to, all of the following:
a.  Senior and subordinated shares of interest, principal, or other cash inflows to be passed-through or paid-through
b.  Premiums due to guarantors
c.  Commercial paper obligations
d.  Residual interests, whether in the form of debt or equity

Beneficial interests can take many different forms, ranging from debt securities to equity interests issued by a limited partnership or LLC. Examples of beneficial interests in securitizations include mortgage-backed securities, asset-backed securities, credit-linked notes, collateralized debt obligations, and interest-only (IO) or principal-only (PO) strips. The primary investors in beneficial interests in securitizations are insurance companies, banks, broker-dealers, hedge funds, pension funds, and other individuals or companies that maintain a significant investment or trading portfolio. Corporate treasury groups may also invest in beneficial interests. For example, many corporations invest in mortgage-backed securities issued by government-sponsored enterprises such as Freddie Mac or Fannie Mae.
Beneficial interests should be evaluated to determine whether they meet the definition of a derivative in ASC 815. Beneficial interests that are not derivatives in their entirety should also be evaluated to determine whether they contain embedded derivatives that should be accounted for separately. See DH 4.4.6 for guidance on determining whether beneficial interests contain embedded derivatives that should be bifurcated from the host contract. ASC 815 provides an exception to derivative accounting for certain IO and PO strips, but the scope exception is limited to the most basic IO and PO instruments. See DH 3.2.12 for guidance on applying the scope exception for IO and PO instruments.
Certain beneficial interests in securitizations that are not derivatives within the scope of ASC 815 are accounted for like debt securities under ASC 320, as detailed in ASC 860-20-35-2.

ASC 860-20-35-2

Financial assets, except for instruments that are within the scope of Subtopic 815-10, that can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment shall be subsequently measured like investments in debt securities classified as available for sale or trading under Topic 320. Examples of such financial assets include, but are not limited to, interest-only strips, other beneficial interests, loans, or other receivables. Interest-only strips and similar interests that meet the definition of securities are included in the scope of that Topic. Therefore, all relevant provisions of that Topic (including the disclosure requirements) shall be applied. See related implementation guidance beginning in paragraph 860-20-55-33.

The term “substantially all” is not defined in ASC 860. However, based on other accounting literature, “substantially all” is generally interpreted in practice to mean 90% of the investment. Financial assets that can be contractually prepaid or otherwise settled in a way that would prevent the holder from recovering substantially all of its recorded investment often contain embedded derivatives that should be accounted for separately in accordance with the guidance in ASC 815. See DH 4 for additional information on embedded derivatives.
ASC 860-20-35-2 requires accounting consistent with ASC 320 even if the financial instrument is not within the scope of that Topic (e.g., non-certificated beneficial interests). Subsequent changes in the fair value of these financial assets should also be recognized in accordance with ASC 320 (through OCI for available-for-sale securities and through net income for trading securities). Because these securities can be contractually prepaid or settled in a manner in which the investor would not recover substantially all of its recorded investment, they may not be classified as held to maturity.

3.2.2.2 Structured notes

ASC 320-10-20 defines a structured note.

Definition from ASC 320-10-20

Structured Note: A debt instrument whose cash flows are linked to the movement in one or more indexes, interest rates, foreign exchange rates, commodities prices, prepayment rates, or other market variables. Structured notes are issued by U.S. government-sponsored enterprises, multilateral development banks, municipalities, and private entities. The notes typically contain embedded (but not separable or detachable) forward components or option components such as caps, calls, and floors. Contractual cash flows for principal, interest or both can vary in amount and timing throughout the life of the note based on nontraditional indexes or nontraditional uses of traditional interest rates or indexes.

Investments in structured notes are often required to be accounted for as debt securities. ASC 320-10-55-10 provides descriptions of various structured notes.
Some structured notes have contractual terms that cause them to be derivatives in their entirety. More commonly, structured notes contain embedded derivative features that require separate accounting. For example, a structured note that pays interest based on changes in the S&P 500 index contains an embedded derivative (the component of the contract that adjusts the interest payments based on changes in the S&P 500 index) that should be accounted for separately. The remaining host contract that pays principal and interest without such adjustment should be accounted for based on the guidance in ASC 320.

3.2.2.3 Purchased options and forward contracts

The guidance in ASC 320 applies to certain physically-settled purchased options or forward contracts to acquire or dispose of a debt security. Many physically-settled purchased option and forward contracts meet the definition of a derivative and should therefore be accounted for in accordance with ASC 815. However, contracts that do not meet the net settlement criterion, or do not otherwise meet the definition of a derivative in ASC 815, need to consider whether the guidance in ASC 320 applies.
ASC 815-10-15-141 describes the option and forward contracts subject to ASC 320. This guidance includes certain option and forward contracts to purchase debt securities. Therefore, these contracts are required to be designated at inception as either held to maturity, available for sale, or trading and measured in accordance with the guidance prescribed by ASC 320, as discussed further in LI 3.3.

ASC 815-10-15-141

The guidance in the Certain Contracts on Debt and Equity Securities Subsections applies only to those forward contracts and purchased options having all of the following characteristics:
a.  The contract is entered into to purchase securities that will be accounted for under either Topic 320 or Topic 321.
b.  The contract’s terms require physical settlement of the contract by delivery of the securities.
c.  The contract is not a derivative instrument otherwise subject to this Subtopic.
d.  The contract, if a purchased option, has no intrinsic value at acquisition.

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