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?
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
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
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.