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3.3 Classification of debt securities
Publication date: 31 May 2022
us Loans & investments guide
The accounting and reporting requirements for debt securities are discussed in ASC 320. Debt securities should be classified into one of three categories at acquisition:
- Held to maturity
- Available for sale
- Trading
The classification of a debt security is important to the application of ASC 320 because the accounting treatment and related disclosures are different for each of the three categories. A reporting entity should document its classification of a debt security at acquisition. Classification as a held-to-maturity security should be reassessed each reporting period.
3.3.1 Classification: held-to-maturity debt securities
ASC 320-10-25-1(c) describes held-to-maturity securities.
Excerpt from ASC 320-10-25-1(c)
Held-to-maturity securities. Investments in debt securities shall be classified as held-to-maturity only if the reporting entity has the positive intent and ability to hold those securities to maturity.
The positive intent and ability to hold debt securities to maturity is different from not having an intent to sell. If a reporting entity’s intention is uncertain, the security should not be classified as held to maturity. A reporting entity’s intent and ability to hold a debt security to maturity is typically evidenced through written representation, as well as other evidence, such as historical experience, board and investment committee minutes, documented investment strategies, instructions to portfolio managers, future business plans, and projections of liquidity and capital adequacy. The intent and ability to hold a debt security to maturity should be reassessed at each reporting period.
The held-to-maturity classification is restrictive. ASC 320-10-25-4 and ASC 320-10-25-5 include specific circumstances and scenarios that preclude a reporting entity from classifying securities as held to maturity. For example, a security may not be classified as held to maturity if it can be contractually prepaid or otherwise settled in such a way that the holder will not recover substantially all of its recorded investment. Securities that a reporting entity may sell based on changes in interest rates, prepayment risk, foreign exchange rates, the entity’s liquidity or funding sources/terms, or the availability of yield on other investments should also not be classified as held to maturity.
An entity shall not classify a debt security as held-to-maturity if the entity has the intent to hold the security for only an indefinite period. Consequently, a debt security shall not, for example, be classified as held-to-maturity if the entity anticipates that the security would be available to be sold in response to any of the following circumstances:
a. Changes in market interest rates and related changes in the security's prepayment risk
b. Needs for liquidity (for example, due to the withdrawal of deposits, increased demand for loans, surrender of insurance policies, or payment of insurance claims)
c. Changes in the availability of and the yield on alternative investments
d. Changes in funding sources and terms
e. Changes in foreign currency risk.
Specific scenarios in which a debt security shall not be classified as held-to-maturity (or where sale or transfer of a held-to-maturity security will call into question an investor's stated intent to hold other debt securities to maturity in the future) are as follows:
a. A security shall not be classified as held-to-maturity if that security can contractually be prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment. The justification for using historical-cost-based measurement for debt securities classified as held-to-maturity is that no matter how market interest rates fluctuate, the holder will recover its recorded investment and thus realize no gains or losses when the issuer pays the amount promised at maturity. However, that justification does not extend to receivables purchased at a substantial premium over the amount at which they can be prepaid, and it does not apply to instruments whose payments derive from prepayable receivables but have no principal balance. Therefore, a callable debt security purchased at a significant premium might be precluded from held-to-maturity classification under paragraph 860-20-35-2 if it can be prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment. In addition, a mortgage-backed interest-only certificate shall not be classified as held-to-maturity. Paragraphs 860-20-35-3 through 35-6 provide further guidance on application of this paragraph. Note that a debt security that is purchased late enough in its life such that, even if it was prepaid, the holder would recover substantially all of its recorded investment, could be initially classified as held-to-maturity if the conditions of this paragraph and paragraph 320-10-25-1 are met. (A debt security that can contractually be prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment may contain an embedded derivative. Therefore, such a security should be evaluated in accordance with Subtopic 815-15 to determine whether it contains an embedded derivative that needs to be accounted for separately.)
b. A debt security that is available to be sold in response to changes in market interest rates, changes in the security's prepayment risk, the entity's need for liquidity, changes in foreign exchange risk, or other similar factors shall not be included in the held-to-maturity category because the possibility of a sale is indicative that the entity does not have a positive intent and ability to hold the security to maturity. A debt security that is considered available to be sold as part of an entity's asset-liability management activities shall not be classified as held-to-maturity. Similarly, an entity that maintains a dynamic hedging program in which changes in external factors require that certain securities be sold to maintain an effective hedge would not have the intent and ability to hold those securities to maturity.
c. Securities that may need to be sold to implement tax-planning strategies (for example, to generate taxable gains to offset existing taxable losses—or vice versa—or in response to changes in the entity's anticipated future profitability—for example, if taxable losses were expected for the next several years) should be classified as available-for-sale, not held-to-maturity.
d. The sale of a held-to-maturity security in advance of any deterioration in the creditworthiness of the issuer, perhaps based solely on industry statistics, will call into question an investor's stated intent to hold other debt securities to maturity in the future. The sale of a held-to-maturity security must be in response to an actual deterioration, not mere speculation. That deterioration shall be supported by evidence about the issuer's creditworthiness; however, the entity need not await an actual downgrading in the issuer's published credit rating or inclusion on a credit watch list.
e. The sale of held-to-maturity securities to meet regulatory capital requirements will call into question an investor's stated intent to hold other debt securities to maturity in the future. An entity's ability and intent to hold securities to maturity would be called into question by the sale of held-to-maturity securities to realize gains to replenish regulatory capital that had been reduced by a provision for loan losses. Gains trading with held-to-maturity securities to meet an entity's capital requirements is inconsistent with the held-to-maturity notion.
f. The exercise of a put option on a security classified as held-to-maturity will call into question an investor's stated intent to hold other debt securities to maturity in the future. Furthermore, a puttable debt security might be precluded from held-to-maturity classification pursuant to paragraph 860-20-35-2.
g. Convertible debt securities shall not be classified as held-to-maturity. Classifying a security as held-to-maturity means that the entity is indifferent to future opportunities to profit from changes in the security's fair value and intends to accept the debt security's stipulated contractual cash flows, including the repayment of principal at maturity. Convertible debt securities generally bear a lower interest rate because the investor hopes to benefit from appreciation in value of the option embedded in the debt security. Given the unique opportunities for profit embedded in a convertible security, it generally would be contradictory to assert the positive intent and ability to hold a convertible debt security to maturity and forego the opportunity to exercise the conversion feature. The exercise of a conversion feature on a security classified as held-to-maturity will call into question an investor's stated intent to hold other debt securities to maturity in the future. (See Section 815-15-25 for additional guidance. If convertible debt is bifurcated into an equity option and a host debt instrument under the requirements of Subtopic 815-15, it generally still would be contradictory to assert the positive intent and ability to hold the debt host contract to maturity and forego the opportunity to exercise the conversion feature.)
h. A documented policy to initially classify all debt securities as held-to-maturity but then automatically transfer every security to available-for-sale when it reaches a predetermined point before maturity (for example, every held-to-maturity security will be transferred to available-for-sale 24 months prior to its stated maturity) so that an entity has the flexibility to sell securities is not consistent with the held-to-maturity classification. Under the policy described, the entity does not intend to hold any security to maturity.
i. An insurance entity or other regulated entity shall not classify securities as held-to-maturity and also indicate to regulators that those securities could be sold to meet liquidity needs in a defined interest rate scenario whose likelihood of occurrence is reasonably possible but not probable.
3.3.1.1 Tainting of held-to-maturity debt securities
Other than the specific circumstances described in ASC 320-10-25-6, ASC 320-10-25-14, and ASC 320-10-25-18, a reporting entity cannot periodically sell or transfer investments from the held-to-maturity category without calling into question:
- A reporting entity’s previous assertions regarding the classification of those securities
- A reporting entity’s assertions regarding the classification of other held-to-maturity securities
- A reporting entity’s future assertions regarding the classification of securities until the reporting entity has reestablished the credibility of its classification policy
However, as a result of reference rate reform, ASC 848 provides an additional circumstance that allows for certain securities to be sold and or transferred without calling into question the reporting entity’s previous assertions that it had the intent and ability to hold the securities to maturity. Pursuant to ASC 848-10-35-1, a reporting entity may make a one-time election to sell and/or transfer certain securities from the held-to-maturity portfolio that reference LIBOR, or another reference rate expected to be discontinued. Refer to REF 2 for further details.
Because a reporting entity’s assertions relate to each investment in the held-to-maturity category, the sale of individual held-to-maturity securities will call into question a reporting entity’s intent to hold all securities in the held-to-maturity category. The held-to-maturity category is purposely restrictive such that the use of amortized cost must be justified for each investment.
Securities should not be “compartmentalized” for the purpose of analyzing the impact of sales or transfers of held-to-maturity securities. That is, all types of securities classified as held to maturity should be considered. For example, a reporting entity should not separate treasury securities from corporate bonds in its held-to-maturity portfolio when evaluating the impact of a sale of a held-to-maturity treasury security on its intent to hold the remaining securities to maturity.
If a sale or transfer of a debt security results in a tainting event, all remaining held-to-maturity securities should be reclassified to available for sale. Securities should not be classified as held to maturity for some period of time following the tainting of the portfolio. This tainting period is intended as time for the reporting entity to reestablish its policies and procedures to ensure that it has both the intent and ability to hold securities to maturity. It also allows the reporting entity to demonstrate its reestablished intent and ability to hold securities to maturity. Practice has generally considered the taint period for sales or transfers of held-to-maturity securities that do not meet the limited exceptions in ASC 320 to be approximately two years.
Once the tainting period has passed, securities that the reporting entity (1) has the positive intent and ability to hold to maturity, and (2) that were acquired and classified as available for sale during the tainting period or were acquired prior to the tainting period and transferred to available for sale, can be transferred to the held-to-maturity category. For purposes of assessing a security’s eligibility for the held-to-maturity category, there is no reason to differentiate between the securities originally classified as held to maturity before the tainting period, held-to-maturity securities purchased during the tainting period, or held-to-maturity securities purchased after the tainting period. Classification of these three types of securities as held to maturity is acceptable if they meet the criteria of held-to-maturity securities under ASC 320 and the reporting entity’s intent is no longer in question. Securities designated as trading before, during, or after the tainting period cannot be reclassified as held to maturity unless the presumption in ASC 320 that such transfers out of the trading category should be rare can be overcome.
Question LI 3-4
Can a reporting entity classify a debt security as held to maturity if it may sell the security in the event that actual or expected interest rates or prepayments change?
Can a reporting entity classify a debt security as held to maturity if it may sell the security in the event that actual or expected interest rates or prepayments change?
PwC response
No. It is inconsistent to assert the intent to hold securities to maturity if those securities may be sold in response to actual or expected changes in market factors, such as interest rates or prepayment rates. Generally, sales under these conditions will call into question the reporting entity’s intentions with respect to its remaining held-to-maturity portfolio.
Question LI 3-5
Certain states require life insurers to perform annual asset adequacy testing based on predefined interest rate scenarios including adverse interest rate shock changes. If an insurance company projects that a debt security will be liquidated prior to maturity under any one of the required asset adequacy scenarios, can that security be classified as held to maturity?
Certain states require life insurers to perform annual asset adequacy testing based on predefined interest rate scenarios including adverse interest rate shock changes. If an insurance company projects that a debt security will be liquidated prior to maturity under any one of the required asset adequacy scenarios, can that security be classified as held to maturity?
PwC response
No. Classification as held to maturity would be precluded based on the guidance in ASC 320-10-25-4 that states that sales made in response to changes in market interest rates are not consistent with the held-to-maturity classification.
3.3.1.2 Sale or reclassification of held-to-maturity securities
The intent to hold a security to maturity may change over time. ASC 320-10-25-6 identifies various circumstances that may justify the sale or transfer of a security classified as held to maturity without calling into question a reporting entity’s intent to hold other debt securities to maturity in the future. Generally, these instances occur due to a change in circumstances that cause a reporting entity to change its intent.
The following changes in circumstances may cause the entity to change its intent to hold a certain security to maturity without calling into question its intent to hold other debt securities to maturity in the future. The sale or transfer of a held-to-maturity security due to one of the following changes in circumstances shall not be considered inconsistent with its original classification:
a. Evidence of a significant deterioration in the issuer’s creditworthiness (for example, a downgrading of an issuer’s published credit rating)
b. A change in tax law that eliminates or reduces the tax-exempt status of interest on the debt security (but not a change in tax law that revises the marginal tax rates applicable to interest income)
c. A major business combination or major disposition (such as sale of a component of an entity) that necessitates the sale or transfer of held-to-maturity securities to maintain the entity’s existing interest rate risk position or credit risk policy
d. A change in statutory or regulatory requirements significantly modifying either what constitutes a permissible investment or the maximum level of investments in certain kinds of securities, thereby causing an entity to dispose of a held-to-maturity security
e. A significant increase by the regulator in the industry’s capital requirements that causes the entity to downsize by selling held-to-maturity securities
f. A significant increase in the risk weights of debt securities used for regulatory risk-based capital purposes.
Additionally, ASC 848-10-35-1 permits a reporting entity to make a one-time election to sell and/or transfer certain debt securities classified as held-to-maturity that reference LIBOR, or another reference rate expected to be discontinued. Refer to REF 2 for further details.
A sale in response to a significant deterioration in the creditworthiness of the issuer must be in response to an actual credit deterioration that can be evidenced (e.g., by a rating agency downgrade or other observable event), rather than speculation, for it to be consistent with the original held-to-maturity classification. ASC 320 does not define what constitutes significant credit deterioration. However, in its deliberations, the FASB indicated that in evaluating credit deterioration, significance should be measured in relation to the individual security rather than in relation to the entire investment portfolio or the investor’s financial position.
Question LI 3-6
A reporting entity has determined that its intent to hold a security to maturity has changed based on a tax law change that eliminates the exemption on the security’s earned income. In response, the reporting entity sells a portion of its holdings in such security. How does this decision to sell a portion of its holdings impact its intent to hold the remaining portfolio of securities, which were impacted by the tax law change but not sold, to maturity?
A reporting entity has determined that its intent to hold a security to maturity has changed based on a tax law change that eliminates the exemption on the security’s earned income. In response, the reporting entity sells a portion of its holdings in such security. How does this decision to sell a portion of its holdings impact its intent to hold the remaining portfolio of securities, which were impacted by the tax law change but not sold, to maturity?
PwC response
The sale of the securities would not be considered inconsistent with the original classification of held to maturity because the sale is permitted under the guidance in ASC 320-10-25-6(b). However, the sale of a portion, but not all, of its holdings in the security would call into question the reporting entity’s intent to hold the remaining portfolio of securities impacted by the tax law to maturity. The reporting entity should consider whether the remaining securities should be classified as available for sale. Any decision to transfer such securities to available for sale must be made in the period of the tax law change to qualify as a change permitted under ASC 320-10-25-6.
The sale triggered by the tax law change is not likely to, by itself, taint the remaining portfolio of held-to-maturity securities (those not impacted by the tax law change) provided the reporting entity concludes that its intent to hold the portfolio to maturity has not changed.
Question LI 3-7
What constitutes a major business combination or major disposition that allows a reporting entity to sell or transfer held-to-maturity securities to maintain an interest rate risk position or credit risk policy that existed prior to the business combination?
What constitutes a major business combination or major disposition that allows a reporting entity to sell or transfer held-to-maturity securities to maintain an interest rate risk position or credit risk policy that existed prior to the business combination?
PwC response
Because ASC 320 does not specify a quantitative threshold for a major business combination or disposition, the significance of such is judgmental and requires analysis. The sale of a segment may be an example of a major disposition. Sales or purchases of financial instrument portfolios, such as loans or deposits, would generally not be considered a business combination or disposal of a business, even if the reporting entity is initiating or getting out of a line of business.
If held-to-maturity securities are sold or transferred in connection with a major business combination or major disposition to maintain the reporting entity’s existing interest rate position or credit risk policy, the sale or transfer should occur concurrent with or shortly after the business combination. It should not be made in anticipation of or otherwise prior to the business combination.
Question LI 3-8
If a reporting entity sells held-to-maturity securities to fund an acquisition would it call into question its intent with respect to its remaining held-to-maturity portfolio?
If a reporting entity sells held-to-maturity securities to fund an acquisition would it call into question its intent with respect to its remaining held-to-maturity portfolio?
PwC response
Yes. Sales of held-to-maturity securities to fund an acquisition is not one of the exceptions permitted in ASC 320-10-25-6 and would call into question a reporting entity’s intent relative to its remaining portfolio.
Question LI 3-9
If a reporting entity is directed to sell certain investments by a regulatory agency, does the resultant sale of affected securities classified as held to maturity impact the classification of other held-to-maturity securities?
If a reporting entity is directed to sell certain investments by a regulatory agency, does the resultant sale of affected securities classified as held to maturity impact the classification of other held-to-maturity securities?
PwC response
Yes. The sale of held-to-maturity securities in this circumstance would not qualify for the exception related to changes in regulatory requirements, and therefore it may taint the remainder of the held-to-maturity portfolio. The exception related to changes in regulatory requirements pertains to a specific change in regulatory rules. A directive by a regulator in and of itself would not be considered a “change in statutory or regulatory requirements.”
ASC 320 requires entities to reassess the appropriateness of the classification of its debt investments. If an entity no longer has the intent or ability to hold securities to maturity, continued classification as held to maturity is inappropriate. ASC 320-10-25-9 details the characteristics of events (in addition to those listed in ASC 320-10-25-6) that can cause a reporting entity to sell (or transfer) a held-to-maturity security without necessarily calling into question its intent to hold other debt securities to maturity.
Very few events are expected to meet these conditions.
In addition to the changes in circumstances listed in paragraph 320-10-25-6(a) through (f), certain other events may cause the entity to sell or transfer a held-to-maturity security without necessarily calling into question (tainting) its intent to hold other debt securities to maturity. Such events must meet all of the following four conditions to avoid tainting its intent to hold other debt securities to maturity in the future:
a. The event is isolated.
b. The event is nonrecurring.
c. The event is unusual for the reporting entity.
d. The event could not have been reasonably anticipated.
In addition, under ASC 320-10-25-14, a sale of a held-to-maturity security would not taint the remaining portfolio if the security is sold close to its maturity date (e.g., three months or less). This is permitted because changes in market interest rates would not significantly impact the security’s fair value. ASC 320-10-25-14 also allows a held-to-maturity security to be sold without tainting the remaining portfolio when a reporting entity has collected a substantial portion of the principal outstanding at acquisition (at least 85%). This can be due to prepayments or scheduled payments, comprising both principal and interest, that are payable in equal installments over the debt security’s term.
Sales of debt securities that meet either of the following conditions may be considered as maturities for purposes of the classification of securities and the disclosure requirements under this Subtopic:
a. The sale of a security occurs near enough to its maturity date (or call date if exercise of the call is probable) that interest rate risk is substantially eliminated as a pricing factor. That is, the date of sale is so near the maturity or call date (for example, within three months) that changes in market interest rates would not have a significant effect on the security's fair value.
b. The sale of a security occurs after the entity has already collected a substantial portion (at least 85 percent) of the principal outstanding at acquisition due either to prepayments on the debt security or to scheduled payments on a debt security payable in equal installments (both principal and interest) over its term. For variable-rate securities, the scheduled payments need not be equal.
3.3.1.3 Classification: other scenarios relevant to HTM debt securities
ASC 320-10-25-18 includes specific scenarios when a debt security may be classified as held to maturity (or when sale or transfer of a held-to-maturity security will not call into question an investor’s stated intent to hold other debt securities to maturity in the future).
Specific scenarios in which a debt security may be classified as held to maturity (or where sale or transfer of a held-to-maturity security will not call into question an investor’s stated intent to hold other debt securities to maturity in the future) are as follows:
a. Although its asset-liability management may encompass consideration of the maturity and repricing characteristics of all investments in debt securities, an entity may decide that it can accomplish the necessary adjustments under its asset-liability management without having all of its debt securities available for disposition. In that case, the entity may choose to designate certain debt securities as unavailable to be sold to accomplish those ongoing adjustments deemed necessary under its asset-liability management, thereby enabling those debt securities to be accounted for at amortized cost on the basis of a positive intent and ability to hold them to maturity.
b. The sale of one or more held-to-maturity securities if an entity chooses to downsize to comply with a significant increase in the industry’s capital requirements would not call into question the classification of other held-to-maturity securities.
c. In some circumstances it may not be possible to hold a security to its original stated maturity, such as when the security is called by the issuer before maturity. The issuer’s exercise of the call option effectively accelerates the security’s maturity and shall not be viewed as inconsistent with classification in the held-to-maturity category.
d. A puttable debt security shall be classified as held-to-maturity only if the entity has the positive intent and ability to hold it to maturity.
e. If a transfer of a held-to-maturity debt security is accounted for as a sale under Subtopic 860-20 and it is transferred for a reason other than those specified in paragraphs 320-10-25-6, 320-10-25-9, and 320-10-25-14, then the transfer would taint the held-to-maturity portfolio. However, if the transfer is accounted for as a secured borrowing, then the transfer would not taint the held-to-maturity portfolio. Transactions involving held-to-maturity securities that are not accounted for as sales under Subtopic 860-20 would not contradict an entity’s stated intent to hold a security to maturity and, therefore, do not call into question the entity’s intent to hold other debt securities to maturity. Examples of such transactions are as follows:
1. Held-to-maturity securities pledged as collateral, provided that the transaction is not accounted for as a sale under Subtopic 860-20 and the entity intends and expects to be able to satisfy the obligation and recover access to its collateral
2. Held-to-maturity securities subject to a repurchase agreement or a securities lending agreement, provided that the transaction is accounted for as a secured borrowing under Subtopic 860-20 and the entity intends and expects to be able to repay the borrowing
3. Beneficial interests classified as held-to-maturity that are desecuritized in a transaction that is not accounted for as a sale if the financial assets received in or that continue to be held after the desecuritization are held to maturity. Unless the debt instrument received or retained as a result of the transaction is held to maturity, the transaction would call into question the entity’s intent to hold other debt securities to maturity. Desecuritizations are not specifically included within the scope of this paragraph. Nevertheless, that guidance is also appropriate for desecuritizations that are not accounted for as sales.
Question LI 3-10
Can a puttable debt security be classified as held to maturity?
Can a puttable debt security be classified as held to maturity?
PwC response
If the terms of a puttable debt security require an investor to surrender the security in exchange for cash upon exercise of its put option (as is typically the case), the puttable security may be classified as held to maturity only if the investor has the positive intent and ability to hold it to maturity (i.e., does not expect to exercise the put option prior to maturity). If a put option can be net cash-settled (i.e., the issuer simply pays the investor the difference between the face amount of the debt and the put price), exercise of the put option would not represent a contradiction to the investor’s stated intent, as long as it continues to hold the debt instrument after the option is exercised. The cash-settled put option in this example is a freestanding financial instrument because the debt instrument continues to exist after the put option is exercised. Consideration should be given to whether the put option is required to be accounted for under the derivatives guidance in ASC 815.
Question LI 3-11
Can a callable debt security be classified as held to maturity?
Can a callable debt security be classified as held to maturity?
PwC response
Yes. A callable debt security can be classified as held to maturity. The issuer’s exercise of the call option is considered an effective acceleration of the security’s maturity. Provided a reporting entity has the positive intent and ability to hold a callable debt security to maturity or until the issuer exercises its call option, it may classify the security as held to maturity. However, if a reporting entity intends to sell a callable debt security if the issuer does not exercise its call option, classification as held to maturity would be precluded.
Question LI 3-12
Does a reporting entity’s acceptance of a tender offer for a held-to-maturity security call into question its intent and ability to hold securities to maturity?
Does a reporting entity’s acceptance of a tender offer for a held-to-maturity security call into question its intent and ability to hold securities to maturity?
PwC response
Yes. A tender offer is an offer by an issuer or another bidder to purchase its securities directly from investors. It is usually at a premium and for cash. The investor may choose whether to accept the offer. A tender offer is not the same as a callable debt security in which the investor is obligated to sell the security. An investor’s acceptance of the tender offer is equivalent to a sale of the security, which will call into question the reporting entity’s classification of the investment.
However, if the investor is required to sell the security due to a “squeeze out merger” (i.e., the investor is forced to tender the security), that disposition would not taint the reporting entity’s held-to-maturity assertion.
Question LI 3-13
Can transferred debt securities subject to a repurchase agreement be accounted for as held-to-maturity securities if the reporting entity (transferor) concludes that the transfer and repurchase agreement should be accounted for as a secured financing based on the guidance in ASC 860?
Can transferred debt securities subject to a repurchase agreement be accounted for as held-to-maturity securities if the reporting entity (transferor) concludes that the transfer and repurchase agreement should be accounted for as a secured financing based on the guidance in ASC 860?
PwC response
Yes. Debt securities subject to a repurchase agreement that are not accounted for as a sale of assets may be accounted for as held-to-maturity securities provided the reporting entity has the positive intent and ability to hold those securities to maturity. The ability to hold the securities to maturity is predicated upon the reporting entity’s expectation that it can repay the borrowing, as discussed in ASC 320-10-25-18(e).
For accounting purposes, debt securities subject to repurchase agreements that are not accounted for as sales are considered to be collateral that is pledged to secure a loan (i.e., the proceeds received from the transfer of the securities). Refer to PwC’s Transfers and servicing of financial assets guide for further information.
Question LI 3-14
Does an intercompany sale of held-to-maturity securities between subsidiaries call into question the held-to-maturity classification in the consolidated financial statements?
Does an intercompany sale of held-to-maturity securities between subsidiaries call into question the held-to-maturity classification in the consolidated financial statements?
PwC response
No, an intercompany sale of a held-to-maturity security between subsidiaries does not call into question the held-to-maturity classification in the consolidated financial statements. However, if a subsidiary that has an intercompany sale of a held-to-maturity security (that qualifies as a sale under ASC 860) prepares stand-alone financial statements, the intercompany sale would call into question that subsidiary’s intent or ability to hold other debt securities to maturity.
Convertible debt securities
Convertible debt securities are debt instruments that either require or permit the investor to convert the instrument into equity shares of the issuer. Investors typically accept a lower stated interest rate on convertible debt securities in exchange for the right to participate in the potential appreciation of the underlying equity shares. For purposes of ASC 320, a convertible debt security is a debt security. The conversion option should be evaluated under ASC 815 to determine if it is an embedded derivative that should be accounted for separate from the host debt instrument. See DH 4.2.1 for guidance on identifying embedded derivatives.
If a convertible debt security is separated into a conversion option and a host debt instrument by the investor based on the guidance in ASC 815, the host debt instrument should be accounted for under ASC 320. When the debt security is converted into equity shares, the shares must be measured in accordance with ASC 321 subsequent to the conversion. Refer to LI 2 for additional information.
Because a convertible debt security is often purchased with the intent to convert the security into equity shares, it should be carried on the balance sheet at fair value and not at amortized cost. Given the unique opportunities for profit embedded in a convertible security in exchange for a lower interest rate, it is generally contradictory to assert the positive intent and ability to hold a convertible debt security to maturity and forego the opportunity to exercise the conversion feature. Therefore, a convertible debt security cannot be classified as held to maturity.
Question LI 3-15
If a reporting entity holds a convertible debt security in which it is required to separate the embedded conversion option from the debt host under ASC 815, can it elect to classify the host debt instrument as a held-to-maturity security?
If a reporting entity holds a convertible debt security in which it is required to separate the embedded conversion option from the debt host under ASC 815, can it elect to classify the host debt instrument as a held-to-maturity security?
PwC response
No. The exercise of the option by the reporting entity would require it to tender the host debt instrument upon exercise of the option. This would be inconsistent with the entity’s assertion that it has the intent and ability to hold the convertible debt security to maturity.
3.3.2 Classification: trading debt securities
ASC 320-10-20 provides a definition of trading securities.
Definition from ASC 320-10-20
Trading Securities: Securities that are bought and held principally for the purpose of selling them in the near term and therefore held for only a short period of time. Trading generally reflects active and frequent buying and selling, and trading securities are generally used with the objective of generating profits on short-term differences in price.
ASC 320-10-25-1(a) provides that securities acquired with an intent to sell within hours or days must be classified as trading. However, the guidance does not preclude a security from being classified as trading if acquired with an intent to hold for a longer period. An entity that classifies debt securities as trading with the intent to hold the securities for a longer period would need to measure the securities at fair value, similar to the measurement it would use if it elected the fair value option under ASC 825. However, for securities measured at fair value under the fair value option, the additional disclosure requirements in ASC 825-10-50-28, 30 and 31 would need to be considered. Additionally, if an entity elects the fair value option for one or more investments, it may use terminology such as “securities carried at fair value” to describe these securities instead of the “trading” terminology in ASC 320.
Excerpt from ASC 320-10-25-1(a)
Trading securities. If a security is acquired with the intent of selling it within hours or days, the security shall be classified as trading. However, at acquisition an entity is not precluded from classifying as trading a security it plans to hold for a longer period. Classification of a security as trading shall not be precluded simply because the entity does not intend to sell it in the near term.
The following factors should be considered when determining whether debt securities should be classified in the trading category:
- The business purpose of the transaction
- The reporting entity’s trading strategy
- Management’s intended exit strategy for the investment
- The reporting entity’s historical trading activity
A reporting entity may use the trading category for securities that are expected to be held for longer periods. However, ASC 320 requires classification as a trading security to occur only at the acquisition date. Transfers to or from the trading category are expected to be rare. For example, we do not believe transfers to or from the trading category due to changes in investment strategies, achieving accounting results more closely matching economic hedging activities, or repositioning the portfolio due to anticipated changes in the economic outlook are permitted because these events are not considered rare.
3.3.3 Classification: available-for-sale debt securities
ASC 320-10-25-1(b) provides that investments that are not classified as held to maturity or trading securities are classified as available-for-sale securities.
Excerpt from ASC 320-10-25-1(b)
Available-for-sale securities. Investments in debt securities not classified as trading securities or as held-to-maturity securities shall be classified as available-for-sale securities.
A debt security cannot be classified as held to maturity if the reporting entity has the intent to hold the security for an indefinite period or may sell the security in response to the changes in economic conditions, as discussed in ASC 320-10-25-4. See LI 3.3.1 for information on held-to-maturity classification. A reporting entity should not transfer an available-for-sale security to the trading category simply because it intends to sell the security and/or because the passage of time has caused the maturity date to be within one year.
3.3.4 Classification of securitized mortgage loans
ASC 948-310-40-1 requires a reporting entity engaged in mortgage banking activities to classify beneficial interests in mortgage-backed securities (or other beneficial interests retained) resulting from a mortgage loan securitization using the guidance in ASC 320. The securitized debt instrument is a debt security under ASC 320 (and is no longer a mortgage loan).
Excerpt from ASC 948-310-40-1
After the securitization of a mortgage loan held for sale that meets paragraph 860-10-40-5’s conditions for a sale, any mortgage-backed securities received by the transferor as proceeds shall be classified in accordance with the provisions of Topic 320.
A mortgage banking enterprise should classify any mortgage-backed securities received as proceeds that it commits to sell before or during the securitization process as trading, as discussed in ASC 948-310-35-3A.
Paragraph 948-310-40-1 states that, after the securitization of a mortgage loan held for sale that meets paragraph 860-10-40-5’s conditions for a sale, any mortgage-backed securities received by the transferor as proceeds shall be classified in accordance with the provisions of Topic 320. However, a mortgage banking entity shall classify as trading any retained mortgage-backed securities that it commits to sell before or during the securitization process. Paragraph 948-310-40-1 states that an entity is prohibited from reclassifying loans as investment securities unless the transfer of those loans meets paragraph 860-10-40-5’s conditions for sale accounting.
Although the guidance requires that a transferor’s beneficial interests be classified in accordance with ASC 320, certain beneficial interests cannot be classified as held to maturity as they can be contractually prepaid or otherwise settled in such a way that a holder would not recover substantially all of its recorded investment based on the guidance in ASC 320-10-25-5(a). Many reporting entities elect to classify beneficial interests as trading securities to avoid the complexity associated with evaluating them for potential embedded derivatives requiring bifurcation.
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