Accounting for Debt Investments

Investments in debt securities are classified into held-to maturity, trading and available for sale categories depending on the management’s intention regarding holding period and holding motive.

Debt securities are financial assets which entitle the holding to a series of cash flows which must be paid in full before any amount can be distributed to the stock-holders. Typical examples of debt instruments include Treasury bonds, corporate bonds, money market instruments, certificate of deposits, etc. They have a range of features, i.e. fixed coupon payments in case of conventional bonds, inflation protection as in TIPs, call options as in callable bonds, no coupon payments as in zero-coupon bonds, etc.

Under the US GAAP, debt securities are classified into either held-to-maturity, trading or available for sale. Held-to-maturity debt investments are accounted for using the amortized cost; trading debt investments are carried at fair value and any changes in fair value are reported in income statement and the available for sale debt investments are carried at fair value and any changes in fair value are reported other comprehensive income.

Held-to-maturity debt investments

Held to maturity debt investments are those debt securities for which the management has both the intent and ability to hold them till maturity.

A typical debt instrument is issued against a sum of money called principal. The bond-holder gets periodic cash flows in return which are either interest-only or a combination of interest and principal. Where the periodic cash flows are interest only, the principal is returned typically at the expiration of the debt. Debt instruments may have a myriad of cash flow patterns, however, the basic accounting approach when the debt is held till maturity is the same: amortized cost.

Under the amortized cost method, the debt investment is initially recorded as an asset at its cost; any excess of the purchase price over par value is recorded as bond premium and any excess of par value over bond price is recorded as a bond discount. The bond premium and bond discount are amortized over the bond life using the effective interest rate method.

The interest income equals the carrying value of the bond multiplied by the prevailing interest rate and it is recognized income statement. Any changes in fair value are ignored. At the time of sale, any difference between carrying value of the debt and the sale proceeds is recognized as gain or loss.

Example: held-to-maturity debt investments

On 1 January 2015, you purchased 10,000 $1,000-par value bonds maturity in 3 years and paying 6% semi-annual coupons at $102. You first need to find the effective interest rate on your bond. The effective interest rate equals the yield to maturity on your bond at time 0.

The effective interest rate works out to 5.27%. You will recognize the debt investment as an asset as follows:

Account Dr Cr
Debt investments - held to maturity 10,200,000
Cash (10,000 × $1,000 × $102/$100 10,200,000

On 30 June 2015, you need to recognize the first interest income using the following journal entry:

Account Dr Cr
Interest receivable (10,000 × $1,000 × 6%/2) 300,000
Debt investments - held to maturity 31,204
Interest income ($10,200,000 × 5.27%/2) 268,796

When you receive the interest income, you will credit the accounts receivable account and debt cash. The carrying value of your debt investment right at the start of the second semi-annual period would be $10,168,796 (=$10,200,000 - $31,204). The bond price is $101 but you need to ignore it because no changes in fair value need to be recognized unless there is impairment.

For the semi-annual period ending 31 December 2015, you will recognize interest income as follows:

Account Dr Cr
Interest receivable (10,000 × $1,000 × 6%/2) 300,000
Debt investments - held to maturity 32,026
Interest income ($10,168,796 × 5.27%/2) 267,974

With each period, the carrying value of your investment will get closer and closer to its par value such. An amortization table helps us determine the periodic allocation of interest income, interest receivable and changes in carrying value of debt investment beforehand.

Let’s say you sold the bonds at $103 right after you received the interest income on 1 January 2016. You need to recognize any gain or loss on the sale in income statement:

Account Dr Cr
Cash (10,000 × $1,000 × $103/$100) 10,300,000
Debt investments - held to maturity 10,140,227
Gain on sale of investments 159,773

Trading debt investments

Debt investments which are solely bought for the purpose of earning short-term gain are called trading debt investments. Trading debt investments are recognized at their cost on the balance sheet and any fluctuation in their value is simultaneously recognized in income statement. Any interest earned is recognized as interest income when it is earned.

Example: trading debt investments

Let’s continue the example above. What if the management purchased to benefit from expected decrease in interest rates. In such a scenario, the investment must be accounted for using fair value through profit and loss method.

The journal entry at the time of purchase would be the same as in example above. The interest earned in first period and second period shall be recognized in income statement. No amortization schedule is needed. The increase in bond price at the end of first and second semi-annual periods must be recognized in income statement.

Date Account Dr Cr
01-Jan-15 Debt investments - held to maturity 10,200,000
Cash (10,000 × $1,000 × $102/$100) 10,200,000
30-Jun-15 Interest receivable (10,000 × $1,000 × 6%/2) 300,000
Interest income 300,000
30-Jun-15 Unrealized (gain) loss on debt investments 100,000
Debt investments - held to maturity 100,000
30-Dec-15 Interest receivable (10,000 × $1,000 × 6%/2) 300,000
Interest income 300,000
30-Dec-15 Debt investments - held to maturity 200,000
Unrealized (gain) loss on debt investments 200,000
01-Jan-16 Cash (10,000 × $1,000 × $103/$100) 10,300,000
Debt investments - held to maturity 10,300,000

Available-for-sales (AFS) debt investments

Debt investments which neither meet the requirements of held-to-maturity debt investment or trading debt investments must be classified as available for sale debt investments.

Debt investments classified as available for sale are recognized and carried at the fair value. Just like held-to-maturity securities and trading securities, interest income is recognized in income statement. However, unlike the trading securities, the unrealized changes in fair value are deposited in other comprehensive income which is part of equity and is not reported on income statement. When the investments are sold, the whole unrealized income or loss is transferred to income statement.

Example: available for sale debt instruments

If the investment discussed in the above two examples doesn’t meet the classification criteria of neither held-to-maturity investments nor trading investments, it must be recognized as available for sale investments. You need to pass the following journal entries:

Date Account FS Dr Cr
01-Jan-15 Debt investments - available for sale Balance Sheet 10,200,000
Cash (10,000 × $1,000 × $102/$100) Balance Sheet 10,200,000
30-Jun-15 Interest receivable (10,000 × $1,000 × 6%/2) Balance Sheet 300,000
Interest income Income Statement 300,000
30-Jun-15 Unrealized (gain) loss on debt investments Balance Sheet 100,000
Debt investments - available for sale Balance Sheet 100,000
30-Dec-15 Interest receivable (10,000 × $1,000 × 6%/2) Balance Sheet 300,000
Interest income Income Statement 300,000
30-Dec-15 Debt investments - held to maturity Balance Sheet 200,000
Unrealized (gain) loss on debt investments Balance Sheet 200,000
01-Jan-16 Cash (10,000 × $1,000 × $103/$100) Balance Sheet 10,300,000
Unrealized (gain) loss on debt investments Balance Sheet 100,000
Realized gain on debt investments Income Statement 100,000
Debt investments - held to maturity Income Statement 10,300,000

At the time of sale, the unrealized gains or losses accumulated in other comprehensive income are transferred to income statement.

Debt investments under IFRS

Under IFRS, classification of debt securities depends on two tests: the business model test and the cash flow test. If the security with the intent to collect the future cash flows and the cash flow characteristics of the bond represents only principal and interest, the debt instrument must be accounted for under the amortized costs method. If the security is held for collection of cash flows and for capital appreciation and the cash flow of the security include only principal and interest, such debt securities must be accounted under the fair value through other comprehensive income (FVOCI). All other debt securities must be accounted for using fair value through profit and loss.

Written by Obaidullah Jan, ACA, CFA and last modified on