Question

Explain how to account for held-to-maturity debt securities at and after acquisition and how they are reported in the financial statements.

Answer 1

Held to maturity securities are securities that companies purchase and intend to hold until they mature. Unlike with trading securities or available for sale securities, companies don’t usually hold on to securities until they reach maturity to realize a large capital gain. Rather, companies mostly use the investments to protect themselves against interest rate fluctuations, diversify their investment portfolios, and realize a small, low-risk capital gain over a longer period of time. Held to maturity securities are usually debt instruments such as government or corporate bonds.

Accounting Treatment

The biggest difference between held to maturity securities and the other security types mentioned above is in their accounting treatment. As opposed to being recorded and updated on the company’s balance sheet according to the security’s fair market value, held to maturity securities are recorded at their original purchase cost. It means that from one accounting period to another, the value of the securities on the company’s balance sheet will remain constant.

Any gains or losses resulting from changes in interest rates (for bonds and other debt instruments) will be recorded when the securities reach maturity. Below is an example of how a 2-year bond will appear on a company’s balance sheet:

Upon purchase, the offsetting account will likely be cash, as the company likely bought the securities with cash. Here, we can see that no changes are recorded in the 2017 accounting period, despite any changes in the fair value of the security during that time period. For instance, if interest rates fell sharply in 2016, which would cause a rise in the market value of the bond, there would be no account of this in the company’s balance sheet.

In 2018, when the bond matured, we see that a capital gain of $500 million has occurred as a result of sliding interest rates. This is the only time that any changes in the price of the security will be recorded.

Interest payments made to the debt-holding company will appear in the company’s income statement on a periodic basis. Let’s assume that the bonds pay a 10% annual coupon rate, which equates to $50 million in additional income each year. Here’s how this would look on a company’s income statemepayments

Here, we can see how the 10% coupon is captured in the interest line item. For simplicity, it is assumed that the company does not have any other interest revenues or obligations to its financiers. Thus, the interest from coupon payments is recorded as a negative number since the “interest” account assumes that companies will usually have to make more interest payments than receive coupon payments