Available-for-sale securities are investments companies hold for an indefinite period. They're reported at fair value on the balance sheet, with unrealized gains and losses recorded in other comprehensive income. This classification offers flexibility in managing investments.

AFS securities are initially recorded at cost and adjusted to fair value each reporting period. Unrealized gains and losses are kept separate from net income to avoid volatility. When sold or impaired, these gains or losses move from OCI to the income statement.

Definition of available-for-sale securities

• Debt or equity securities not classified as held-to-maturity or trading securities fall under the available-for-sale (AFS) category
• AFS securities are investments that a company intends to hold for an indefinite period but may sell in response to changes in market conditions or liquidity needs
• These securities are reported at fair value on the balance sheet, with unrealized gains and losses recorded in other comprehensive income (OCI)

Accounting for available-for-sale securities

Initial recognition of securities

• AFS securities are initially recorded at their acquisition cost, which includes the purchase price and any transaction costs (brokerage fees)
• The entry to record the purchase of AFS securities is:
  • Debit: Available-for-sale securities
  • Credit: Cash
• For example, if a company purchases 100 shares of XYZ stock at $50 per share with a $10 brokerage fee, the initial recognition would be:
  • Debit: Available-for-sale securities $5,010
  • Credit: Cash $5,010

Subsequent measurement of securities

• At the end of each reporting period, AFS securities are adjusted to their fair value
• Fair value is determined using quoted market prices for identical or similar securities (Level 1 inputs) or valuation techniques (Level 2 or 3 inputs)
• The entry to record the change in fair value is:
  • Debit/Credit: Available-for-sale securities (to adjust to fair value)
  • Debit/Credit: Unrealized gain/loss on AFS securities (OCI)

Unrealized holding gains vs losses

• Unrealized holding gains or losses arise when the fair value of AFS securities changes from the previous reporting period
• Unrealized gains occur when the fair value increases, while unrealized losses occur when the fair value decreases
• These gains or losses are not recognized in net income but are instead recorded in other comprehensive income (OCI) until the securities are sold or impaired

Other comprehensive income treatment

• OCI is a separate component of shareholders' equity that captures gains and losses not included in net income
• Unrealized gains and losses on AFS securities are reported in OCI to avoid volatility in the income statement
• The accumulated balance of unrealized gains and losses in OCI is known as "accumulated other comprehensive income" (AOCI)
• When AFS securities are sold or impaired, the unrealized gains or losses are reclassified from AOCI to net income

Impairment of available-for-sale securities

Indicators of impairment

• Impairment occurs when the fair value of an AFS security declines below its amortized cost basis and the decline is considered other-than-temporary
• Indicators of impairment include:
  • Significant financial difficulty of the issuer
  • Breach of contract (missed interest or principal payments)
  • Probability that the issuer will enter bankruptcy or financial reorganization
  • Disappearance of an active market for the security
• If an impairment is deemed other-than-temporary, the unrealized loss is recognized in net income

Determining fair value

• Fair value is the price that would be received to sell the security in an orderly transaction between market participants
• For AFS securities with readily determinable fair values (quoted market prices), the fair value is easily obtained
• For securities without readily determinable fair values, valuation techniques (discounted cash flow analysis, comparable company analysis) are used to estimate fair value

Recognizing impairment losses

• If an AFS security is impaired and the impairment is deemed other-than-temporary, the unrealized loss is reclassified from OCI to net income
• The entry to record an other-than-temporary impairment is:
  • Debit: Unrealized loss on AFS securities (income statement)
  • Credit: Available-for-sale securities (to write down to fair value)
• The new cost basis of the AFS security becomes the fair value at the date of impairment, and any subsequent recoveries in fair value are not recognized in net income

Sale of available-for-sale securities

Calculating realized gain or loss

• When an AFS security is sold, the difference between the selling price and the security's carrying value (amortized cost) is recognized as a realized gain or loss in net income
• The realized gain or loss is calculated as:
  • Realized gain/loss = Selling price - Carrying value (amortized cost)
• For example, if a company sells an AFS security with a carrying value of $1,000 for $1,200, the realized gain would be:
  • Realized gain = $1,200 - $1,000 = $200

Reclassifying unrealized gains or losses

• Upon sale, any unrealized gains or losses previously recorded in OCI must be reclassified to net income
• The entry to reclassify unrealized gains or losses is:
  • Debit: Unrealized gain/loss on AFS securities (OCI)
  • Credit: Realized gain/loss on sale of AFS securities (income statement)
• This reclassification ensures that the total gain or loss (realized and unrealized) is recognized in net income in the period of sale

Impact on financial statements

• The sale of AFS securities affects both the balance sheet and income statement
• On the balance sheet, the carrying value of AFS securities is reduced by the amount sold, and cash is increased by the selling price
• On the income statement, the realized gain or loss is reported as a component of net income, and any reclassified unrealized gains or losses are included in net income as well

Presentation of available-for-sale securities

Classification on balance sheet

• AFS securities are reported as a separate line item under the non-current assets section of the balance sheet
• They are typically classified as long-term investments unless management intends to sell them within the next 12 months
• If any portion of AFS securities is expected to be sold within the next 12 months, that portion is classified as a current asset

Disclosures in financial statement notes

• Companies are required to disclose information about their AFS securities in the notes to the financial statements
• Disclosures include:
  • Description of the securities (issuer, type, maturity date)
  • Amortized cost and fair value
  • Unrealized gains and losses recognized in OCI
  • Realized gains and losses recognized in net income
  • Impairment losses recognized in net income
  • Transfers between investment categories
• These disclosures provide transparency and help users of financial statements understand the nature and performance of a company's AFS securities

Transfers between investment categories

Accounting for transfers into AFS

• Securities can be transferred into the AFS category from the held-to-maturity or trading categories
• When a security is transferred into AFS from held-to-maturity, any unrealized gain or loss at the date of transfer is recorded in OCI
• The entry to record the transfer is:
  • Debit: Available-for-sale securities (at fair value)
  • Credit: Held-to-maturity securities (at amortized cost)
  • Debit/Credit: Unrealized gain/loss on AFS securities (OCI)

Accounting for transfers out of AFS

• Securities can be transferred out of the AFS category into the held-to-maturity or trading categories
• When a security is transferred out of AFS, any unrealized gain or loss in OCI is reclassified to net income
• The entry to record the transfer is:
  • Debit: Held-to-maturity or trading securities (at fair value)
  • Credit: Available-for-sale securities (at fair value)
  • Debit/Credit: Unrealized gain/loss on AFS securities (OCI)
  • Debit/Credit: Realized gain/loss on transfer of AFS securities (income statement)

Comparison to other investment types

AFS vs held-to-maturity securities

• Held-to-maturity (HTM) securities are debt investments that a company intends to hold until maturity
• Unlike AFS securities, HTM securities are reported at amortized cost on the balance sheet, and unrealized gains and losses are not recognized
• HTM securities are less liquid than AFS securities because they are intended to be held until maturity
• If a company sells an HTM security before maturity, it may call into question its ability to hold other HTM securities to maturity

AFS vs trading securities

• Trading securities are investments that a company intends to sell in the near term for profit
• Like AFS securities, trading securities are reported at fair value on the balance sheet
• However, unrealized gains and losses on trading securities are recognized in net income, whereas unrealized gains and losses on AFS securities are recognized in OCI
• Trading securities are more liquid than AFS securities because they are actively bought and sold

Tax considerations for AFS securities

Taxable vs non-taxable interest

• Interest income from AFS securities can be either taxable or non-taxable, depending on the type of security
• Taxable interest income is earned on corporate bonds and other debt securities issued by taxable entities
• Non-taxable interest income is earned on municipal bonds and other debt securities issued by tax-exempt entities (state and local governments)
• Companies must track and report taxable and non-taxable interest income separately for tax purposes

Tax impact of gains and losses

• Realized gains and losses on the sale of AFS securities are subject to capital gains tax
• The tax rate applied to capital gains depends on the holding period of the security:
  • Short-term capital gains (securities held for one year or less) are taxed at ordinary income rates
  • Long-term capital gains (securities held for more than one year) are taxed at preferential rates
• Unrealized gains and losses recognized in OCI are not subject to tax until the securities are sold and the gains or losses are realized
• When an other-than-temporary impairment is recognized, the loss is deductible for tax purposes in the year of impairment