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Investment Accounting Considerations

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Investment Accounting Considerations Investment Accounting Considerations In February 2005, PriceWaterhouseCoopers announced that they would no longer qualify auction rate securities as cash equivalents on the balance sheet. Overnight, the balance sheets of companies that held these securities shifted cash into short-term investments. The consequences of PriceWaterhouseCoopers’ decision highlight the impact of the accounting community’s effort to clarify investment accounting assumptions. The broad lack of standardized investment accounting assumptions indicates that this is not the last time companies will have to deal with the headache of an investment reclassification or restatement. Changes in investment accounting assumptions are a fact of life. The Case for Consistent Investment Major Investment Accounting Accounting Assumptions Assumptions, Options and Suggested Standards Consistent investment accounting assumptions across all company portfolios are critical to the accuracy and The following is a list of investment accounting assumption alternatives that will be discussed later in clarity of financial statements. Combining disparate detail. assumptions to create general ledger entries introduces ambiguity and errors in reporting. 1. Trade date vs. settlement date accounting 2. Tax lot vs. average cost security costing If your company currently generates investment method entries using accounting reports from more than one 3. First-in-first-out (FIFO), LIFO, average cost vs. investment service provider (i.e. investment manager, specific-lot selection tax lot inventory method custody or safekeeping bank, etc.) your company may 4. FASB interest/constant yield/scientific vs. well be using inconsistent accounting assumptions as straight-line amortization method the basis for the investment entries. This is analogous 5. Amortization on callable securities to the first to recognizing revenue differently from customer to call date and accretion to the legal final customer depending on the customer’s preference. maturity vs. amortization/accretion to final maturity As a test, have each of your investment service 6 Amortization on bonds with embedded options providers define exactly what investment accounting 7. Amortization on securities with an embedded assumptions are used to generate the fiscal period- prepay option (e.g., asset backed, mortgage end reports. Compare their responses. Or you could backed securities) to a static effective maturity review each provider’s SAS70 Type ll. This date (weighted average life) defined on trade examination should reveal the level of consistency or date and accretion to the legal final maturity disparity of accounting assumptions being utilized vs. amortization/accretion to a dynamic among your service providers. Most often this effective maturity date inspection reveals significant inconsistency and a need 8. Balance sheet classification to legal final to remedy a potentially serious situation. maturity on all products including variable rate products and bonds with an embedded option (i.e. callable bonds), classification according to the next reset date vs. product specific 2 Investment Accounting Considerations classification (i.e. auctions classified as short 2005. If the $2 million corporate note defaults the day term) after trade date (July 12, 2005) the company is 9. Amortization and accretion calculated and contractually obliged to deliver cash to the presented on an actual/actual basis vs. using counterparty in exchange for the now heavily the securities’ stated day count. discounted bonds. The company owns the securities at the agreed upon price on trade date regardless of If it is a surprise that there are various investment the performance of the securities prior to settlement. accounting assumptions with no accepted standard, Because the company has contractually agreed to take this opportunity to address this issue before it terms and owns the risk, it is logical that the company becomes an audit issue. Identify the assumptions that should report transactions as of trade date. drive your current investment accounting entries, define a single, consistent set of accounting The consequences of settlement date accounting on assumptions for all investment portfolios and require SOX controls can be profound. Certain companies each of your service providers to comply. that use settlement accounting on transactions spanning a fiscal period end (traded before the fiscal In the case of multiple investment service providers period-end for settlement after the period) have been where each provides reports based on inconsistent cited by their auditors for "a significant deficiency or accounting assumptions, an organization should material weakness" in financial controls because the strongly consider alternative methods of obtaining auditor decided the company was not reporting the investment accounting entries, such as master outstanding liability (and off-setting asset) on the custodian services or a comprehensive investment financial statements. accounting solution. In one case the auditor stated that using settlement date accounting provided no way to monitor manager Trade date accounting activity and the company's liabilities prior to trade settlement, generally days after the trade occurred. The CPA Journal's New Guide on Brokers and The auditor was alluding to a general concern with Dealers in Securities, a standard for corporate settlement date accounting; the potential for investment accounting contains the following manipulation and abuse. For example, a manager statement on trade date accounting: could buy a security and record no transaction until "There are two critical dates in all securities settlement date, exposing the company to financial, transactions: trade date and settlement date. On trade compliance and regulatory risk that is unknown to date, an agreement is entered into that establishes the anyone within the company for days or weeks prior to negotiated elements of the transaction including the settlement date. security description, quantity, price, and delivery terms. The date the securities must be delivered and For companies that use trade date accounting there payment received is referred to as the settlement date. are often questions about how best to classify the Since generally accepted accounting principles require position pending settlement and the related payable on use of accrual accounting, the financial statements the balance sheet (FAS115 classification). In brief, the should be presented on a trade-date basis since the security pending settlement should be classified on the potential risks and benefits of each transaction balance sheet according the number of days to final become effective on that date." maturity and the related payable (due on settlement date) should be classified as cash & cash equivalents. For this reason, the majority of professional custody banks and corporate clients use trade date accounting for accounting entries and investment policy Tax lot security costing method compliance monitoring. Each time you execute a securities transaction, the To illustrate let's say a company purchases $2 million new position comprises a distinct tax lot. For example, of 2-year maturity corporate note at a price of 100.25 if a company bought $1 million par value of a specific on July 11, 2005 for settlement 3 days later on July 14, security (defined by an individual CUSIP or ISIN 3 Investment Accounting Considerations number) on a particular date and bought an additional First-in-first-out is the most commonly used and $2 million par value of the same security on a different straightforward tax lot inventory method. It is less date, then the company would have two distinct tax susceptible to manipulation and misinterpretation. lots. Each lot has its own original cost, amortized cost and unrealized gain or loss. FASB interest/constant yield/scientific There are two basic ways to account for multi-lot amortization method holdings. One approach is the average cost method, where the company would average the cost for all lots. Accounting assumptions dealing with amortization and The other approach is to use tax lot accounting, where balance sheet classification of investment assets are the company would track each lot separately. among the most important. This significance stems from the fact that they are commonly misunderstood Tax lot accounting provides an easier, more accurate by investment service providers and clients and when method for investment accounting and tax reporting booked, flow directly to the income statement (in the while minimizing the investment income statement case of amortization) and the balance sheet (in the volatility that can accompany the average cost case of investment classification). method. Allowing the investment manager to choose the The process of dollar-cost averaging the purchase amortization method or balance sheet classification of price of new lots with the amortized cost of the assets lets the manager directly affect the company’s previous lots can be complex and prone to mistakes if financial statements. In this case, the manager should done manually by the investment manager. Most be subject to an independent audit, SAS70 Type II, companies prefer to use the tax lot method because it verifying the financial statement decisions the is simpler, more transparent and avoids adjusting the manager makes for the company. amortized cost on existing positions when a new position is purchased at a different price. The chosen amortization method
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