Introduction to Investments in Securities: Videos & Practice Problems

Companies often invest their excess cash for two primary reasons: to generate additional income or to exert influence over another company. When a company has more cash than it can reinvest in its own operations, it may choose to purchase investments that yield income. Alternatively, by acquiring a significant amount of stock in another company—typically more than 20%—a company can influence that company's decision-making processes. However, this discussion focuses on investments where ownership is less than 20%, allowing companies to earn income without controlling the other entity.

The term "security" encompasses any financial instrument that holds monetary value, including stocks and bonds. Securities can be classified into two main categories: equity securities and debt securities. Equity securities represent an ownership interest in a company, such as common stock or preferred stock. Investors earn income from equity securities primarily through dividends and capital gains. Dividends are payments made by the company to its shareholders, while capital gains occur when the value of the security increases, allowing the investor to sell it for a profit.

For example, if an investor purchases 10 shares of a stock for \$400 and receives a dividend of \$1 per share, the total dividend income would be \$10. If the stock's price rises to \$55 per share, the investor can sell the shares for \$550, resulting in capital gains of \$150. Therefore, the total income from this investment would be the sum of the dividends and capital gains, amounting to \$160.

On the other hand, debt securities involve lending money to another entity, which must be repaid with interest. Bonds are a common form of debt security, where the investor receives periodic interest payments until the bond matures. This type of investment provides a steady income stream through interest payments, distinguishing it from equity securities.

Understanding these classifications of securities is crucial for companies looking to manage their investments effectively and maximize their income potential.

When classifying investments on financial statements, it's essential to understand the three main categories: trading securities (TS), available-for-sale securities (AFS), and held-to-maturity securities (HTM). Each category reflects the investor's intent regarding the investment's duration and trading activity.

Trading securities are investments that an entity plans to sell in the near term, typically characterized by active trading. These securities are classified as current assets on the balance sheet because they are expected to be liquidated quickly. The initial measurement of trading securities is at cost, but their value is adjusted to fair value over time. This adjustment results in unrealized gains or losses, which are reported on the income statement. For example, if shares of a company are purchased at \$50 and later valued at \$75, the increase in value is recognized as an unrealized gain.

Available-for-sale securities occupy a middle ground. While these investments are not actively traded, they are still intended to be sold if favorable conditions arise. Available-for-sale securities can be classified as either current or long-term assets, depending on the investor's intent and the time frame for potential sale. Similar to trading securities, these are initially recorded at cost and subsequently adjusted to fair value. However, unrealized gains or losses for available-for-sale securities are reported in other comprehensive income rather than the income statement.

Held-to-maturity securities are exclusively debt securities, as equity securities cannot be held to maturity due to their indefinite lifespan. These investments are intended to be held until their maturity date, such as bonds that pay back principal after a set period. Held-to-maturity securities are recorded at amortized cost, reflecting the initial investment adjusted for any principal repayments and amortization of premiums or discounts. Unlike the other two categories, there are no unrealized gains or losses reported for held-to-maturity securities since their value does not fluctuate based on market conditions.

In summary, understanding the classification and measurement of these securities is crucial for accurate financial reporting. Trading securities are actively managed and reported at fair value with gains or losses on the income statement, available-for-sale securities are adjusted to fair value with gains or losses in other comprehensive income, and held-to-maturity securities are recorded at amortized cost with no unrealized gains or losses.