How are securities measured after acquisition?

Answer 1

MEASUREMENT OF SECURITIES AFTER ACQUISITION

Debt Securities Held to Maturity

Firms sometimes acquire debt securities with the intention of holding these securities until maturity.

For example, an electric utility, has $100 million of bonds payable outstanding that mature in five years. The utility acquires U.S. government securities whose periodic interest payments and maturity value exactly equal those on the utility's outstanding bonds. The firm intends to use the cash received from the government bonds to make required interest and principal payments on its own bonds.

The electric utility could also have used its cash to purchase its bonds in the marketplace. The example illustrates a mechanism that firms might use instead of bond repurchases for bond issues that are widely held. The mechanism avoids the considerable transaction costs of identifying and locating all of the bondholders and persuading them to sell their bonds to the electric utility before maturity.

U.S. GAAP and IFRS require firms to measure marketable securities for which firms have an intent and ability to hold to maturity at amortized acquisition cost. A firm initially records these debt securities at acquisition cost. This acquisition cost will differ from the maturity value of the debt if the coupon rate on the bonds differs from the required market yield on the bonds at the time the firm acquired them. The firm must use the effective interest method to amortize any difference between acquisition cost and maturity value over the life of the debt as an adjustment to interest revenue. The amortization procedure involves compound interest computations.

The amortization procedure involves the following steps:

1 . The holder of the debt securities (the investor) records interest revenue each period at an amount equal to the carrying value of the debt at the start of the period multiplied by the market rate of interest applicable to that debt on the day the firm acquired the debt. It debits the Marketable Securities account and credits Interest Revenue, which after closing entries increases Retained Earnings.

2 . If the investor receives cash each period, it debits Cash and credits the Marketable Securities account. The result of this process is a new carrying value (called the amortized cost) for use in the computations during the next period.