Marketable Securities and its implications on Statement of CFs

[Ernest Seow]

Dear all,
2 quick questions pertaining to marketable securities (i.e. trading securities, AVS securities) and statement of cash flows.
Question 1: For both unrealized gain/loss (from trading securities) and realized gain/loss from disposal of trading securitites; they will not be deducted from Net Income when indirect method of computing for CFO is used? This is in contrast with items such as gain/loss from disposal of fixed assets; which will be removed from Net Income (as they belong to investing instead of operating).
For realized gain/loss from disposal of AVS securitites, they will not be deducted from Net Income too (when indirect method is used to compute CFO.) However, for unrealized gain/loss from AVS securitites, they will hit other comprehensive income instead and hence, the unrealized amount will not be in Net Income and no adjustments are required to be made. Am I right?
Question 2: For unrealized loss/gain, I’m curious which part of the income statement will they appear in? So they will be part of the final Net Income figure? If so, I think in the course of analysis, the analyst should take note of the presence of unrealized loss/gain and may consider excluding in their analysis?
Thanks.
Cheers,
Ernest

 

[Finkid]

Ernest Seow wrote:
Question 1: For both unrealized gain/loss (from trading securities) and realized gain/loss from disposal of trading securitites; they will not be deducted from Net Income when indirect method of computing for CFO is used?

Unrealized Gain/loss from trading securities will be deducted/added back to the Net Income because it is not REALIZED. (It has not been converted to cash). Any gain/loss that you made on your trading securities is on paper only.
In fact, you will reverse the effects of any UNREALIZED item for CFO calculation (indirect method) because it is not CASH. (It is unrealized not realized)
Realized Gain/loss on trading securities will be included in the CFO calculation because trading securities are part of CFO.

Ernest Seow wrote:
This is in contrast with items such as gain/loss from disposal of fixed assets; which will be removed from Net Income (as they belong to investing instead of operating).

True. Gain/loss on fixed assets will be reversed as they belong to CFI category and not CFO.

Ernest Seow wrote:

For realized gain/loss from disposal of AVS securitites, they will not be deducted from Net Income too (when indirect method is used to compute CFO.) However, for unrealized gain/loss from AVS securitites, they will hit other comprehensive income instead and hence, the unrealized amount will not be in Net Income and no adjustments are required to be made. Am I right?

You are right about Unrealized part but not right about Realized part.
Realized Gain/Losses on AFS securities are included in net income but they should be deducted/added back to Net Income for CFO calculation (indirect method) because AFS and HTM securities are part of CashFlow from Investing (CFI) category.
Think about AFS and HTM in the same manner as you are thinking about Fixed Assets.
You are right about unrealized gain/losses on AFS securities.

Ernest Seow wrote:
Question 2: For unrealized loss/gain, I’m curious which part of the income statement will they appear in? So they will be part of the final Net Income figure? If so, I think in the course of analysis, the analyst should take note of the presence of unrealized loss/gain and may consider excluding in their analysis?

Unrealized Gain/losses (for HFT only) come after operating income and before tax. However, Accounting standards differ so some companies might include it in operating section as well. You are right, analyst should exclude them for operating margin calculation. However, it is more of a case-by-case thing. Losses on HFT securities could be included in operating income for banks but not for a candy maker.
Unrealized Gain/losses for AFS go in OCI and for HTM, they are ignored.
P.s Do you mean Available for sale (AFS) securities when you say AVS or AVS is something else which I am not aware about?

 

[Ernest Seow]

Thanks Finkid for the detailed explanation! My apology for the typo- It should have been AFS instead.
I wish to take the discussion further by drawing your attention to the following:
I think it will be good if we can take a step back and look/reacess marketable securities.
According to Investopedia, I quote:
Marketable securities are very liquid securities that can be converted into cash quickly at a reasonable price.
Marketable securities are very liquid as they tend to have maturities of less than one year. Furthermore, the rate at which these securities can be bought or sold has little effect on their prices.
I think it makes better sense to avoid generalising that Held-to-maturity securities (“HTMs”), Trading securitites (“TS”) and Available-for-sale securities (“AFSs”) into marketable securities. Instead, the duration of holding is one consideration factor. Though securities like HTMs might be short-term; we cannot restrict the fact that HTMs may have duration more than 1 year.

Finkid wrote:
Unrealized Gain/loss from trading securities will be deducted/added back to the Net Income because it is not REALIZED. (It has not been converted to cash). Any gain/loss that you made on your trading securities is on paper only.
In fact, you will reverse the effects of any UNREALIZED item for CFO calculation (indirect method) because it is not CASH. (It is unrealized not realized)
Realized Gain/loss on trading securities will be included in the CFO calculation because trading securities are part of CFO.
Realized Gain/Losses on AFS securities are included in net income but they should be deducted/added back to Net Income for CFO calculation (indirect method) because AFS and HTM securities are part of CashFlow from Investing (CFI) category.
Think about AFS and HTM in the same manner as you are thinking about Fixed Assets.

Next, personally I think classification of cash flows are not something casted in stone but rather other considerations will also be taken during classification.The nature of the business is one factor. Using your example earlier- a banking insitution vs a candy shop. TS are most likely part of a banking instutition’s usual course of business and at such anything related to TS can be classifed as CFO. However, if we turn our attention to candy shop, TS might not be their normal course of business. My question is, in this case, can we classify TS as CFI instead of CFO ? I rememeber that it has been mentioned in Schweser Notes (for reading on Understanding Cash Flow Statements), under Key Concepts, thar Operating activites typically relate to firm’s current assets and current liabilities. Can I say that for the case of the candy shop; though TS are placed under current assets (by definition), the related cashflows are classified as CFI still.

Finkid wrote:
Question 2: For unrealized loss/gain, I’m curious which part of the income statement will they appear in? So they will be part of the final Net Income figure? If so, I think in the course of analysis, the analyst should take note of the presence of unrealized loss/gain and may consider excluding in their analysis?
Unrealized Gain/losses (for HFT only) come after operating income and before tax. However, Accounting standards differ so some companies might include it in operating section as well. You are right, analyst should exclude them for operating margin calculation. However, it is more of a case-by-case thing. Losses on HFT securities could be included in operating income for banks but not for a candy maker.
Unrealized Gain/losses for AFS go in OCI and for HTM, they are ignored.

Agreed

 

[Finkid]

Ernest Seow wrote:
I think it will be good if we can take a step back and look/reacess marketable securities.
According to Investopedia, I quote:
Marketable securities are very liquid securities that can be converted into cash quickly at a reasonable price.
Marketable securities are very liquid as they tend to have maturities of less than one year. Furthermore, the rate at which these securities can be bought or sold has little effect on their prices.
I think it makes better sense to avoid generalising that Held-to-maturity securities (“HTMs”), Trading securitites (“TS”) and Available-for-sale securities (“AFSs”) into marketable securities. Instead, the duration of holding is one consideration factor. Though securities like HTMs might be short-term; we cannot restrict the fact that HTMs may have duration more than 1 year.

Actually, HTM securities are usually long term because HTM include DEBT securities only. Why? Because Accounting Standards require that you MUST have the ABILITY and INTENT to hold a security till maturity and you can only do that in case of debt securities. You can’t hold a stock till maturity because there’s no maturity of a stock. (Going concern assumption).
Yes, duration of holding is indeed a consideration regarding what goes/does not go in the marketable securities. Most companies here in Pakistan define their marketable securities with a maturity of <= 3 months. They follow IFRS.

Ernest Seow wrote:
Next, personally I think classification of cash flows are not something casted in stone but rather other considerations will also be taken during classification.

I was answering your query from exam perspective. In reality, you can adjust/re-adjust things as per your judegement. In fact, that’s why there is a need for Analysts. If there was a set pattern that was to be followed by everybody, then employers could just bring in a computer that would do everything asked in less time and money.

Ernest Seow wrote:
The nature of the business is one factor. Using your example earlier- a banking insitution vs a candy shop. TS are most likely part of a banking instutition’s usual course of business and at such anything related to TS can be classifed as CFO. However, if we turn our attention to candy shop, TS might not be their normal course of business. My question is, in this case, can we classify TS as CFI instead of CFO ? I rememeber that it has been mentioned in Schweser Notes (for reading on Understanding Cash Flow Statements), under Key Concepts, thar Operating activites typically relate to firm’s current assets and current liabilities. Can I say that for the case of the candy shop; though TS are placed under current assets (by definition), the related cashflows are classified as CFI still.

Again, if you ask from the exam perspective, then it goes in the CFO (even for the candy maker). In real life, you could classify it as CFI if you think that is more appropriate.
If you are using Schweser, then go to the beginning of the Cash flow reading. They have given a really nice table showing which item goes where. They have classified the securities in the following way
HFT (CFO)
AFS and HTM (CFI)

 

[Ernest Seow]

Finkid wrote:

Ernest Seow wrote:
I think it will be good if we can take a step back and look/reacess marketable securities.
According to Investopedia, I quote:
Marketable securities are very liquid securities that can be converted into cash quickly at a reasonable price.
Marketable securities are very liquid as they tend to have maturities of less than one year. Furthermore, the rate at which these securities can be bought or sold has little effect on their prices.
I think it makes better sense to avoid generalising that Held-to-maturity securities (“HTMs”), Trading securitites (“TS”) and Available-for-sale securities (“AFSs”) into marketable securities. Instead, the duration of holding is one consideration factor. Though securities like HTMs might be short-term; we cannot restrict the fact that HTMs may have duration more than 1 year.

Actually, HTM securities are usually long term because HTM include DEBT securities only. Why? Because Accounting Standards require that you MUST have the ABILITY and INTENT to hold a security till maturity and you can only do that in case of debt securities. You can’t hold a stock till maturity because there’s no maturity of a stock. (Going concern assumption).
Yes, duration of holding is indeed a consideration regarding what goes/does not go in the marketable securities. Most companies here in Pakistan define their marketable securities with a maturity of <= 3 months. They follow IFRS.

Ernest Seow wrote:
Next, personally I think classification of cash flows are not something casted in stone but rather other considerations will also be taken during classification.

I was answering your query from exam perspective. In reality, you can adjust/re-adjust things as per your judegement. In fact, that’s why there is a need for Analysts. If there was a set pattern that was to be followed by everybody, then employers could just bring in a computer that would do everything asked in less time and money.

Ernest Seow wrote:
The nature of the business is one factor. Using your example earlier- a banking insitution vs a candy shop. TS are most likely part of a banking instutition’s usual course of business and at such anything related to TS can be classifed as CFO. However, if we turn our attention to candy shop, TS might not be their normal course of business. My question is, in this case, can we classify TS as CFI instead of CFO ? I rememeber that it has been mentioned in Schweser Notes (for reading on Understanding Cash Flow Statements), under Key Concepts, thar Operating activites typically relate to firm’s current assets and current liabilities. Can I say that for the case of the candy shop; though TS are placed under current assets (by definition), the related cashflows are classified as CFI still.

Again, if you ask from the exam perspective, then it goes in the CFO (even for the candy maker). In real life, you could classify it as CFI if you think that is more appropriate.
If you are using Schweser, then go to the beginning of the Cash flow reading. They have given a really nice table showing which item goes where. They have classified the securities in the following way
HFT (CFO)
AFS and HTM (CFI)

Awesome Thanks for reassuring me!
But well, since you mention from exam perspective that cash flows pertaining to trading securities are classified as CFO; then what should we do if the question mention that there is a disposal of trading securities?
My take is, if balance sheet account datas are available, find the change in trading securities account and add the gain/loss on disposal to arrive at the cash flow?