Creative Cash Flow #1: Investments Classified as Trading Securities

Investments in debt and equity securities may be classified as held for trading purposes or as available for sale. In addition, because they have fixed maturity dates, a third classification, held to maturity, can also apply to debt securities. As the title suggests, trading securities are held to take advantage of very short-term price swings. Holding periods are very short, at times possibly even less than a day. Debt securities that are classified as held to maturity are investments for which a firm has the intent and ability to hold until maturity. The plan is to collect the debt instrument’s principal amount at maturity. All other investments are classified as available for sale, a default classification that can include both short-term and long-term investment positions.

The classification of investments as trading, held to maturity, or available for sale directly affects the classification of cash flows associated with their purchase or sale. When investments are classified as held to maturity or available for sale, the use of cash in their purchase or the proceeds generated by their sale are classified as cash flow from investing activities. In contrast, cash used to purchase or cash provided by the sale of investments classified as trading securities is reported as operating cash flow.

Rules for classifying investments as trading, held to maturity, or available for sale are malleable. This flexibility provides an opportunity for companies to alter reported operating cash flow. For example, cash flows associated with investments in short-term debt instruments classified as held to maturity would be reported as investing cash flow.

However, changing their classification to trading would result in the same cash flows being classified as operating cash flow.

Financial institutions—companies such as banks, insurance companies, and brokerage firms—routinely trade financial instruments. It is part of what they do. Cash flows associated with this activity are properly included with operating cash flow. However, when nonfinancial companies classify investments as trading securities, cash used to purchase the investments or cash provided by their sale does not fit the operating designation. At a minimum, such cash flows are not sustainable and will stop when an investment portfolio has been liquidated.