Question

2) Suppose a company wants to classify a security as HTM and not AFS because they believe that in the short-term, the security will lose value and they want their income statement to look as strong as possible. What would prevent them from classifying the security as such?

Answer 1

Mark-to-market is required for investment in AFS securities, but not in the case of investment in HTM securities. In other words, AFS securities are to be carried at fair market value on the balance sheet on the reporting date. This requirement is not there for HTM investments, unless there is a permanent decline in their value.

Unrealized holding gains or losses on investment in AFS securities of a company do not affect the income statement for the period. They are recognized in the statement of other comprehensive income. These gains or losses appear in the balance sheet as additions to or deductions from accumulated other comprehensive income. Therefore, unrealized holding losses will not impact the current period net income.

Also, it would be unethical for the management of the company to classify an AFS investment as HTM  just because it wants to depict a strong income statement, What matters is whether it intends to sell the investment in the short-to-medium term , or to hold it till its maturity.