Cash Management

Auction-Rate Securities: Short-Term or Long?

Most U.S. corporations have treated these securities like cash or cash equivalents, but are they more appropriately classified as ''investments''?
Stephen TaubMarch 25, 2005

The Big Four accounting firms are advising their corporate clients to change the way they account for so-called auction-rate securities.

Until recently, most U.S. corporations have treated these securities like cash or cash equivalents, but the accounting firms believe that they are more appropriately classified as “investments,” according to The Wall Street Journal.

Auction-rate securities are long-term bonds and preferred stocks that resemble short-term instruments because their interest rates are reset periodically — usually every 7, 28, 35, or 49 days — according to Twenty-First Securities Corp. The rate is reset by a modified Dutch auction process; because investors can sell or buy the securities on those auction dates, it explained, the securities have long been regarded as cash equivalents.

In the past few years, investors have favored these short-term investments that frequently offer higher yields than conventional products; explained the Journal. Issuers like auction-rate securities, the newspaper added, because they can raise long-term money but can price the securities like short-term paper, then periodically reset the rate.

But late last month, reported the Journal, a PricewaterhouseCoopers memo warned clients that there is one key difference between auction-rate securities and other short-term securities: broker-dealers and not issuers conduct the auctions. Should the auction fail, the memo reported counseled, existing investors would have to hold on to the securities — and would be able to access their funds — until the next auction.

“The legal maturity of auction-rate securities is 20 to 30 years and, as such, the securities ordinarily should not be classified as cash equivalents, but rather as investments,” PricewaterhouseCoopers said in the memo, according to the paper. PwC reportedly added that Ernst & Young, Deloitte & Touche, and KPMG essentially agree with this analysis.

A number of companies have announced that they have reclassified or plan to reclassify auction-rate securities as short-term investments, including PetsMart Inc., Network Appliances Inc., Citrix Systems Inc., Geac Computer Corp., and JetBlue Airways Corp.

Though reclassification doesn’t affect a company’s cash flow, the Journal observed, a company could wind up in technical default with loan covenants that require it to maintain certain current ratios.