Question

Mary Burden is the CFO of Tidewell Corporation and Tommy Brown is the Treasurer. Mary has been with the company for seven years and Tommy just started earlier this year. They meet to discuss the classification of the corporation's investment portfolio. Mary notes that Tidewell Corporation is having a good year and net income is already more than was forecasted, so she proposes investments that have increased in value since last year be classified as available-for-sale. She also proposes that any that have decreased in value be classified as trading securities. Her logic is that this will result in some amount of reported loss, but that net income will still be more than forecasted. Also, by classifying the securities that have increased in value as available fore sale, Tidewell Corporation will have some reserve gains for future periods. Tommy is not sure about Mary's proposal and thinks it would make more sense to classify the investments that have increased in value as trading, and subsequently sell them to capture the profit. He also believes that classifying the investments that have decreased in value as trading makes more sense, which will give the investments time to recover and not impact net income.

Answer the following questions:

#1Will what Mary and Tommy each suggest have the effect on net income that they suggest? Why or why not?

#2Is what Mary and Tommy each propose ethical? Why or why not?

#3If Tommy prevails and they classify the securities as he proposes for the end of the year, what would you expect Tidewell Corporation to do with the two types of investments shortly after the classification decision is made?

#4If what should happen in #3 doesn't occur, is the classification decision ethical? Why or why not?

Answer 1

1. Yes. In case of investments in available for sale securities, unrealized holding gains and losses are not recognized in the income statement. Therefore, any appreciation in fair value of AFS investments would be parked in Fair Value Adjustment account, which is a part of Other Comprehensive Income in Stockhollders' Equity, but not the current year Income Statement.

On the other hand, investments in trading securities by their very nature, are held principally to sell in the near term. Therefore, any increase or decrease in fair value of trading securities would be recognized in the Income Statement, and would therefore impact the net income of the current period, and consequently the stock price.

2. No, it is not ethical. The users of the financial statements are entitled to a true and fair representation of the operating results and the financial position of the company. Investments in AFS securities are not expected to be liquidated in the near term, while investments in trading securities are.

What Mary and Tommy propose, through their earnings management scheme, is going to convey a distorted view to the investors and other stakeholders by classifying investments in trading securities as available for sale and investments in available for sale securities as trading securities. While trading securities are short term investments, AFS investments are not.

Also, both Mary and Tommy wish to ensure that their respective bonuses are intact for the next year too.

3. Shortly after the classification decision, Tidewell Corporation is going to be made to sell the investments classified as trading, to the detriment to the investors in the company. Both Mary and Tommy would need to prove to the world that those investments were indeed intended to be sold in the short term.

4. As already stated, the classification decision is not ethical, even though the investments are not sold. The users of the financial statements are entitled to a true and fair view of the assets of the company.

Even if the investments classified as trading are not sold during the year, the damage has already been done. The unrealized loss on these securities is to be reported on the Income Statement, and therefore will affect net income for the year. As a result, there would be dilution in shareholder wealth, because lower than expected net income and earnings per share would adversely impact the Tidewell stock price.