Question

A. If you treated a trading security like a available for sale security by accident in the accounting records, what would be the effect on 1) Net income 2) retained earnings 3) stockholder's equity after one year and then two years. B. If you treated an available for sale security like a trading security by accident in the accounting records, what would be the effect on 1) Net income 2) Retained earnings 3) stockholder's equity after one year and then two years. Please explain answer in terms of net income, retained earnings, and overall equity being OVER/UNDER in terms of what they should be

Answer 1

Any increase in the value of the trading security is recognised and added to profit. For example the value of the trading security increased by $5,000 then $5,000 will be recorded in the income statement as operating income. Any increase in the value of the available for sale security is unrecognised and is considered as comprehensive income. This comprehensive income is represented on the balance sheet under stockholders' equity.

Treated trading security as a available for sale security, effect on :

1) Net income : Understated because increase in value of security is added to stockholders' equity instead of net income.

2) Retained earnings: : Understated because increase in value of security is added to stockholders' equity instead of net income. This understated net income is transferred to the retained earnings creating an understated balance.

3) Stockholder's equity: Overstated because the increase in the value of security is added to Stockholder's equity instead of net income.

Treated available for sale security as trading security, effect on :

1) Net income : Overstated because increase in value of security is added to net income instead of Stockholder's equity.

2) Retained earnings Overstated because increase in value of security is added to net income instead of Stockholder's equity. The overstated net income is transferred to retained earnings creating an overstated balance.

3) Stockholder's equity: Understated because the increase in the value of security is added to net income instead of Stockholder's equity.