Question

Qtip Corp. owns stock in Maxey Corp. The investment represents a 10 percent interest, and Qtip is unable to exercise significant influence over Maxey.

The Maxey stock was purchased by Qtip on January 1, 2016, for $23,000. The stock consistenly pays an annual dividend to Qtip of $2,000. Qtip classifies the stock as available for sale. Its fair value at December 31, 2016, was $21,600. This amount was properly reported as an asset in the balance sheet. Owing to the development of a new Maxey product line, the market value of Qtip's investment rose to $27,000 at December 31, 2017.

The Qtip management team is aware of the provisions of SFAS No. 115. The possibility of changing the classification from available for sale to trading is discussed. This change is justified, the managers say, because they intend to sell the security at some point in 2017 so they can realize the gain.

Required:

a. Discuss the role that managerial intention plays in the accounting treatment of equity securities that have a readily determinable fair value under SFAS No. 115.

b. What income statement effect, if any, would the change in classification have for Qtip?

c. Discuss the ethical considerations of this case.

d. Opponents of SFAS No. 115 contend that allowing a change in classification masks effects of unrealized losses and results in improper matching of market-value changes with accounitng periods. Describe how the accounting treatment and the proposed change in classification would result in this sort of mismatching.

Answer 1

a) As per SFAS No. 115, the accounting treatment of equity securities that have a readily determinable fair value will depend on the categorization of equity securities as trading securities or available for sale securities.Management intention is the main criterion in the above categorization. Since management intent is subjective the accounting treatment may vary depending on how they intend to classify the securities which may contribute to increased volatility in earnings.

b) For Qtip, if the classification of investment in Maxey stock, is changed from available for sale to trading, then the unrealized gain of $ 5,400 ($27,000 - $ 21,600) will be included in earnings in the income statement for year ending Dec 31 2017.

c. Form an ethical standpoint it is not right on the part of Qtip management to change the classification from "available for sale" to "trading" because it allows the management to selectively manage its earnings by including unrealized gains and excluding unrealized loss.

d. Change in classification will lend to comparability difficulties between accounting periods. If the change in market value is favaourable the management will change classification from available for sale to trading and include the upside in the income statement leading to increased earnings. When the market value is down, they may again change from trading to availbale for sale which would enable them to not capture the downside in the market value in the income statement.

For year ending Dec 31 2016 since the investment was classified as available for sale there would not have been any impact on the income statement. All changes in Fair market value will affect only the Balance sheet and the shareholders equity would have been reduced by $ 1,400 (23,000-21600).

For year ending Dec 31 2017 unrealized gain of $ 5,400 ($27,000 - $ 21,600) will be included in earnings in the income statement due to change in classification.

Thus the above contibute to mismatch in earnings between accounting periods.