Question

Harding Financial Services Company holds a large portfolio of debt and stock securities as an investment. The total fair value of the portfolio at December 31, 2017, is greater than total cost. Some securities have increased in value and others have decreased. Ann Bales, the financial vice president, and Kim Reeble, the controller, are in the process of classifying for the first time the securities in the portfolio.

Bales suggests classifying the securities that have increased in value as trading securities in order to increase net income for the year. She wants to classify the securities that have decreased in value as long-term available-for-sale securities, so that the decreases in value will not affect 2017 net income.

Reeble disagrees. She recommends classifying the securities that have decreased in value as trading securities and those that have increased in value as long-term available-for-sale securities. Reeble argues that the company is having a good earnings year and that recognizing the losses now will help to smooth income for this year. Moreover, for future years, when the company may not be as profitable, the company will have built-in gains.

 

Instructions

(a) Will classifying the securities as Bales and Reeble suggest actually affect earnings as each says it will?

(b) Is there anything unethical in what Bales and Reeble propose? Who are the stakeholders affected by their proposals?

(c) Assume that Bales and Reeble properly classify the portfolio. At year-end, Bales proposes to sell the securities that will increase 2017 net income, and that Reeble proposes to sell the securities that will decrease 2017 net income. Is this unethical?

Answer 1

(a)

As per the guidelines the mark to market losses on traded securities need to apportioned to the P&L as a trading loss (since this is not a cash loss, it is like making a provision) but none the less it will reduce the earnings, however at the same time if there is a mark to market profit no impact on the P&L for the respective period. These guidelines are not applicable for long term holdings which can continue to be held at cost price unless there is a serious impairment in value which is subjective call. Thus we can see that the earnings will be impacted (reduced) only if Reeble recommendation.

 

(b)

This is unethical since the classification of a security as trading or long term should be performed at the time of purchase as per the rationale & recommendations of investment committee and not specifically for the managing the P&L statement of the firm. The financial statements should reflect the true and fair information for all the stakeholders and this move can potentially all the stakeholders:

 

Existing investors will not see full value of the firm in their holdings if the earnings are under reported to mantain steady earnings projections

 

A potentail investor if buying will be able to purchase stock at lesser price than if the under reporting was not being done, hence in a way the new investors will be partaking in gains of existing investors without even being part of the company.

 

(c)

This is more difficult to adjudge since selling a loss making security can also be seen as risk management. Though we know that Reeble is trying to manage the earnings hence if the intention is same then it is unethical but it will be difficult to isolate the single motive from portfolio management, hence it may not be seen as unethical.

(a)

As per the guidelines the mark to market losses on traded securities need to apportioned to the P&L as a trading loss (since this is not a cash loss