Question

In: Accounting

Overview How we account for and present debt and equity investments on the financial statements is...

Overview

How we account for and present debt and equity investments on the financial statements is an important part of U.S. GAAP as we move towards an asset/liability approach as to how certain transactions are recorded. The application of the principles of fair value accounting in regards to these assets can be extremely important in how investors determine a company's financial position. It is an area that has had some interesting ramifications in the financial world.

Instructions

Buckingham Company holds a large portfolio of debt securities as investments. The total fair value of the portfolio is greater than its total original cost, even though some of the individual debt securities have decreased in value. Julia, the CFO, and Sam, the Controller, are near year-end in the process of classifying, for the first time, this investment portfolio in accordance with U.S. GAAP. Julia wants to classify those securities that have increased in value during the period as trading securities in order to increase net income this year, and wants to classify those that have decreased in value as held-to-maturity. Sam, on the other hand, disagrees. He wants to classify the securities that have decreased in value as trading securities and those that have increased in value as held-to-maturity. He contends that the company is having a good earnings year and the recognizing the losses will help to smooth the income this year, and thus the company will have built-in gains for future periods when the company may not be as profitable.

Answer the following questions:

1- Will classifying the portfolio as each proposes actually have the effect on earnings that each says it will? Why or why not?

2- Is there anything unethical in what each of them proposes? Who are the stakeholders affected by their proposals? Be sure to include a solid analysis of current U.S. GAAP standards that the company should be following for debt investments, including properly cited references.

3- Assume that Julia and Sam end up properly classifying the entire portfolio into proper categories, but then each makes a different proposal just before year end: Julia wants to sell those securities with gains and Sam wants to sell only those with losses to accomplish their individual desired effects on net income. Is this unethical? Why or why not?

4- Is the financial community in the U.S. in agreement with the current U.S. GAAP standards as to how to present investments at fair value (often called mark-to-market accounting)? What impact did these standards have in the 2008 financial crisis? Research this on the internet and summarize what you find, being sure to include properly cited references.

Solutions

Expert Solution

Q1)
Yes they Will. As for Julia’s case, classifying the investments that have increased in value as trading securities (otherwise referred to as available for sale (AFS)) will actually help the company gain from selling the investment since the prices of the investments have gone up. Those held to maturity too will get time to gain value before they are made trading securities, probably in the next period. Doing this will help the company earn more profit. Sam’s argument is also correct in that, his approach will help the company retain the profit it has made in the form of investment. Selling off the investments that have decreased their values will also help the company offload baggage.

q2)
The U.S GAAP standards on debt investments can be found in ASC 320, which is the primary source that guides investments in both marketable equity and debt securities. ASC 320, is clearer than what was in place before since it narrows down to instruments that matter. One of the basic requirement for investments, according to ASC 310, is that for all debt securities that a company classifies as held to maturity (HTM), or those classified as Available for Sale (AFS or trading securities), their costs should be paid to the one selling the debt security, including any fee that is paid less. The payment should be done directly. All fees received by the organization should be featured in the initial investment of the debt security. Secondly, an organization is free to recognize a debt security on settlement-date basis or on trade-date bases. ASC 320 doesn’t give guidance for this and so it is up to an industry to decide the most suitable one depending on the accounting entity. For debt security to qualify as HTM, the management has to have the will and ability to hold it until it is mature. Either, an investment that hasn’t been actively traded in the market yet, and means some set conditions, can also quality as HTM. Debt securities classified as HTM should however be accounted for fully at amortized cost

q3)
Making different proposals is unethical. From basic principles of accounting, it is paramount that an organization fulfils the conservatism principle, which means that the company is obligated to table matching proposals. According to the principle in context, the accounting department is supposed to agree on the alternative that will bring about less asset amount, or less income. The principle also demands that the final proposal should not be biased in any way. Julia and Sam should then put their own biasness aside and agree on the alternative that will satisfy the conservatism principle. The accounting guidelines also require them to share the same objective despite of their differences.

q4)
The reforms that came along with the introduction of the current standards were received well. The U.S. GAAP bought reforms to accounting and financial reporting when it was employed amidst the 2008 crisis. First, the use of securitization to make financial statements look neat was discourages. Secondly, additional disclosures were made paramount. The disclosures will help those using financial statements to understand them better.  


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