In: Accounting
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.
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.