Question

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:

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

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.

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?

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.

Answer 1

The above Question consist of Multiple Question like Classification of “Large Portfolio of Debt Securities as Investment” .

In this Question , asked for Ethical policy is being followed or Not in case of Investment Portfolio disclosure

Last part has been asked about Whether US in agreement with the current US GAAP standard and presentation in case of Investment @ Fair market value and impact on if this standard would have been in 2008 Financial Crisis time ?

Start with part 3 – We need to understand “ What is Fair value in Case of Investment “. As per new Standard + SEC the fair value option is represents that Business to record its Financial Instrument. As per Standard , Financial Instrument includes Financial Asset, Liability , firm commitment . As per Standard , Fair value do so on an Instrument by Instrument basis

Under Mar to Market or fair value accounting mainly represents that how to do Fair value of an asset and Liability based on Current market price . Fair value accounting is became part of US GAAP .

We always challenge with Mark to Market base fair value accounting VS Historical cost method . Historical cost method was simple and based on past transaction with not much complication but we never factored “ Current Market Price”

Mark to market pricing base Investment is very Volatile because market prices are fluctuate very frequently and changes Unpredictably. This volatility definitely impacted Cash flow + Earnings

Regarding classification of Equity and Debt under financial statement – first we classified as per FAS 115

As per FAS 115 – Investment in Equity Instrument – Fair value basis . where as in case of Debt Instrument – classified Investment in three category – Debt securities that Company hold to maturity ( HTM ) – classified as Amortized cost basis also considered Impairment base

Other category of Debt Instrument – treated as “ Trading Securities and reported at Fair value basis

Unrealized gain / loss part of earnings

Last one of Debt Instrument classified as “ Available for Sale” and reported at fair value and unrealized gain /loss must be parked under OCI

What happen in case of 2008 Financial Crisis – In case of Mortgage backed Security ( MBS) , Fair value accounting rule has created more mortgage crisis . As per valuation rule , companies to adjust the value of marketable securities tio their market value and avoid historical base concept.

During year 2007 and 2008 , Market value of Securities started getting down and they are not able to get proper sale value of the asset and They are forced to recognised significant losses during this period due to above reason . Due to this disturbance , it impact to reduce the value of Bank Regulatory Capital , required additional capital raising and creating uncertainty on relates to Bank Financial Health

So overall Borrowing money to Invest , limited money in the recession , margin call disturbance alomg with large reported loss – these all together create major crisis . Finally in the year 2009, FASB issued an official update and ease the mark to market rules when the market is unsteady or inactive .

First Part

As per IFRS 9 and US GAAP other than Investment in Equity Instrument , Loan , receivable , Investment in Debt Instrument can qualify for measurement as Amortized cost or FVOCI . As per new standard , we need to understand Business Model objective . If objective is to hold assets only to collect cash flow( as per contractual) and with help of contractual l cash flow, repayment of SPPI test

As per Standard , Any Investement in Debt Securities with Fixed payment on fixed date – Treated as AMC + FVOIC

In case of derivative transaction where Option , Swap and forward contract – Company can recognised through FVTPL

In case of floating rate loan – Loan Interest resent on every 3 months basis and not major impact on Cash flow – treated as AMC + FVOCI

In other case , where floating rate on Interest decided every 3 Months based on the 6 Months BA rate and impacted major in Cash flow – considered under FVTPL

As per Standard , Investment in Debt Instrument must pass through two test 1) Business Model test and 2) cash flow contractual test . Any Debt Instrument not cover in both cases , then it will valued under FVTPL . Business model as well as contractual cash flow test already explained above .

Under hedging , debt instrument also determined either amortized cost or FVOCI basis

Any hedge instrument impacted on Profit and loss account based on Effective Interest rate method

Looks like Sham And Julia was followed IFRS 9 Standard properly and they want to increase Income statement with hep of wrong accounting treatment Both are ethically not correct .