Question

Tara Enterprises has numerous investments in debt and equity securities. The controller, James Cameron is preparing its year-end financial statements and is in the process of classifying for the first time the securities in the portfolio.

The poor economy in the past year has caused the portfolio's overall fair value to substantially decline; however, some securities have increased in value and others have decreased. Cameron earns a bonus each year, which is computed as a percent of net income.

Cameron presents a schedule classifying the securities for the COO's review. In reviewing the schedule the COO notices that the securities that have increased in value have been classified as trading securities while the securities that have decreased in value are classified as long-term available-for-sale securities.

1. Who might be affected by the suggested classification?
2. Will the suggested classification affect Cameron's bonus? Explain.
3. In your opinion, is the suggested classification ethical? Explain.

Answer 1

Answer:-

Trading securities are those securities that are kept in a company's portfolio with an intention to sell them in the short term to earn a profit. These securities are recorded at their fair value in the balance sheet. Any increase in the fair value of these securities is recorded as a gain in the income statement. So Cameron has put the securities showing increase in value as trading securities to increase the net income of the company.

Available for sale securities are those securities that are not classified as held to maturity, or a trading security. Any decline in the value of such securities will not be reported as loss in the income statement. The notional loss will be recorded as a loss under the head - other comprehensive income. Such losses will not affect the company's earnings. Hence Cameron has reported such securities as available for sale, so as to not undermine the company's net income. This is in order to protect his bonus.

Yes, the suggested classification will affect Cameron's bonus. Any increase in the value of traceable securities is reported as gain in the income statement, thus increasing net income. This will increase his bonus.

Any decline in the value of available for sale securities, will not affect the net income. This strategy protest’s Cameron's bonus from any decline in the value of securities. Had such securities been reported as trading securities, decline in their value would have been reported as loss in the income statement, decreasing the net income and in turn Cameron's bonus.

No, the suggested classification is not at all ethical. The classification has been done to maximize the net income. This is not the correct basis of classification as per the accounting standards. The securities should have been classified on their merit and type (whether they are held for short term trading purpose or whether they are held till maturity). The practice adopted by Cameron is nothing but cooking up the books of accounts.