Bartlet 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, 2012 is greater than total cost. Some securities have increased in value and others have decreased. Deb Faust, the financial vice president, and Jan McCabe, the controller, are in the process of classifying for the first time the securities in the portfolio. Faust 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 2012 net income. McCabe 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. McCabe 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. Questions (a) Will classifying the securities as Faust and McCabe suggest actually affect earnings as each says it will? (b) Is there anything unethical in what Faust or McCabe propose? Who are the stakeholders affected by their proposals? (c) Assume that Faust and McCabe properly classify the portfolio. Assume, at year-end, that Faust proposes to sell the securities that will increase 2012 net income, and that McCabe proposes to sell the securities that will decrease 2012 net income. Is this unethical?

Classifying the securities under the two different methods advocated will produce higher or lower reported net income. It might be questionable to classify the securities as available-for-sale (AFS) versus trading securities solely to cosmetically enhance reported net income, but Bartlet must be consistent about the classifications in future years regardless of which method it selects. The stakeholders affected by the proposals are shareholders and potentially employees and executives, as well. It is not unethical to sell under-performing or outperforming securities.

Expert Answers

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a) Generally accepted accounting principles (GAAP) require that available-for-sale (AFS) securities – those debt or equity securities purchased with the intent of selling before maturity – be reported at fair value. Gains and losses from AFS securities are not reflected in net income. Classifying the securities that have depreciated in value as AFS securities would produce higher reported net income. Classifying them as trading assets would result in lower reported earnings. Thus, classifying the securities as the two different financial executives advocate will result in higher or lower reported net income in the current year, as they indicate.

It is important to keep in mind that either classification method will impact the financial statements. If AFS securities decline in value, it will show up in Bartlett’s balance sheet and impact shareholder equity and book value, which are important metrics that investors use to monitor the financial health of a company.

b) If the company actively trades the securities, they should be reported as trading securities and vice versa. Thus, it might be questionable to classify the securities as AFS versus trading securities with the sole objective of cosmetically altering reported net income. Regardless, Bartlet should disclose the overall breakdown of its investment portfolio and be consistent about its methodology.

In other words, it cannot change the classification of an individual security depending on whether that security has appreciated or depreciated in value in future years. If Bartlet decides that Security A should be classified as an AFS, then Security A must remain an AFS in future reporting periods regardless of how the security performs. Moreover, Bartlet should also disclose the breakdown of its overall investment portfolio.

The stakeholders affected by their proposals are the company’s shareholders, employees and executives. If Bartlet is publicly traded, its share price is probably highly correlated to net income. The method could impact its share price, hurting or benefiting public shareholders. Moreover, executive compensation is often tied to operating results, including net income. Finally, if the company’s employees own the shares through the Bartlet pension fund, they will be impacted as well.

c) It is not unethical to sell under-performing securities, but it is foolish to make large scale trading decisions based on the short-term optics of how it will hurt or help the company’s net income instead of evaluating the longer-term prospects the securities offer.

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Basic accounting standards, regulated by the SOX (Sarbanes-Oxley Act), COSO and the SEC, govern how debt and security investments are reported by corporations. While there are advanced complex considerations--like relevance and reliability, comparability and consistency, and periocity and matching--that affect real-world accounting situations, basic accounting decisions are regulated by law, and violations can result in charges of financial manipulation and fraud as in the 2015 case of the SEC (Securities Exchange Commission) against the Computer Sciences Corporation, who were charged with a $190 million penalty. Further, while real-world debt and security investment accounting present subtleties and complexities, it is professional and personal ethics that provide the foundation for applying regulated basic accounting standards (Kermis & Kermis, "Financial reporting regulations, ethics and accounting").

Ethical Accounting: Intent
The underlying standard of accounting for debt and security investments is intent: "accounting for investments in the debt and equity securities ... requires management to categorize the securities based on the intent for holding the investment" (Judy Laux, "Investment in Securities"). Along with following basic accounting standards, in order for either Faust or McCabe to perform investment accounting ethically, they must categorize legitimately according to actual intent for holding any given debt or security investment.

Accounting Treatment for Trading versus for Available-for-Sale
Securities held with the intent of trading--meaning that they are held with the aim of selling when the value of the security increases, generating a short-term profit for the corporation--have their present market values reported on the balance sheet, through the step of year-end adjustments, in addition to having gains and losses (of original market value and present market value) reported on the income statement; this is regardless of whether the trading security has been sold or is still held. Thus this accounting entry on the income statement has ramifications for year-end profitability reporting. In contrast, securities held with the intent of available-for-sale are not reported on the income statement at all. Available-for-sale investments are reported only on the balance sheets in the stockholders' equity section (as an asset value for stockholders); compare this to trading investments being reported on the balance sheet as year-end adjustments. Accounting treatment differences for trading and available-for-sale investments do not affect corporate earnings.
Faust and McCabe: Ethical or Unethical
Faust, the Financial VP, and McCabe, the Financial Controller, want to classify the investments based on increased and decreased values and on their effects on present or future year income. On the face of it, this is an unethical approach that ignores intent for holding an investment, thus violating the accounting standard requiring classification of investments as trading or available-for-sale based upon intent for holding. Additionally, choosing to classify based on income projections for varying years may affect stockholders who may gain or lose asset value based upon the classification decisions.

Stakeholders are a larger, more comprehensive group than stockholders, including sub-groups or individuals that can either affect or be affected by decisions made by the corporation; some stakeholders are the government, boards of directors, unions, community members and individual securities investors.

Year-End Net Income
On the face of it, classifying debt and security investments to optimize selectively chosen year-end incomes has the same ethical problems mentioned above: regulated basic accounting standards established by SOX and COSO (Committee on Sponsoring Organizations) and the SEC, require that classification of debt and security investments be made based on intent for holding the investment. Making classifications on other, arbitrarily chosen income advantages violates this fundamental basic accounting standard requirement.

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