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.