Tara Enterprises has numerous investments in debt and equity securities. The con

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. ln 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. D (Ctr)v

Explanation / Answer

1. James Cameron himself will be affected by the suggested classification.

2. Yes, the suggested classification will affect Cameron’s bonus since it is computed as a percent of net income.

Per GAAP, changes in fair value of trading securities are reported in the income statement while the changes in fair values of available for sale securities are reported not in the income statement but in the stockholders’ equity. Thus, classifying securities having increased fair values as trading securities will result in an increase in the net income and classifying securities with decreased fair values as trading securities will result in a decrease in the net income.

James Cameron has thus deliberately classified securities with increased fair values as trading securities so as to inflate the net income which will result in a higher bonus being paid to him.

3. The suggested classification is not ethical as it is done with an intent to benefit James Cameron and not as provided by GAAP.

The securities should be classified as trading securities only if they are purchased and sold to earn short-term profits from changes in their fair values.

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