Accounting for
Marketable Securities
15.511 Corporate Accounting
Summer 2004
Professor SP Kothari
Sloan School of Management
Massachusetts Institute of Technology
July 7, 2004
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Marketable Securities: Agenda
Understand when accounting departs from
the “transactions- based” model and
towards market-driven valuations
Illustrate the role of judgment in applying
the lower-of-cost- or-market (LCM) rule for
inventory
Understand how marketable securities are
valued on companies’ Balance Sheets
Understand the Income Statement effects
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of valuation adjustments
Should changes in market
value be recognized?
Accounts receivable
Estimates of uncollectibles
Changes in credit risk
Inventory
Purchase/production cost
Changes in input prices, obsolescence
Fixed Assets
Acquisition cost (historical basis)
Obsolescence
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Lower of cost or market
rule for Inventory
When Market Value of Inventory < Capitalized Cost
Loss on inventory write-down = Capitalized cost - Market
Value
This is added to Cost of Goods Sold, expense
increases, income decreases
Market value = Lower of the replacement cost and selling
price
Once inventory is written down in the balance sheet,
it cannot be “written up” in subsequent periods
Reliable evidence is absent to write up inventory
Issues
Susceptibility to write-downs of LIFO vs. FIFO
“Hidden reserves” and income smoothing 4
Valuation Adjustments: K-Mart
Source: Kmart Corporation Press Release. “Kmart
On July 25, 2000, Kmart announced strategic actions designed to make its
stores, inventory, and information systems more effective. It took a $290 million
pretax charge “to state the inventory at its net realizable value” and $75 million “to
reflect the anticipated loss in value of inventory at the closed locations...” Total is
$365 million. -
Corporation Announces Strategic Actions to Enhance Financial Performance.” 25 July 2000.
http://www.kmartcorp.com/corp/story/pressrelease/archive_00/news/pr000725.stm (accessed July 12, 2004).
13 Weeks Ended July 26, 2000
($ in millions) Charge For Excluding
As Reported Strategic Actions Charge
Sales $ 8,998 $ - $ 8,998
Cost of sales, buying
and occupancy 7,518 365 7,153
Gross margin 1,480 (365) 1,845
Data Source: Kmart Corporation Press Release. “Kmart Corporation Reports Second Quarter 2001 Results.” 23 August 5
2001. http://www.kmartcorp.com/corp/investor/financialpress/earnings/pr010823.stm (accessed July 12, 2004).
Should changes in market value of
Marketable Securities be recognized?
Marketable securities
Corporate and government bonds, treasuries
Common stock
Derivative instruments: options, swaps, etc.
What is different about marketable securities
such that both gains and losses can be
recognized?
Objective (i.e., reliable, verifiable) market values of
the assets are easily available
Enron troubles due in part to the reliance on
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prices of illiquid securities
New Accounting Rules
(adopted in 1994) SFAS 115
Prior to 1994, marketable securities
involving stock and bonds are valued at
“lower of cost or market” on a portfolio
basis
SFAS 115: Mark-to-market accounting:
gains and losses treated similarly
New classifications
Trading securities (debt and equity)
Available for sale (debt and equity)
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Held-to-maturity (debt only)
New Accounting Rules
(adopted in 1994) SFAS 115
Controversy: where should changes in
market value be reported?
Taxes are paid/credited only on realized
gains/losses
Deferred taxes on unrealized
(paper) gains/losses
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Marketable Securities
Trading securities (debt and equity)
Acquired for short-term profit potential
Changes in market value reported in the income statement (net
of taxes), investment marked to market in the balance sheet
Purchases and disposals reported in operating section of SCF
Held to maturity (debt only)
Acquired with ability and intent to hold to maturity
No changes in market value reported in the income statement,
thus investment carried at historical cost in the balance sheet
Interest income reported in operating section of SCF
Available for sale (debt and equity)
Securities not classified as either of above
Changes in market value reported in “Other Equity” (net of
taxes), instead of the income statement!
Purchases and disposals reported in investing section of SCF
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What Is “Other Equity”?
So far, what have we seen in class?
Stockholders’ Equity (SE) =
Contributed capital (CC) + Retained Earnings
(RE)
The above is a simplification! It is known as
the “Clean Surplus Equation”.
In fact, Clean Surplus is often violated
SE = CC + RE + Other Equity
What causes changes in “Other Equity”?
Changes in the market value of AFS securities, for
one!
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Marketable Securities: Income patterns
Trading Available for Sale
5,500 5,500
4,500 4,500
2,500 2,500
02 03 04 -1,500
-1,500 02 03 04
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Marketable Securities: Income patterns
Trading Available for Sale
5,500 5,500
4,500 4,500
2,500 2,500
-1,500 02 03 04 -1,500
02 03 04
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Reclassifications of
Marketable Securities
Trading to Available for sale
Gains or losses of the period recognized on
reclassification date
Subsequent market value changes reported
in “Other Equity”
Available for sale to Trading
Cumulative gains or losses, including those of
current period, recognized on reclassification date
Subsequent market value changes reported in the
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income statement
Why does recognition
of gains/losses matter?
Former SEC Chairman Breeden, on mark-to-market (ca 1990):
“If you are in a volatile business, then your balance sheet and income statement should
reflect that volatility. Furthermore, we have seen significant abuse of managed earnings.
Too often companies buy securities with an intent to hold them as investments, and then
miraculously, when they rise in value, the companies decide it's time to sell them.
Meanwhile, their desire to hold those securities that are falling in value grows ever
stronger. So companies report the gains and hide the losses.”
Current SEC Chairman Arthur Levitt, Jr (1997):
“It is unacceptable to allow American investors to remain in the dark about the
consequences of a $23 trillion derivatives exposure. We support the independence of the
FASB as they turn on the light.”
Federal Reserve Chairman Greenspan, on derivatives (ca 1997):
“Putting the unrealized gains and losses of open derivatives contracts onto companies’
income statements would introduce ‘artificial’ volatility to their earnings and equity.
Shareholders would become confused; management might forego sensible hedging
strategies out of purely window dressing concerns.” 14
A compromise in GAAP?
Recognize all unrealized gains/losses for “trading
securities” in Net Income
Mark “available for sale” securities to market value, but
don’t report changes in the income statement
Reduces earnings volatility
Managers dislike income volatility
They complain similarly about other accounting method
changes that increase reported earnings volatility even though
underlying cash flows are unaffected
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Ignore value changes for “held to maturity” category
Marketable Securities in
other countries
Canada: LCM for investments classified as current
assets; historical cost for non-current assets, but
recognize “permanent” declines in value
Mexico: Carry marketable securities at net realizable
value, report gains/losses in the income statement;
LCM for other investments
Japan: Marking-to-market for marketable securities
Others: Typically either LCM or mark-to-market,
exclusively
International Accounting Standards: Similar to US
GAAP
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Summary
Valuation adjustment necessary when changes
in market values are objectively measurable
Lower of cost or market applied to inventory valuation
New GAAP in marketable securities: mark-to-market
treats gains and losses equally
Disclosure vs. Recognition in mark-to-market
accounting:
Not all gains and losses are reported in the income statement
A compromise!
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