Marketable Securities and
Deferred Taxes
15.501/516 Accounting
Spring 2004
Professor S. Roychowdhury
Sloan School of Management
Massachusetts Institute of
Technology
1
Marketable Securities and Deferred
Taxes: 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
of valuation adjustments 2
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
3
Lower of cost or market rule for
Inventory
When Market Value of Inventory < Capitalized Cost
Loss on inventory writedown = 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 writedowns of LIFO vs. FIFO
“Hidden reserves” and income smoothing 4
Valuation Adjustments: K-Mart
On July 25, 2000, Kmart announced a series of strategic actions
designed to enhance the productivity of its store base, inventory and
information systems.” “A pretax charge of $290 million was taken 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
$365 million.
13 Weeks Ended July 26, 2000
($ 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
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
prices of illiquid securities 6
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)
Held-to-maturity (debt only) 7
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
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
9
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!
10
An Illustration: Acquisition and
Dividends (2002)
On Jan. 1, 2002, Ace acquired 500 common shares of security MITCo for $25/share.
C MS +MSadj = DTL OE RE
Trading:
AFS: “Adjunct”
account
On Nov. 30, 2002, Ace received $625 in dividends ($1.25/share of MITCo)
C MS +MSadj = DTL OE RE
Trading:
AFS:
An Illustration: Acquisition and
Dividends (2002)
On Jan. 1, 2002, Ace acquired 500 common shares of security MITCo for $25/share.
C MS +MSadj = DTL OE RE
Trading: (12,500) 12,500
AFS: Same as above
On Nov. 30, 2002, Ace received $625 in dividends ($1.25/share of MITCo)
C MS +MSadj = DTL OE RE
Trading:
AFS:
An Illustration: Acquisition and
Dividends (2002)
On Jan. 1, 2002, Ace acquired 500 common shares of security MITCo for $25/share.
C MS +MSadj = DTL OE RE
Trading: (12,500) 12,500
AFS: Same as above
On Nov. 30, 2002, Ace received $625 in dividends ($1.25/share of MITCo)
C MS +MSadj = DTL OE RE
Trading: 625 625
AFS: Same as above “Investment income” on I/S
Unrealized Gains and Losses (2002)
On Dec. 31, 2002, MITCo is trading at $30/share. Ace elected to keep the shares, and
has a tax rate of 30%.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500
EB:
AFS: C MS +MSadj = DTL OE RE
BB: 12,500
EB:
Unrealized Gains and Losses (2002)
On Dec. 31, 2002, MITCo is trading at $30/share. Ace elected to keep the shares, and
has a tax rate of 30%.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500
2,500 2,500
($30 – 25) x 500 “Investment
income” on I/S
EB:
AFS: C MS +MSadj = DTL OE RE
BB: 12,500
EB:
Unrealized Gains and Losses (2002)
On Dec. 31, 2002, MITCo is trading at $30/share. Ace elected to keep the shares, and
has a tax rate of 30%.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500
2,500 2,500
750 (750)
2,500 x 0.3 “Income tax
expense” on I/S
EB:
AFS: C MS +MSadj = DTL OE RE
BB: 12,500
EB:
Unrealized Gains and Losses (2002)
On Dec. 31, 2002, MITCo is trading at $30/share. Ace elected to keep the shares, and
has a tax rate of 30%.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500
2,500 2,500
750 (750)
EB: 12,500 2,500 750
AFS: C MS +MSadj = DTL OE RE
BB: 12,500
EB:
Unrealized Gains and Losses (2002)
On Dec. 31, 2002, MITCo is trading at $30/share. Ace elected to keep the shares, and
has a tax rate of 30%.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500
2,500 2,500
750 (750)
EB: 12,500 2,500 750
AFS: C MS +MSadj = DTL OE RE
BB: 12,500
2,500 750 1,750
No I/S effect
EB:
Unrealized Gains and Losses (2002)
On Dec. 31, 2002, MITCo is trading at $30/share. Ace elected to keep the shares, and
has a tax rate of 30%.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500
2,500 2,500
750 (750)
EB: 12,500 2,500 750
AFS: C MS +MSadj = DTL OE RE
BB: 12,500
2,500 750 1,750
EB: 12,500 2,500 750 1,750
Unrealized Gains and Losses (2003)
On Dec. 31, 2003, MITCo is trading at $27/share. Ace elected to keep the shares.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500 2,500 750
EB:
AFS: C MS +MSadj = DTL OE RE
BB: 12,500 2,500 750 1,750
EB:
Unrealized Gains and Losses (2003)
On Dec. 31, 2003, MITCo is trading at $27/share. Ace elected to keep the shares.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500 2,500 750
(1,500) (1,500)
($27 - $30) x 500
“Investment income” on I/S
EB:
AFS: C MS +MSadj = DTL OE RE
BB: 12,500 2,500 750 1,750
EB:
Unrealized Gains and Losses (2003)
On Dec. 31, 2003, MITCo is trading at $27/share. Ace elected to keep the shares.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500 2,500 750
(1,500) (1,500)
(450) (450)
($1,500) x 0.30 “Income tax
EB: benefit” on I/S
AFS: C MS +MSadj = DTL OE RE
BB: 12,500 2,500 750 1,750
EB:
Unrealized Gains and Losses (2003)
On Dec. 31, 2003, MITCo is trading at $27/share. Ace elected to keep the shares.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500 2,500 750
(1,500) (1,500)
(450) (450)
EB: 12,500 1,000 300
AFS: C MS +MSadj = DTL OE RE
BB: 12,500 2,500 750 1,750
EB:
Unrealized Gains and Losses (2003)
On Dec. 31, 2003, MITCo is trading at $27/share. Ace elected to keep the shares.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500 2,500 750
(1,500) (1,500)
(450) (450)
EB: 12,500 1,000 300
AFS: C MS +MSadj = DTL OE RE
BB: 12,500 2,500 750 1,750
(1,500) (450) (1,050)
No I/S effect
EB:
Unrealized Gains and Losses (2003)
On Dec. 31, 2003, MITCo is trading at $27/share. Ace elected to keep the shares.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500 2,500 750
(1,500) (1,500)
(450) (450)
EB: 12,500 1,000 300
AFS: C MS +MSadj = DTL OE RE
BB: 12,500 2,500 750 1,750
(1,500) (450) (1,050)
EB: 12,500 1,000 300 700
Realized Gains and Losses (2004)
On Feb. 14, 2004, Ace sold all of its investment in MITCo, then trading at $36/share.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500 1,000 300
EB:
AFS: C MS +MSadj = DTL OE RE
BB: 12,500 1,000 300 700
EB:
Realized Gains and Losses (2004)
On Feb. 14, 2004, Ace sold all of its investment in MITCo, then trading at $36/share.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500 1,000 300
18,000 (12,500) (1,000) 4,500
$36 x 500 “Plug” that equals ($36 - $27) x
Remove existing accounts 500 “Investment income” on I/S
EB:
AFS: C MS +MSadj = DTL OE RE
BB: 12,500 1,000 300 700
EB:
Realized Gains and Losses (2004)
On Feb. 14, 2004, Ace sold all of its investment in MITCo, then trading at $36/share.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500 1,000 300
18,000 (12,500) (1,000) 4,500
(1,650) (300) (1,350)
Pay tax on the full gain Recognize tax expense for gain
EB: ($18,000 - $12,500) x 0.30 in this year’s I/S, $4,500 x 0.30
AFS: C MS +MSadj = DTL OE RE
BB: 12,500 1,000 300 700
EB:
Realized Gains and Losses (2004)
On Feb. 14, 2004, Ace sold all of its investment in MITCo, then trading at $36/share.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500 1,000 300
18,000 (12,500) (1,000) 4,500
(1,650) (300) (1,350)
EB:
AFS: C MS +MSadj = DTL OE RE
BB: 12,500 1,000 300 700
18,000 (12,500) (1,000) (300) (700) 5,500
$36 x 500
EB: Remove existing accounts “Plug” that equals ($36 -
$25) x 500 “Investment
income” on I/S
Realized Gains and Losses (2004)
On Feb. 14, 2004, Ace sold all of its investment in MITCo, then trading at $36/share.
Trading: C MS +MSadj = DTL OE RE
BB: 12,500 1,000 300
18,000 (12,500) (1,000) 4,500
(1,650) (300) (1,350)
EB:
AFS: C MS +MSadj = DTL OE RE
BB: 12,500 1,000 300 700
18,000 (12,500) (1,000) (300) (700) 5,500
(1,650) (1,650)
EB: Pay tax on the full gain
Recognize tax expense for the gain
($18,000 - $12,500) x 0.30 in this year’s I/S, $5,500 x 0.30
Marketable Securities: Income patterns
Trading Available for Sale
5,500 5,500
4,500 4,500
2,500 2,500
02 03 04 02 03 04
-1,500 -1,500
31
Marketable Securities: Income patterns
Trading Available for Sale
5,500 5,500
4,500 4,500
2,500 2,500
02 03 04 02 03 04
-1,500 -1,500
32
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
income statement 33
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. 34
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
Ignore value changes for “held to maturity” category 35
Marketable Securities in other
countries
Canada: LCM for investments classified as current
assets; historical cost for noncurrent 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: LCM for marketable securities
Others: Typically either LCM or mark-to-market,
exclusively
International Accounting Standards: Similar to US
GAAP
36
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!
37
