ACCT 406 - ACCOUNTING THEORY Homework Question 3 - Fair Value Accounting and the Relevance of Other
Question:
ACCT 406 - ACCOUNTING THEORY
Homework Question 3 - Fair Value Accounting and the Relevance of Other Comprehensive Income
Some have claimed that OCI is an unfortunate engineering innovation dropped into US GAAP so that US GAAP could adopt Fair Value Accounting for derivatives. From this perspective one would prefer NOT to see OCI and therefore AOCI in the financials. Let's explore if you think OCI (and AOCI) are relevant.
Consider Company A that purchases a 2 year Treasury Note on the day it is issued through auction. The note's price and fair value is its Face Amount because the interest rate is set at the prevailing yield for 2 year Treasuries. The value of the note changes with interest rates. The Chart Below shows the changes in Fair Value of the Note from the date of purchase to its maturity date. Company A elects to treat the note as Available for Sale. This means that interest income is recorded in Earnings but changes in Fair Value are recorded in OCI. The note is held from the purchase date, when it comes into existence, to its maturity date when the investor is repaid the principal invested and that amount is equal to the face amount of the note. Of necessity, as the maturity date approaches the note's fair value converges to its face value. The values in the chart below ignore interest accruals.
| ANNIVERSARIES | |||||||||
| DATE | Purchase Date | 1st Quarter ("Qtr.") | 2nd Qtr. | 3rd Qtr. | 1 Year | 1 Year and 1 Qtr. | 1 Year and 2 Qtrs. | 1 Year And 3 Qtrs. | 2 Years |
| Face Amount | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 |
| Fair Value | 100 | 98 | 97 | 99 | 101 | 102 | 103 | 104 | 100 |
| Fair Value Change (OCI) | n/a | -2 | -1 | +2 | +2 | +1 | +1 | +1 | -4 |
| AOCI (the cumulative sum of OCI) | 0 | -2 | -3 | -1 | -+1 | +2 | +3 | +4 | 0 |
| Note that across the 2 years, the sum of all the Fair Value changes is 0. This is consistent with buying a note with a face amount of 100 and holding it until it matures and your 100 investment is returned. |
When considering this accounting policy you are offered only one alternative: do not report the fair value changes, and in turn, close and do not report OCI and AOCI. This is what "accounting purists" would prefer.
Here is the question - is reporting OCI gains and losses value relevant or do you prefer the "accounting purist" approach, which is the same as accounting for the note as Held-to-Maturity?
Question 4: A faction in Company A's controller's office strongly favors the OCI policy above. As a result the company never classifies as debt security as Held to Maturity and always classifies debt securities as Available for Sale.
The treasurer announces a new investment policy. Half of investable funds going forward will be invested in the common stock of ExxonMobil. The treasurer asks the controller to sketch out the accounting for the EXXON MOBIL shares and the controller produces the chart below in the form of a Comparison of how Debt and Equity investments are treated under US GAAP. The Dividend Income on the Exxon Mobil shares is ignored in estimating its Fair Value.
| GENERIC SECURITY (whether debt or equity) | ANNIVERSARIES | ||||||||
| DATE | Purchase Date | 1st Quarter ("Qtr.") | 2nd Qtr. | 3rd Qtr. | 1 Year | 1 Year and 1 Qtr. | 1 Year and 2 Qtrs. | 1 Year And 3 Qtrs. | 2 Years |
| Face Amount | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 |
| Fair Value | 100 | 98 | 97 | 99 | 101 | 102 | 103 | 104 | 100 |
| Fair Value Change | n/a | -2 | -1 | +2 | +2 | +1 | +1 | +1 | -4 |
| Note to Treasurer: The Accounting treatment for the Fair Value Change depends on whether the security investment is an equity (Exxon Mobile shares) or a Treasury Note (in which case you are reminded that our policy is to account for all Treasury Notes you buy as "Available for Sale."). | |||||||||
| Case # 1 - You buy a Treasury Note and we account for it as Available for Sale. The Fair value changes are recorded in OCI. | |||||||||
| OCI | n/a | -2 | -1 | +2 | +2 | +1 | +1 | +1 | -4 |
| AOCI | 0 | -2 | -3 | -1 | -+1 | +2 | +3 | +4 | 0 |
| Case # 2 - You buy EXXON MOBIL shares. There is only one way to accounting for them in US GAAP. The Fair value changes are recorded in Earnings and that means they flow to Retained Earnings. | |||||||||
| EARNINGS | n/a | -2 | -1 | +2 | +2 | +1 | +1 | +1 | -4 |
| Retained Earnings | 0 | -2 | -3 | -1 | +1 | +2 | +3 | +4 | 0 |
The treasurer studies the chart carefully. What he sees is that the nature of the security, debt or equity, determines whether fair value changes are recorded in Earnings or OCI. That does not make sense to him. Also his bank considers Retained Earnings as part of the Equity of the company for making loans but choose to ignore AOCI. The choice of security might also impact the creditworthiness of the company as measured in Retained Earnings.
Here is the question: Explain (1) why these US GAAP accounting rules make sense or (2) why they do not make sense because they might lead to wild and capricious swings in Earnings as described by Warren Buffet.
Expert Answer:
