Mark To Market Securities

Mark To Market Securities 2020-06-08T09:53:04+00:00
 

Question A: In its 2006 annual report Agora Company shows that as of 1 October 2006, it owned $87.5 million in marketable securities designated as NonTrading Securities. On the same date, Agora Company owned $53.5 million in marketable securities designated as Trading Securities. Additionally, Agora Company owned $65.5 million in marketable securities designated as Held-For-Collection investments. Assume that Agora Company sold no marketable securities (stocks or bonds) during the month of October.

What would have happened to Agora Company net income for the month ended 31 October 2006, if on 25 October 2006 the stock market crashed and the share price valuations for marketable securities and bonds felt on average, by 50%? Assume that the market is expected to rebound to pre-cash levels in three months. Give a detailed answer indicating how each of Agora Company three types of investments would impact the net income due to the market crash and explain the rational for the accounting for each type of investment.

Answer Part A

In response to stock market crash, only Trading Securities will impact net income of Agora Company as it accounts for unrealized gain/loss. It is also cleared from itsdefinition; a trading security will be sold in the near future at its market value. Other securities like Non- Trading Securities and Held-For-Collection investment reflects only realized gains/loss so, there will have no immediate effect upon Income Statement.

Management’s preference in different types of investment depends on how long the company intends to hold these securities. It also has to ensure good liquidity position of company along with productive use of idle cash. So, the management used different heads marketable securities to meet aforementioned objective.

Question B: What are the problems (weaknesses) of using Mark-To-Market accounting for investments?

Answer Part B

Mar to Market accounting limits a company’s ability to potentially manipulate its reported net income. Sometimes management may purposely arrange certain asset sales, for example, to use gains or losses from the sales to increase or decrease net income as reported at its desired time. Using Mar to Market accounting, gains or losses from any price change for an asset or liability are reported in the period in which they occur. While an increase in asset value or a decrease in liability value adds to net income, a decrease in asset value or an increase in liability value reduces net income.

Mark to Market accounting can also pose challenges to the companies and the users of the reported financial statements. The situation of the markets in which such assets and liabilities are traded may become volatile or fluctuate some times. Applying Mark to Market accounting, companies reassess the current value of those assets and liabilities even in those volatile market conditions, that potentially create large swings in the value of such assets and liabilities. But after the markets get stabilize, the changes in values often get reverse to the past normal levels and thus in the process, make any previously reported gains or losses temporary, which means Mark to Market accounting could also provide misleading information in the past or at that time.

Moreover, the use of Mark to Market accounting may further affect a down market unfavorably. Like after the downward revaluation of an assets because of drop in the current market trading price, this lower value of that asset may trigger larger selling of the assets at a potentially even more low price. Without valuation markdown as required by Mark to Market accounting, the companies may not feel that they are required to sell an asset in a down market for the prevention of potentially itsmore downward valuation. In the absence of additional selling pressures, the market may itself get stabilize with the passage of time, which would help preserve the value of that asset.

Question C: Using the notation O (overstated), U (understated) and NE (no effect), indicate the effects os Assets, Liabilitites, Equity, Net Income and Debt Ratio of each of the independent errors that follow. Ignore income tax effects.

Please provide brief details of your reasoning

 

  Assets Liabilities Equity Net Income Debt Ratio
A firm holding securities
classified as Non-trading
securities neglected to increase
the securities to an increase
market value at the end of the
year
Understate-    This is because the non-trading securities should be marked to market value and hence to their increased market value No effect Understated as the gain in value would have been reported under other income No Effect Debt ratio is over stated because of the increased equity, it should have come down
In applying the equity method, the parent company correctly records its share of the Associate’s net income for the year. However, when receiving a dividend from the Associate, the Parent records dividend revenue No Effect because the decrease investment in associate will be offset by the increase in cash No effect No Effect No Effect because the dividend income would be part of other income or other comprehensive income and not the net income No Effect because this transaction does not affect assets or liabilities.