Tale of Stable Mable\'s Unstable Investment John

¶ … Tale of Stable Mable's Unstable Investment

John Smith

Accounting 101

Stable Mable is a privately held company with a fiscal year ending on September 30th. Because of its private status, the only external reporting requirement on the company is that they must provide audited annual financial statements to shareholders and other financial leaders.

In order to seek additional levels of income, Stable Mable invested $20 million into a mutual bond fund in October of 1997. By the end of the following fiscal year, the investment went south and had an unrealized holding loss of $1.3 million. Stable Mable had to classify and establish just how to adjust their financial statements for the investment's losses. Their options were to account for the losses as realized losses or to exclude the losses from earnings as a separate component of shareholders' equity.

In addition, decisions made now could effect future financial statements because Stable Mable is considering an IPO offering. Investors would like to see the financial statement process in accordance with the SEC's accounting standards.

Key Issues

During the 1998 fiscal year, Stable Mable adopted the provisions of Financial Accounting Standards Board (FASB): Securities Statements of Financial Accounting Standards (SFAS), Statement No. 115, Accounting For Certain Investments In Debt And Equity (Issued 5/93).

Statement 115 addresses accounting and reporting for investments and based on statement 115, Stable Mable classified the deteriorating investment as 'available-for-sale' during the fiscal year of 1998. The unrealized holding loss was listed as a separate component of shareholder's equity.

At the end of the 1998 fiscal year, the company performed an 'impairment analysis' on the investment and concluded that the overall investment decline was not 'other than temporary' and an independent auditor concurred.

As the bond fund continued to deteriorate, a second impairment analysis was done in 1999 as the investment continued to lose value. Stable Mable had to recognize a $1.8 million charge against 1999 earnings.

After terminating the relationship with the previous independent auditors, Stable Mable brought in a second independent auditing firm. The new firm questioned whether or not Stable Mable should have taken the impairment charge in 1998 or 1999.

Review Generally Accepted Accounting Principles (GAAP) Rules

Each day, accountants make decisions as to how they should record business transactions. Decisions are often based on the financial objectives of the organization they work for but at other times the accountants use Generally Accepted Accounting Principles (GAAP). GAAP rules are not a fixed set of rules -- they are simply guidelines or a group of objectives and conventions that govern how financial statements are prepared.

A review of Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (Issued 5/93):

Statement 115 addresses accounting and reporting for investments in equity securities and those investments are to be classified in categories:

Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as 'held-to-maturity' securities and reported at amortized cost.

Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity.

As is true with most GAAP, the definition for "impairment" is a company interpretation. Although the regulations are complex, the fundamentals are relatively easy to understand. Under the new rules, all goodwill is to be assigned to the company's reporting units that are expected to benefit from that goodwill. Then the goodwill must be tested (at least annually) to determine if the recorded value of the goodwill is greater than the fair value. If the fair value is less than the carrying value, the goodwill is deemed "impaired" and must be charged off.

Apply rules to key issues

The rules that apply to the key issues are that when Stable Mable first adopted the FASB Statement 115, they classified the investment as available-for-sale and therefore they interpreted that the loss should be a separate component of shareholders' equity.

When they performed the impairment analyses at the fiscal year end 1998 they incorrectly concluded that the decline in the fair value of the Fund Investment below its amortized cost basis was not 'other-than-temporary'.

At that point the company and the independent auditors should have accepted that it was probable that Stable Mable would not be able to collect all amounts due according to the contractual terms of the debt security. They should have classified the impairment as other-than -temporary.