Marketable securities are reflected on the balance sheet at market value. Because these securities can be readily converted into known amounts of cash, such a valuation rule seems quite reasonable. Analysts evaluate the liquidity of a firm, in part, by examining current assets. The amount of cash a marketable security can be transformed into is likely to be much more relevant for liquidity assessment than is a security’s historical cost.
Your accounting common sense probably suggests that all unrealized gains and losses on marketable securities should appear on the income statement. SFAS No. 115 precludes this treatment for securities classified as available-for-sale. The FASB’s justification for this position relates to liabilities. The FASB tried but failed to agree on how to measure changes in the value of liabilities. Because net income might be distorted by including asset value changes in income while excluding similar changes for liabilities, the FASB decided to exclude changes in asset values from reported income.
The FASB’s required procedures can be challenged on at least three grounds. First, some argue that two wrongs do not make a right. Changes in the value of marketable securities are valid gains and losses and should be included in net income, regardless of how liabilities are treated. Not doing so reduces the usefulness of net income as a measure of wealth changes and as an indicator of managerial performance.
Second, the FASB’s procedures provide an opportunity for profit manipulation by management. By selecting to sell those securities that have either risen or fallen in value, managers can dictate whether gains or losses will be reported.
Third, the FASB created a new element of shareholders’ equity (unrealized gain/loss on marketable securities) in order to exclude changes in the value of marketable securities from net income. This element is a new (and somewhat unusual) addition to the conventional financial accounting framework. Its existence compromises the basic notion that the change in shareholders’ equity for a period equals net income plus the effects of direct contributions/withdrawals by the shareholders.