Is It OK to Strategically Classify Securities?

You have recently been hired as a staff assistant in the office of the chairman of the board of directors of Clefton, Inc. Because you have some background in accounting, the chairman has asked you to review the preliminary financial statements that have been prepared by the company’s accounting staff. After the financial statements are approved by the chairman of the board, they will be audited by external auditors. This is the first year that Clefton has had its financial statements audited by external auditors.

In examining the financial statement note on investment securities, you notice that all of the securities that had unrealized gains for the year have been classified as trading, whereas all of the securities that had unrealized losses have been classified as available-forsale.

You realize that this has the impact of placing all the gains on the income statement and hiding all the losses in the equity section of the balance sheet. You call the chief accountant who confirms that the securities are not classified until the end of the year and that the classification depends on whether a particular security has experienced a gain or a loss during the year. The chief accountant states that this policy was adopted, with the approval of the chairman of the board, in order to maximize the reported net income of the company. The chief accountant tells you that investment security classification is based on how management intends to use those securities; therefore, management is free to classify the securities in any way it wishes.

You are uncomfortable with this investment security classification strategy. You are also dismayed that the chief accountant and the chairman of the board seem to have agreed on this scheme to maximize reported income. You are also worried about what the external auditors will do when they find out about this classification scheme. You have been asked to report to the chairman of the board this afternoon to give your summary of the status of the preliminary financial statements. What should you do?