Hello. I'm Professor Brian Bushee. Welcome back. In this video, we're going to look at a footnote disclosure related to marketable securities, to see what kind of information we can pull out of there. It'll also provide a nice review of those three methods: trading securities, available for sale securities and held to maturity. Let's get started. So in our disclosure example, we're going to be looking at BOC Automotive, otherwise known as BOCA. They have a financial services segment that helps its customers finance the purchase of their cars. As part of its business, that segment invests in marketable securities. So we're going to use BOCA's footnote disclosures to answer the following questions. What's the cost, fair value and book value or balance sheet value of BOCA's marketable securities at the end of the year? What were any accumulated unrealized gains or losses as of December 31, 2012? Where have they been recognized? Did BOCA recognize gains or losses from selling securities during 2012? What was the book value of the securities they sold? And, could BOCA have increased its pre-tax income in 2010 through changes in how it managed its marketable securities? So here is footnote 6 from BOCA's annual report, which summarizes their marketable securities. So looking at the rows, we have trading securities, available-for-sale securities, and then held-to-maturity securities. Looking at the columns, we have amortized cost, which is the original cost. Any unrealized, gains or losses since it was purchased, and then the current fair value as of December 31, 2012. And note that trading securities we get just the total available for sale and how the maturity it's broken out by what kind of securities. So US government debt, municipal debt, foreign governments, corporate debt, that would be corporate bonds, mortgage-backed securities, other debt, and then equity securities. >> Why doesn't BOCA give us more details about their trading securities? >> Are they trying to hide something? >> Yes, they are trying to hide something. Companies will often not provide a breakdown of their trading securities because they're trying to earn short-term profits. They've got some kind of strategy or some kind of information advantage, and they're afraid that providing the detailed breakdown of where they have their investments and securities might give away where their information advantage is. So in the name of keeping their investment secrets, secret, they showed just one lite item for trading securities. So let's start answering some of these questions. Starting with, what's the cost of those securities? And we look in the amortized cost column, and we can see at the bottom it's 6,025, so that's the answer, 6,025. What's the fair value? Again, there's a total at the bottom of the fair value column, $5,746. What's the book value? So, what's the amount that this is going to show up on the balance sheet? Well, that's a little more complicated. Trading securities, TS, are going to show up at their fair value 711. Available for sale securities will show up at their fair value, 3,707. But held-to-maturity will show up at their cost, 1,363. So what shows up as book value on the balance sheet is 5,781. >> Really? BOCA knows the fair value of its HTM securitIes but does not put it on their balance sheet. How can they get away with that? >> So remember, the idea of this held-to-maturity method, was that some companies argued hey, if I'm going to have a five year bond and I intend to hold it for five years and just collect the interest and principal, who cares whether the value goes up or down in the mean time? So Lafasby said fine, you can do that under that method, but they threw in this kicker that you have to disclose fair values of all your financial instruments, your marketable securities. So even though it doesn't show up on the balance sheet, we can at least go to the footnote and see what the fair value of these securities are. So it's not really hidden from us, we can just dig into the footnote and find the answer if we want to know what that fair value is. Next question. What are the accumulated unrealized gains and losses? So the total gains or total losses between when the security was originally bought, and what it's worth today. So the gains, the total accumulated unrealized gains, are 49, which is the total in this column here. And losses, it's the total of the gross unrealized loss column, which is 328. >> How can they have both unrealized gains and unrealized losses? And look at those losses! They are almost as bad at managing their portfolio as my brother is at managing his! >> How would you like to have losses in your teeth! >> Come on guys. Just calm down. Let's finish the video and then maybe you can take it outside or something. Anyway, so when we look at these categories like foreign debt securities or equity securities, obviously it's lumping together a lot of investments. So within equity securities, you could have investments in a large number of companies, and even within the same company, you could have investments that were bought in the a long time ago versus more currently, and then each of these different investments are going to have embedded gains and embedded losses. Now we want to keep track of those embedded gains or embedded losses separately, so that when we sell the securities, we know whether that individual security we've got a gain or a loss. So we aggregate all of these together but in a more detailed level that we don't see here, we do keep track of individual unrealized gains and losses on all of our different investments. Now, let's talk about where these unrealized gains or losses have been recognized in the financial statements. So, the ones that have gone into the AOCI are from the available for sale securities, and what we put in the AOCI is a net unrealized loss of 240. So that's the 279 of unrealized losses minus the 39 of unrealized gains leads to a net unrealized loss at AOCI from the available-for-sale securities of 240. What's gone into net income? Well, trading securities is the method where the unrealized gains or losses go to net income. So if we look up to trading securities, it's going to be a net of 4 in losses that have been recognized. So, that's 10 of unrealized losses minus 6 of unrealized gains, leads to net recognition of 4 of unrealized losses. Now notice, those are not all necessarily during this period in net income, because it's marked to market all through the time you hold it, but that four is the cumulative net income effect from when those securities were bought up until now. And then finally, how much has not been recognised at all? That's the, how the maturity part, remember how the maturity, you don't market to market so those losses never have to go anywhere else. So they held the maturity of 35 of net unrealized losses, 39 minus four. But that's never been recognized anywhere in the financial statements because it stayed at cost. So now let's go to the question of what are the gains and losses on securities that are sold? So here's the rest of Footnote 6 from Marketable Securities. [SOUND] And at the top, it talks about proceeds from sales of available-for-sale securities were $9.1 billion in 2012. Gross gains of $24 million and gross loss of $56 million were realized on those sales. So if gains of $24, losses of $56, a net loss of $32. And remember we've talked about this. You can have both gains and losses because you're selling individual securities. And each individual security has their own embedded gain or loss up to this point. So what was the book value of the security sold? We know we had a realized loss. We know the cash, we have to find I think another piece of information to figure out the book value. And that other piece of information it's going to come from the next part of the footnote, which is the change in accumulated other comprehensive income or loss that's due to available for sale securities in 2012. So let's walk through the journal entry and then we'll see how this works. So first, we can debit cash for $9.1 billion because as it says right up here in the note, we received cash of $9.1 billion from selling the securities. Next we can debit loss on the sale of investments for $32. Now I'm going to just grab the net loss, but you could have also debited loss of $56, credited gain of $24. It gets you the same net number of $32. Now we're going to use this AOCI footnote and we see there's a line in there that says, net unrealized gains or losses transferred to income, 18. Now, cumulative, comprehensive income if you look above they have losses in parenthesis, so basically if it's in parenthesis it means it's a debit entry. If it wasn't in parentheses, it would be a credit entry. I'm going to grab the pretax number, because we're going to do all of this pretax. We're going to debit AOCI for 18. That's what the footnote is telling us pretax. >> Really? Do you expect us to understand that Accumulated Other Comprehensive Nonsense footnote? >> Yeah, so I'm happy to explain this footnote, and I think to do so, I'm going to put it in a T account. So let me bring up a T account. All right, here we go. So, AOCI is a stockholders equity account, which means that it normally has a credit balance if it's gains. But if it has a debit balance, then it's accumulated losses. And that's what we have here. So the brackets around the 145 means that the beginning of the year there was a debit balance. There were accumulated losses on a marketable securities. Now again that's net, some of the securities may have had gains a lot of them had losses. The next line of the footnotes says that during the year there were new net losses added to the account, so that 47 in brackets means that there was a debit of 47. Again, there was a mix of gains and losses during the year but the net amount was to add losses to the account. The next line tells us the use of AOCI based on securities sold. So, I didn't say that right, but, taking gains out of AOCI when we sold the securities. So, 18 in brackets is a debit. Now we know those are gains because initially, the gains would have went in the account as credits, and to get them out we have to debit them. So any time you're taking something out with a debit, it must have gone in as a credit or gain. And then we end up with the ending balance of 240 on the debit side. So it looks like what happened is, even though we had net unrealized losses on our securities coming end of the year, we had a bunch of securities in there which had gains, they had gone up in value. We sold those during the year. So we pulled those gains out, but they had come down in price substantially so we suffered net losses on those securities. So that's my attempt to try to fight through all the information that we get in this footnote. So now that we have the debit to AOCI in there, we are only missing one thing, which is the book value of the marketable securities sold. So we can plug that credit as 9,150, so that's the credit that makes this balance, and we can see what the book value is of the securities that they sold. Last question to work on, are there any ways to increase 2012 pre-tax income by changing how we manage our marketable securities? One thing we could have done is through the available-for-sale securities, is sold the securities with unrealized gains, which would've basically brought those gains from AOCI into the income statement, and we could have increased our pre-tax income by as much as 39. >> Can a company actually choose whether to sell securities with gains instead of those with losses? My brother would never be able to do that. He never has any securities with gains. >> Yes, a company could absolutely choose to sell certain securities that had gains versus certain securities that have losses. There's a technical term for this activity. It's called cherry picking. And one of the reasons that we look through the financial statements, is to try to get a sense whether managers may have been acting in that kind of behavior. Another way you could have increased your pre-tax income is, don't sell securities with unrealized losses. Now, if you remember we recognized 56 of losses based on selling securities during the prior year. If you don't remember, let me run back to that slide. There it is. Up here, we recognized gross losses of $56 million, based on sales available for sale securities. If we hadn't sold those, we would have never had those losses run into net income. So that could have helped us by as much $56 in our pre-tax income. And the last thing is, we could have reclassified some of these securities. We could have changed our intent for holding them. So for instance the trading securities that have losses, the losses of 10 gross unrealized losses. If we reclassify those two available for sale, then those loses don't hit the income statement, instead they go into ALCI. Or, for the available for sale securities that have gains instead of selling them, we could have reclassified them as trading securities, which would have then had the gain go through the income statement, instead of AOCI, helping pretax income by as much as 39. Or the same thing with the held-to-maturity securities that have gains. So we had held the maturity securities, which have gross gains of 4 that doesn't show up anywhere on the financial statements, but if we had reclassified them as trading securities, they would have been marked to market, and that 4 would have gone through the income statement. Not making a big impact, but it still would have increased pre-tax income. >> Really? It seems shady that a company could change methods just to make their net income higher. Real companies never manipulate their financial statements, do they? >> I'm sorry to say that [LAUGH] there are some companies that have been known to manipulate their financial statements in the past. That's why it's important to read these disclosures, try to understand them so that maybe you can spot these kinds of problems. So a company actually could change their method or their classifications for individual securities to try to help their income. Now one thing that might help us, is the auditors would be there to ask questions. So, a company could probably get away with this once. Say our intention has changed, change the classification, get some extra income. But if they kept changing classifications every quarter, every year, the auditors would get suspicious and it would be hard to do this behavior. So maybe you can do it once, but not much more than that. So now that I just taught you how to manipulate financial statements by creative use of your marketable securities, we should probably wrap up the video before I get into any more trouble. Now of course the idea is I'm not teaching you to do this, I'm teaching you to catch companies that are doing this. Big difference. I'll see you next time. >> Really? We are done already? Oh well. See you next video.
