Can someone please explain this statment: “Accounting for changes in the value of investments considered to be “available for sale” biases the valuation by incorrectly stating ROE but not book value of equity”
When you have an AFS security Balance sheet adjusts to Fair Value at the end of the period. But the unrealized gains/losses flows thro’ the OCI (Equity portion). So if you used NI/Equity = ROE to do stuff with relation to the RI Model -> Net Income is actually not correct, since the unrealized gain/loss for the AFS security did not pass thro’ the Income statement. Common equity is fine - since OCI is part of common equity. So ROE is actually mistated. If you thought of an AFS security that had a loss -> Common Equity went down, no change in Net Income - so ROE is higher. But if it had been a HFT security - NI would have gone down, Common Equity would have been the same, ROE would thus have been lower. Compare the above treatment to what happens if it were a HFT security.
changes in the value of investments considered to be “available for sale” go to other comprehensive income - this is part of equity but net income stays the same, so ROE will be higher.
In general, any gains or losses that bypass IS and go straight to BS violate the clean surplus assumption and bias RI based valuation. Examples 1. Foreign currency gains or losses that go straight to retained earnings under all-current method 2. Any liability adjustments in pension accounting 3. unrealised gains or losses on available for sale securities that go staright to BS