I thought statement 2 made by Davenport was correct? *spoiler 2. Accounting for changes in the value of investments considered to be “available-for-sale” biases the valuation by incorrectly stating both book value of equity and ROE. Answer: Accounting for changes in the value of investments considered to be “available-for-sale” biases the valuation by incorrectly stating ROE but not the book value of equity. I thought: The book value is biased because if the investment was a trading security, its unrealized gain for example, would increase income, and the effect of this investment after tax would should up in Equity. However, if the investment was considered available-for-sale, its unrealized gain would be recognized directly in Equity, without the tax deduction. The difference would be the tax paid on the investment, therefore incorrectly stating the book value of equity. Am I not right?
Equity will always be affected, either through Net Income flowing to Retained Earnings or via a direct adjustment in comprehensive income.
So is the answer is wrong? The answer says Accounting for changes in the value of investments considered to be “available-for-sale” biases the valuation by incorrectly stating ROE but not the book value of equity.
Sorry had to ask the question twice, I can’t delete this post.
I think you make a good point frangoya. However, in the long run though, these differences should reverse themselves as the available for sale security is eventually sold and gains/losses are recognized in the income statement (taxes will be in effect). I suppose the only catch would be if the company’s tax rate changed over time. That said, the question and item set did not mention anything about this, so the correct answer should be that equity does not change.