If the same securities were trading securities and their value increased by 10, with a 40% tax rate, what is the impact on Net Income?

If the same securities were trading securities and their value increased by 10, with a 40% tax rate, what is the impact on Net Income?

• A. Net income increases by 10
• B. Net income increases by 6
• C. Net income decreases by 4
• D. Net income unchanged

Answer: (B)

Trading securities are carried at fair value, and changes in fair value are included in net income. When their value increases by 10, that creates a pre-tax gain of 10 in earnings. With a 40% tax rate, taxes on that gain are 4, so the after-tax increase to net income is 6. Therefore net income rises by 6. If these had been available-for-sale securities, the unrealized gain would affect other comprehensive income, not net income, which is why the impact here is specific to trading securities. The remaining options ignore the tax effect or the direction of the impact.

Trading securities are carried at fair value, and changes in fair value are included in net income. When their value increases by 10, that creates a pre-tax gain of 10 in earnings. With a 40% tax rate, taxes on that gain are 4, so the after-tax increase to net income is 6. Therefore net income rises by 6. If these had been available-for-sale securities, the unrealized gain would affect other comprehensive income, not net income, which is why the impact here is specific to trading securities. The remaining options ignore the tax effect or the direction of the impact.