Current values: finding a way forward.Historical cost is out and market value is in, some say. Not a chance, others say. Here's one suggestion on how to resolve the debate. New initiatives in accounting are always controversial. The current debate over using current values to measure and report marketable securities Marketable Securities Very liquid securities that can be converted into cash quickly at a reasonable price. Notes: Marketable securities are very liquid as they tend to have maturities less than one year, and the rate at which these securities can be bought or sold has in financial statements certainly is no exception. Market-value proponents have no doubt that current value is the best way to determine comprehensive income and measure an investment's contribution to the owner's net worth. Opponents to market value are equally certain historical cost is best. This morning's investment value will inevitably change, they say, probably by this afternoon, and those changes in value, which are not realized, are irrelevant in measuring company performance. We suggest a way forward. Our framework would retain the essential structure of the current accounting model, but would provide for greater recognition of market values in the financial statements. Financial assets Financial assets Claims on real assets. that have ready markets would be carried at market value on the balance sheet. Unrealized changes in the values of these assets would be excluded from the traditional measurement of earnings. Rather, these changes in values, which are provisional Temporary; not permanent. Tentative, contingent, preliminary. A provisional civil service appointment is a temporary position that fills a vacancy until a test can be properly administered and statutory requirements can be fulfilled to make a permanent appointment. until the asset is sold, would be captured and reported in a new, fourth financial statement that we call a "Statement of Changes in Provisional Values." WHY THE DEBATE? Today's complex economic and regulatory environments have tested the limits of the current accounting model. In addition to competition and escalating costs, companies cope with a broad array of financial market risks. For example, a sudden increase in interest rates can adversely affect a financial institution that has not matched the duration of its assets and liabilities. A stronger dollar can erode Erode (ĕrōd`), city (1991 urban agglomeration pop. 361,755), Tamil Nadu state, S India, on the Kaveri River. The city is located in a cotton-growing region, and its industries include cotton ginning and the manufacture of transport equipment. the profits of a multinational consumer products company when it has an important market share in another country. Exacerbating ex·ac·er·bate tr.v. ex·ac·er·bat·ed, ex·ac·er·bat·ing, ex·ac·er·bates To increase the severity, violence, or bitterness of; aggravate: the risks of the financial markets is their volatility. GAINS TRADING Many regulators, including the SEC, are critical of certain practices that are rooted in the historical cost accounting model. One particularly troublesome practice is known as gains trading, in which the investor hopes to profit from changes in the direction of future interest rates. In its simplest form, the investor, believing that interest rates will decline, accumulates a portfolio of fixed-rate debt instruments. If interest rates decline as anticipated, the investor sells the securities. Under the historical-cost model, the resulting gains are realized and included in profits. But if interest rates rise and the value of the investments declines, the investor most likely will elect to hold the securities as long-term Long-term Three or more years. In the context of accounting, more than 1 year. long-term 1. Of or relating to a gain or loss in the value of a security that has been held over a specific length of time. Compare short-term. investments. Traditionally, the ability and intent to hold debt securities to maturity have permitted the investor to carry those instruments at historical cost. Under the historical-cost accounting model, the investor has not realized a loss, even though the economic value of the investments has declined. These outcomes are a consequence of the transaction-oriented, historical-cost accounting framework, under which gains and losses on investments are often reported only at the time they are sold. Critics point to the apparent contradiction CONTRADICTION. The incompatibility, contrariety, and evident opposition of two ideas, which are the subject of one and the same proposition. 2. In general, when a party accused of a crime contradicts himself, it is presumed he does so because he is guilty for of reporting profits in the income statement while the balance sheet may actually be weakened weak·en tr. & intr.v. weak·ened, weak·en·ing, weak·ens To make or become weak or weaker. weak  en·er n. by
unrecognized declines in the value of securities held.A company can also use its investment portfolio to manage its interest-rate risk. Assume, for example, that a bank has a negative gap--its interest-rate-sensitive liabilities exceed its interest-rate-sensitive assets. If interest rates climb, the bank is exposed. By selling fixed-maturity debt securities and reinvesting the proceeds in variable-rate or short-term instruments, the bank can narrow or close the negative gap. At large financial institutions, portfolio adjustments to help balance asset and liability exposures occur frequently. Although the motivations are vastly different, gains trading and portfolio management both result in a sale of debt instruments in advance of maturity. Current-value advocates question how the maturity value of a debt instrument has relevance if the investor will sell the debt instrument before its maturity and at an amount that reflects market conditions at the time of sale. Today's accounting model is perceived to be relatively simple. But historical cost is a misnomer misnomer n. the wrong name. MISNOMER. The act of using a wrong name. 2. Misnomers, may be considered with regard to contracts, to devises and bequests, and to suits or actions. 3.-1. for what is a relatively complex accounting framework. It would more aptly be described as a mixed-attribute model. Original cost, fair value, or an amount in between can each be the right answer under the current framework, depending on the circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact. 2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or . For example, a financial institution might own two identical debt securities, but account for one at market if it is held for trading, and account for the other at amortized cost if it is held for long-term investment. Given that the right choice often depends on the quality of the asset and the intent of management, it is no wonder that management, auditors, and financial statement readers have difficulty communicating. WHEN DOES CURRENT VALUE MAKE SENSE? In a typical operating cycle Operating cycle The average time between the acquisition of materials or services and the final cash realization from that acquisition. operating cycle , assets move through the balance sheet--from manufacturing plants to short-term marketable Marketable are securities that can be easily converted into cash. Such securities will generally have highly liquid markets allowing the security to be sold at a reasonable price very quickly. securities-on their way to cash. At some point during the trip, the current value of the asset becomes more relevant than its historical cost. Operating on the premise that investors and creditors ultimately focus on cash flow, we suggest that financial reporting should depart from historical cost measurements in favor of upon the side of; favorable to; for the advantage of. See also: favor current values when current values most closely approximate the asset's ability to realize cash. The concept is best demonstrated at the extremes. Assume, for example, that a manufacturer enjoys eight consecutive record quarters. Surplus cash is invested in short-term U.S. Treasury U.S. Treasury Created in 1798, the United States Department of the Treasury is the government (Cabinet) department responsible for issuing all Treasury bonds, notes and bills. Some of the government branches operating under the U.S. Treasury umbrella include the IRS, U.S. bills, while management evaluates whether to increase the dividend, expand overseas, or some combination of the two. Few would argue that the historical cost of the Treasury bills is a better measure of their ability to generate cash than their market value. But if the manufacturer declares the dividend and sells the investments, current value is the best measure of the available cash. Let's also assume that the manufacturer owns a state-of-the-art research facility, which is the spawning ground for the ideas that give the manufacturer its competitive edge. The current market value of the facility is a fraction of its cost. Many of the improvements that have been made to the facility have no other use, and real estate and credit conditions have depressed land prices. But the company's engineers keep turning out ideas; the innovations translate into products that are manufactured and sold; and the receivables Receivables An asset designation applicable to all debts, unsettled transactions or other monetary obligations owed to a company by its debtors or customers. Receivables are recorded by a company's accountants and reported on the balance sheet, and they and include all debts owed from the sales are ultimately collected to produce cash. The research facility's worth is as a spawning ground of ideas, not as a store of monetary value. Sometimes determining when the next step in the operating cycle is cash is complicated by factors beyond management's control. A conglomerate conglomerate, in business conglomerate, corporation whose asset growth, often very rapid, comes largely through the acquisition of, or merger with, other firms whose products are largely unrelated to each other or to that of the parent company. might instruct in·struct v. in·struct·ed, in·struct·ing, in·structs v.tr. 1. To provide with knowledge, especially in a methodical way. See Synonyms at teach. 2. To give orders to; direct. v. its investment bankers Investment Banker A person representing a financial institution that is in the business of raising capital for corporations and municipalities. Notes: An investment banker may not accept deposits or make commercial loans. to identify suitable buyers for a profitable electronic component subsidiary. Should an electronics component company sell at a multiple of 5 times earnings, or is 2 more realistic? And who are the prospective buyers? A commercial bank might hold a bridge loan that it made to a highly leveraged, troubled company. Can the bank sell the note? If not, how and when will it be settled? ln circumstances such as these, the ability to convert an asset to cash or to estimate the proceeds that could be received are not so clear. The practical solution for the present: Use current values when the next step is cash and the asset is readily marketable. HOW SHOULD CHANGES BE IMPLEMENTED? Some historical-cost advocates claim that even limited changes to the mixed-attribute model are seriously flawed flaw 1 n. 1. An imperfection, often concealed, that impairs soundness: a flaw in the crystal that caused it to shatter. See Synonyms at blemish. 2. . Long-term investments can go up or down in value many times during an extended holding period; as a result, interim changes in value have little significance. A second defect defect - bug , charge the critics, is that current-value proponents focus principally on assets. When the value of a company's investment falls because interest rates increase, an offsetting economic gain is often embedded Inserted into. See embedded system. in the investor's liability structure. Both criticisms have merit. The longer the term of a fixed-rate debt instrument, the more impact changes in interest rates will have on the investment's value. Critics of current-value measurement point out that investors will favor shorter-term investments to avoid the roller roller, common name for brightly colored Old World birds noted for performing somersaults in flight. They include the rollers proper (subfamily Coraciinae) and ground rollers (subfamily Brachypteraciinae coaster What a bad CD-R disc is often called. See CD-R and underrun. effect on reported income. One solution would be to uncouple the income statement and the balance sheet. Under current accounting standards, most gains and losses are reported in the income statement. We propose that standard-setters give serious consideration to introducing a fourth financial statement, the "Statement of Changes in Provisional Values" (in addition to the balance sheet, income statement, and statement of cash flows) to deal with conflicts in the objectives of reporting financial position as of a point in time and reporting earnings for a period of time. Under this approach, assets could be adjusted to current values on the balance sheet. Earnings could continue to be measured and displayed in the income statement as it is now. Changes in provisional values, including unrealized gains Unrealized Gain A profit that results from holding on to an asset rather than cashing it in and using the funds. Notes: Let's say you own a stock that has doubled, but you haven't sold it yet. This is said to be an unrealized gain. and losses not recognized in earnings, would be reported in the "Statement of Changes in Provisional Values" and as an increase or decrease in stockholders' equity Stockholders' Equity The portion of the balance sheet that includes capital received from investors in exchange for stock (paid-in capital), donated capital, and retained earnings. This is equal to total assets minus liabilities, preferred stock and intangible assets. . FAIR-VALUE LIABILITIES A company can benefit from changes in market conditions if it has the right capital structure. A company's fixed-rate debt, for example, might immunize im·mu·nize v. 1. To render immune. 2. To produce immunity in, as by inoculation. im it from the economic loss of holding low coupon interest bearing investments in a rising interest rate environment. Critics of current-value accounting believe that these facts are too often ignored. One solution, favored by some, is to use historical-cost measurements on the theory that the unrecognized changes in asset values are offset by corresponding effects on liabilities. A more realistic solution would be to measure both investments and related liabilities at current values. Although a company's capital structure can help it avoid the effect of unexpected changes in market conditions, ignoring the current value of both assets and liabilities implies that the change in the value of each, if measured, would perfectly offset. The difficulty, however, is that accountants have little understanding of what the fair value of a liability represents and little experience in trying to communicate the sources and effects of changes in value. These issues need to be carefully studied. To date, one of the major unresolved Not completed; not finished; not linked together. See resolve. issues in expanding the use of current values has been a lack of consensus on how to deal with liabilities. WHAT NEXT? The current accounting model is better suited to a more stable, less global commercial environment. Most businesses have recognized the need to address changing and sometimes hostile market forces, and manage their operating and financial activities to avoid the risks and capitalize on Cap´i`tal`ize on` v. t. 1. To turn (an opportunity) to one's advantage; to take advantage of (a situation); to profit from; as, to capitalize on an opponent's mistakes s>. the opportunities. Changes are needed to recognize the primary interest of users of financial reporting in information that will best enable them to assess an entity's prospects for future cash flows. Tailoring the model to fit the circumstances of the economic environment of today will require care. A company's capital structure as well as its investment portfolio needs to be considered. And the alterations should accommodate reporting provisional value changes without distorting the concept of earnings that management and financial statement users have come to understand. ACCOUNTING FOR INTEREST-RATE SWAPS Interest-rate swaps are a good example of financial instruments that are not easily accommodated by current generally accepted accounting principles The standard accounting rules, regulations, and procedures used by companies in maintaining their financial records. Generally accepted accounting principles (GAAP) provide companies and accountants with a consistent set of guidelines that cover both broad accounting . And even though swaps having a notional principal amount Notional Principal Amount In an interest rate swap, the predetermined dollar amount on which the exchanged interest payments are based. Notes: Each period's rates are multiplied by the notional principal amount to determine the value of each counterparty's payment. of over $3 trillion One thousand times one billion, which is 1, followed by 12 zeros, or 10 to the 12th power. See space/time. (mathematics) trillion - In Britain, France, and Germany, 10^18 or a million cubed. In the USA and Canada, 10^12. are outstanding today, there is little recognized guidance on how they should be accounted for. While a "vanilla vanilla, a plant of the genus Vanilla of the family Orchidaceae (orchid family). Vines of hot, damp climates, most are indigenous to Central and South America, especially Mexico, but are now cultivated in other tropical regions. " interest-rate swap seems straightforward, accountants have great difficulty applying conventional accounting rules. Is the swap akin to a debt instrument? Like interest on variable-rate debt, swap payments vary depending on the prevailing levels of interest rates. But, unlike the holder of debt, a swap counterparty Counterparty The other participant, including intermediaries, in a swap or contract. may enjoy net cash receipts or suffer net cash payments over time. So, if a counterparty risks Counterparty Risk The risk to each party of a contract that the counterparty will not live up to their contractual obligations. Notes: In most financial contracts, counterparty risk is known as default risk. an all-in negative return, is the swap more like an equity investment? But, unlike most equity investments, a swap has a distinct term and is certain to have zero value at its maturity. In truth, a swap is similar to a series of forward contracts. But tha accountant does not draw much comfort from that analogy analogy, in biology, the similarities in function, but differences in evolutionary origin, of body structures in different organisms. For example, the wing of a bird is analogous to the wing of an insect, since both are used for flight. : Generally accepted accounting principles provide little--and sometimes contractictory--guidance on accounting for forwards.
ACCOUNTING FOR INVESTMENTS UNDER THE MIXED-ATTRIBUTE MODEL
The following illustrates the array of methods that the current
mixed-attribute model offers for common types of investments.
Intended
Asset Holding Period Accounting Basis
Debt instrument Long-term Historical cost
Debt instrument Indefinite Lower of
historical cost
or market value
Debt instrument Actively traded Market value
Debt instrument- Estimated amounts
credit concerns to be realized;
adjustment
included in
income
Marketable equity Short-term Lower of cost or
security market;
adjustment
included in
income
Marketable equity Long-term Lower of cost or
security, temporary market;
decline in value adjustment
excluded from
income
Marketable equity Long-term Lower of cost or
security, "other than market adjustment
temporary," decline in included in
value income
Nonmarketable equity Long-term Historical cost
security
Nonmarketable equity Estimated amounts
security, value to be realized;
impaired adjustment
included in
income
Note: As part of its ongoing financial instruments project, the
Financial Accounting Standards Board is examining the
accounting for debt and equity securities and impaired loans.
The Board's conclusions may affect this summary.
MEASURING LIABILITIES AT CURRENT VALUES Which method should be used for measuring the current value of a liability? Here are some methods that have been proposed: MARKET VALUE Measure the liability at market value. This objective is simple. But most liabilities aren't traded and have no ready market. Also, when the value of a bond goes down, it often is due to the borrower's credit problems. ESTIMATED CURRENT VALUE Measure the liability at the present value of the contractual cash flows using a discount rate that reflects the best current estimate of market conditions and the borrower's standing. Disadvantage? The method requires frequent recomputations and is very subjective. MARKET-ADJUSTED VALUE Measure the liability at the present value of future debt service requirements using a discount rate that reflects changes attributable only to external market conditions rather than changes in the issuer's credit standing. Disadvantages? The approach does not measure true current value. FUNDING VALUE Measure the liability at an amount equal to the hypothetical Hypothetical is an adjective, meaning of or pertaining to a hypothesis. See:
An asset which has a certain future return. Treasuries (especially T-bills) are considered to be risk-free because they are backed by the U.S. government. Notes: that would generate just the right amount of cash to match (defease) the debt-service requirements. This method focuses on pure changes in market interest rates. But even the best borrowers pay more for their debt than the U.S. government. The result? Even high-quality borrowers have a "loss." Mr. Sutton is national director, accounting and auditing professional practice, of Deloitte & Touche. Mr. Johnson is national consultation partner of the firm. |
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