FASB 115: it's back to the future for market value accounting.Like time travel, comprehensive market value accounting still lies in the future. In an era of deregulated interest rates and massive losses from thrift thrift: see leadwort. and bank failures, a debate has raged over the accounting for financial instruments. Market value accounting has been called a panacea Some antidote or remedy that completely solves a problem. Most so-called panaceas in this industry, if they survive at all, wind up sitting alongside and working with the products they were supposed to replace. by some and a placebo placebo (pləsē`bō), inert substance given instead of a potent drug. Placebo medications are sometimes prescribed when a drug is not really needed or when one would not be appropriate because they make patients feel well taken care of. by others. The Financial Accounting Standards Board Financial Accounting Standards Board (FASB)
Board composed of independent members who create and interpret Generally Accepted Accounting Principles (GAAP). , under intense pressure from the Securities and Exchange Commission and others to resolve the issue, accelerated part of its financial instruments project to focus on accounting for debt securities. In May, the FASB FASB
See: Financial Accounting Standards Board
See Financial Accounting Standards Board (FASB). issued Statement no. 115, Accounting for Certain Investments in Debt and Equity Securities (see page 128 for the full text).
To many, the new FASB standard may seem like deja vu See DjVu. . It resembles both current accounting guidelines guidelines,
n.pl a set of standards, criteria, or specifications to be used or followed in the performance of certain tasks. and various aspects of a proposal advanced by the American Institute of CPAs accounting standards executive committee several years ago. Before reviewing Statement no. 115, it's important to understand 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 that preceded it.
NEW BUSINESS ENVIRONMENT
The business strategies of financial institutions and other investors have become more dynamic since interest rates were deregulated over a decade ago. At one end of the spectrum are investors that manage a part of their investment portfolios as a trading account Trading Account
1. An account similar to a traditional bank account, holding cash and securities, and is administered by an investment dealer.
2. An account held at a financial institution and administered by an investment dealer that the account holder uses to employ a . At the other end are those that purchase debt instruments, rarely (if ever) sell them before maturity and seek only to earn an interest spread relative to their cost of funds Cost of Funds
The interest rate paid on an outstanding loan.
Money isn't free! Cost of funds is the cost of borrowing money.
See also: Interest Rate
Cost of funds
Interest rate associated with borrowing money. . In the middle, however, are many other investors that buy and sell parts of their investment portfolios to manage interest rate risk, to comply with regulations, to take advantage of market opportunities and to meet other business objectives.
Because the accounting model for debt instruments was designed in simpler times, its continued relevance has been questioned, particularly in the case of portfolios carried at cost. Accounting standards that allow financial statements to overstate significantly a business enterprise's underlying economic value--as was the case with many failed banks and savings and loans--are fair game for criticism. Many believe market value accounting is the best way to move the accounting model into the future.
MARKET VALUE ACCOUNTING OPTIONS
There generally are three approaches to adopting market value accounting:
* Accounting for only certain assets.
* Linking selected liabilities to selected assets.
* Determining market values for all on-and off-balance-sheet financial assets Financial assets
Claims on real assets. and liabilities.
Accounting for only certain assets. Requiring market value accounting for certain types of assets, but not for liabilities, is the easiest approach to implement. It can, however, result in misleading financial reporting.
To illustrate the problem of marking to market Marking to market
Settling or reconciling changes in the value of futures contracts on a daily basis. Also refers to the practice of reporting the value of assets on a market rather than book value basis. only certain assets, the Federal National Mortgage Association performed several calculations on its own portfolio of mortgage-backed securities Mortgage-backed securities (MSBs)
Securities backed by a pool of mortgage loans. . First, the change in market value of Fannie Mae's approximately $15.8 billion mortgage-backed securities portfolio between September 30 and December 31, 1991, was determined. (This period was selected because it witnessed a substantial decline in interest rates.)
Next, the change in value on the liability side of the balance sheet was calculated for the same period. Because asset maturities at Fannie Mae Fannie Mae: see Federal National Mortgage Association. are funded with liabilities of similar duration (match-funded), a pro rata [Latin, Proportionately.] A phrase that describes a division made according to a certain rate, percentage, or share.
In a Bankruptcy case, when the debtor is insolvent, creditors generally agree to accept a pro rata share of what is owed to them. share of the change in value of liabilities equal to the $15.8 billion in assets generated the following results:
Unrealized gain on assets $490,000,000 Unrealized loss on liabilities (450,000,000) Net unrealized gain $40,000,000
If only the mortgage securities were marked to market in the fourth quarter of 1991, additional pretax income pretax income
Reported income before the deduction of income taxes. Pretax income is sometimes considered a better measure of a firm's performance than aftertax income because taxes in one period may be influenced by activities in earlier periods. of approximately $490 million would have been recorded. The unrealized gain Unrealized Gain
A profit that results from holding on to an asset rather than cashing it in and using the funds.
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. would have represented a 93% increase in pretax pre·tax
Existing before tax deductions: pretax income.
pretax adj [profit] → vor (Abzug der) Steuern earnings in that quarter. However, the $450 million unrealized loss Unrealized Loss
A loss that results from holding onto an asset rather than cashing it in and officially taking the loss.
Let's say you own a stock that is down 50%, but you haven't sold it to realize the loss yet. This is said to be an unrealized loss. on liabilities would not have been reported during the same quarter, substantially overstating true economic earnings. On the other hand, the $40 million net unrealized gain, which included marking to market a pro rata share of the liabilities, would have represented only about 8% of Fannie Mae's fourth-quarter 1991 pretax earnings.
Clearly, marking to market only certain assets results in inaccurate reporting for match-funded institutions and provides no insight into their level of interest rate risk. As the above example illustrates, valuing only assets could lead one to conclude an institution has a great deal of interest rate risk when in fact it has relatively little.
Linking selected liabilities to selected assets. If only some investment assets are marked to market, it seems logical to link certain liabilities to them so they also can be marked to market. However, this is easier said than done. There generally are two methods of linking liabilities to part of the investment portfolio.
Specific identification method. Specific debt issuances and other liabilities other liabilities
Small and relatively insignificant liabilities. For financial reporting purposes, firms often combine small liabilities into this single category rather than listing each liability separately. are assumed to fund specific investment securities. However, when asset and liability maturities are managed in the aggregate, allocating specific funding components to investment securities is highly subjective.
As both assets and assigned liabilities amortize amortize
To write off gradually and systematically a given amount of money within a specific number of time periods. For example, an accountant amortizes the cost of a long-term asset by deducting a portion of that cost against income in each period. over time, reallocations inevitably must be made to balance the amount of liabilities linked to the specific assets marked to market. Reallocation Noun 1. reallocation - a share that has been allocated again
allocation, allotment - a share set aside for a specific purpose
2. reallocation of debt requires an inordinate amount of recordkeeping. In addition, deciding which debt should be added to or deleted Deleted
A security that is no longer included on a specified market. Sometimes referred to as "delisted".
Reasons for delisting include violating regulations, failing to meet financial specifications set out by the stock exchange and going bankrupt. from the portfolio funding specific investments is arbitrary and has considerable potential for earnings manipulation.
Notional-pro-rata method. A less subjective way of matching liabilities to investment securities, at least from an accounting perspective, is to calculate the market value of all liabilities and provide a valuation account for the pro rata share of liabilities equal to the same aggregate balance as the assets marked to market (the method used in the example above). The advantage of this approach is it makes determining asset and liability linkage linkage
In mechanical engineering, a system of solid, usually metallic, links (bars) connected to two or more other links by pin joints (hinges), sliding joints, or ball-and-socket joints to form a closed chain or a series of closed chains. less subjective.
A pro rata approach, however, assumes all funding, is fungible A description applied to items of which each unit is identical to every other unit, such as in the case of grain, oil, or flour.
Fungible goods are those that can readily be estimated and replaced according to weight, measure, and amount. and not related to specific assets, highlighting its primary weakness. Pro rata debt allocation when the maturities of the specific assets being marked to market are significantly different from the maturities of other financial assets can distort financial reporting and make it less relevant. This would be so, for example, in the case of an institution that invests in both securities backed by fixed-rate mortgages and adjustable-rate mortgage Adjustable-rate mortgage (ARM)
A mortgage that features predetermined adjustments of the loan interest rate at regular intervals based on an established index. The interest rate is adjusted at each interval to a rate equivalent to the index value plus a predetermined spread, or loans (ARMs); long-term fixed-rate securities and ARMs are funded in significantly different ways.
Another liability valuation challenge concerns core deposits. A certain core portion of demand deposits often exhibits an inelastic inelastic
Of or relating to the demand for a good or service when quantity purchased varies little in response to price changes in the good or service. relationship to interest rate changes. Depository institutions Depository institution
A financial institution that obtains its funds mainly through deposits from the public. This includes commercial banks, savings and loan associations, savings banks and credit unions. economically benefit from funding longer maturity investments with low-cost core deposit accounts. When interest rates increase and thereby reduce investment assets' market value, some argue the recorded value of core deposits also should be reduced. The proposition that core deposits have intrinsic value Intrinsic Value
1. The value of a company or an asset based on an underlying perception of the value.
2. For call options, this is the difference between the underlying stock's price and the strike price. seems to be bolstered bol·ster
A long narrow pillow or cushion.
tr.v. bol·stered, bol·ster·ing, bol·sters
1. To support or prop up with or as if with a long narrow pillow or cushion.
2. by the fact that when financial institutions are sold, the economic value of core deposits is considered in determining the institution's purchase value.
On the other hand, many CPAs have a fundamental problem with reducing the recorded value of any liability below its settlement price. In addition, determining the appropriate method of calculating changes in the value of core deposits is a concern. If core deposits are not adjusted for interest rate changes, depository institutions face the same financial reporting problems that the assets-only approach presents.
Comprehensive market value approach. Comprehensive use of market values as the only method of accounting for financial instruments eliminates both the subjectivity in evaluating investment intent and the difficulty in linking liabilities to specific assets. However, establishing a range of values for complex debt instruments, commercial loans, liabilities and off-balance-sheet items not actively traded remains subjective. Such valuations are based on financial models driven by theoretical assumptions that are subject to second-guessing or manipulation.
One of the benefits often ascribed to market value accounting is its ability to measure interest rate risk. It's true such accounting highlights significantly mismatched maturities of assets and liabilities during periods of interest rate volatility. However, it is an effective barometer of historical interest rate risk only when rates change. At a balance sheet date and during periods of low rate volatility, when market values remain relatively constant, market value accounting provides little new information about the future level of interest rate risk.
Another fundamental problem often associated with full market value accounting is the seeming 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 accounting for a going concern as if its assets will be sold and its liabilities settled. In addition, a business's intangible or franchise value, which is a component of stock market valuations, is not considered by market value accounting.
WHAT TO DO?
While many have called for more relevant financial reporting for financial instruments, it's clear there are no easy ways to achieve that objective. The FASB deliberated during a time of highly charged debate. The accounting profession, financial institutions, regulators, the SEC, the General Accounting Office, members of Congress and others were vocal in advancing their views on the subject.
After considering a number of different approaches, the FASB issued Statement no. 115, which turned out to be more evolutionary than revolutionary. It isn't likely to please either those who wanted to maintain the status quo [Latin, The existing state of things at any given date.] Status quo ante bellum means the state of things before the war. The status quo to be preserved by a preliminary injunction is the last actual, peaceable, uncontested status which preceded the pending controversy. or those who wanted to move to the future with comprehensive market value accounting. The new standard clearly is a compromise.
STATEMENT NO. 115
Statement no. 115 applies to all investments in debt securities and to equity securities with readily determinable Liable to come to an end upon the happening of a certain contingency. Susceptible of being determined, found out, definitely decided upon, or settled.
determinable adj. fair values. It supersedes FASB Statement FASB Statement
A standard set by the Financial Accounting Standards Board regarding a financial accounting and reporting method. Essentially, FASB statements determine the acceptable accounting practices that Certified Public Accountants use in reporting no. 12, Accounting for Marketable Securities Marketable Securities
Very liquid securities that can be converted into cash quickly at a reasonable price.
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 . While it applies to financial assets in security form, it does not apply to loans or liabilities. Under Statement no. 115, securities are classified into three categories:
* Held to maturity. Debt securities meeting the requirements for this category are reported at amortized cost. Debt securities not included in this classification and equity securities with readily determinable market values are assigned to one of the following categories.
* Trading. Debt and equity securities in this category are reported at fair value; changes in unrealized gains and losses are included in the income statement. These securities are bought and sold to make short-term profits as opposed to being held to realize longer-term gains from capital appreciation.
* Available for sale. Debt and equity securities not assigned to one of the above categories are included here. These investments also are reported at fair value, but unrealized gains and losses (net of tax effects) are reported in a separate component of shareholders' equity Shareholders' Equity
A firms' total assets minus its total liabilities. Equivalently, it is share capital plus retained earnings minus treasury shares. Shareholders' equity is the amount by which a company is financed through common and preferred shares. .
Debt securities qualify for the amortized cost method only if the investor has the ability and a positive intent to hold them to maturity. Positive intent is undermined if securities are sold in response to certain events but not others. (See exhibit 1, page 52, for examples.) In most situations, however, once a debt security is put in the held-to-maturity category, it generally cannot be sold or transferred to another category. (See exhibit 2, below, for a discussion of accounting for transfers among categories). Otherwise, the cost method might not be available for some or all of the investment securities included in the held-to-maturity category.
These are some other key provisions of Statement no. 115:
* Dividend and interest income, including amortization of premium and discount, continue to be included in income for all three categories of investment.
* All realized gains Realized Gain
A gain resulting from selling an asset at a price higher than the original purchase price.
There may be tax consequences for a realized profit. and losses resulting from sales of any of the three categories of investments are included in income.
* A write-down to a new cost basis will be recorded in earnings for securities classified as either available for sale or held to maturity that have an other than temporary decline in fair market value below amortized cost.
* Mortgage-backed securities held for sale in conjunction with mortgage banking activities, currently accounted for at the lower of cost or market lower of cost or market
A method for determining an asset's value such that either the original cost or the current replacement cost, whichever is lowest, is used for financial reporting purposes. under FASB Statement no. 65, Accounting for Certain Mortgage Banking Activities, are classified as trading securities. Other mortgage-backed securities are classified based on the other criteria discussed previously.
* Not-for-profit organizations, entities already reporting substantially all investments at fair value, investments in equity securities accounted for under the equity method and investments in consolidated subsidiaries are excluded from the new standard's scope.
* A considerable number of new disclosures are required (see exhibit 3, at left, for a listing).
* The effective date is for financial statements issued for fiscal years beginning after December 15, 1993; earlier application is permitted but may not be applied retroactively ret·ro·ac·tive
Influencing or applying to a period prior to enactment: a retroactive pay increase.
[French rétroactif, from Latin .
* Initial application can be at the end of an entity's fiscal year if annual financial statements have not been issued but retroactive Having reference to things that happened in the past, prior to the occurrence of the act in question.
A retroactive or retrospective law is one that takes away or impairs vested rights acquired under existing laws, creates new obligations, imposes new duties, or attaches a application to previous interim periods is not allowed.
Of particular interest is what Statement no. 115 does not change. A form of gains trading--a practice of selling above market assets at gains reported in the income statement and retaining "underwater Underwater
1. The condition a call option is in when its strike price is higher than the market price of the underlying stock.
2. The condition a put option is in when its strike price is lower than the market price of the underlying stock. " assets on the balance sheet at cost--is still possible. For example, the full difference between fair value and amortized cost is recorded as a realized gain in the income statement when securities classified as available-for-sale are sold. Thus, it is possible for selected unrealized gains to be reversed out of the separate component of shareholders' equity and reported in earnings when the related available-for-sale securities are sold.
A second key issue, ostensibly os·ten·si·ble
Represented or appearing as such; ostensive: His ostensible purpose was charity, but his real goal was popularity. outside Statement no. 115's scope, is the accounting for loans. While the lower of cost or market method remains in effect for loans held for sale, it's not clear if the new, more restrictive requirement of a positive intent to hold to maturity will apply to loans held for investment.
Statement no. 115 is a response to genuine concern about the relevance of current financial reporting for marketable securities. Although the new standard may lack conceptual purity, it does restrict entities' ability to overstate assets and manage reported earnings.
Significant problems remain to be ironed out before some or all liabilities can be reported at fair value. Without fair value reporting for liabilities and off-balance-sheet obligations, broader application of an assets-only approach could compromise the value of financial reporting. Only time will tell whether Statement no. 115 will be an effective solution to the market value accounting dilemma. Since it's also probably not the final solution, stay tuned for "Back to the Future II."
* THE FINANCIAL ACCOUNTING Standards Board issued Statement no. 115, Accounting for Certain Investments in Debt and Equity Securities, to address concerns about how entities account for financial instruments.
* BECAUSE THE CURRENT accounting model was designed in simpler times, many have questioned the relevance of current financial reporting for marketable securities. Market value accounting is believed by some to be the best way to move this model into the future.
* STATEMENT NO. 115 APPLIES to all investments in debt securities and to equity securities with readily determinable fair values. It supersedes FASB Statement no. 12, Accounting for Marketable Securities. Statement no. 115 classifies securities into three categories: held to maturity, trading and available for sale.
* THE EFFECTIVE DATE for Statement no. 115 is for financial statements issued for fiscal years beginning after December 15, 1993. Earlier application is permitted but may not be applied retroactively.
* SIGNIFICANT PROBLEMS remain to be resolved before liabilities and off-balance-sheet financial instruments can be reported at fair value. Few expect Statement no. 115 to be the final word on market value accounting.
FASB Statement no. 115-accounting for transfers among the three categories of investments
Transfers among the three categories are accounted for as sales and repurchases at fair value. The loss at the transfer date is accounted for as follows:
* Transfers from trading.
There is no reversal of an unrealized gain or loss that is already recognized in earnings.
* Transfers into trading.
Any unrealized gain or loss is recognized in earnings immediately.
* Transfers from hold to maturity to available for sale.
Any unrealized gain or loss is recognized immediately as a separate
component of shareholders' equity.
* Transfers from available for sale to held to maturity.
The unrealized gain or loss already reflected in a separate component of
shareholders' equity at the date of transfer
is not reclassified but is amortized over the remaining life of the security as a yield adjustme
method of amortizing any related premium or discount.
FASB Statement no. 115-disclosure requirements
Balances. For securities classified as available for sale or held to maturity, disclosure is made (as of each balance sheet date and for each major security type) of
* Aggregate fair value.
* Gross unrealized holding gains.
* Gross unrealized holding losses.
* Amortized cost basis.
Maturities. As of the date of the most recent financial statement presented, information must be disclosed about contractual maturities. Financial institutions must disclose separately for securities classified as available for sale and those classified as held to maturity the fair value and amortized cost based on at least four maturity groupings:
* Within 1 year.
* After 1 year through 5 years.
* After 5 years through 10 years.
* Over 10 years.
Securities not due at a single date (such as mortgage-backed securities) may be disclosed separately rather than allocated among several groupings. If they are allocated, however, the basis of allocation must be disclosed.
For each period an income statement is presented, the following disclosures are made:
* Proceeds from sale of available-for-sale securities and the gross
realized gains and losses on those sales.
* The cost basis (specific identification, average cost, etc.) used in
computing computing - computer realized gains and losses.
* Gross pains and losses included in earnings resulting from transfers
from available for sale to trading.
* The change during the period in net unrealized holding gain or
loss on available-for-sale securities included in shareholders' equity.
* The change during the period in net unrealized holding gain or
loss on trading securities included in earnings.
* For any held-to-maturity securities Held-to-Maturity Securities
Debt securities that a firm has the ability and intent to hold until maturity.
These are reported at amortized cost, therefore, they are not affected by swings in the financial markets.
See also: Debt, Maturity sold (or transferred to another
category), the security's amortized cost, the resulting realized or
unrealized gain or loss and the circumstances leading to the decision
to sell or transfer are disclosed.
JAMES T. PARKS, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , is vice-president for financial standards and corporate taxes at the Federal National Mortgage Association in Washington, D.C. He is a member of the American Institute of CPAs accounting standards executive committee and of the Washington, D.C., chapter of the Financial Executives Institute.
Mr. Parks is an employee of the Federal National Mortgage Association. The views expressed in this article do not necessarily reflect those of Fannie Mae.