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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 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 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 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."


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 the profits of a multinational consumer products company when it has an important market share in another country. Exacerbating the risks of the financial markets is their volatility.


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 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 of reporting profits in the income statement while the balance sheet may actually be weakened 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 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. 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.


In a typical operating cycle, assets move through the balance sheet--from manufacturing plants to short-term marketable 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 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 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 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 might instruct its investment bankers 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.


Some historical-cost advocates claim that even limited changes to the mixed-attribute model are seriously flawed. 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, 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 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 coaster 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 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.


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 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 issues in expanding the use of current values has been a lack of consensus on how to deal with liabilities.


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 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.


Interest-rate swaps are a good example of financial instruments that are not easily accommodated by current generally accepted accounting principles. And even though swaps having a notional principal amount of over $3 trillion are outstanding today, there is little recognized guidance on how they should be accounted for.

While a "vanilla" 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 may enjoy net cash receipts or suffer net cash payments over time. So, if a counterparty risks 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: Generally accepted accounting principles provide little--and sometimes contractictory--guidance on accounting for forwards.
The following illustrates the array of methods that the current
mixed-attribute model offers for common types of investments.
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;
 included in
Marketable equity Short-term Lower of cost or
security market;
 included in
Marketable equity Long-term Lower of cost or
security, temporary market;
decline in value adjustment
 excluded from
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
Nonmarketable equity Estimated amounts
security, value to be realized;
impaired adjustment
 included in
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.


Which method should be used for measuring the current value of a liability? Here are some methods that have been proposed:


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.


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.


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.


Measure the liability at an amount equal to the hypothetical cost of a portfolio of risk-free assets 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.
COPYRIGHT 1993 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Corporate Reporting; includes related articles
Author:Johnson, James A.
Publication:Financial Executive
Date:Jan 1, 1993
Previous Article:Market value: the debate rages.
Next Article:At long last, meet EDGAR!

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