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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 and bank failures, a debate has raged over the accounting for financial instruments. Market value accounting has been called a panacea by some and a placebo by others. The Financial Accounting Standards Board, 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 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. It resembles both current accounting guidelines 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 that preceded it.


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. 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. 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.


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 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 only certain assets, the Federal National Mortgage Association performed several calculations on its own portfolio of mortgage-backed securities. 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 are funded with liabilities of similar duration (match-funded), a pro rata 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 of approximately $490 million would have been recorded. The unrealized gain would have represented a 93% increase in pretax earnings in that quarter. However, the $450 million 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 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 over time, reallocations inevitably must be made to balance the amount of liabilities linked to the specific assets marked to market. Reallocation of debt requires an inordinate amount of recordkeeping. In addition, deciding which debt should be added to or deleted 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 less subjective.

A pro rata approach, however, assumes all funding, is fungible 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 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 relationship to interest rate changes. Depository institutions 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 seems to be bolstered 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 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.


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 or those who wanted to move to the future with comprehensive market value accounting. The new standard clearly is a compromise.


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. 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.

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 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 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.

* Initial application can be at the end of an entity's fiscal year if annual financial statements have not been issued but retroactive 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" 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 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

Balance sheet

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.

Income statement

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 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 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, 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.
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Author:Parks, James T.
Publication:Journal of Accountancy
Date:Sep 1, 1993
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