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Market value: the debate rages.

Current value, fair value, market value, mark-to-market all mean one thing: one of the most hotly debated accounting issues of our time.

Securities and Exchange Commission Chairman Richard Breeden lit a new fire under the decades-old debate over market-value accounting when he announced several years ago that the historical cost model is no longer relevant in our volatile world.

The Financial Accounting Standards Board initiated its financial instruments project in 1986. Since that time, the FASB has issued a number of exposure drafts and several statements of accounting standards. The FASB's most recent exposure draft, "Accounting for Certain Investments in Debt and Equity Securities," was issued in September 1992.

The provisions of the new ED have inspired heated discussion. One such debate occurred at Financial Executive Institute's recent conference on financial reporting issues. The participants in that debate were four well-known and outspoken experts on the issue: Thomas E. Jones, executive vice president, Citibank; Patrick W. Kenny, group executive-finance and administration, Aetna; James J. Leisenring, vice chairman, Financial Accounting Standards Board; and Walter Schuetze, chief accountant, Securities and Exchange Commission. Donald J. Kirk, professor of accounting, Columbia University and former FASB chairman, moderated the panel. Reproduced here is the substance of their debate.

DONALD KIRK: Fair-value accounting and the alleged shortcomings of the historical cost accounting model have been on the agenda of practically every professional or regulatory entity in recent years.

Let's start our discussion with the SEC's chief accountant, Walter Schuetze.

WALTER SCHUETZE: The SEC has been urging the Financial Accounting Standards Board to require that marketable debt and equity securities be accounted for at fair value or market value in the face of the financial statements. There are those who argue that footnote disclosure of fair value is enough. They point out that the AICPA's Statement of Position 90-11 and FASB Statements 12 and 60 already require disclosure of the fair value of marketable debt and equity securities. Statement 107 |"Disclosures About Fair Value of Financial Instruments"~, which went into effect in December, requires the disclosure of market value for additional items.

Financial analysts are not clamoring for formal accounting for marketable debt and equity securities at market prices, and some are even opposed to formal mark-to-market accounting. They would, however, oppose eliminating the disclosures of market value.

So why am I pushing so hard for formal mark-to-market for marketable securities? Because historical cost is not useful or relevant for decision-making, especially by retail investors and policymakers. Retail investors use the information published by investor services, which does not include the footnote disclosures. And policymakers look at industry-wide statistics when they set policy; again they don't read the footnote disclosures. Both groups assume that capital based on generally accepted accounting principals is the real amount of capital. But we know that isn't a correct assumption.

During the last year, as more and more financial institutions have reexamined their accounting for securities held for investment, the center of this debate has shifted from whether to mark-to-market to how to mark-to-market. How to identify those liabilities that need to be marked to market if it is decided that liabilities need to be marked to market. How to get a good number for assets that are not traded every day, for example, for foreclosed assets that must be marked to market under current accounting standards at the time of foreclosure, for loans that are going over to a collecting bank to be sold, for disclosures under Statement 107.

The SEC addressed the "how" question for foreclosed assets and for in-substance foreclosed assets in its Financial Reporting Release 28, issued in December 1986. The release specifies that current market prices should be used to value foreclosed assets at the time of foreclosure even if those market prices come from an auction market where the buyers hope to profit by holding the assets for future price increases.

Fair-value accounting will soon be applied to loan impairment. The FASB has proposed that formally restructured loans be remeasured at their fair values. |The FASB exposure draft, "Accounting by Creditors for impairment of a Loan," was issued in June 1992.~ Some commentators on the exposure draft have suggested that all impaired loans should be measured at fair values. Others, of course, believe that no change in practice is necessary.

Fair-value accounting has another application in writing down the carrying amounts of impaired non-monetary assets. When an asset is acquired, the acquisition price is its fair value. That fair value is, at least in theory, the present value of a series of future cash flows. When identifying and measuring impairment, we need to look at the fair value of that asset at subsequent balance-sheet dates. And if fair value is not readily available, we need to estimate that amount by projecting the cash flows from the asset and discount that amount using a risk rate appropriate to those cash flows.

So fair value is the relevant attribute in identifying and measuring impaired assets when historical cost is no longer relevant or useful for decision making.

JAMES LEISENRING: This debate is not about market-value accounting per se. Most people concede that market value or discounted present value are essentially the same in initial measurement. Rather, the debate is about subsequent measurement.

Many of our constituents say that the FASB is moving toward across-the-board market-value accounting. Our project on impairment, for example, has attracted a great many comment letters suggesting that any notion of marking down to a recoverable amount that is something less than historical cost is in essence market-value accounting. We have another neutral discussion memorandum, "New-Basis Accounting," which is often referred to as the push-down issue. The DM discusses a variety of circumstances where new bases might be recognized. A good many comment letters on this DM suggest that it too is part of the grand move to market-value accounting.

In truth, the FASB never realized that this was the issue. We were looking at what happened when actual cost of a given transaction was pushed down into financial statements. We did not see it as a movement toward subsequent measurement at market value.

The majority of members of the Board that voted for the loan impairment exposure draft would emphatically deny that it represents market-value accounting. The ED would not adopt market value as an ongoing measurement for troubled debt restructurings. It's a judgment that a new measurement should take place because the loan has been restructured. When there is an impairment but not a restructured loan, the impaired loan is not measured at a market rate of interest but at the same discount rate used at the inception of the loan. Neither of these two approaches is market-value accounting.

Many have argued market-value accounting is imprecise and doesn't provide comparable information. I agree that we do have to go through a learning process to estimate market values of some instruments. But historical costs are surely not comparable. They will always show that $1,000 spent for a 4-percent bond in 1992 is exactly the same as $1,000 spent for a 13-percent bond in 1983, both of which will still be on the balance sheet at $1,000. To imply that the two $1,000 expenditures are comparable is misleading.

Relevance is the correct arena for our debate. Market-value accounting advocates say that the most relevant information about an entity's financial instruments at each reporting date is their market values and the gains and losses from economic events that occurred within the reporting period. Historical-cost advocates say that market values are the least relevant because they represent a liquidation value--a liquidation amount that in all likelihood will not be realized.

This last point leads me to the argument that we hear most frequently, and that concerns volatility. Gains and losses on investment securities for financial institutions have been very volatile for years. As the ED on accounting for debt and equity securities points out, market-value accounting actually is less volatile in the period in which the gains and losses are realized than it is to recognize all realized gain or loss in one period. This suggests to me that volatility is not the real argument; rather it is control over the recognition of the volatility.

PATRICK KENNY: Insurance entities operate an asset/liability matched business. The relationship between the two sides of the balance sheet is maintained by carefully matching the duration of the assets to that of the liabilities and by constantly monitoring that relationship to respond to business conditions. From a financial reporting perspective, if we change the way we value the asset side of this relationship, it only stands to reason that similar changes must be made to the liability side.

The application of market-value accounting to one side of the balance sheet does not adequately portray the economics of an asset/liability matched business. I don't want to downplay the complexities of determining fair-value liabilities, but it is better to take on that challenge than to adopt the one-sided approach suggested in the FASB's exposure draft on debt and equity securities.

The FASB generally took a balanced approach to disclosure of market-value information in Statement 107. I think Statement 107 will present useful information, and I strongly recommend that we allow financial statement users some time to use that information and to understand the relevance of that information before we proceed down the road to market-value accounting.

While the FASB is debating the merits of market-value accounting, the SEC has taken a more aggressive approach. The SEC now requires financial reporting that, for insurance companies at least, is more restrictive than today's generally accepted accounting principals and differs from FASB's exposure draft. This inconsistency is confusing and possibly misleading to financial statement users and preparers. And it places an unnecessary burden on companies to restate financial statements to conform to the SEC's aggressive interpretation of accounting standards that may well change.

It is important to keep in mind that this issue affects not only the financial services industry, but manufacturing and other industries as well.

THOMAS JONES: I am not against mark-to-market accounting in its proper place. Citicorp has tens of billions of dollars of assets marked to market every day. I'm also not against mark-to-market accounting because of the results. For example, substantial loan-loss reserves are already on the books, and because pressure for this kind of change always happens at the end of a downturn, the economic cycle is likely to help rather than hinder the numbers.

But I am against the way mark-to-market is being handled. Every time you look around there's another camel's nose under the tent. Loan impairment is one. Securities is another--although I will admit that some of us should be embarrassed about the number of times securities portfolios that were supposed to be held to maturity were turned over. But the market-value accounting discussion is a subtle undercurrent. It's being done piecemeal, and it's not out in the open being debated on the merits.

Let's take financial instruments. Because it's being done in bits and pieces, we need to do the work two or three times. Statement 107 is mark-to-market disclosure, and if mark-to-market accounting on loans and securities follows, we will take on an entire new workload. All of this makes us uncompetitive with companies outside the U.S. that don't have this problem. This piecemeal treatment establishes a bad precedent.

I also argue that market-value accounting is bad accounting. The stampede to mark-to-market was caused by the savings and loan crisis, which wasn't caused by generally accepted accounting principles (GAAP). Accounting for S&L's wasn't under GAAP anyway. We're mixing up regulation with accounting. If we force mark-to-market on an industry such as real estate, which is going through a severe downturn, we'll get liquidation accounting, not going-concern accounting. And that's not GAAP.

Business--the preparers--are supportive of things that need to be done. Take OPEB |Statement 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions"~, for example. Most businesses recognized the necessity for change, even though it has been very damaging to their reported earnings.

But most business people don't see anyone getting such tremendous value from broad application of mark-to-market. I'm not against mark-to-market where it makes sense, but I am very much against mark-to-market across the balance sheet.

So mark-to-market is a victory of liquidation accounting over going-concern accounting and doesn't necessarily reflect the underlying purpose of the assets.

That leads to bad policy, at least from a bank's point of view. The purpose of a commercial bank is to make loans to customers and then, within the limits of possibility, provide liquidity for them through bad times. Marking loan portfolios to market will force banks to take a short-term view that is inconsistent with their fundamental business proposition.

So I make the case that mark-to-market accounting is bad accounting, bad policy and bad precedent.

KIRK: Tom Jones finds evidence that the more the FASB denies it's marching towards current-value accounting, the more people are convinced it is. The question is, Walter, can the man on the street, that retail investor, decipher the meaning of an income statement if all these unrealized gains and losses are in that income?

SCHUETZE: The exclusion of these amounts from the face of the financial statements omits important information for the individual investor, for the sophisticated investor, and for the policymakers. It's more than just the retail investor.

But the SEC is not targeting market-value accounting. To be sure, we want market value for marketable debt and equity securities, but we are not talking about market value for loans, for plants, for patents, for copyrights, or the like.

LEISENRING: The FASB has purposely kept unrealized gains and losses on marketable debt and securities out of the income statement for two reasons: first, because liabilities are not included and, second, because they are unrealized.

KIRK: But by running unrealized gains and losses through equity, you haven't solved what the SEC has said is a bad practice--gains trading, or cherry picking. Why didn't the FASB solve that particular issue in the way the SEC thinks it should be solved?

LEISENRING: The only way it can be solved is to put all gains and losses through earnings. It's very difficult to demonstrate that investment securities haven't been abused. But we haven't solved the cherry-picking issue, and we have to accept that.

SCHUETZE: I think the financial analysts would be better served if realized gains and losses are shown below the line. The primary reason the analysts do not want recognition of realized gains and losses is that it messes up their predictions. But if they would agree to formal recognition of market values in the face of the financial statements with realized and unrealized gains and losses below the line in the income statement, that would be worthwhile.

JONES: We're underestimating the users of financial statements. When a company has a quarter in which it has a lot of income from a one-time gain or sale of investment securities, there isn't a user who doesn't exclude that immediately. I don't think it's as big an issue as we're making it.

KIRK: I want to switch to the appropriateness of valuing the asset side and not the liabilities side. Do you think that marking a financial institution's bond portfolios to market would be misleading if its liabilities were not also marked to market?


JONES: I agree.

LEISENRING: As the ED suggests, we would have liked to have reached some conclusions about liabilities but could not. Some Board members took the view that for deposits, for example, and for some values in life insurance contracts, the only notion of market value that has any relevance is the settlement amount. If someone can walk in the bank and demand a million dollars, it is not necessarily going to enhance financial reporting to record the liability at, say, $950,000 because of changes in interest rates. A study that KPMG did recently for the Association of Reserve City Bankers |"Estimating Fair Value for Financial Instruments"~ acknowledges this. In fact it says that those deposits are already at market on balance sheets. The study goes on to advocate the recognition of the so-called core-deposit intangible. But that was a much broader question than we could come to grips with in the context of equity and debt securities.

KIRK: What will this move towards market-value accounting do to the behavior of companies? If we look at it in terms of the financial institutions, the representations are that people will change their investment horizons, and that if we move it towards loans, it may also change banks' lending practices. What's the reaction of the SEC to such representations as that?

SCHUETZE: I say again we're not talking about mark-to-market on the loan and real estate portfolios.

KIRK: What about banks changing the duration or maturities of government securities they own as a reaction to the proposals?

SCHUETZE: I don't know if banks will do that. Accounting standards ought to produce information that is neutral, that does not influence behavior in one way or another. Bank holdings of marketable securities on the historical cost standard exceed their commercial and industrial loan portfolios, perhaps because the Basel Accords require no capital whatsoever with respect to interest-rate risk. We should not use accounting standards to regulate action. Rather, accounting standards should produce information that is neutral and that investors can use in capital-raising and capital-allocation decisions.

JONES: I'm delighted to hear that the SEC is not interested in mark-to-market accounting more broadly, but I have a hard time believing it. Statement 107 is already a good step on the way. And the loan impairment project is basically mark-to-market. This is a financial institution issue right now, but, believe me, it's coming down the pike for everyone sooner or later. And I don't know if everyone realizes what is being asked for.

With the FASB's proposal on loan impairment, we are being asked to forecast the timing and the amounts of all future cash flows on every loan that gets into difficulty. We've talked about the difficulty of measuring liabilities, but in this case you're talking about measuring assets. It is almost impossible. And because it happens at the beginning of an economic downturn, it front-ends the future interest cost as well. Front-ending the entire principal loss and future interest loss for all the financial institutions at the start of a recession is not much help. I hope it occurs after I've retired.

KENNY: I also think that it will cause financial institutions to invest shorter rather than longer. So this accounting information is hardly neutral.

LEISENRING: But loan impairment accounting as it has been proposed by the FASB is not mark-to-market accounting. When you measure something at initial recognition that purports to be a present-value measurement, what should you do about changes in the factors that determined the initial measurement? Should you incorporate, in a subsequent measurement, your new estimate of the inbound cash flow stream, or should you not?

And should you incorporate in your measurement the observation that interest rates have or have not changed? The Board decided that reflecting the change in interest rates would be remeasuring at market and should not be done. But it did say you should consistently measure the item at its present value of the assumed inbound cash flow stream at the interest rate inherent at the inception of the loan. This decision does impose the burden of determining the timing of cash, but it should not impose a new burden to think about the amount. Presumably, you cannot meet existing standards without thinking about the amount of a loan that you're going to collect.

KIRK: What would be an acceptable standard that would respond to the concerns raised?

JONES: There's no objection to the concept of mark-to-market when there is a deep, liquid market that the company intends to access. In the days when the banks were being chastised for the LDC debt, the mark-to-market cry was very loud, and there was absolutely no market at all. These days there is a fair amount of market and, lo and behold, most banks have either written down to or reserved up to the market value, and it isn't an issue.

It's absurd to think about a deep liquid market for commercial real estate loans today, but over time that will change. ln the absence of a market, the loan-loss reserve is designed to help customers through bad times. The loan-loss reserves bring the value on the balance sheet down to a recoverable value. That is the substitute right now for mark-to-market.

SCHUETZE: But we have a ton, a long ton, of anecdotal evidence that the reserve for bad debts in many financial institutions did not measure up. Under the loan impairment standard we're going to get a much better measure of the actual impairment when companies have to foreclose and sell the foreclosed asset.

JONES: But that's a totally different issue. Obviously foreclosed assets have been written down to market value. What I'm talking about are the loans that are already in difficulty and for which we're going to have to predict the future principal and interest cash flows.

SCHUETZE: If you're talking about collateralized loans, maybe it's easier to just get the fair value of the collateral and use that number to measure the impairment. But we have lots of signature loans where we're going to have to try to measure impairment. You're not suggesting that we not make a reasonably good stab at that, are you, Tom?

JONES: Hey, listen, for a guy who is not pushing market-value accounting, you're doing a good job right now.

KIRK: What is the attitude of the SEC and the FASB with regard to the possibility of valuing intangibles and attempting to value operating assets of other sorts ?

SCHUETZE: The SEC has not addressed operating assets. We do have a rule that requires oil and gas companies using full-cost accounting to write down the cost of their assets when it is in excess of certain ceilings. But, other than that, we have not looked at this issue.

I note that the Association of Investment Management and Research, in a statement of position that it issued tn the fall, recommended that all unidentifiable intangibles be written off to equity. They apparently do not find those representations useful. They also recommend that all executory obligations be recognized on the face of the balance sheet.

LEISENRING: Of course we're interested in certain intangible accounting questions, but again that's not necessarily mark-to-market accounting.

The AICPA has the advertising cost capitalization issue, an issue of soft-cost recognition. Last spring we approved for exposure their statement of position |"Reporting on Advertising Costs"~, although some of us certainly had some qualms about it. It, again, is not mark-to-market accounting, but it is recognition of an asset that has previously been considered too soft for recognition. I would predict we will have more of these questions. We're much more of a service economy than we once were, but our model is oriented to bricks and mortar. So it's inevitable that we will continue to have questions about recognition of intangible assets.

KIRK: Won't the subjective nature of many fair-value estimates for the purpose of measuring impairment shoot holes in what should be bullet-proof balance sheets?

SCHUETZE: To be sure, in the absence of a liquid market, getting estimates of fair value is difficult. However, once historical cost is impaired, it has lost its relevance. When we look for a substitute number, we need to look for the one that is the most relevant. If we have a number that is verifiable but not relevant, the most relevant number should always win out. It is going to be a difficult learning process to go through these measurements, but what we're after is numbers that have relevance for investors.
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Title Annotation:Corporate Reporting
Publication:Financial Executive
Article Type:Panel Discussion
Date:Jan 1, 1993
Previous Article:Beakers & bellows.
Next Article:Current values: finding a way forward.

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