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Market-value or historical cost accounting.

"Market-value accounting" is a hot buzzword this season in financial circles and regulatory bodies. With the increasing concern in the public and private sectors about the adequacy of financial statement reporting by financial institutions, market-value accounting concepts have received considerable attention from the Congress, the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC) and others as a possible means to improve financial reporting. There is widespread belief in some quarters that the current use of historical cost accounting by banking institutions has been a contributing factor in masking both the true value of their assets and the need for further intervention by regulators, especially those seeking to limit federal insurance fund losses. Other ramifications of the current-value accounting initiatives may be of concern to state and local government finance officials.

The issue surfaced in 1986 when the FASB began a project to consider comprehensive disclosures about risk, liquidity, interest rates and market values of financial instruments. A FASB exposure draft was circulated in December 1990 proposing a standard that would expand market value disclosure requirements to many types of financial instruments. The final FASB standard, Statement No. 107, Disclosures About Fair Value of Financial Instruments, was issued in December 1991. This standard, with some exceptions, requires all entities to supplement their historical cost financial statements with disclosures about the fair values of financial instruments reported in those statements. The standard will be effective for calendar year 1992 financial statements, except for companies with less than $150 million in assets; these companies have an additional three years to comply.

The FASB undertook a related project in June 1991 to consider an accounting rule that would require holders of debt securities for investment purposes to record those securities at market value in their financial statements. As of January, the board was considering issuing an exposure draft on this rule.

Other initiatives in current-value accounting also came to the fore in January with a Wall Street Journal headline: "SEC Renews Call for Pressure on Banks and S&Ls to Update Accounting Rules." This report highlighted a speech by the new chief accountant of the SEC in which he reiterated his long-standing interest in market-value accounting and added a new sense of urgency to the debate by revealing the SEC's impatience with the rule-making process. The SEC has authority over accounting rules, but gives day-to-day responsibility for the standards to the FASB. The SEC's new chief accountant praised the FASB standard issued in December 1991, but emphasized that because it requires only note disclosure, it does not change the balance sheets. This is not informative enough for most investors, he asserted.

Federal Reserve Board Chairman Alan Greenspan entered the fray in February when he was questioned on market-value accounting by Senator Jim Sasser at his renomination hearing. Greenspan raised both economic and technical concerns in arguing against market-value accounting and pointed out the inimical results which he foresaw for securities issued by small municipalities if the SEC's plans were put into effect.

What do GFOA members think of these initiatives, and what effect might the FASB standards have on their governments? For sample opinions, Government Finance Review asked committee leaders and others to comment on the following question: "In your opinion, would current-value accounting enhance or diminish the attractiveness of municipal securities as investments?" Their replies are presented below.

E. Barrett Atwood, Sr., chair,

GFOA Committee on Accounting,

Auditing and Financial Reporting;

deputy department director for

finance, South Florida Water

Management District.

The impact that such a ruling would have on governments is twofold: initially, on the marketability of our own debt securities and longer term, on the potential change in our own accounting for securities of others that we hold in our investment portfolios.

The proposed measure could only reduce the marketability of state and local government bonds, thus costing our taxpayers more in higher interest costs. The largest impact may come to smaller jurisdictions who may sell their bonds in a private placement to local financial institutions. In such cases, the bonds are frequently not rated and a market value does not readily exist.

I'm not sure what guidelines the SEC would provide for banks to "mark to market" the interim value of municipal bonds. As a result, the local bank may be very hesitant to invest in the local community bonds because there may be a negative impact on the earnings statement if it were forced to record bonds at interim market values even though it is the bank's intent to hold those bonds to maturity and receive full face value. If this were to occur, the government would be forced to incur the added expense to enter larger bond markets.

One can more readily understand market-value accounting for equity securities held by banks and other public companies. There is no guaranteed payment to holders of common or preferred stock or even debt securities of private companies. However, government bonds will nearly always guarantee full payment when held to maturity.

If the SEC were to require market-value accounting for holders of investment securities, it should exclude government securities, especially those of state and local governments. We have already felt the heavy impact of the federal "tinkering" indirectly with our bond markets through tax reform and arbitrage rebates. Let's not close off another opportunity for low interest costs for our taxpayers.

The potential longer-range impact on governmental accounting standards also sends out the yellow caution flags. If the FASB were to make such a rule, the Governmental Accounting Standards Board (GASB) in turn, may feel compelled to set the same accounting standard for governments.

Many state and local governments concentrate their investment portfolios in U.S. government obligations. With some of the wide swings in interest rates in recent decades and the resulting fluctuations in bond market values prior to maturity, this could have significant impact on our actual operating statements and budgets. I certainly hope the SEC excludes government securities from any future rule on market-value accounting. Likewise, I would think the GASB should have the foresight to do the same.

Robert J. Freemen, GFOA member,

professor of accounting at Texas

Tech University; member of the

GASB.

This issue might be approached from the perspective of current-value accounting and financial reporting by municipalities or by investors in municipal securities. I have not analyzed any research study that specifically and competently addresses the pros and cons of this issue from either perspective. Accordingly, I could only speculate on the impact of a change from note disclosure requirements (as currently provided for investments) to a financial statement display requirement, and such speculation would not be appropriate.

Q: Does the GASB have an interest in current-value accounting? The GASB is intersted in all potentially useful asset valuation and liability determination methods. But it would be premature to either state or imply that the GASB has any leanings in the measurement and valuation of assets or liabilities. GASB positions are reached only after extensive deliberation and due process, including public comment. However, the GASB will be exploring the valuation issue soon in at least one major project on our technical agenda.

The issue of investment valuation in the financial statements of public employee retirement systems (PERS) is scheduled for discussion at the GASB's March meeting. In its 1990 exposure draft on pension accounting by employers, the board proposed that plan assets generally should be valued at a smoothed market value rather than current value or cost, but the proposal refers only to asset valuations for the purpose of calculating employers' pension expenditures. The exposure draft did not address how investments should be valued in the financial statements of PERS. That issue will be discussed at the March meeting. Because the GASB staff is still conducting research on this topic, and I have not reviewed or debated the results of this research with my colleagues at the GASB, it would not be appropriate for me to comment on the issue at this time.

Investment valuation will eventually be addressed by the GASB for all government investments. However, because of the nature of the government environment and the governmental accounting and financial reporting model, I doubt that the subject of current-value accounting for liabilities will be a high priority in the foreseeable future.

Sandra M. Davis, chair, GFOA

Committee on Cash Management;

treasurer and tax collector, County of

Los Angeles, California.

In evaluating the impact of current-value accounting, it is important first to briefly discuss the current accounting practice. The American Institute of Certified Public Accountants' Industry Audit Guide for Banks and Savings and Loans suggests the following: * marketable equity securities are carried

at the lower of cost or market; * nonmarketable equity securities are

carried at cost; * securities held as part of the institution's

trading account are carried at market

value; * securities held as inventory for sale are

carried at the lower of cost or market; * securities held for investment are carried

at amortized cost. Thus, depending on how the instrument is carried on the financial statements, current-value accounting already may be impacting the institution's balance sheet, and the following discussion would not apply.

Q: In your opinion, would current-value accounting enhance or diminish the attractiveness of municipal securities as investments? The Securities and Exchange Commission's increasing pressure on banks and thrifts to value bank held securities based on current market rather than the time of purchase would have a negligible impact on the marketability of large municipal issues. The proposed accounting change, however, could diminish the attractiveness of long-term, bank-qualified securities.

It is anticipated that banks and thrifts, in order to avoid large fluctuations on their quarterly income statements, would shift their interest in bank qualified issues to the shorter term maturities. Such a shift in demand would reduce the liquidity of longer term securities, steepen the yield curve and could ultimately result in higher borrowing costs to smaller issuers.

Since current tax regulations effectively preclude banks and thrifts from purchasing securities which are not bank-qualified for their own portfolio and because bank-qualified issues represent such a small portion of the total municipal credit market, such an accounting change would have a negligible impact on the market-ability and liquidity of large issues in particular and the overall municipal credit markets in general.

It also should be noted that due to their small issue size, many bank-qualified issues are amortized over an intermediate term which further reduces the impact of a market-value based accounting standard on the overall attractiveness of the municipal credit market.

Q: In what ways would current-value accounting affect investment decisions of public-sector investors? Recognizing unrealized market gains and losses may introduce continued volatility into the institution's balance sheet. The changing balance sheet will impact the institution's capital requirements and may impact its ability to meet federal requirements.

These factors may impact investment strategies in two ways: 1) smaller institutions having large balance

sheet fluctuations may not be prudent

investments for governmental agencies

and, 2) because of the volatility, investments in

smaller institutions may be limited to

shorter maturities.

Ralph Horn, president and chief

operating officer, First Tennessee

National Corp.; immediate past

president, Public Securities

Association.

A FASB initiative to require financial institutions to mark-to-market certain assets would have a very negative and long-lasting effect on the ability of municipalities to raise funds.

Financial institutions currently make investments in long-term fixed rate securities that are normally funded with offsetting long-term fixed rate liabilities. These investments are made, generally, with the intention of holding them to maturity. If these financial institutions must mark these assets to market on an ongoing basis, different levels of current interest rates would create wild swings in reported earnings of those financial institutions. This would be very confusing to equity investors in financial institutions and would likely cause many of them to seek other investment alternatives. The only way the financial institutions could avoid this situation would be to sell all of their longer-term fixed rate assets and purchase only short-term instruments which mature in no more than one to three years or, alternatively, purchase only variable-rate investments.

The mass selling of these securities would flood the secondary market and drive up interest rates on municipal securities, and many small issuers who depend almost solely on their local and regional banks to purchase their securities would lose the only buyer for their long-term fixed rate debt. They would then be unable to gain access to the capital markets to fund their long-term capital projects.

Regarding the broader economic impact of market-value accounting, it would exacerbate the credit crunch. Financial institutions also would sell their mortgage-backed securities and would refrain from purchasing any new fixed rate mortgage-backed instruments that must be marked to market. This would create a dramatic increase in interest rates for home buyers. Also, if the newly appointed chief accountant at the SEC is correct in his statement that requiring marking to market for the marketable securities is just the first step, then the same requirement would be expected to apply to loans in the future, resulting in the elimination of long-term fixed rate credit for small businesses that depend on local financial institutions for credit.

Market-value accounting is supposed to accomplish the following three things: 1) discourage the practice of "gains

trading" by financial institutions; 2) encourage better interest-rate risk management

by financial institutions; and 3) provide a clearer financial picture of

financial institutions to investors in

financial institutions.

While all of these results are admirable, market-value accounting is certainly not the answer. The regulators have already dealt with gains trading by imposing new, strict regulations. The ability of a financial institution to manage its interest-rate risk would be diminished dramatically if the proposal only calls for marking assets (and not offsetting liabilities) to market, and the wild fluctuations in earnings would be confusing to investors in financial institutions and possibly drive them to other investments.

Last year the Financial Accounting Standards Board approved a new rule that will require all financial institutions to disclose the fair values of their assets and most of their liabilities. The result of this requirement may create some confusion in the marketplace, but it is certainly more desirable than market-value accounting.
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Title Annotation:new accounting standard by Financial Accounting Standards Board
Publication:Government Finance Review
Article Type:Panel Discussion
Date:Apr 1, 1992
Words:2363
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