Implications of accounting standards on market value for banks

INTRODUCTION

The Statement of Financial Accounting Standards (SFAS) No. 115 entitled "Accounting for Certain Investments in Debt and Equity Securities" is one of the challenging accounting standards covering financial institutions, especially the banking industry. sup 1 SFAS No. 115 attempts to: (1) provide better uniformity in financial reporting of financial institutions; (2) standardize portfolio accounting practices across industry lines; (3) establish guidelines for the recognition and measurement of investments in debt and equity securities; and (4) discourage financial institutions from selectively selling securities recorded at historical cost in an attempt to manage their reported earnings (gains trading). The Statement has generated widespread interest and criticism primarily because it requires the use of market value accounting (MVA) for certain investments in debt and equity securities. Critics of SFAS No. 115 have argued its significant adverse volatility impact on the reported earnings and shareholders' equity resulting from recognition of unrealized holding gains or losses for market adjustment and its failure to properly reflect the economic reality of financial institutions. sup 2

The effective date of SFAS No. 115 is for fiscal years beginning and after December 15, 1993. Thus, calendar-year financial institutions would have to apply the Statement in 1994. The affected institutions are allowed to adopt SFAS No. 115 earlier in financial statements for fiscal years beginning after the issuance of this Statement and should not be applied retroactively to prior years' financial statements. Adoption of SFAS No. 115 will have a significant impact on asset/liability management strategies and funding decisions of financial institutions. Thus, it is important for financial institutions to understand provisions, effects, and implementation concerns of adopting SFAS No. 115. This article: (1) examines the provisions of SFAS No. 115; (2) discusses the possible financial and managerial impact of adopting SFAS No. 115; and (3) describes implementation challenges of the Statement.

PROVISIONS OF SFAS NO. 115

The Statement will provide comparability and usefulness of financial reporting by financial institutions. Because different measurement attributes apply to the categories, SFAS No. 115 requires investment securities to be classified into one of three categories: held-to-maturity, trading, and available-for-sale. The FASB set forth the following guidelines in SFAS No. 115:

1. Uniformity: provides more uniformity in reporting for certain investments in debt and equity securities;

2. Comparability: standardizes portfolio accounting practices across the industry;

3. Measurement: addresses concerns expressed by the financial community regarding the recognition and measurement of investments in debt securities;

4. Method of MVA: requires a piecemeal MVA approach of marking to market for a portion of assets, but not related liabilities utilized to fund them;

5. Restriction: restricts the circumstances in which debt and equity are reported at amortized cost;

6. Gains Trading: prevents financial institutions from selectively selling securities recorded at historical cost in an attempt to manage their reported earnings;

7. Held-to-maturity Investments: these securities are those debt securities with positive intent and ability to hold to maturity, with no anticipation that they would be available to be sold in response to changes in circumstances such as changes in market rates, needs for liquidity, or changes in foreign currency risk. These securities should be initially accounted for at cost and be subsequently adjusted for amortization of premium and accretion of discount;

8. Trading Securities: these securities are invested for profit and should be reported at market value, and resulting realized or unrealized holding gains and losses should be included in the determination of net income;

9. Available-for-sale Securities: these securities are investments other than trading and held-to-maturity which may be sold prior to maturity. These investments should reflect market value with any resulting unrealized holding gains or losses reported as a net amount in a separate component of shareholders' equity until realized. Any realized gains or losses of these securities should be included in earnings;

10. Transfer: any transfer of securities between suggested investment categories should be accounted for at fair market value and resulting transferred unrealized holding gains or losses should be recognized accordingly. There should be no reversal of an unrealized gain or loss for transfers from trading which is already recognized in earnings. For securities transfer into the trading category, any unrealized holding gains or losses should be recognized in earnings immediately. Any unrealized gains or losses as a result of transferring from held-to-maturity to available-for-sale should be recognized immediately as a separate component of shareholders' equity. For transfers from available-for-sale to held-to-maturity securities, any already unrealized gains or losses reflected in a separate component of shareholders' equity should be amortized over the remaining life of securities as a yield adjustment consistent with the method of amortizing any related premium or discount;

11. Mortgage-backed Securities: any securities held for sale in conjunction with mortgage banking activities should be considered trading securities;

12. Dividend and Interest Income: investment earnings, including amortization of premium and discount, should continue to be included in earnings for all three investment categories;

13. Trading Securities: these securities should be classified as current assets on the balance sheet, while held-to-maturity and available-for-sale securities should be classified as either current or noncurrent, based on their time period to maturity as appropriate;

14. Debt Instruments: SFAS No. 115 applies to all debt instruments that meet the definition of a security as stated in the Statement, even if they have been reported as loans in the financial statements. These types of loans include mortgage securitized loans and unrelated industrial development bonds (e.g., Bradly bonds);

15. Mortgage Derivative Product: a high-risk mortgage security should not be classified as a held-to-maturity security at acquisition if it could become a "high-risk mortgage security" as a result of subsequent changes in market interest rates and related changes in the security's prepayment risk. An example of these mortgage derivatives is a collateralized mortgage obligation (CMO), which is typically issued in maturity classes to minimize the uncertainty of the timing of payments. CMO's, even those that are not considered highly risky, cannot be classified as a held-to-maturity; therefore, they should be marked to market;

16. Classifications: category determination of securities should be made on a security by security basis, and the appropriateness of security classifications should be reassessed at each reporting period. Although a market valuation must be performed on a quarterly basis, a monthly market adjustment is recommended in order to monitor the impact that market value changes have on reported earnings and capital.

FINANCIAL AND MANAGERIAL IMPACTS OF SFAS NO. 115

SFAS N. 115 has created much discussion and criticism regarding feasibility, desirability, applicability, and relevance of MVA for financial reporting. Proponents of MVA argue that historical-based financial reporting contributed to the lack of credibility and usefulness of financial information; therefore, MVA should be utilized to gain credibility and usefulness of financial reporting and to evaluate entities' financial health. sup 3 Opponents, on the other hand, argue that MVA measures are subjective and its adoption would distort financial reporting and thus create a false sense of security, create volatility in owners' equity, and have negative effects on external reporting. sup 4 The provisions of SFAS No. 115 may have no immediate impact on entities' cash flows, but they may cause fluctuations in the reported earnings as well as shareholders' equity.

The banking industry has been depicted as strongly opposed to any move towards market value accounting. Indeed, a survey of bankers, analysts, and users of financial reporting conducted by KPMG Peat Marwick reported that about 90 percent of the respondents opposed the adoption of market value accounting for financial reporting. sup 5 The survey also revealed that 95 percent of the respondents preferred historical cost accounting, along with supplemental fair market value disclosures. Furthermore, the survey found a significant difference of opinion towards market value accounting between preparers and users of financial statements. A majority of users believed that fair market value disclosures would be useful, while over 70 percent of preparers questioned the reliability, comparability, and timeliness of market value accounting.

Adoption of the Statement will affect entities' asset/liability management strategies and funding decisions. Institutions, in an attempt to balance liquidity needs and interest rate sensitivity, may reclassify a significant portion of their portfolio as "available-for-sale." Banks will divest long-term debt securities (e.g., long-term bonds) primarily because the value of these bonds can widely fluctuate along with interest rates. Banks' earnings and/or capital will become erratic due to the fluctuations in the value of these securities being quarterly or annually adjusted for market values. Banks may act in a suboptimal manner to boost earnings by selling securities whose values are high while keeping underwater securities.

In compliance with the provisions of SFAS No. 115, institutions may try to shorten the life of their securities by either increasing holdings in short-term investments (e.g., trading securities) or decreasing long-term investments (e.g., hold-to-maturity securities). On the other hand, banks, in an attempt to avoid fluctuations in earnings and equity, may suboptimally choose to hold a great portion of securities to maturity despite the changes in market conditions, liquidity needs, and regulatory demands. Capital is a critical factor in the banking industry, and any significant fluctuations in equity could have regulatory implications and unfavorable impacts on a bank's lending limit. Thus, banks may attempt to reclassify their available-for-sale securities into either trading or held-to-maturity in order to minimize fluctuations in equity. The impact of adopting SFAS No. 115 to a large extent will depend on the institution's revised asset/liability management strategy.

Financial institutions, in an attempt to avoid regulatory restrictions such as dividend and growth restrictions, having to close when tangible equity falls below two percent of recorded assets, or increase in FDIC insurance premiums resulting from volatility in capital, may increase regulatory capital. Increased volatility in banks' capital also makes computation of risk based regulatory capital, commonly known as Tier 2 capital, more difficult. However, volatility in capital resulting from market value fluctuations can be minimized if the financial institutions' regulators decide to exclude unrealized gains or losses from the definition of risk-based regulatory capital.

IMPLEMENTATION CONCERNS AND CHALLENGES OF SFAS NO. 115

SFAS No. 115 presents bank management and accountants with a new set of challenges. Proper implementation of the Statement requires careful evaluation of: (1) how investment securities should be recorded, measured, and adjusted for market value; (2) how securities should be transferred between categories; (3) how earnings and capital volatility resulting from market adjustments can be minimized; and (4) how to manage a securities portfolio to minimize the possible negative impact of the adoption of the Statement on cash flows and income tax liability. Thus, the effective and efficient implementation of SFAS No. 115 requires bank management and accountants to prepare an adoption plan consisting of the following steps:

1. Obtain a complete knowledge and understanding of the provisions of SFAS No. 115, including circumstances in which debt and equity are reported at amortized cost and transfer of securities between suggested investment categories. Management should provide in-house training for employees directly involved in the implementation process on proper establishment of an MVA system and the financial reporting impacts. During implementation, the working group should obtain a thorough understanding of the provisions of SFAS No. 115. The working group should initially brainstorm various methods that can be used in implementing SFAS No. 115 in order to maximize the perceived benefits of adopting MVA, while minimizing the implementation costs.

2. Establish policies and procedures regarding classification of investments in debt and equity into three suggested categories of "trading," "available-for-sale," and "held-to-maturity." Periodically value the subject assets and liabilities in accordance with the established policy and other applicable rules and regulations.

3. Develop a new accounting information system or modify the existing system to comply with the provisions of SFAS No. 115 and other market value requirements (e.g., the IRS code Sec. 475) in providing adequate disclosure while not revealing critical data about the bank's financial instruments or any underlying characteristics of debt and equity securities to competitors, customers, or suppliers.

4. Establish an adequate and effective internal control system for investment securities. Such a control system should: (a) maintain appropriate source documents to support management intent, justifications, and judgment in classifying securities in compliance with the provisions of SFAS No. 115; (b) keep accurate subsidiary ledgers for all investment securities; and (c) reconcile periodically all investment securities on the general ledger to the supporting subsidiary ledgers. This internal control system should contain a policy statement establishing market measures, basis, and factors that should be used in calculating market value. The established internal control system should also indicate methodologies and opportunities that may be used in calculating market value measures such as discounted cash flow.

5. Hire outside consultants or accountants to determine: (a) how other comparable institutions are implementing SFAS No. 115 and (b) find out about bank regulations and other materials on new market value rules.

6. Avoid an SEC investigation or an enforcement action by complying with all applicable market value requirements and by considering all available choices for implementing SFAS No. 115.

7. Systematically review subject assets and liabilities for each and every quarter. This review should include an assessment of all relevant indications of market value, including assumptions made in calculating market value, discount rate used, and underlying change in the economic climate that may have an impact on the market value. This review should be documented to show that all relevant measures and indicators of market value are gathered and assessed.

8. Provide sufficient documentation and a rationale for securities classification to the suggested three groups. Reassess the appropriateness of security classifications at each reporting period and perform a market valuation at least on a quarterly basis. Provide supplemental information to support the held-to-maturity investment classification and management intent in holding securities to maturity. Provide documentation of all the procedures and methods utilized in arriving at market value to demonstrate that you made a good attempt to comply with provisions of SFAS No. 115 and other SEC related rules.

9. Use market value measures for internal performance evaluation. Managers should be evaluated on the basis of performance of the securities portfolio on an MVA basis.

10. Work directly with external and internal auditors in understanding and assessing the managerial and financial impacts of converting to MVA. Auditors' involvement in designing MVA systems is important in preparing financial statements in conformity with SFAS No. 115, as well as in considering effective dates, assessing the financial impact, and deciding whether early adoption of the Statement would be appropriate.

11. Consult with the tax experts and seek advice from the IRS to provide reasonable assurance of compliance with tax laws related to the adoption of MVA. IRS Sec. 475 of the code requires mark-to-market accounting treatment for certain securities held. sup 6 The code states that a security's classification for financial reporting purposes is not contradictory of the security's classification for federal tax purposes. Security holdings that are not classified as held-to-maturity according to SFAS No. 115 may be qualified for the held-for-investment exception to mark-to-market roles under the Code Sec. 475.

12. Communicate the financial impact of adopting SFAS No. 115 to all interested parties, especially shareholders, creditors, and bank's regulators. Shareholders and creditors may overreact to the volatility in earnings and equity caused by implementing SFAS No. 115 and, accordingly, withdraw funds and destabilize the banking industry which is important to the economy in general. The bank's secretary should be involved to ensure that key shareholders and financial analysts are notified of accounting changes for debt and equity securities and their possible impacts on the financial reporting process.

CONCLUSIONS

SFAS No. 115 is one of the challenging accounting standards concerning financial institutions. The FASB suggests a piecemeal approach in adopting MVA because it requires MVA for the asset side, but not for the liability side of the balance sheet. However; SFAS No. 115 may be considered the first step toward virtually applying MVA for all bank financial items. SFAS No. 115 attempts to resolve the substantial controversy and perceived lack of credibility in financial reporting of the banking industry by: (1) providing more uniformity in reporting for certain investments in debt and equity securities; (2) better reflecting the true economic value of an institution's equity by providing market value information of its assets and liabilities; (3) providing early warning signals of those institutions whose capital is impaired; (4) restricting the circumstances in which debt and equity are reported at amortized costs; (5) discouraging cosmetic transactions intended primarily to improve reported earnings (e.g., gains trading by selling appreciated assets while retaining depreciated assets); and (6) standardizing portfolio accounting practices across the banking industry and financial institutions.

The immediate impact of the adoption of SFAS No. 115 will be changes in the classification of securities. However, this impact, to a large extent will depend on the institution's established asset/liability management strategies and funding decisions. Banks' earnings and/or capital will become erratic due to the fluctuations in the value of these securities being quarterly or annually adjusted for market values. Banks may act in a suboptimal manner to boost earnings by selling securities whose values are high while keeping underwater securities. SFAS No. 115 presents financial institutions with a set of challenges. This article examines the provisions and impacts of adopting SFAS No. 115. It also provides some guidelines for the effective and efficient adoption and implementation of the Statement.

ENDNOTES

1. Financial Accounting Standards Board, "Accounting for Certain Investments in Debt and Equity Securities," Statement of Financial Accounting Standards No. 115, Norwalk, Conn. (May 1993).

2. Shaffer, Sherrill, "Marking Bands to Market," Federal Reserve Bank of Philadelphia (July/August 1992), pp. 13-21; Sutton, Michael H. and James A. Johnson, "Current Value: Finding a Way Forward," Financial Executive (January/February 1993), pp. 39-43; and Morris, Charles S. and Gordon H. Sellon, Jr., "Market Value Accounting for Bankers: Pros and Cons," Economic Review, Federal Reserve Bank of Kansas City (March/April 1991).

3. Dayton G. Lierley and Richard L. Brezovec, "Proposed Rules for Investment Securities: A Piecemeal Adoption of Market-Value Accounting?" Bank Accounting and Finance (Spring 1993), pp. 41-43.

4. Morris, Charles S. and Gordon H. Sellon, Jr., "Market Value Accounting for Bankers: Pros and Cons," Economic Review, Federal Reserve Bank of Kansas City (March/April 1991).

5. KPMG Peat Marwick, "U.S. Survey Shows Opposition to Fair Market Value Accounting," The CPA Journal (December 1992), p. 15.

6. Internal Revenue Service (IRS) Code Sec. 475.

Copyright National Association for Bank Cost & Management Accounting 1994
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