Synaptic

Writing Anthology: Engage in critical reading to gain insight to form your own ideas on a chosen focused topic relevant to the course. Papers should reflect independent thinking based on evidence.

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Labeled “The Battle of the Beancounters” from those on the outskirts of the combat zone, the debate over the merits of historical cost as opposed to current value accounting includes three formidable groups: the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), and the Federal Reserve Bank. Each group possesses its own agenda which ranges from maintenance of the status quo to radical change. Reacting to the enormous scandal created by the failure of the savings and loan industry, the FASB has recently released Statement of Financial Accounting Standards Number 107-Disclosures about the Fair Value of Financial Instruments. While reaction to this standard has been mixed, it lays the foundation for further advances in reporting assets at current value. Before delving into the topic, it is first necessary to discuss the exact meaning of current value. When the FASB released the 1990 Exposure Draft which preceded Statement 107, some respondents were concerned with the use of the term market value to define the dollar amount at which the asset or liability would be reported. Market value, to them, had an association with items traded on active secondary markets (such as exchange and dealer markets). In contrast, market value, as defined by the Exposure Draft is applicable whether the market for an item is active, inactive, primary, or secondary. To avoid the possible confusion, the term fair value is used in keeping with recent terminology used in similar disclosure proposals by other national and international standard-setting organizations (SFAS No. 107, paragraph 37). Fair value is often based on information obtained from market sources, though in broader terms, it not only encompasses active secondary markets as mentioned above, but also brokered and principal-to-principal markets (SFAS No. 107, paragraph 19). Including all four markets explicit in the definition of fair value rectifies the misunderstanding with the use of market value, although both terms are used interchangeably throughout accounting literature.

History

In the early 1980s, current value accounting became a much-discussed topic as the savings and loan Industry suffered through a succession of what should be termed as “mini-crises” when viewed in the light of its ultimate demise. Central to the problem was the nature of business which a thrift undertakes. An S&L issues deposit-type obligations and invest the acquired funds primarily in mortgage loans. The effective maturities on deposits are short because interest rates may be adjusted frequently on most of them while, in contrast maturities on mortgage loans are up to forty years long. This practice is termed “maturity mismatching” (Johnson and Peterson, 1984). Since market values of financial assets and liabilities move inversely with interest rates, a period of great economic change signals doom for S&Ls. When interest rates rise sharply, S&Ls are forced to pay higher rates on nearly all deposits while charging higher rates only on new loans (Johnson and Peterson, 1984). This leads to a severe mismatching of return on assets to the increasing costs of liabilities. For this reason, the economics of this industry are such that historical cost provides misleading, if not incorrect, financial information.

Due to this pervasive problem, accountants comprehensively evaluated the option of current value accounting. Considering the qualitative characteristics necessary in all accounting information, researchers devised a plan which utilized contra accounts. These accounts would serve as current value reserves and could be adjusted as the market interest rates fluctuated and changed the value of assets and liabilities (Johnson and Peterson, 1984). Though the FASB never adopted such a proposal, the S&L situation clearly demonstrated that some sort of change loomed on the horizon.

Introduction to the Debate

Prior to the passage of Statement 107, a vigorous debate ensued between the SEC and the Federal Reserve Bank. Seeking to preempt a series of bank failures similar to the S&L debacle, Richard Breeden, head of the SEC, desired that banks report their financial instruments at their current, or market, value so that investors are able to assess the financial stability of the company. Also interested in preventing a complete collapse of the banking industry is Federal Reserve Chairman Alan Greenspan, who claims that a current value representation of financial assets could also potentially mislead statement users. As values would fluctuate greatly in times of economic unrest, a financial institution would appear unstable when, in fact, regulatory agencies require such banks to boost their reserves against such potential losses, thus circumventing any severe financial problems (Yang, November 26, 1990).

Proponents of Current Value

As stated above, proponents of current value accounting view historical cost data skeptically as they feel that it does not accurately represent the financial condition of an institution. Accounting principles have always allowed banks and thrifts to record debt securities held for long-term investment at historical cost. Theoretically, these institutions generally hold their bonds to maturity (Baldo, 1991). In the 1980s, S&Ls set a nasty precedent by selling securities which had appreciated in order to boost their earnings. Yet when bonds turned sour and their market value declined, thrifts kept them on the books without recognizing the loss in value. This combination masked the industry’s slow hemorrhaging (Yang, 1990). Richard Breeden summed up the situation while testifying before Congress: “If misused, accounting principles can conceal insolvency from creditors, investors, and regulators. Misuse of accounting standards played an extremely large, and In some ways pivotal, role in allowing the rapid and reckless growth of the thrift industry” (Baldo, 1991). Breeden’s long-range objective was to alter the way that banks account for all of their assets and liabilities. Given that no one has been able to devise a consistent manner in which to evaluate the current value of liabilities, Breeden’s first goal was to target a bank’s Investment portfolio. Such a step is necessary since it would eliminate some of the accounting abuses which plagued and ultimately ruined the S&L industry (Yang, 1990). The impact of this move ten years earlier would have been dramatic for the thrift industry. According to 1981 estimates, the net worth of S&Ls was $42.4 billion if assets and liabilities were valued at historical cost If marked at current value, however, the net worth of the same companies was $44.1 billion (Johnson and Peterson, 1984). Given the public perception that banks are teetering on the same cliff of disaster, Breeden hoped to act prospectively, rather than retroactively.

Proponents of Historical Cost

Advocates of historical cost accounting contend that the concept of current value is infinitely subjective and that accounting in this manner severely compromises the reliability of financial statements. Erring on the side of conservatism, proponents of historical cost blame people, and not accounting systems, for the horrible failure of the savings and loan Industry. Bankers and the Federal Reserve Bank itself vigorously oppose Breeden’s proposal since they fear his actions constitute a form of backlash against financial institutions in light of their colleagues’ demise.

Most persuasive in the Greenspan camp lies the argument that solely honing In on the assets section of the balance sheet (as proposed by Breeden) would cause asset values to change widely in interim financial statements. In periods of high-interest rates and market swings, earnings and capital levels would gyrate wildly from quarter to quarter (Yang, 1990). Banks contend that they should be allowed to mark to market liabilities “related” to their securities holdings in order to control such haphazard swings (“The Truth Will Out”, 1992). Especially at a time when cynicism reigns and confidence In financial Institutions is low, any changes which negatively impact the balance sheet carrying values of assets of banks will compound the current crisis in the financial Industry. Moreover, accounting changes which place United States companies at a competitive disadvantage with foreign counterparts only serves to magnify the U.S.’s impotence in controlling its own economy (Powers, 1991). Such a sweeping change, according to historical cost advocates, involves ramifications far beyond those considered by the SEC.

Action by the Financial Accounting Standards Board

In May 1986 the Financial Accounting Standards Board added a project on financial Instruments and off balance sheet financing to its agenda. Issues considered by this project included, among other things,. . . “how financial instruments should be initially and subsequently measured and how best to disclose the potential favorable or unfavorable effects of financial instruments” (SFAS No. 105. paragraph 1). The paragraphs in Statement of Financial Accounting Standards Number 105 which pertained to financial instruments were later superseded by Statement Number 107, but its very passage signaled the increasing importance of the current value accounting issue. At the crux of the matter is Statement Number 107:

This Statement extends existing fair value disclosure practices for some instruments by requiring all entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the statement of financial position, for which it is practicable to estimate fair value. If estimating fair value is not practicable, this Statement requires disclosure of descriptive information pertinent to estimating the value of a financial instrument. Disclosures about fair value are not required for certain financial instruments listed in paragraph 8. (SFAS 107, summary)

This rule applies to all publicly owned entities such as banks, thrifts, and other financial institutions.

In Appendix C, which describes background information and the basis for conclusions, the FASB justifies its stance by applying the primary qualitative characteristic of relevance to current value. The FASB concluded that fair value meets the first objective of financial reporting stated in FASB Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises, that is, to provide information that is useful to present and potential investors, creditors, and other users In making rational investment, credit and similar decisions (SFAS 107, paragraph 39). Essential to the presentation of fair value data is the ability of users to predict the amount timing, and uncertainty of future cash flows. Information about current value enables Investors, creditors, and other users to assess the consequences of an entity’s investment and financing strategies, that is, to assess its performance (SFAS 107, paragraph 41). Current value data, as a supplement to that of historical cost, would make a difference in measuring an association’s liquidity, solvency, and income. In a dynamic economy, representation of current value is an integral component in evaluating the future in terms of current and not past, circumstances.

Cost-benefit analysis is another crucial element to consider in adopting a new standard for accounting. Clearly described in this analysis have been the benefits in providing fair value accounting data. However, the costs have not been mentioned. The FASB has recom¬mended only minimal guidelines for the adjustment of liabilities to market value since this is, as of yet, an inexact science. Providing such liberal boundaries in which to maneuver has allowed each company the liberty of selecting the most cost-beneficial manner of valuing liabilities. With such little guidance, some of the benefits is compromised, but the Board feels that the increased disclosure still outweighs the accompanying costs.

Reaction to Financial Accounting Statement No. 107

As mentioned at the onset of this paper, the reaction to Financial Accounting Statement No. 107 has been mixed. Proponents of current value accounting see the accept¬ance of this statement as a small victory in the ultimate conquest of the entire balance sheet Opponents have provided numerous persuasive reasons as to why the practice of marking to market must be disallowed. A small battle has been won, but the war is far from over.

One of the most persuasive criticisms of the new statement is that it discourages financial institutions from investing in long-term securities. Since long-term investments are susceptible to large up and down movements, banks will try to dodge such swings by stuffing their investment portfolios with far more stable short-term bonds. Also less attractive for investors will be municipal bonds, which are often relatively risky, not actively traded, and more prone to wide swings in value (Worthy, 1992). The weight of this decrease in investment by financial institutions will ultimately fall on the shoulders of the average taxpayer, who will be forced to pay more in higher interest costs. Bankers will become obsessed with the earnings statement and shy away from anything that would taint its success. Proponents of current value do not sympathize with these cries from financial institutions. They state that if reporting information truthfully causes such groups to be more reluctant in purchasing long-term securities, then, “so be it” (‘Uncook the Books”, 1992). The highest objective of accounting Information is that It be useful to the statement user, not to provide each and every company with a glossy financial statement with a gleaming net income.

Another concern of the opponents of current value accounting is the method of valuation for current liabilities. However, assuming that most bankers perform such calculations for internal purposes, it does not seem unreasonable to expect them to apply these formulas in external reporting circumstances. The proliferation of products for estimating current values, along with the development of complex mathematical pricing models, now makes it feasible to estimate market values for most financial instruments. Though these calculations depend on a lot of assumptions, the judgment required is not more extensive or imprecise than what GAAP currently expects of bankers in estimating loan loss reserves (Worthy, 1992). It may seem rather subjective at the moment but market value still yields a closer evaluation of a financial institution’s net worth than historical cost. For the most part, this argument seems to have been pre-empted by advocates of current value accounting. Given time, patience, and some good mathematical models on which to rely, current value accounting will most likely surpass all expectations in accurately defining the economic health of a financial institution.

Future

Statement No. 107, in effect, opens the door for marking to market most items on the balance sheet At first glance, it seems absurd to look at financial statements in any other way, but in keeping with the accounting profession, the writer feels that the FASB should be cautious in its approach to dramatic change. Nothing will be gained from careless calculations of financial instruments if they are not reliable or comparable. The FASB could have pacified the SEC in a different manner, rather than issuing a statement which provides little guidance in terms of application for the financial institution. Until objective methods are established for determining the fair value of liabilities, the writer is not convinced that market value accounting provides what it is supposed to provide. Historical cost accounting is laden with inherent problems, but so is its likely successor. Running ahead blindly will only magnify the problem. Beneath all the politics and rhetoric lies current value. It is elusive, yet it is theoretically a more accurate predictor of current financial stability than historical cost. However, its random and inconsistent application to financial statements will only diminish the value of such information in terms of comparability and credibility. The cost of undermining users’ confidence in statements may be greater than the expected benefit of such information, and given that it is the user who accounting information serves, current value is, at present a precarious leap of faith.

Works Cited

“Accounting and Auditing Report.” The Practical Accountant, January 1992, pp. 54.

Baldo, Anthony. “Past Tense: SEC Chief Richard Breeden Wants Banks to Use More Current Value on Their Balance Sheet. Why Stop There?” Financial World. Volume 160, April 30, 1991, pp. 22-24.

FASB, March 1990, Statement of Financial Accounting Standards No. 105: Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk. Stamford, Connecticut: FASB.

FASB, December 1991, Statement of Financial Accounting Standards No. 107: Disclosures about Fair Value of Financial Instruments. Stamford Connecticut: FASB.

Johnson, Ramon E. and Paul T. Peterson. “Current Value Accounting for S&Ls: A Needed Reform?” Journal of Accountancy, Volume 157, January 1984, pp. 80-85.

Khalaf, Roula. “Garbage in. Garbage Out” Forbes, Volume 149, May 11, 1992, pp. 82. “Market-value or Historical Cost Accounting?” Government Finance Review, April 1992, pp. 26-28.

“Official Releases.” Journal of Accountancy, May 1992, pp. 139-144.

Powers, Ollie S. “Historical Cost Accounting—Are Changes Needed?” Business Credit, May 1991, pp. 23-24.

“The Truth Will Out.” The Economist, Volume 323, May 9. 1992, pp. 98-100.

“Uncook the Books.” The Economist, Volume 323, May 9. 1992, pp. 20.

Worthy, Ford S. “The Battle of the Beancounters.” Fortune, Volume 125, June 1, 1992, pp. 117-124.

Yang, Catherine. “The Bean-Counters Have the Banks Cowering.” Business Week, Volume 76, November 26, 1990, pp. 56