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  New Accounting Standards May Be Opportunity or Trap
New Accounting Standards May Be Opportunity or Trap

By J. William Mantz

 In February of this year, the Financial Accounting Standards Board released Statement 159, which allows fair-value accounting for most financial assets and liabilities. This is no surprise, as this treatment has been on their minds for some time. The board’s objective in creating the standard was to eliminate the earnings volatility associated with asymmetric accounting for certain financial instruments.

Derivatives often do not qualify for hedge accounting under Statement 133. Changes in fair value are recorded to the profit-and-loss statement in the current period, where the hedged item is accounted for using historical cost methodologies. For example, a bank may seek to limit its exposure to a decline in the prime rate, generally thought of as a variable or short-term rate. This could be done with the purchase of an interest-rate floor. The rate would be fixed at a specific level as interest rates fall. The floor provides dollar-for-dollar cash payments to offset the reduction in income on the underlying prime-based assets. However, fair-value accounting requires the recognition of the change in the value of the floor contract. As rates fall, and the floor is “in the money,” its fair value reflects the present value of all future payments, an amount most certainly larger than the cash reimbursement the floor is producing.

Statement159 would allow the change in value of the underlying prime-based assets be used to offset the value of the floor, neutralizing the impact on the income statement.

To further provide an incentive for institutions to embrace this treatment, a loophole was created that allowed instruments that were recognized at fair value through other comprehensive income to be transferred to the fair-value account without going through the current-period profit-and-loss (P&L) statement. This loophole created an unintended consequence.

Assessing Intent

Financial institutions have been carrying old assets with yields of less than 4 percent that were acquired when the federal fund rate was at 1 percent. With the short-term cost of funds at 5.35 percent, they are upside-down on spread by more than 135 basis points. The old assets were not being sold and reinvested into current assets where the yields were better because such transactions are non-economic. The loss on the sale would never be recovered by income earned on the replacement assets due to the inversion in the yield curve and narrow spreads.

Numerous proposals were developed by brokerage houses to take advantage of an accounting “mulligan,” where the old portfolio could be marked to market without taking a trip through the P&L. Further, a gain could be recognized through the P&L, since asset values have improved since the beginning of this year, and on sale of the old assets, current income could be enhanced by upgrading the yield to current levels. Keep in mind that the institutions would not have undertaken the transaction on an economic basis.

A blizzard of guidance, commentary and position papers has been the result. Several institutions already have announced portfolio restructurings. Major accounting firms have presented and revised guidance as comprehension of the consequences of this particular application of the loophole sinks in.

The most important question seems to be: Are the reasons for adoption of FAS 159 consistent with the intent and stated objectives for issuing the standard? If the reasons are related to obtaining an accounting result, it could reasonably be concluded that the portfolio enhancement strategy is not consistent with generally accepted accounting principles.

Things auditors and examiners will look for to assess intent will be the specific assets selected for fair-value accounting. Why were only underwater assets selected when similar assets at a gain were unaffected? Why are the replacement assets returned to the familiar old categories of “available for sale” or “held to maturity”? Does management have the intent to apply fair-value accounting on a go-forward basis? Have the strategies and rationale been communicated to boards of directors and audit committees, and do financial statements include accurate and honest explanations of the rationale for early adoption? Can management’s assertions that they had the ability and intent to hold impaired securities to maturity or price recovery be challenged? Should a charge for impairment other than temporary be recognized as part of the restructuring?

A survey of over 200 financial institutions by the Financial Managers Society found that only 11 percent were choosing to early-adopt the standard. The remainder of the survey participants were still studying the advantages and disadvantages. Institutions that implemented a portfolio-enhancement strategy for purposes of obtaining favorable accounting treatment may find themselves in the position of one who begs mercy from the court after murdering his parents because he is an orphan.

 


J. William Mantz is founder of Danvers, Mass.-based J. William Mantz Investment Advisors, an investment advisory firm serving more than two-dozen community banks, primarily on the East Coast. “At the Margins” is a regular feature in Banking New York focusing on banking strategies and balance-sheet trends.

 

 
Copyright 2007 The Warren Group


Posted on Tuesday, September 25, 2007 (Archive on Monday, January 01, 0001)
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