Standards Board is reviewing proposals for including intangible items in bank financial statements. Banks would periodically estimate and record current market values of these, and perhaps other, intangible assets on their balance sheets. Present standards simply permit footnote disclosures of these assets. Conceptually, reliable information on values of intangible "relationship" assets would provide a much superior basis for management and investment decisions than the present accounting model. Yet my response to a request for comment on this proposal was that it would be unwise, at least for the present. The requisite value estimates are unlikely to be reliable. Among the many types of relationship assets, deposit intangibles are among the most difficult to value. They often represent customer relationships extending beyond deposits. Moreover, the demarcation between deposits as relationship assets and deposits as financial instruments is not always clear. Bankers, bank regulators, consultants, and accountants alike have no demonstrated capability for preparing and monitoring valuations of these assets. Banks have long experience with recording and amortizing deposit and other relationship intangibles for financial and tax reporting of acquisitions by purchase. That experience is not encouraging. Bankers typically regard valuing these assets to be mere accounting exercises otherwise detached from the business of banking. Tax court cases on deposit intangibles demonstrate that indifference. Bankers apparently ignored what their tax advisers and valuation consultants were doing. Defying banking common sense, some consultants defined "core deposits" as excluding small-denomination certificates, or assumed that the funding alternative to deposits is long-term debentures. Management decisions affecting customer relationships are investment decisions, with consequences extending well into the future. The resulting relationship assets, primarily tied to deposits, typically make up about half the true underlying capital of a bank. Few banks could earn adequate returns on their tangible assets in the absence of those relationship assets. Maximizing shareholder values requires developing those sources of value using "value contribution" or "economic value added" analysis. As bankers persist in emphasizing earnings rather than values, they exhibit little understanding of the value components of their business. How can one have confidence in value estimates when bankers regard their underlying principles to be largely irrelevant? Relationship intangibles contribute most of the premium, or "franchise," value in bank acquisitions and mergers. Dilution effects in acquisitions by stock reflect the relative contributions of relationship assets by the merging parties. Yet again, direct analysis of the value characteristics of these assets is extremely rare. Preparing and auditing financial statements representing market values is entirely different from traditional historical cost accounting. Valuation analysis and accounting are very different disciplines. The accounting standards for recording purchases of assets require recording and amortizing those assets individually. Thus, if an acquisition premium includes more than one intangible, the accounting standards require allocation of that premium according to the value of each. Accountants tend not to take this requirement seriously. The purchase price sets the addition to assets in any event. Thus, a common view is that the allocation of that price does not affect the primary objective of avoiding overstatement of total assets and capital. Of course, overstatement could develop with subsequent amortization of those assets at different rates. The typical solution to this problem is to promote amortization that is more rapid than the actual erosion in value. Examples of this casual attitude toward asset allocation were frequent prior to 1992, when allocations among intangible assets became unnecessary for tax amortization. Some banks used improbably low values of purchased deposit intangibles for financial reporting purposes, and significantly higher values for tax purposes. The objective, sanctioned by their accountants, was to reduce amortization expenses in their public financial reports while obtaining larger tax deductions. Valuations of deposit and other intangibles for tax purposes normally required independent expert valuations. Most of those valuations were substantially mechanical, lacking economic substance and banker inputs. Many failed to recognize that the value actually arises from expectations of future patronage by customers, and thus attaches to those customers. Thus, common practice was to value different types of deposit accounts as if there were separate financial instruments, with no recognition that many were simply portions of broader customer relationships. Before the 1992 tax revisions, there were tax incentives to analyze these assets, and bankers did gain insights into the value characteristics of depositor and other banking relationships, even if much remained to be learned. Now, however, these tax incentives are gone. Not only have opportunities to develop new insights disappeared, but worse, much of what was previously learned is dissolving. In the abstract, market value accounting - reporting all assets and liabilities, including intangibles - would generate the information that is most relevant for management and investor decisions. It expressly recognizes that the predominant corporate objective must be developing value for shareholders. Nevertheless, no one has yet begun to develop standards for market value financial statements or audits. Without such standards, market value accounting might sacrifice reliability while achieving little gain in relevance. Experimenting with market value accounting is creating a hybrid model whose purpose and outcomes are unclear. Someone needs to address how these efforts will result in improved decision-making among bankers as well as regulators and investors. Mr. Morgan is a consultant based in Falls Church, Va.
