The Financial Accounting Standards Board has turned its attention to fair-value measurement as a means of simplifying accounting, but banks find only more complexity in the plan.
Though using fair value to measure assets is nothing new, finding a more consistent approach is a key objective of FASB's planned evolution to principles-based standards.
Critics, including many banks, have expressed what FASB delicately calls "concerns."
"The board believes that in large part, those concerns result because there is limited application guidance for how to measure fair value," according to FASB's Web site. "The guidance that currently exists has evolved 'piecemeal' over time and is dispersed among the many pronouncements that require fair-value measurements. Differences in that guidance have created inconsistencies that have added to the complexity in GAAP."
Last month FASB issued a draft version of "Fair Value Measurements," the culmination of a year's work on the most recent iteration of the plan and more than a decade of applying fair-value concepts to accounting standards.
And, in an ominous echo of the much-lamented Derivatives Implementation Group, the board has established the Valuation Resource Group to help accountants with fair-value measurements.
The current project will define fair value and its application in existing and future accounting standards. In the evolutionary spectrum, fair value is just emerging from the primordial goo.
Under generally accepted accounting principles, fair value is the amount at which an asset can be bought or sold in a current transaction between willing parties. Obviously, an asset carried on the balance sheet can vary in value, and at regular intervals the assets are marked to market.
Changes in value would flow through the income statement. For instance, if the value of an asset increased between periods, the appreciation would add to income. A decrease in the value of the asset would be subtracted from income.
Asking public companies to carry their assets at fair value seems innocuous, maybe even fair. Except that the simple turns out to be - surprise - pretty complicated when it comes to bank assets.
"FASB has clearly been wanting to move to mark-to-market accounting for a long time, and they have been moving that way incrementally," said Fred Cannon, an analyst with Keefe, Bruyette & Woods Inc. This is "problematic for banks, because they have numerous instruments that are hard to value and the value of those instruments changes all the time. Unlike a manufacturer, where you are primarily valuing land and production assets, when you are evaluating financial assets that change with the markets, to some extent the accounting is always trying to catch up with the market."
Many financial instruments are relatively easy to value. In fact, banks already apply mark-to-market principles to substantial amounts of equity and debt securities.
(That, too, is not quite as simple as it sounds. Under FAS 115, "Accounting for Certain Investments in Debt and Equity Securities," the way that banks account for securities depends on where they hold them. Securities in the trading portfolio are marked to market regularly, and gains and losses flow through the income statement. Securities in the held-to-maturity portfolio are carried at amortized cost. And though securities in the available-for-sale portfolio are marked to market, the unrealized gains and losses do not affect income. They are instead reflected in accumulated other comprehensive income, an entry in shareholder's equity. More on that later.)
It's not as easy when banks have to value their most fundamental asset: loans, especially nonconforming ones such as small-business and agricultural loans.
"If you are talking about a loan to the local cobbler shop for $100,000 to buy equipment, how marketable is that loan and how do you value it?" asked Denis Laplante, the head of bank research at Keefe Bruyette. "Bankers might be able to estimate changes in value, but how much extra costs are you adding in the process, and are investors really better off with the added information?"
The problems spiral in density from there. Applying fair values to derivatives is no easy task. Derivatives that banks use generally are not traded on exchanges but are written as custom contracts in the over-the-counter market. Mortgage servicing rights are complicated, as are retained interests in securitizations.
"A lot of people would suggest that fair-value accounting would simplify a lot of things," said an accounting official with a federal banking agency. "The fallacy with that argument is that for most of the financial instruments on a bank's balance sheet, you can't go to The Wall Street Journal and find out what the fair value is."
Banks therefore would have to go through a lot of machinations to come up with values for instruments without readily observable prices. That implies costs and burdens for the bank, but the investor bears some risk, too.
"A lot of these marks that go through the income statement aren't truly mark to market; they are mark to model," Mr. Cannon said. A bank might use a model to value mortgage servicing rights, and "depending on how that model is written and the assumptions you put in, the outcomes can vary."
That means banks could end up valuing the same asset differently.
Clark Maxwell, the director of financial institutions at the consulting firm Chatham Financial Corp. in Kennett Square, Pa., identified these variables in a series of questions. "Who do you have helping with the valuation? What are they inputting into the model? What assumptions are they using?"
"If you look at a bank that does a lot of securitizations, the value of those retained interests is heavily dependent on what assumptions you are making, like prepayment speed, and discount rate. Is it 10%, 12%, 15%, or 18% discount? Banks that use 10% versus 18% get very different numbers."
The accounting official said regulators generally have been telling FASB officials that "they need to strengthen the guidance in determining the fair value to achieve greater consistency. You change a few numbers, you can be miles apart from another institution with the identical asset."
Even if the standards board could resolve the problem of assigning market values to complex and illiquid assets, it would not solve the thorniest accounting issues raised by the move to fair value.
Some accounting standards require that companies mark some assets to market, but generally not their liabilities. That's a huge disparity for banks and other companies whose assets and liabilities are so closely linked.
The accounting standard that banks use to value their securities, FAS 115, requires marks to market in the trading and available-for-sale portfolios. But any funding the bank used to purchase the securities is carried at cost.
Notwithstanding other salient criticisms of these leverage programs, they can hurt GAAP equity if interest rates rise, since unrealized gains and losses are reflected in an equity account.
"Only a piece of the balance sheet is marked to market, which distorts the value of tangible equity," said Mike McMahon, an analyst in San Francisco with Sandler O'Neill & Partners LP.
It's a particularly sensitive topic now that interest rates, at historical lows in recent years, are moving higher.
"Companies that have low-cost, fixed-rate debt financing mortgage-backed securities in a higher-rate environment would not be able to mark the debt to market," Mr. McMahon said. "The accounting is marking to market on only one side of the balance sheet."
That disparity applies to other financial instruments, including derivatives. In fact, the mixed-attribute problem, as it is called, is one thing that makes derivatives accounting such a chore.
Gains and losses on a hedge frequently do not match up exactly with fluctuations in the value of the hedged asset, and that can distort the relationship of hedge and hedged asset. Hedge accounting under FAS 133 was an attempt to avoid that distortion.
"The instant you try to make the economics match up between the hedge and the hedged item, you need some kind of hedge accounting to make it work out," said Ron Lott, a senior technical adviser at FASB.
But the economics of hedging is intricate as well. It's hard to find financial transactions that precisely offset the changes in value of even the most mundane assets a company wants to hedge. Accounting standards require a high degree of precision - referred to as effectiveness - to qualify for hedge accounting.
Companies that actively hedge mortgages, including Fannie Mae and Freddie Mac, are occasionally hamstrung by the difficulty of finding effective hedges. (See
"Most hedges aren't perfect, and they have to be pretty close before you can get hedge accounting," Mr. Lott said. As a result, mortgage banks "end up with this mixed-attribute problem where they have derivatives run through earnings and the mortgages stay at amortized cost. They have a big problem because they can't make the hedge accounting work very well."
If the market value of all financial instruments were easy to measure, fair value could theoretically wipe away the vagaries of hedge accounting by rendering it unnecessary.
The standards board "could say, 'Mark all your derivatives to markets and run the unrealized gains and losses through income,' " said Benjamin Neuhausen, the national director of accounting at BDO Seidman LP in Chicago. "That would be simple, everyone would understand it, but no one would believe that was portraying the economic reality of hedges."
Henry Coffey, an analyst at Ferris, Baker Watts & Co. in Baltimore, said marking assets to market is fundamentally flawed.
Fair value, along with gain on sale accounting and accounting for unconsolidated subsidiaries, is a sign that the FASB's "focus has been away from GAAP earnings approximating operating cash flows, to GAAP earnings being more and more affected by changes in balance sheet items," he said. "It translates balance-sheet values into the income statement, and I think it is not what investors focus on. I think they focus on operating results and cash flows."
Mr. Cannon at Keefe Bruyette made much the same observation.
"Most valuation techniques by the analyst community are looking at valuing cash flow, and many of these rules are not cash-flow-oriented rules," he said. "We are getting more noncash items going through the income statement, and that's problematic for investors who like to look at companies based on current and projected cash flows."
But relying solely on operating results was as misguided as relying solely on GAAP, Mr. Cannon said.
"The reason people go back to GAAP is that coming up with operating earnings has been used opportunistically by companies and by analysts," he said. "GAAP does matter, and I never ignore what the GAAP numbers say."
Next: Accounting standards are going global and the new Public Company Accounting Oversight Board is revising auditing standards, but neither may prove a match for good old-fashioned fraud.
