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Claiming a "mixed attribute" accounting model provides a better picture of a company's business and earnings engine, bank trade groups blast full fair value.
Marie Leone, CFO.com | US
April 14, 2008
Trade groups representing the international banking community say that current accounting standards requiring fair-value measurement of financial instruments are, as American Bankers Association president and CEO Edward Yingling put it in a statement, "a step in the wrong direction."
The ABA and its international counterpart, the International Banking Federation, contend that full fair-value measurement, as proposed by U.S. and international accounting standard setters, is appropriate for financial instruments that are held for trading purposes. However, for assets and liabilities that are not based around short-term trading, or are held to maturity — such as loans, deposits, and receivables — fair-value measurement leads to income statement volatility (undertatements and overstatements), according to the groups.
The bankers are complaining about FASB and IASB's recent "Invitation to Comment" discussion paper, which calls for fair value for financial instruments, and rules such as the Financial Accounting Standards Board's FAS 159 The Fair Value Option for Financial Assets and Financial Liabilities, and the International Accounting Standards Board's IAS 39 Financial Instruments: Recognition and Measurement, as well as FAS 157, Fair Value Measurement. Indeed, FAS 159 give companies the irrevocable option to use the fair value option for most financial instruments, but bankers are not keen on rules that mandate the full fair value model. (Fair-value measurement is not required for non-financial assets, so far.)
Instead, bankers prefer a mixed-attribute financial reporting model to a strict fair-value regime for financial instruments. A mixed-attribute model is one that uses both fair value and historical cost calculations. To illustrate the bankers' point, the banking groups suggest looking at a loan.
Consider that loans are held to generate income via receiving interest over time until final maturity or until called. As a result, the expected cash flows of a loan and the matching receivables are known, because they are contractual, and the asset and liabilities are recorded as amortized costs. Further, the amortized costs are transparent to investors, as is the impact of the loan payments or receivables on future income statements, explains an IBFed report, "Accounting for Financial Instruments Conceptual Paper." However, in this case, a fair value calculation that requires a periodic mark-to-mark update of the loan could lead to a less predictive value because expected future cash flows are not always represented, argues IBFed.
"Fair-value accounting may have value where it is both relevant and can be reliably determined," acknowledges Yingling. But, absent relevance and reliability, IBFed is calling for a more "useful" way to measure the real financial conditions and value of assets and liabilities. "Under the stress of current market conditions, accounting policy should focus on measuring the heat of the flame instead of pouring gasoline on the fire," declares Yingling.
The discussion paper on fair-value measurement released by the International Accounting Standards Board, "offers a choice between full fair value today and full fair value tomorrow," noted Sally Scutt, CEO of IBFed, in a press statement. "This is at odds with the banking industry's view that a mixed measurement model is essential for the faithful representation of an entity's business model and how it generates earnings."
The bankers' reaction to full fair value underscores their fervor about an issue that is still up for debate. While FASB released FAS 157, Fair Value Measurement — the rule that tells companies how to fair-value assets and liabilities — in 2007, the board is still discussing fair value proposals — including how to fair value leases and pension obligations. What's more, the idea of full fair value remains a part of the gargantuan effort by FASB and IASB to shape a conceptual framework that defines fair value for accounting purposes. "Nothing is happening real quickly to change those things," says FASB chairman Robert Herz.
Nevertheless, Herz thinks bankers may be somewhat off-base about using a mixed-attribute model for financial instruments. He points out that currently, companies are required to take a write-down if asset value falls significantly, and carry whole loans at cost. "If the banking community is arguing that it doesn't want to take that kind of write down, it is being a little Pollyanna-ish," Herz tells CFO.com
The ABA says that while impairment is a different issue, it agrees that items permanently impaired should be written down. However, the group does not believe other assets or liabilites should be written up or down for the purposes of fair value measurement.
Regarding the concept of measuring loans at fair value, Herz points out three counter arguments to the bankers' claims: loans are a financial instrument and should be covered by any rule that affects those instruments; loans are not always held to maturity; and loans are increasingly parceled out through securitizations, which gives them a short-term feel. "The old originate and hold model has been replaced by the originate and distribute model," contends Herz.
Meanwhile, investors are calling for more fair value. In a March survey that polled 2,000 investment professionals, the CFA Institute found that 79 percent of the respondents said that fair value requirements for financial institutions improve transparency and contribute to investor understanding of the risk profiles of the institutions. Meanwhile, 74 percent thought fair value requirements "improve" market integrity, in general.
In addition, in its 2007 report, "A Comprehensive Business Reporting Model: Financial Reporting for Investors," the CFA Institute, argued that fair value accounting was "useful" in calculating whether loans would be repaid, "because fair values are likely to reflect the most up-to-date market assessments of that probability."
On the flip side, the CFA Institute complained that the mixed-attribute model unduly burdens investors that rely on fair values to make decisions. That's because reworking historical cost calculations depends on the quality of the reporting company's disclosures. "Most, if not all, of this effort would be eliminated if the financial reporting standards were to require that companies record assets and liabilities at fair value at the inception with periodic revaluation."