Hey, That’s Fair Value Accounting in a Nutshell

Analysts are really catching on.  With the current release of banking institution’s 2011 earnings, analysts are noticing, and being somewhat critical of, bank profits related to fair value adjustments on their own debt.  Analysts “discomfort” comes from the “somewhat” logical observation that, despite the economic change in the value of these debt obligations, the company will have to settle the obligation for its recorded amount. To “realize” the gain, the bank would have to settle the debt currently.

Typical of these observations is an article by Michael Rapport in the 1/13/12 WSJ titled “J.P. Morgan Results Show Accounting Quirk” (http://online.wsj.com/article/SB10001424052970203721704577159121049807632.html).

But, really,  financial institutions applying the same economic notion when they use fair value accounting for certain investment in financial assets.  With such a security, management has the right but not the obligation to sell it into the market at its fair value.  For some portion of their portfolio, they might decide, on occasion to do just that.  Where they meet the related accounting rules, they are permitted to account for certain financial assets at fair value.  Such accounting has been in place in some form or another as long as I can remember.

In fact, when the FASB deliberated on the standard that became SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”, which included a fair value approach for investments in certain marketable securities, banking institutions complained that they should be permitted to similarly mark certain portions of their deposit portfolio to market.  That way, they argued, they would be reflecting the way in which they managed the financial assets and financial liabilities in their portfolios.

Of course, now that they are permitted to apply fair value accounting to certain financial liabilities, analysts are uncomfortable with the notion that changes economic environment affects financial assets and financial liabilities

In conjunction with their consideration of the recognition and measurement of financial assets and financial liabilities, the FASB will reconsider their conclusions on reporting certain financial liabilities at fair value.  In fact, a quick perusal of their website shows that, at least tentatively, they continue to support allowing fair value reporting for some financial liabilities.  As noted in the minutes of their September 8, 2011 Board meeting, in which they discussed their project on “Accounting for Financial Instruments: Classification and Measurement” (http://www.fasb.org/cs/ContentServer?site=FASB&c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=1176159267718) the Board tentatively concluded:

“Conditional Fair Value Option for Groups of Financial Assets and Financial Liabilities

The Board decided that at initial recognition, an entity would be permitted to measure a group of financial assets and financial liabilities at fair value with changes in fair value recognized in net income if the entity (1) manages the net exposure relating to those financial assets and financial liabilities (which may be derivative instruments) and (2) provides information on that basis to the reporting entity’s management.

The Board voted 4-3 on this issue.”

This conclusion followed an earlier board meeting in which the Board tentatively concluded that the fair value option would be permitted for certain categories of financial liabilities, mainly to be consistent with the accounting for a related portfolio of financial assets.  

Of course, at this date, all of these conclusions are tentative and subject to reconsideration.

However, I am certain that the Board and its staff have taken note of the current lack of agreement with the year-end profits reported by financial institutions associated with their financial liabilities.

About docjonz

I am an Associate Professor of accounting at Hofstra University in Hempstead, NY. Additionally, I have more than 30 years of professional accounting experience in various capacities including auditing, accounting standard setting and corporate accounting policy.
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