Investment versus trading - a misnomer. (classifying debt securities)by Fisher, Donna J.
What a misnomer! Although the street moniker for this issue is "investment versus trading," its more descriptive term should be "classifying debt securities." This issue is causing genuine confusion within the financial services industry.
Specifically, the issue focuses on how debt securities should be classified in the balance sheet. Although the result of applying this proposed classification scheme will mean a change in how debt securities are reported, the accounting treatment for each particular classification is not in question. The accounting treatment is simple-- amortized cost is appropriate for investment securities, lower of cost or market (LCM) is appropriate for securities held for sale, and market is appropriate for trading securities. The key issue is whether the classification of debt securities held for investment is appropriate, or whether part or all of those debt securities are actually held for resale. Depending on the outcome, this classification question could mean an enormous difference in the way financial institutions manage their businesses--particularly affected will be commercial banks, savings and loan institutions, finance companies, and insurance companies.
During the last year and a half, various financial groups, including the American Bankers Association, have actively participated in the ongoing debate with the accounting and regulatory groups (i.e., AICPA, FASB, SEC, and the bank and thrift regulators) involved in resolving this issue.
The issue has been kicking around since the fall of 1988 when the Federal Home Loan Bank Board (FHLBB) first wrote the FASB concerning what should be the appropriate rules for determining when debt securities owned by thrifts should be classified as held for sale. During the next several months, a series of letters went back and forth between the FHLBB and the FASB, wherein the FASB staff set forth its views. Subsequently, the FHLBB codified such views into a Statement of Policy dated May 18, 1989. About the same time, the Chief Accountant of the SEC wrote a letter to the AICPA Accounting Standards Executive Committee AcSEC) that explained his view on investments in debt securities--"historical cost is a privilege, not a right."
AcSEC then added a project to its agenda and began the arduous process of developing guidance. After devoting portions of four meetings to hotly debating the issue, AcSEC has finally sent to the FASB an exposure draft of a proposed SOP, Reporting by Financial Institutions of Debt Securities Held as Assets (Draft SOP).
Under AcSEC's Draft SOP, a financial institution could use amortized cost for investment debt securities only if it has the ability to hold those securities to maturity and it intends to hold them for the foreseeable future, as defined.
* The Foreseeable Future. For the purposes of this proposed statement of position, the foreseeable future is generally the period ending one year after the balance sheet date. However, certain events that are currently expected to take place over a longer period, such as those resulting from a strategy to sell certain assets in light of capital requirements, liquidity needs, or operating decisions, should also be viewed as affecting an institution's current intention. Accordingly, the institution's evaluation of matters that affect its intention should include events that may take place during the period ending one year from the balance sheet date and events currently expected to take place over a longer period. (Emphasis added.)
* Susceptible to Prudent Evaluation. An institution should consider which events might be reasonably expected to cause it to decide to sell debt securities. For example, an institution can generally determine whether a change in interest rates could be reasonably expected to cause it to decide to sell. The institution should then determine which of those events are susceptible to prudent evaluation. Events that are susceptible to prodent evaluation are, for purposes of this proposed statement of position, generally those that could reasonably be anticipated, evaluated, and addressed before the events occur. For example, whether interest rates will change (but not the degree of change) would usually be susceptible to such evaluation, as would a need to sell some assets over the next year in response to known capital requirements or identified liquidity needs.
Some have argued that the Draft SOP should be acceptable to the financial industry since it finally established standards as to when sales of investment securities will trigger LCM accounting. On the other side, opponents continue to argue that the problem with the Draft SOP is evaluating which events are probable and which ones are not.
HOW THE INDUSTRY SEES
Many in the banking industry have had serious reservations about the FHLBB (now Office of Thrift Supervision) Statement of Policy and the related views expressed in the SEC's letter. The AcSEC Draft SOP does nothing to eliminate those reservations. In summary, the Draft SOP still sets forth very restrictive criteria for classifying debt securities as investments (and reporting them at amortized cost) by requiring that an institution demonstrate a positive intent and ability to hold for the foreseeable future, as defined. Unless the criteria are met, those debt securities would be classified as held for sale and reported at LCM.
All of the restrictive positions described will result in a shift of some investment securities to a held for sale classification, and they will be marked to the LCM on a periodic basis with any adjustment flowing through the income statement. Among other things, these positions will result in wide volatility in earnings of banks, possibly causing unfounded safety and soundness concerns. One likely result is that banks will shorten the maturities of their debt securities holdings. What impact this will have on the debt securities markets and the Federal Reserve's monetary policy is also significant unknown.
The following arguments against the proposal have been advanced by members of the banking industry:
* The positions ignore economic reality and the business purposes for entering into debt securities transactions that are the result of prudent investment portfolio management.
* The positions significantly conflict with GAAP and practices in existence today.
* A piecemeal approach to adopting LCM accounting for valuing certain earning asset categories on a current rate basis is inconsistent in its application and constitutes a detriment to the usefulness of the balance sheet.
* In the absence of a current intent to sell, or a very high probability of intent to sell, the use of LCM is inappropriate.
* Loss recognition should be triggered only by the actual realization of loss rather than by the application of an unwarranted LCM policy.
* The positions appear to focus on a mechanical process and a predetermined definition of what constitutes a holding period rather than focusing on the prudent actions that must be exercised under an investment management strategy that mitigates interest rate risk, adverse earnings impacts and liquidity pressures.
Accounting policies should reflect the economics of the underlying transactions rather than dectate economic behavior. Specifically, the investment portfolio is the byproduct of a bank's operating environment and is maintained as part of its ordinary commercial banking activities. Those activities include maintaining a source of liquidity (i.e., to offset the uncertain cash flows of loans and/or core deposits), minimizing and offsetting interest rate risk exposure, meeting seasonal demands, maximizing earnings by investing idle cash, complying with pledging requirements to collateralize public deposits and trust funds, and as an alternative asset allocation vehicle in the case of weak loan demand. Each of these variables is subject to change based on changes in activities or changes in the marketplace.
A bank often has an Asset/Liability Management Committee (ALMAC) that is responsible for managing these variables through the establishment of an overall investment policy and the setting of limits/objectives with regard to liquidity and interest rate risk management. Investment securities are one of th e tools used to manage interest rate risk based on ALMAC's assessment of existing conditions, inteerst sensitivity positions, future interest rate levels and the current yield curve. As the yield curve and/or the mix of loans and liabilities change, a bank needs the flexibility to rebalance its investment securities prior to their maturity dates to minimize exposure to adverse interest rate risk.
SETTING INVESTMENT POLICY
A positive intent to hold to maturity criterion was more easily demonstrated and realized during a regulated interest rate environment when market fluctuations were minimal. However, in the current environment, that approach is no longer feasible or realistic. Allowing a bank to rebalance investment securities serves to reduce risk. Any accounting rule that reduces an investment portfolio manager's ability to make prudent decisions to sell debt securities and improve net income is contrary to the business objective of enhancing shareholder value. This is most clearly an issue of form over substance. No such rule should make it more difficult to meet prudent portfolio management objectives or to decrease exposure to interest rate movements.
Trading versus Investing
Trading and investing functions differ both with regard to the intent of management and the characteristics of these activities. Characteristics of trading include frequent buys and sells, a short holding period, and an intent to benefit from short-term price changes. On the other hand, investing is characterized by entirely different attributes. First, the income benefit from investing is in optimizing yield, not short-term gain or loss. Second, since credit quality affects the pricing of debt securities, credit characteristics of the typical investment portfolio are monitored, and quality reviews and controls are in place. This monitoring is similar to loan portfolio review. Third, the maturity structure of the portfolio is not an independent consideration. It is a major component of asset/liability management and can vary based on the maturity and repricing characteristics of other earning asset categories and of all funding sources. Finally, the investment portfolio is managed as a source of liquidity with potential sales of debt securities used as an alternative to additional financing and increased borrowing costs.
In this regard, it is a fact of life that the movement of interest rates and the shape of the yield curve are largely unforeseen events. Othrwise, balance sheets would be perfectly matched, margins optimal, and there would be no need to sell investment securities before maturity.
Unfortunately, this is not the case. How many investors in the vast array of financial institutions could have foreseen the stock market crash of October 1987 and positioned themselves to avoid adverse results, or even the 1989 summer stock market rally that was followed by another October crash? Interest rates move in a similar unpredictable fashion. Unforeseen conditions do have an impact on the intent and ability to hold to maturity. In the final analysis, conditions justifying sales of debt securities purchased with the intent and ability to hold to maturity evolve from the purpose of holding and managing an investment portfolio: to improve yield, improve credit, improve the maturity and rate match with other changing parts of the balance sheet, and to provide liquidity.
Banks do not hold debt securities in the investment portfolio for the purpose of realizing short-term price appreciation/depreciation or for gain/loss trading. Instead, the intent is quite the opposite, focusing on holding such securities for the reasons set forth here. However, the objectives of prudent asset/liability management and portfolio rebalancing may result in debt securities being sold from time to time prior to their maturity dates. When debt securities are sold for the aforementioned reasons, and gains/losses are realized, this should not be viewed as abusive but as a result of prudent portfolio management.
Examples May Help
The actions and considerations of prudent portfolio management, and the impact of a change in accounting rules, are illustated in Examples 1 and 2.
Example 1. Assume a simple balance sheet consisting of $75 million in fixed-rate loans and $25 million in fixed-rate (2-year) debt securities, funded by $85 million in fixed-rate deposits, $10 million in variable- rate deposits and $5 million in capital. Figure 1 presents the balance sheet.
This balance sheet configuration exposes the bank's earnings in the event that interest rates rise or fall due to the fixed-rate nature of 100% of the assets but only 90% of the liabilities and capital. If management wishes to avoid the financial risk of this maturity imbalance between assets and liaiblities, then it would sell $10 million of the fixed-rate debt securities and reinvest in short-term, variable-rate assets with the proceeds from the sale.
Under the current accounting model, the sale of $10 million of fixed- rate debt securities would result in either a gain or a loss depending on the current level of interest rates. Furthermore, the sale of $10 million of fixed-debt securities and the purchase of $10 million of variable-rate debt securities eliminates the interest rate risk and the related fluctuation in earnings that a change in interest rates would entail. The use of amortized cost for the new and remaining debt securities should not be affected by this legitimate sale.
Assume that market interest rates now rise 100 basis points. The elimination of the interest rate mismatch by the sale of fixed-rate debt securities funded by variable-rate liabilities enabled the bank to maintain its net interest margin as shown in Figure 2.
However, if the sale of the debt scurities triggers a requirement to apply LCM to the remaining $15 million 2-year fixed-rate debt securities, then the result would be a realized loss of $260,000; and total income of only $1.49 million versus $1.75 million.
On the other hand, if management decides to hold the $25 million of debt securities rather than sell $10 million because of the fear of shifting to a more restrictive LCM accounting, only $1.65 million of income would be recognized. The lower income would be attributable to the holding of unsuitable debt securities (i.e., fixed-rate instruments). (See Figure 3.)
In summary, this example shows that the use of LCM can increase risk and produce poor economic results.
Example 2. Assume that a bank is asset sensitive and buys a sufficient quantity of longer-term debt securities to neutralize its interest sensitivity and earnings risk. Market rates later fall. Because of its previous balance sheet actions, management has protected itself from incurring any adverse earnings impact from this rate decline.
Still later, events beyond management's control cause the balance sheet to shift. A market perception develops that interest rates are bottoming out and will soon begin to rise. Retail customers respond to this possibility of rising rates by shortening their deposit maturities. The balance sheet, therefore, becomes unbalanced (liability sensitive), exposing the bank to both liquidity and earnings risk.
Prudent management recognizes that the investment portfolio should be shortened in maturity to regain balance sheet harmony and minimize risk. However, the proposed change in accounting standards places the bank in an untenable position of forcing it to select from two highly undesirable choices, as follows:
1. The bank could shorten the investment portfolio by selling longer- term debt securities and replacing them with shorter-term debt securities. However, the act of selling any debt securities presumably would place the bank in jeopardy of being forced to convert all or some of its investment portfolio from an amortized cost basis to LCM. Therefore, an act of prudent balance sheet management designed to provide adequate liquidity, earnings stability, and financial well- being, would carry the heavy penalty of volatile earnings caused in the future by the required conversion to LCM.
2. If the bank chooses to avoid any possible conversion to LCM, it would elect not to realign its portfolio. Therefore, two elements of very real risk remain uncorrected. Should rates rise as expected, the bank's liability sensitivity would cause earnings to decline. Additionally, since the shorter-term deposits would mature more rapidly than the debt securities, a liquidity problem could decelop if the bank was unable to replace the maturing deposits fully.
GAAP SUPPORTS CURRENT
Current industry practice is generally to carry investment securities at amortized cost. Although some of the literature focuses on a "hold to maturity" concept, industry practice is supported by the current accounting literature, which establishes the general criteria for carrying investment securities at amortized cost as long as the entity has the ability and intent to hold the securities "on a long-term basis" or "for the foreseeable future."
For example, the AICPA Audit and Acounting Guide, Audits of Banks (1983), states that "if they (banks) have the ability and intent to hold these securities on a long-term basis, banks do not customarily provide for unrealized declines in their value resulting from interest rate fluctuations." It also notes that a loss should be recognized "if bank management intends to dispose of a part of its investment securities portfolio in the foreseeable future or the bank is unable to hold a significant portin of its investment portfolio."
SFAS 65 paragraph 6 states in part: "A mortgage loan or mortgage- backed security shall not be classified as a long-term investment unless the mortgage banking enterprise has both the ability and intent to hold the loan or security for the foreseeable future or until maturity."
Sec. AU 9332.14 of the AICPA Auditing Standards concentrates on the foreseeable future. It states: "For those securities for which there is no evidence indicating that they will be disposed of in the foreseeable future to meet the company's operational needs, the auditing considerations are similar to those discussed for marketable securities classified as noncurrent assets."
ACCOUNTING SHOULD BE
To reflect economic reality, accounting standards should either strive to mark all interest rate or price changes within a balance sheet to LCM or none at all. Piecemeal accounting results in inaccurate presentation as suggested by proposing a LCM set of rules only for the investment portfolio, especially since such debt securities are not purchased with an intent to sell.
As was previously mentioned, the investment portfolio is the byproduct of a bank's operating environment--funded with deposits and other sources that are accounted for on a historical cost basis. The net interest margin resulting from investment portfolio activities will be significantly distorted if the investment securities are accounted for on a different basis than the related funding sources. This issue does not arise for trading account assets since they are funded with resources that have maturity characteristics similar to the short holding period associated with those assets. This is not, therefore, a piecemeal approach to balance sheet presentation, since ther is symmetry.
LOSSES SHOULD BE
Assets that are truly held for sale should be reported at LCM. In those circumstances, banks do use LCM (e.g., mortgages under SFAS 65). Because investment securities are not held for sale, the application of LCM accounting is inappropriate unless a permanent impairment loss has occurred. Within the definition of LCM for inventories, ARB 43 states that "no loss shall be recognized unless the evidence indicates clearly that a loss has been sustained" and that "where the evidence indicates that cost will be recovered with an approximately normal profit upon sale in the ordinary course of business, no loss shall be recognized even though replacement or reproduction costs are lower." Although inventory is held for sale and investment securities are not held for sale, this loss recognition theory can equally be applied to investment securities. Losses should only be recognized on investment securities when they have been or will be clearly realized.
However, a distinction must be made between realization of inventory held for sale and investment securities. Realization of goods held for sale is accomplished only by sale. Realization of investment securities can not only occur by sale, but also by receipt of periodic interest and principal payments through maturity.
In addition, investment securities provide economic benefit if they are used for asset/liability management purposes. If a bank has the ability to hold the debt securities to their maturities, then no accounting loss will be sustained on investment securities until a decision has been made to dispose of those investment securities whose market values are below cost before their maturities. Recognition of loss in the financial statements is predicated upon the economic realization of such a transaction, just as a gain would be. Impairment of value for credit or other reasons may also necessitate recognition of loss before maturity.
A decrease in investment securities' market value, as a result of rising interest rates, does not mean that a loss has been incurred that must be recognized. To be sure, the remaining balance sheet that is being carried at historical cost has similar and offsetting unrealized gains from rising interest rates that are not being reflected. To record a loss in the investment portfolio would result in unfair presentation. If a bank has the ability to hold to maturity and the intent to hold until the market value is recovered, then a loss has not been sustained, and therefore, amortized cost accounting should be permitted.
The interest in this issue has arisen as a result of abuses, particularly in the savings and loan industry. Accordingly, such abuses should be addressed directly--not by changing accounting rules but by targeting those abuses through closer scrutiny during audits, both regulatory and financial. Improving financial statement disclosures may be effective in highlighting such abuses. Because banks already provide market value information concerning their debt securities in their financial statements, disclosures should be enhanced by highlighting the book-to-market relationships as shown in Figure 4.
Also, detailed disclosure should be made in the investment activities section of Management's Discussion and Analysis that would include descriptions of the business and how interest rate and liquidity risks are managed with investment securities, any permanent impairment of value, and market value and net interest income information.
In addition to closer audit scrutiny, additional controls should be established. Investment portfolio management and asset/liability management are necessary due to unforeseen changes. Because of those unforeseen changes, banks should methodically document the strategic thinking surrounding their investment portfolio transactions. Controls should be put in place to monitor excessive "gains trading" or other perceived abuses. Such controls should be reviewed by regulators and auditors. Regulatory examinations and audits should include scrutiny of portfolio sale transactions to ascertain that the transactions are consistent with overall asset/liability management strategies and interest rate risk strategies as reported in the ALMAC minutes.
Although the Draft SOP does provide overall guidance, it nevertheless generates implementation questions that ultimately would have to be addressed and answered by the accounting profession. For example:
Situation 1. Assume that there are foreseeable events, such as a shift in the yield curve, that a bank should have known about, but did not. As a result, the bank sold a portion of its debt securities. Do the remaining debt securities have to be marked to LCM? Alternatively, what if events, such as a shift in the yield curve, that a bank thought would occur did not occur and the debt securities were sold in anticipation of such events occurring? Who defines what is a foreseeable event, management or the auditors?
Situation 2. A community bank lends primarily to farmers. Its loan business is seasonal--loans are made in the spring and are repaid in the fall.
a. Loan demand is unusually high in one year and the bank sells debt securities to meet loan demand.
1) Is regular seasonality a foreseeable event?
2) Is irregular seasonality a foreseeable event?
b. Assume that the bank knows that certain deposits will run off and that cash will be needed in six months. To meet cash needs from the combined seasonal increase in loan demand and deposit runoff, the bank sells more than an immaterial amount of its debt securities. Is this a foreseeable situation:
1) If the bank knows which debt securities will be sold?
2) If the bank has no idea which debt securities will be sold? If yes, which debt securities go to LCM?
3) If the bank plans to sell those debt securities with the greatest gain (or greatest loss) at the end of the six-month period? If yes, which debt securities go to LCM?
Final Questions. Are there any parameters in determining reasonable (foreseeable) interest rate changes?
After a March 12, 1990, meeting between AcSEC and FASB and a fifth AcSEC meeting on March 13, 1990, a final version of the Draft SOP was hammered out that basically requires all debt securities to be classified as held for sale. Paragraph 16 of this latest Draft SOP now states:
The intent to hold securities for the foreseeable future should be explicitly stated by management in the notes to the financial statements and should be supported by an evaluation of events that might be reasonably expected to cause the institution to decide to sell. If it is considered probable that such events will occur in the foreseeable future, the intent-to-hold test is not met. If the intent-to-hold test is not met, the securities should be classified as held for sale. The evaluation need not extend to events that are not susceptible to prudent evaluation. the evaluation should consider pertinent historical experience.
Although the banking community has not yet formally commented on this Draft SOP, the preliminary indications are that this version is as equally unacceptable as the earlier versions. Since interest rate movements are always probable, LCM accounting is required by default. This means that the Draft SOP still ignores the sound asset/liability management reasons why debt securities are purchased for inclusion in the investment portfolio.
David M. Morris, CPA, is Chairman of the Accounting Committee of the American Bankers Association.
Donna J. Fisher, CPA, is the Accounting Policy Staff Representative of the American Bankers Association.
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2009 The New York State Society of CPAs. Legal Notices
Visit the new cpajournal.com.