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Monday, September 14, 2009

Fed's Duke on Accounting Changes

by Calculated Risk on 9/14/2009 08:44:00 AM

Fed Governor Elizabeth Duke presented some thoughts today on possible accounting changes: Regulatory Perspectives on the Changing Accounting Landscape

... I feel it is crucial that an accounting regime directly link reported financial condition and performance with the business model and economic purpose of the firm. It is difficult for me to comprehend the value of an accounting regime that doesn't make that link.

As a regulator, I focus on the viability of individual financial institutions and the financial system as a whole. To be frank, it has been frustrating to try to assess that viability when the value of an asset is based on the nature of its acquisition rather than the way in which it is managed or the way in which its economic value is likely to be realized.
If the business model is predicated on the trading of financial instruments for the realization of value, or other strategies that essentially focus on short-term price movements, then fair value has relevance. In the trading business model, reporting fair value focuses risk management on short-term price movements and in most cases incentivizes management to define the organization's risk appetite and to mitigate risk through hedging or other means. Fair value also incentivizes the entity to raise and maintain capital at a level sufficient to cover the price volatility of its assets. For example, if the business model is an originate-to-distribute model, then fair value has relevance.

In contrast, if the business model is predicated on the realization of value through the return of principal and yield over the life of the financial instrument, then fair value is less relevant. Consider, for example, a bank that finances the operations of a commercial enterprise. The realization of value will come from the repayment of cash flows. Risk management is based on an assessment of the borrower's creditworthiness and the entity's ability to fund the loan to maturity. In this case, the accounting should incentivize the entity to maintain sufficient funding to hold the instrument to maturity and to hold a sufficient amount of capital to cover potential credit losses through the credit cycle, preferably in a designated reserve. Indeed, the use of fair value could create disincentives for lending to smaller businesses whose credit characteristics are not easily evaluated by the marketplace.

Admittedly, some have used the business model argument to manipulate accounting results. But the actions of those entities do not diminish the relevance of the business model to the measurement principle. Indeed, over time if the valuation model is not relevant to the business model, the business model itself is likely to change. Rather, the lesson to be learned from such manipulation is that we--preparers, users and auditors of financial statements--need to be vigilant in evaluating actual business practice, and restrict the use of particular measurement principles to the relevant business models.

To this end, safeguards should be implemented to eliminate a firm's ability to overstate gains or understate losses by switching back and forth between business models or by reclassifying assets from one business segment to another. For example, from a regulatory perspective, assets in a financial institution's liquidity reserve, by their nature, imply utility through sale and, therefore, should be valued at market price.
Take a mortgage loan. If the business model is to hold the loan to maturity, Duke believes the loan should be valued based on future cash flow (considering the creditworthiness and capacity of the borrower). However if the business model is based on trading mortgage loans, then she believes the loan should be valued based on fair market prices.

Duke goes on an discusses the Stress Test accounting and current FASB and IASB discussions.