Yesterday, Federal Reserve Governor Elizabeth A. Duke delivered a speech before the AICPA National Conference on Banks and Savings Institutions regarding current and proposed accounting standards that will impact the operation and supervision of the U.S. banking system, specifically accounting standards such as the Statement of Accounting Standards No. 157 (FAS 157), which governs “fair value” accounting, as recently modified by the Financial Accounting Standards Board (FASB), and Statement of Accounting Standards No. 114 (FAS 114), which governs loan loss reserves.
Governor Duke began by noting the accounting concepts of relevance and reliability. In particular, she noted that the relevance of an accounting standard to a particular institution depended on the business model of that institution. For example, “fair value” accounting would be highly relevant for an institution whose business model is predicated on the trading of financial instruments for the realization of value, or other strategies that focus on short-term price movements. In her opinion, in those instances, the accounting standards used should incentivize the institution to raise and maintain capital at a level sufficient to cover the price volatility of the assets.
By contrast, for an institution whose business model is predicated on the realization of value through the return of principal and yield over the life of a financial instrument, fair value accounting has less relevance. In those cases, the accounting standards used should incentivize the entity to maintain sufficient funding to hold the financial instrument to maturity and to hold a sufficient amount of capital to cover potential credit losses. She noted that the use of fair value accounting by such an institution could create disincentives for lending to smaller businesses whose credit characteristics are not easily evaluated by the marketplace.
She acknowledged that the using an institution’s business model to analyze the relevance of the accounting standard could lead to manipulation of accounting results. However, in her view this does not discredit the use of the business model as a tool for analysis of accounting standard relevance; rather, it means that the preparers, users, and analysts of financial statements must evaluate the actual business practices of the entity and restrict use of particular standards to the relevant business models.
She noted that the principle to be followed in evaluating the reliability of accounting standards should be to calculate a value within a reasonable range of confidence throughout the economic cycle and the life of the financial instruments. She noted that Level 1 inputs to fair value accounting provide a high degree of reliability because of the existence of an observable, active market. Level 2 and 3 inputs, by contrast, provide less reliability because of the decreasing confidence in the ability of the reporting entity to reach a consistent fair value within a reasonable range of values.
Governor Duke then discussed evaluation of loan losses by financial institutions. She noted that the Supervisory Capital Assessment Program, or the so-called “stress tests” provided a glimpse of the likely future of bank supervision. She stated that in the stress tests, the Federal Reserve focused on pre-provision net revenue, potential losses and final equity capital. She discussed the difficulty that regulators faced in evaluating loan losses of portfolios acquired in business combinations due to the elimination of pooling-of-interest accounting treatment by Financial Accounting Standards No. 141 (FAS 141). In conducting the stress tests, and consistent with her views on accounting relevance and reliability, she noted that the regulators evaluated trading assets on a fair value basis, loan assets on the basis of expected credit loss through an adverse business cycle, assets on an as-managed rather than as-acquired basis and included off-balance sheet assets on the balance sheet. She also praised the transparency of the stress tests in publishing both the results and the methodology behind the conclusions reached.
Governor Duke then discussed the “convergence” concept, or the efforts between FASB and the International Accounting Standards Board (IASB) to create common standards, and contrasted that effort with the different approaches in financial instrument measurement pursued by the FASB and IASB. She noted the differences between the FASB approach, which measures all financial instruments at fair value through the income statement or other comprehensive income, and the IASB approach, which measures financial instruments at amortized cost only if they have the characteristics of a basic loan and are managed on a yield basis.
Finally, Governor Duke outlined her accounting standard preferences and proposed the following:
- Trading assets should be accounted for at fair value with market value gains and losses recognized through the income statement
- Assets held for secondary liquidity should be shown at fair value with market value gains and losses recognized in the capital account through other comprehensive income
- Assets held to maturity and managed for yield and return of principal over time should be shown at amortized cost with a reserve reflecting life-of-loan or through the cycle potential credit losses
- For business combinations, there should be identical accounting treatment for acquired assets and similarly managed assets on the acquirer’s balance sheet.
She concluded by noting that the Federal Reserve was examining the differences between equity capital as measured by GAAP and regulatory capital, in an effort to coordinate the determination of an appropriate level of capital for banking supervision. She also noted that this coordination extended to an evaluation of capital standards in other countries.