Academic journal article Review - Federal Reserve Bank of St. Louis

The Effects of Fair Value Accounting on Investment Portfolio Management: How Fair Is It?

Academic journal article Review - Federal Reserve Bank of St. Louis

The Effects of Fair Value Accounting on Investment Portfolio Management: How Fair Is It?

Article excerpt

During the late 1980s, the Securities and Exchange Commission (SEC) challenged the use of historical cost accounting for financial instruments because this method values these assets using the interest rate in effect at the purchase date. Thus, it does not reflect changes in values that arise from changes in market interest rates. In a 1992 address to the American Accounting Association, Walter Schuetze, the chief accountant of the SEC, claimed the magnitude of losses in the thrift industry were increased by a lack of regulatory discipline made possible by the use of historical cost accounting.(1) He argued that regulators were able to avoid making decisions about capital adequacy in the thrift industry when estimates of the deficit in net worth of the industry on a market value basis were as high as $118 billion, because the net worth of the industry on a historical cost basis was positive. The experience in the thrift industry, combined with the large number of bank failures in the 1980s, caused former SEC Chairman Richard Breeden to express concerns that historical cost accounting might contribute to even larger losses in the banking industry.(2)

In a 1990 letter, the SEC lobbied accounting rulemakers to require financial institutions to use market values when accounting for securities investments. The letter argued that historical cost accounting produces information that is irrelevant to valuing investment portfolios and provides an opportunity for managers to manipulate the numbers reported in financial statements.(3) The Financial Accounting Standards Board (FASB) responded by adopting Statement of Financial Accounting Standards Number 115 (SFAS 115) in May of 1993. This statement requires that investment securities be valued using market interest rates, and requires that equity accounts be adjusted to reflect changes in these fair, or market, values.(4)

The adoption of this standard has been controversial. Opponents of fair value accounting have objected to the new standard because it focuses on a single type of asset. Bankers and regulators have claimed that the mismatching caused by ignoring concurrent changes in the values of other assets and liabilities such as loans and deposits will induce unrealistic volatility in bank equity. Bankers claim that efforts to mitigate this increase in volatility will result in reductions in the proportion of assets held in investment securities, the maturity of investments held, and in the flexibility of investment portfolio management.

These arguments were important in the recent decision by regulators to exclude the effects of SFAS 115 from the definition of regulatory capital ratios. In addition, bankers argue that the new standard will not eliminate the opportunity to manipulate the financial statements.

The arguments by both sides rely on the assumption that actions by regulators, investors, or depositors and creditors are based strictly on the numbers reported in the financial statements. This assumption is important in the debate over the effects of this accounting change because financial statement disclosures contain the information necessary to restate the investment account from a cost- to a fair-value basis.

This article examines the adoption of SFAS 115 by bank holding companies to determine if a desire to influence the numbers in the financial statements, including reported equity volatility, affects investment portfolio management. The focus of this article is on whether investment portfolio management was changed by the adoption of SFAS 115. I did not attempt to verify the claims of bankers and regulators that these changes will reduce income earned from investment securities or increase exposure of the market value of banks to interest rate changes. Evidence in this article suggests that SFAS 115 did affect investment portfolio management, and it suggests the need for further research.


In May of 1993, the FASB issued SFAS 115, which must be followed in fiscal years beginning after December 15, 1993. …

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