Understanding Investment Standards in the Banking Industry
Green, Brian Patrick, Reinstein, Alan, The Journal of Lending & Credit Risk Management
Many lending officers and managers of financial institutions trekked through their business education when investments were valued at lower-of-cost-or-market (LOCM) - a method to value investments using the conservative principle of "never overstate an asset." The systematic undervaluing of most investments was motivated by the Great Depression of 1929. Since then, investment markets, in seeking to minimize information risk when stock prices free-fall, have instituted such fail-safe features as breakers to suspend trading if the market falls too quickly. Breakers, also used to prevent recurrences of equity market instabilities of the late 1980s, appear generally to work, at least temporarily.
In 1994, SFAS Standard No. 115, Accounting for Certain Investments in Debt and Equity Securities, eliminated the historical LOCM contrivance and relied heavily on managers' proficiency to estimate a true fair market value for most investments, their capacity to assess intent, and their ability to hold such investments to maturity. Removing LOCM allows marking-up company investments to current fair-market-value, which can overstate the value of company investments, especially during periods of market instability. Effective in 1998, the AICPA's SAS No. 81, Auditing Investments, primarily seeks to offer guidance to CPAs concerning management's valuation of and intent to hold various investments. Bank managers can also apply the tools to assess their own reporting of investments.
Investments may constitute a significant amount of total assets for both banks and some businesses that use the credit that lending institutions offer. Nonservice industries, such as manufacturing and mining, often face misstatements in accounts receivable and inventory. However, banks, which normally have minor amounts of such assets, face misstatements in loan receivables and investments. Information derived from both of these account groups contributes heavily towards management's planning of the institution's liquidity projections. Overstatements give the appearance of the availability of future resources that may no longer exist. Like the loan receivable area, the recent SFAS allows flexibility in management judgment when reporting investments' final values. Institutions planning future liquidity needs can face potential risks when portfolio managers use less conservative estimates of their investments' current value.
SFAS No. 115: The Basics
SFAS No. 115 required all companies to change from a historical LOCM to a market value approach for valuing their marketable debt and equity securities. The Standard gives management much latitude in determining the expected length of its debt instruments, such as short- or long-term investments, and the marketability of all debt and equity financial instruments, even virtually bankrupt securities. SFAS No. 115 is particularly important to the banking and financial services industry, which carries large portfolios of financial instruments and evaluates its clients' financial stability. For example, infrequently traded securities can be valued at a company's book value per share, even when the last trading price or current fair market values are available.
SFAS No. 115 defines debt or equity securities as financial instruments. Equity securities investments with "readily determinable" market values and all investments in debt securities must be classified as either held-to-maturity, trading, or available-for-sale. Debt securities include U.S. Treasury bonds, U.S. agency securities, municipal securities, convertible debt, corporate bonds, commercial paper, and such secured debt instruments as collateralized mortgage obligations. Equity securities consist of an entity's ownership interest in another entity or the right to acquire or dispose of such an interest at a fixed or determinable price, including common stock, stock rights and warrants, and put and call options. Financial instruments may also include foreign currency forward contracts, loan agreements, financial options and guaranties, loan commitments, and letters of credit. …