ANTHONY H. CATANACH JR. is an associate professor in the School of Business at Villanova University, as well as the Cary M. Maguire Fellow at the American College Center for Ethics in Financial Services. His professional experience includes five years as an audit manager with KPMG and six years in the financial services industry. Dr. Catanach has received numerous awards for his publication, teaching, and curriculum innovation efforts. He has authored numerous articles on a variety of accounting, finance, and management issues, as well as several business education texts..
In a recent article, Michael Rapoport says “What quirks in accounting rules giveth, they also taketh away.” We agree whole-heartedly.
In the essay Rapoport explains how banks have had gains because of a decline in the value of the debt. The decline occurs because of a worsening of the banks own credit risk. The opposite occurs when the bank’s own credit risk improves.
This rule is found in FAS 157 Fair Value Measurements. See paragraphs B2 and C42.
Rapoport illustrates this accounting quirk with J.P. Morgan Chase. The enterprise had a $1.9 billion gain in the third quarter because of adverse changes in its own credit risk. But, in the fourth quarter the bank discloses a loss of $567 million due to an improvement in its own credit risk.
Critics have long pointed out that this rule produces a perverse effect on financial statement analysis, including traditional ratio analyses. The firm with a weaker credit standing would display a lower liability valuation on the balance sheet, which in turn would generate better debt-to-equity and similar debt ratios than the business entity with a stronger credit standing.
The problem is that the FASB does not know its mission. Its objective should be to develop concepts, principles, and implementation guidelines to require firms to disclose to the investment community the information it needs when making one of many possible decisions. The FASB’s purpose is not to require firms to carry out the financial statement analysis for investors and creditors. If the board would remember its raison d’être, then it would reduce the number of these accounting quirks.
This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.
J. EDWARD KETZ is an associate professor of accounting in the Smeal College of Business at Pennsylvania State University. He has a bachelor’s degree in political science, a master’s degree in accountancy, and a Ph.D., all from Virginia Tech. Professor Ketz has been a member of the Penn State faculty since 1981. He also has taught at the University of Connecticut and the University of Maryland. Professor Ketz has authored and edited 17 books including Hidden Financial Risk (Wiley, 2003) which examines the corporate culture and the institutional setting that engendered recent accounting scandals. Dr. Ketz has been cited in the popular and business press, including The Wall Street Journal, The New York Times, The Washington Post, Business Week, and USA Today. He also has appeared as an accounting commentator on CNN, National Public Radio, and Bloomberg Radio.