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.