Debt Value Adjustment Memorandum

MEMORANDUM

From:        

To:            

Subj:        Debt Valuation Adjustment (DVA)

Date:        

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Primary Issue(s)

In this case, Banks are currently reporting the effects of unrealized gains on debt on their Income Statements. This is currently inflating profits, and potentially making financial statements misstated. GAAP justifies this by assuming the banks will actually repurchase the debt at the lower price, and the gains will be realized. However, many firms don’t act on this, and the financial statements are misleading.

(1) What is the core accounting issue in this article? What is the alleged “quirk.”?

(2) What precise accounting rules are relevant? (3) What judgment is required to implement these rules? 

(4) What are the pros and cons of the current rules?

(5) Do the rules affect any other companies?

(6) Has the FASB changed the rules? If so, provide specifics. Do you recommend the rules should stay as stated in the article, or do you recommend a change to the rules?

Main Issues Analysis

(1) What is the core accounting issue in this article? What is the alleged “quirk.”?

The case is involved in the debt valuation adjustment, which gives banks the option of valuing some balance-sheet finance items at “fair value”. It means that by applying this accounting rule, the banks can use the market value rather than the historical costs to measure the financial assets or liabilities. Usually, the fair market price of bonds is decided by two factors: 1) the market interest rate, 2) the creditworthiness of the company issuing bonds. With a high market interest rate, the bonds tend to be sold at a discount. If the company’s creditworthiness is questionable, the fair market price will increase for a premium is needed to make up for the default risk. Under the accounting rule, it is assumed that when the fair value of the bond goes down, a gain should be recognized by the company. The logic behind it is that as the value of a bank’s debt declines in the market, the bank could repurchase the bonds at a lower price so that it can earn a profit. But it leads to a quirk: when the financial market goes down, the debt price will fall, and thereby the financial firms can recognize gain from it. However, actually the financial firms themselves are confronted with operational difficulties, and their creditworthiness is deteriorated. In other words, the worsening creditworthiness helps the firms get more earning.

(2) What precise accounting rules are relevant? (3) What judgment is required to implement these rules? 

Under FASB, the following rule are relevant: 820-10-55-1, 825-10-25-7, 825-10-15-4, 825-10-20, 825-10-35-4, 825-10-45-5, 825-10-50-15, and 470-50-40-2.

ASC 820-10-55-01 establishes Fair Value Measurement Approach. Under this codification, the objective of a fair value measurement is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. This gives 4 criteria to measure at fair value: (1) Determine the particular asset or liability that is the subject of the measurement (consistent with its unit of account); (2) For a nonfinancial asset, determine the valuation premise that is appropriate for the measurement (consistent with its highest and best use); (3) Determine the principal (or most advantageous) market for the asset or liability; (4) Determine the valuation technique(s) appropriate for the measurement. This requires a human estimate of the price to sell an asset or transfer liability the market at a point in time. Judgment is difficult when prices are drastically decreasing.

ASC 825-10-25-7 states that the fair value option may be elected for a single eligible item without electing it for other identical items, which means that single item can be measured by using fair value option even if firm does not use this for identical items. Under this code, if debt is an eligible item, the company may choose fair value method to measure debt.

ASC 825-10-15-4 explains what kind of items are eligible to be recorded at fair value. 825-10-15-4 states that all entities may elect the fair value option for any of the following eligible items: a) a recognized financial asset and financial liability; b) a firm commitment that would otherwise not be recognized at inception and that involves only financial instruments; c) a written loan commitment; d) the rights and obligations under an insurance contract that has certain characteristics; e) the rights and obligations under a warranty that has certain characteristics; f) a host financial instrument resulting from the separation of an embedded nonfinancial derivative from a nonfinancial hybrid instrument. In this case, the bank’s debt belongs to the type (a), which includes the financial asset and financial liability. ASC 825-10-35-4 states that A business entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings. In the case, the company records the gain even if it doesn’t actually buy back the debt. In the financial crisis, the financial firms experiencing the financial difficulties, some of them even receiving aid from the government, usually don’t have the ability to repurchase the bonds. This kind of earning has poor quality.

ASC 825-10-20 has a definition of financial liability. Financial liability is a contract that imposes on one entity an obligation to do either of the following: a. Deliver cash or another financial instrument to a second entity; b. Exchange other financial instruments on potentially unfavorable terms with the second entity. Thus, the debt in this case belongs to financial liability. The company may elect the fair value option to measure the debt.

ASC 825-10-45-5 (pending content-as of 12/2017) talks about the detailed accounting treatment for the fair value option. If an entity has designated a financial liability under the fair value option, the entity shall measure the financial liability at fair value with qualifying changes in fair value recognized in net income. Besides, the entity shall present separately in other comprehensive income the portion of the total change in the fair value of the liability that results from a change in the instrument-specific credit risk. As for the definition of the instrument-specific credit risk, the entity should consider the portion of change in fair value that excludes the amount resulting from base market risk, such as risk-free rate or a benchmark interest rate, as the result of instrument-specific credit risk. In short, the companies should recognize the fair value change resulting from the base market risk in net income and those resulting from instrument-specific credit risk in other comprehensive income. It decides that the earning should be recorded in net income or other comprehensive income. However, 825-10-45-5 is still pending content, which means that it hasn’t put into effect. It only provides guidance for the users.

ASC 825-10-50-15 says that “In disclosing the fair value of a financial instrument, an entity shall not net that fair value with the fair value of other financial instruments—even if those financial instruments are of the same class or are otherwise considered to be related (for example, by a risk management strategy).”

ASC 470-50-40-2 says that a difference between the reacquisition price of debt and the net carrying amount of the extinguished debt shall be recognized currently in income of the period of extinguishment as losses or gains and identified as a separate item. Gains and losses shall not be amortized to future periods. If upon extinguishment of debt the parties also exchange unstated (or stated) rights or privileges, the portion of the consideration exchanged allocable to such unstated (or stated) rights or privileges shall be given appropriate accounting recognition. Moreover, extinguishment transactions between related entities may be in essence capital transactions.

(4) What are the pros and cons of the current rules?

Pros of current rules:

In this case, the good things about current rules: firstly, it is easy to read if the gains or loss states on Income Statement instead of OCI. Secondly, the false confidence of banks could lead to investor’s confidence. Thirdly, Non-Financial Statement companies are likely to act on the change in fair value and repurchase debt.

Cons of current rules

The recording method for financial assets and liability is controversial. More management tends to think that this accounting standard in unhelpful. It may represent the value of the company unfairly and mislead the investors. There are some disadvantages of the fair value option: 1) the lack of disclosure, specifically regarding how management estimate the fair value. The company discloses the fair market value in financial statements but lack a description of how to get the number; 2) the possible use of the financial assets and liabilities for earnings management. For example, by manipulating the fair value of financial assets and liability, the management can achieve earning smoothing. In the year of prosperity, they understate the earning on purpose and put forward the earning to the year of depression; 3) the lack of liquidity. If there is not a liquidate market for the particular types of financial assets or liability, it is hard to decide a reliable fair value. Some researches show that the market participants are concerned about the reliability of management’s estimates of fair values and they less rely on the information of financial assets and liabilities of which the fair value is difficult to measure. That kind of information is less valuable; 4) the financial statements can be misleading. The companies are reporting profits they don’t actually have. Some researches are about the association between the amount of the company’s fair-valued assets and the quality of earnings forecasts made by financial analysts working as brokerage. One of the most significant functions of financial statements is to provide information for the investors or debtors to make forecast. The research specifically investigated analysts’ earnings forecast errors and dispersions for companies with a large proportion of fair-valued assets to total assets and found that both the errors and dispersions were higher for those firms. In short, a high proportion of fair-valued assets in a financial statement prevents analysts from obtaining the information they need to make reliable earnings forecasts.