Banks Get Relief on Accounting Headache
New treatment to alter lenders’ debt-value adjustments
The banking industry’s least-favorite accounting rule is being scrapped.
Accounting rule-makers on Tuesday changed a provision that in recent years has resulted in huge—and often head-scratching—swings in bank earnings. James Dimon, J.P. Morgan Chase & Co.’s chief executive, has called the rule “one of the more ridiculous concepts that’s ever been invented in accounting.”
Analysts and accounting experts also have criticized the rule—which requires banks to record big, counterintuitive gains and losses known as “debt-valuation adjustments,” or DVAs—for yanking earnings up and down from quarter to quarter regardless of how the banks’ operations are performing. They say the result of Tuesday’s change will be a cleaner presentation of earnings, possibly as soon as the fourth-quarter reports, which the banks will issue later this month.
“It does make the results more understandable,” said Mark LaMonte, chief credit officer of the financial institutions group at Moody’s Investors Service.
The problem stems from a 2007 accounting rule that allowed banks to use market prices to value some of their debt.
That required the banks to record losses when the debt was considered safer and rose in value and to log gains when the debt was considered riskier and declined in value. The rationale for that odd scenario was that lower market prices make it cheaper for banks to repurchase their own debt, so the banks’ earnings should reflect the profits or losses they would get if they did so.
Banks initially loved the rule—and the industry pushed for it for years—because it helped them manage the accounting around a form of their own debt that they sold to retail investors, called structured notes. Indeed, the rule didn’t apply to all bank debt, only the bonds the firms chose at the time the securities were issued.
But after the financial crisis, when the value of bank debt began to gyrate, the rule became a major headache as the resulting gains and losses regularly distorted earnings by hundreds of millions of dollars or more each quarter.
For example, in the first quarter of 2012, Morgan Stanley’s earnings were hurt by nearly $1.5 billion in losses tied to the rule. Just two quarters earlier, in the third quarter of 2011, the bank had a gain of $2.1 billion from the rule.
The effect on bank earnings recently has been more muted. Morgan Stanley recorded gains of this type totaling $477 million in the first nine months of 2015. A Morgan Stanley spokesman declined to comment.
Tuesday’s move by the Financial Accounting Standards Board will strip those sorts of gains or losses out of the banks’ net income. Instead, those gains and losses will land in “other comprehensive income,” a separately reported basket of earnings that includes a variety of items that don’t stem from a bank’s operations, such as foreign-currency adjustments and changes in the value of pension assets.
In a statement, FASB Chairman Russell G. Golden said the move would help “to better meet the requirements of today’s complex economic environment.”
Robert Willens, an accounting and tax expert who heads his own firm, Robert Willens LLC, said the change “makes perfect sense.”
Banks can adopt the change immediately, but it isn’t clear whether they will do so quickly enough to have it affect this month’s fourth-quarter earnings reports, or whether they will need to take more time to review the details of the change before adopting it.
A spokesman for J.P. Morgan said the bank was “aware of the change” and was evaluating when the lender would adopt it. Representatives forCitigroup Inc. and Bank of America Corp., which also have recorded significant DVA gains or losses in the past, had no comment.
In recent years, the DVA requirement “just made it that much more difficult to understand bank earnings,” said Chris Kotowski, an analyst at Oppenheimer & Co.
Each quarter, bank executives are left trying to explain how the rule has either unjustly hurt or unjustly helped their results—and they typically provide adjusted numbers to investors that exclude the DVA effects. “People are happy to think of the earnings excluding DVA as the ‘real’ number,” Mr. Kotowski said.
Mike Gullette, the American Bankers Association’s vice president of accounting and financial management, said the group “fully supports” the change,” noting that banks for years have been backing out these gains and losses from the earnings announcement. “So the actual standard will now match what we have been doing,” he said.
The DVA change, which the FASB has been discussing since 2012, is part of a broader rule the board issued Tuesday that revamps the way banks record and measure financial assets and liabilities. While banks can adopt the DVA charge now, most of the rule won’t take effect until 2018.
Source: WSJ – Banks Get Relief on Accounting Headache
