Accounting Standards in the U.S. Banking Industry during the Financial Crisis

Accounting Standards in the U.S. Banking Industry during the Financial Crisis

Jorge A. Romero (Towson University, USA)
DOI: 10.4018/978-1-4666-9484-2.ch007
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Abstract

The global financial crisis became evident when U.S. house prices fell related to the subprime mortgage-backed securities crisis. In the years preceding the financial crisis of 2008, there was a real estate bubble that pushed U.S. real estate prices to high levels, and at the same time financial institutions were holding large amounts of subprime mortgage-backed securities. Fair value accounting (FVA) and its link to the recent global financial crisis has been a focus of discussion and interest for accounting researchers, financial analyst and policy makers. During the financial crisis, a large percentage of assets in the balance sheets of banks were calculated using fair value. The main concern was that those assets were calculated using mark-to-model accounting (Goh, Ng, & Yong 2009). There are still contradictory conclusions on the implications of fair value accounting and the global financial crisis (Laux & Leuz, 2009). The main objective of this chapter is to provide a better understanding of the global financial crisis and of the mechanisms of fair value accounting.
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Introduction

The global financial crisis became evident when U.S. house prices fell related to the subprime mortgage-backed securities crisis. In the years preceding the financial crisis of 2008, there was a real estate bubble that pushed real estate prices to high levels, and at the same time financial institutions were holding large amounts of subprime mortgage-backed securities. An estimated subprime debt of $500 billion was linked to $140 trillion in global assets (Wallison, 2008). The bubble burst when house prices fell, generating large losses on mortgage-backed securities. Fair value accounting (FVA) and its link to the recent global financial crisis has been a focus of discussion and interest for accounting researchers, financial analysts and policy makers. During the financial crisis, a large percentage of assets in the balance sheets of banks were calculated using fair value. The main concern was that those assets were calculated using mark-to-model accounting (Goh, Ng, & Yong, 2009). This kind of behavior was a concern because the calculation of fair values during a period of economic distress may have not been the most efficient way to estimate the real value of assets.

A common problem was that financial institutions were not holding loans that they originated because of the widespread use of securitization. Securitization occurs when the loan originator sells loans and debt obligations to investors, so the loan originator may be biased towards lowering its underwriting standards, therefore increasing the risk of default. Underwriting is the process to determine the probability of the borrower to pay back the loan. During the financial crisis, a large percentage of mortgage loans, often interest-only mortgages (Financial Crisis inquiry Commission, 2011), were granted to buyers or investors using relaxed standards that, under stricter standards, would have not been approved. These types of accounting practices increased the risk of default. Wallinson (2008) mentions a list of guilty parties such as loan originator with low underwriting standards, ineffective credit risk models provided by credit rating agencies, high risk borrowers taking loans that they cannot afford, and ineffective supervision by regulatory entities.

Key Terms in this Chapter

Firm Performance: A measure of performance of a company that may not only depends on the efficiency of the company itself but also on the market where it operates. In the financial sector, it also known as financial stability or financial health. There are different financial measures that can be used in order to evaluate the performance of a company. Some of the common financial measures are: revenue, return on equity, return on assets, profit margin, sales growth, capital adequacy, liquidity ratio, and stock prices, among others.Depending on the industry on which the company operates, some financial ratios will be more meaningful than others. For instance, in a manufacturing company, total unit sales, return on assets and inventory turnover may be key ratios to monitor, while for financial institutions, stock prices, cash flow, revenue and operating income may the key ratios to monitor. For companies in the consulting business, return on assets and inventory turnover may not be meaningful given the fact that it is not an asset intensive industry. Another factor to consider in order to evaluate the performance of a company is the relative value of the financial measures of the company in relation to competitors within the same specific industry, because each industry is unique and making comparison across industries may provide bias interpretation about the performance of a company. For instance, comparing return on assets between a manufacturing company and a consulting company may be meaningless because while one of them is asset intensive, the other one is not.In the case of U.S. financial institutions, the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA) provide deposit insurance to guarantee the money of clients kept at the corresponding financial institutions (banks or credit unions). In the case of the FDIC, it provides deposit insurance up to $250,000 in an insured bank, while in the case of NCUA provides insurance protection up to $250, 000 in a federally insured credit union. FDIC and NCUA also provide quarterly financial performance reports that are publicly available. In addition to the data provided by the FDIC and NCUA, some public rankings of banks are prepared using data provided by SNL Financial, which is a company based in Virginia that specifically collects financial and market variables related to the banking industry. Some of the variables collected to measure the financial health of banks are: nonperforming loans (NPLs) as a percentage of loans, nonperforming assets as percentage of assets, and reserves as a percentage of NPLs.

Sarbanes-Oxley Act: It is a U.S. federal law enacted on July 30, 2002 as a response to multiple corporate scandals by major corporations such as Enron, Worldcom, Arthur Andersen, Global Crossing, Imclone Systems Incorporated, Adelphia and Tyco international among other companies. This Act was proposed by U.S. senator Paul Sarbanes and U.S. representative Michael Oxley. In the case of Enron, shareholders lost millions of dollars while the company was hiding huge loses and at the same time stock prices were steadily increasing in value. The Sarbanes-Oxley Act (SOX) required stricter standards to publicly traded companies in order to avoid accounting irregularities and penalized fraudulent activities. Some of the stricter standards were to require officers of the company to sign financial statements so they can be personally responsible for any accounting irregularity. If fraudulent activities were uncover, then higher fines will be imposed and prison sentences were also contemplated.SOX included the Securities and Exchange Commission (SEC) to oversee the compliance of the new regulations and got more authority to investigate suspicious accounting activities, and created a nonprofit, the Public Company Accounting Oversight Board (PCAOB), to certify the audits of public companies. SOX is also very clear on the roles of auditors in order to avoid conflict of interest given the fact that before SOX, auditing firms used to provide other non-auditing services to companies that they were auditing. Companies are responsible for hiring independent external auditors. SOX has several sections, but the two main sections are section 302 and 404. In Section 302, CEOs and CFO are required to take responsibility for the accuracy of financial reports. In Section 404, independent external auditors must certify the accuracy and effectiveness of the internal controls.

IFRS: International Financial Reporting Standards. It is a nonprofit organization with the goal of developing a global set of accounting standards.

Fair Value: Trading value under ideal market conditions. There may be different fair values for the same item depending on which method is used to calculate the value of the asset and which factors are taken into account for the calculation. The calculation may be based on similar assets available in the market or theoretical model used to forecast a value.

Historical Cost: It is a measure of the cost of the asset based on its original price when it was acquired. Under U.S. GAAP regulations, few assets are not recorded using their historical values, such as marketable securities. While, most of the assets are recorded using their historical cost, although their value may have changed over time. For instance, a building may have been acquired for $50,000 in 1900, and although its value today is $1’000,000, it is still recorded on the balance sheet at $50,000. It means that it has not been adjusted for inflation since the asset was acquired by the company. Using historical values of assets for valuation purposes may not give investors a current and accurate idea of the value of the asset today, because the purchase power of a U.S. dollar today is greater than the purchase power of a U.S. dollar ten years ago. The same effect could be applicable to other currencies. Therefore, investments with a shorter maturity period may be preferable for some investors because the value of the money over time may not have an effect on the nominal return of the investment. Otherwise, investor can calculate the present value of the return in a future period. In order to calculate the present value of the return in a future period, the investor will need to use the corresponding consumer price index. The calculation of the present value will provide valuable information to the investor, given the fact that if the present value of the return is negative then it will signal the investor that it is not a good investment, while if the present value is positive then it will signal the investor that it may be good investment. The Bureau of Labor Statistics of the U.S. Department of Labor publishes consumer price indexes for different types of activities, industries and assets. They have five major databases: All Urban Consumers, Urban Wage Earners and Clerical Workers, All Urban Consumers-Chained CPI (C-CPI-U), Average Price Data, and Department Store Inventory Price Index. The All Urban Consumer price index is different than the All Urban Consumers-Chained CPI on the fact that the C-CPI-U is calculated based on a Tornqvist formula using several consecutive periods that take into account spending data from adjacent periods in order to control for substitutions that consumers may have incurred in those periods. The chained CPI is a relative new technique designed to provide a better “cost-of- living” index estimation. Monthly averages, semiannual averages, and annual averages of consumer price indexes are available from The Bureau of Labor Statistics of the U.S. Department of Labor. Another definition that it is linked to business-decision making is sunk cost. Sunk cost is defined as a cost that has been incurred and cannot be recovered in the future. The calculation of sunk cost is based on historical values and not on current market values.

Depreciation: It has two major interpretations. The first one is from an economics perspective and is related to a drop in the value of assets or currency under unfavorable market conditions and in relation to foreign assets held by local entities or foreign currency correspondingly. For instance, depreciation will be present when the local currency has less purchasing power in other countries. This was observed during the Russian ruble crisis of 1998 although the Russian Central Bank tried to control the exchange rate. The second interpretation is from an accounting perspective and takes into account the fact that an asset may need to be replaced at the end of its useful life therefore the asset will suffer a reduction in its value over time because of wear and tear, or obsolescence. Therefore, it is a non-cash accounting expense and not a real expense that will require cash disbursements from the asset holder. This accounting expense will be allocated over the useful life of the asset under one of the depreciation methods allowed by local tax regulations. Given the fact that this is an accounting expense, and then it will reduce earning at the end of the accounting period. For instance: a company acquired a machine for $20,000 and it will depreciate the machine using the straight line method. The machine is expected to be obsolete after ten years and the estimated salvage value is $1,000. Therefore, the annual depreciation expense will be calculated as follows: (20000-1000)/10=$1,900. $1,900 is an annual non-cash charge. There is also a possibility that the actual salvage value after ten years may be $100 instead of the original estimated value of $1,000. If this is the case, then the company will need to report a loss of $900. The Internal Revenue Service (IRS) is the U.S. federal government agency in charge of the revenue code and in charge of collecting taxes. The IRS defines depreciation as an income tax deduction in the form of an annual allowance. Under IRS regulations, most tangible and intangible assets are depreciable, such as buildings, machines, equipment, software, and patents among others. IRS regulations do not allow land to be depreciated. There are different methods of depreciation, but among the main ones we find the Straight-line method, Declining balance method, Units-of-production depreciation method, Sum-of-years-digits method, and the Accelerated Cost Recovery System. The IRS uses The Modified Accelerated Cost Recovery System (MACRS) to encourage companies to engage in capital investment more often. Under MACRS, depreciation is calculated using one of the following methods: declining balance method or straight line method. Depreciation is reported under Form 4562 of the IRS. For instance, if a company buys a machine for $100,000 and expects a useful life of 10 years, then the machine will be depreciated over a period of 10 years. If the straight line method is used to depreciate the machine, then every year, the company will report an expense equivalent to $100,000/10 = $10,000 per year.

IASB: International Accounting Standards Board. It is a standard-setting body that replaced the the International Accounting Standards Committee in 2001.

IFRS 9: International accounting regulation issued by the International Accounting Standards Board in order to replace IAS 39. The last version was completed in July of 2014 and it will be effective after January 1 of 2018. It is supposed to fix some of the weaknesses in IAS 39 and it is supposed to have a logical model for classification and measurement of financial assets and financial liabilities.

Collateral Loan: Collateral loans are also referred as secured loans because the loan requested to the lender will be secured by an asset that the customer owns. The financial institutions operationalized it placing a lien on the property, and holding the deed or title of the property until the loan is repaid in full. Therefore, if the borrower decides to sell the asset before the loan is paid, then the financial institution as a lien holder gets paid before the owner of the asset. A lien is a formal of legal claim to secure the payment of a debt or other obligations. Liens can be consensual and non-consensual. It is a consensual lien when a client requests a loan from a financial institution. The lender uses its own valuation criteria to estimate the market value of the asset being used as collateral, and usually the market value estimated by the lender is lower than the value that could be obtained if the asset is sold at the moment of getting the loan and lower than the amount of money paid to obtain the asset. In a secured loan, the lender will use the asset to make sure that they will not lose the money that they are lending in case the customer is unable to pay the loan back. If the customer is unable to pay the loan back, then lender can use the asset to recover their money. Even after the lender sells the asset to recover its money, it is possible that the client is still responsible for the full amount of the loan. This is common practice in the banking industry, and bank use this policy to minimize the risk that maybe taking when lending money. Depending on the financial institution, the types of assets accepted as collateral may differ, but in general terms, the following assets are usually accepted as collateral: real estate, automobiles, saving accounts, certificate of deposits (CDs), stocks, bonds, annuities, valuables and collectibles. In contrast to collateral loans or secured loans, unsecured loans also exist. In the case of a customer that cannot pay back an unsecured loan and given the fact that the financial institution does not have any asset as collateral, then financial institution can take legal actions against the customer or report the customer to a credit bureau as a non-paying client and therefore the credit score of the client will be reduced and as consequence other loans requested by the same client may be denied by other financial institutions or the client may need to face stricter requirements in order to reduce the risk of the other financial institutions. In the case of some financial institutions, it may be easier to get a secured loan rather than an unsecured loan, and usually in unsecured loans the interest rate is higher, the repayment period is shorter, and the amounts are smaller in comparison to secured loans because financial institutions are taking more risks. Some examples of secured loans are as follows: home equity loans, home equity lines of credit, home or business improvement loans, vehicle loans (for personal use or business use), and boat loans. Some examples of unsecured loans are as follows: credit card lines of credit, personal lines of credit, business lines of credit, and student loans.

Subprime Mortgage-Backed Securities: They consist of loans made to subprime borrowers. Subprime borrowers are those borrowers with a low credit score or high debt to income ratio, and lenders consider them as risky clients because of the capacity to repay the loan. Usually, loans to subprime borrowers are subject to higher interest rates. Some U.S. financial institutions use credit risk scores provided by the U.S. credit bureaus (Equifax, Experian, or TransUnion) in addition to the FICO credit score because depending on the provider of the credit risk score, the credit risk score may be different although it may have been calculated for the same quarter. FICO is a software company that predicts consumer behavior using big data and proprietary statistical models in order to provide credit scores in order to quantify the risk associated with clients. It is based on San Jose, California, but it has operations in different countries. A low credit score is usually as a result of late payments, missed payments, or excessive debt. For instance, the range of the FICO score goes from 300 to 850, and scores under 600 may be considered subprime. The debt to income ratio is also a common ratio used by financial institutions to identify subprime borrowers. The debt to income ratio shows the amount of total debt that a client has in relation to the gross amount of income generated. Therefore, the lower the value of the ratio the better. For instance, if a client has a monthly gross income of $5,000, monthly mortgage payment of $2,000, a monthly car payment of $400, and a monthly alimony expense of $600, then debt to income ratio will be calculated as follows: Debt to income ratio= (2000 + 400 + 600) / 5000 = 0.6 = 60% In a case like this, the debt to income ratio is high because 60% of the gross income goes towards covering current debt, so the possibility of this client being approved for a loan is low. Therefore, the client has to lower the amount of his monthly expenses or increase the amount of his income in order to reduce the value of the ratio.

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