The strange accounting that tripped up Bank of America is on its way to being changed. That accounting rule has been around since 2007.
The rule has provoked a lot of criticism about how ludicrous accounting results could be, and the people who write the standards have been moving to change the rule. Just last week, the Financial Accounting Standards Board tentatively agreed, on a 5-to-2 vote, to end that practice at a date to be determined.
The existing rule applies to companies that adopt what is known as the “fair value option” for financial assets and liabilities. In practice, that mostly means large banks.
Under the rule, they mark certain assets and liabilities to market value each quarter and reflect the net change in their income statements.
That made sense when it was originally adopted in 2006, when the quality of bank credit was generally taken for granted. If a bank issued a bond that matured in 10 years and at the same time made a 10-year loan at a fixed interest rate, marking the asset — the loan — to current value might make no sense unless the value of the liability — the bond — was also changed. If interest rates rose, the market value of the loan would fall. Should that lead to a loss? No, because the value of the bond would also fall.
Then Lehman Brothers failed, and suddenly the assumption of unvarying credit quality among large banks no longer made any sense.
The result was that in 2008 and 2009, the market value of bonds issued by big banks fell, and their reported profits were increased. Then in 2010 and later, the banks appeared to be in better shape, and the market value of their bonds rose. That cut reported profits.
Bank regulators understood that — whatever the accounting rationale — it made no sense to raise or lower a bank’s profits because its credit standing had changed. Banks would ultimately pay their liabilities in full or they would fail. So the regulators told the banks to disregard those adjustments in calculating capital. And Bank of America did that.
The bank said on Monday that it mishandled the adjustments to its capital. It says that it properly raised its reported capital levels to offset the reported loss caused by unrealized changes in the valuation of the securities it had issued. But it also raised the capital levels to offset losses that had been realized, something it should not have done. The realized changes came when securities issued by the bank were paid at maturity or repurchased at an earlier date. That mistake improperly increased its reported capital.