Show-me-the-money inc. is a medium-sized bank. The bank's stock is owned primarily by residents in the city where the bank operates. During the last decade, the bank lent money for numerous real estate developments. Most of the loans went to developers who constructed office space and expected to repay the loan from office rent. Aggressive lending and building practices resulted in overbuilding. A downturn in the local economy drastically reduced demand for office space. As a result, many of the building are now largely empty. Rent from the facilities is insufficient to pay interest on several of the bank's larger loans. The bank has permitted several borrowers to restructure their loans, providing a longer period of repayment and lower interest rates. The market value of the property backing these loans has decreased approximately 40% since its construction. The bank's proposed year-end balance sheet reports loans in the bank's long-term investment portfolio at $43 million. This amount is net of a loan loss reserve of $5 million. The balance sheet also includes $18 million of property among the bank's assets. This property was acquired through foreclosures on several loans. The property is valued at the present value of the original loan payments, including interest the bank expected from the original borrowers. The bank is collecting rent from tenants and expects to sell the property when real estate values return to higher levels. The bank's total assets are $80 million, and total stockholders' equity is $10 million. The bank's proposed income statement for the year reports profits of $6 million. The year-end audit is now underway, and the bank's auditors are reviewing the proposed financial statements. They have questioned management about its loans and property values. The auditors believe that the current market value of the loan portfolio is about $35 million. They are less sure about the value of the property. The bank's managers are arguing that the current market value of the loans is not relevant because they do not expect to sell the loans. Instead, they expect to hold the loans until they mature. Also, they do not plan to sell the property until they can recover the amount the bank invested.
Do you believe the investors and creditors of the bank will be well served by the financial statements that the bank's management proposes to report? Explain.
2. Do you see any ethical problems with the way the bank's managers want to report its assets? Why?
3. What problems may arise for the bank if it reports its loans at current market value?
Asset valuation by financial institutions has been a major accounting issue in recent
years. Traditional accounting rules permitted banks to report loans and other assets
at historical cost. Nonperforming loans were written off. Restructured loans could
be reported after adjusting for the lower expected cash receipts, resulting from
changes in loan terms. An important question in this problem is whether investors
are likely to be misled by the bank’s financial report. Are investors facing a risk that
is not apparent? If so, some disclosure of this risk that is sufficient to permit
investors to assess the risk and the effect it has on the value of their investments
would appear necessary. Otherwise, an ethical problem arises because management
is concealing information that has a bearing on the welfare of the bank’s investors.
This information also may affect decisions of depositors, employees, and
government authorities.
On the other hand, if the bank’s valuation of $43 million is a fair representation of the present value of the expected cash flows the bank expects to receive from the loans, the amount may not be misleading. A relevant issue is whether the loan loss reserve is sufficient to cover the losses the bank should expect from nonperforming loans. If the bank writes its loans down to market value, it would recognize a loss of $8 million on the loans ($43 million at cost, adjusted for expected losses – $35 million at market). This loss would wipe out its current year profits and most of its equity. The loss could result in problems for the bank with regulatory agencies and depositors.
A separate issue is valuation of the property held by the bank. The book value of the property appears to be less than its market value. The property should be reflected on the bank’s statements at an amount approximating its value to the bank. This value could be approximated by discounting the expected cash flows the bank expects from the property.
A criticism of accounting rules is that they do not necessarily require organizations to report information about the current market value of their assets. These values may be useful to decision makers. Managers and auditors often argue against reporting these amounts because they often are subjective and may be difficult to determine.