The Bizarro World of FAS 159

Do you remember the episode of Seinfeld titled “The Bizarro Jerry”? In this episode, which was based on Bizarro Superman, everything is backwards, i.e., up is down, down is up, in is out, out is in.

Well, financial institutions have entered the Bizarro World as a result of the “Statement of Financial Accounting Standards No. 159: The Fair Value Option for Financial Assets and Financial Liabilities.” Issued in 2007, the standard gives companies the option of measuring a broad array of financial assets and financial liabilities at their fair market value instead of their historical cost. Examples of items that can be measured at fair value are: financial instruments, investments in consolidated subsidiaries, pension and postretirement benefit obligations, and leases. Once a company elects to measure a financial assets/liability at fair market value, any subsequent changes are reported on the income statement. Although companies are allowed to choose which financial assets and liabilities they would like to measure at fair value, once the decision is made, it is irrevocable.

For example, suppose a financial institution purchases $10 million in fixed income securities and chooses to measure them at fair value. At the end of the quarter, if the fair market value of the securities is $9 million, the company will report the securities on its balance sheet at $9 million and then recognize the $1 million decline in fair value as a loss on its income statement. At the end of the next quarter, the current fair market value of the securities would be compared to their previous fair market value (in this case $9 million) and a gain or loss would be recognized accordingly.

Now, we enter the Bizarro World because what is done to assets can also be done to liabilities. Suppose this same financial institution issues $50 million of bonds at par value (100) and chooses to measure these bonds at fair value. During the quarter, this financial institution experiences some type of operating difficulties and investors perceive that its credit worthiness has declined. As a result, the fair market value of the bonds declines to $47.5 million (95) by the end of the quarter. The institution will have to mark down the value of its bonds on its balance sheet (thereby improving its debt ratios) and will report a $2.5 million gain on its income statement (the underlying rationale is that the issuing firm could buy back its bonds at lower prices). Therefore, bad is good! As the creditworthiness of this institution declines so will the fair market value of its bonds. Its net income, however, will increase.

This is exactly what happened with JPMorgan Chase. On October 13, 2011, the company reported third quarter net income of $4.3 billion, or $1.02 per share, on revenue of $24.4 billion. This included a $1.9 billion pretax, or $0.29 per share after-tax, “benefit” from “debit valuation adjustments (“DVA”) on certain structured and derivative liabilities, resulting from the widening of the Firm’s credit spreads,” according to the firm’s press release. The third quarter was a difficult period as worries over Greece and the European debt crisis affected investors’ perceptions of the viability and credit worthiness of many financial institutions. However, JPM was able to benefit from this, because 28% of its quarterly earnings were due to the fact that its financial liabilities declined in value. In the earnings announcement, Jaime Dimon, chairman and chief executive officer of JPMorgan Chase said, “The DVA gain reflects an adjustment for the widening of the Firm’s credit spreads which could reverse in future periods and does not relate to the underlying operations of the company.” Excluding the gain, IB revenues would have declined by almost 39% from the second quarter, but, with the gain, they declined by only 13%. More important, without this gain, they would have reported a 28% decline in third quarter EPS ($0.73) from the same period in 2010 ($1.01) instead of a 1% increase in EPS ($1.02).

To be fair, JPMorgan Chase is not doing anything wrong; it is simply following generally accepted accounting principles. It is not the only Wall Street firm that has benefitted from this accounting rule (think Citigroup, Merrill Lynch, and Goldman Sachs). Financial institutions have been using this accounting method for the past four years. In fact, a 2010 survey conducted by CFA Institute found support for fair value measurement of liabilities.

So what is an investor to do? Besides developing a solid grasp of accounting, investors need to read companies’ earnings releases carefully and adjust their financial statements for all of these noncash charges to get a better idea of each company’s earning power.

Below are links to some very good articles on this issue.

• Banks are suffering from lackluster demand for their basic products and have been using Statement 159 to prop up their results, according to reporters at Bloomberg.
• Merrill Lynch & Co., Citigroup Inc. and four other U.S. financial companies have used an accounting rule adopted last year to book almost $12 billion of revenue after a decline in prices of their own bonds.