The Obscure Accounting Rule Taking Center Stage

As the second-quarter earnings season progresses, it's becoming exceedingly obvious that an obscure accounting rule is taking center stage and, in some cases, entirely wiping out shareholder gains. The rule concerns the valuation of securities held by companies of all stripes, from Apple (NASDAQ: AAPL  ) to Bank of America (NYSE: BAC  ) and everything in between. The net result on book values has been described as nothing short of a bloodletting.

Known as mark-to-market accounting, the rule requires certain companies that hold investment securities to regularly update the carrying value based upon current market prices. As my colleague Matt Koppenheffer noted in a recent article, this accounting treatment is particularly pronounced in the financial industry, which is reeling from an uptick in interest rates and a concomitant decline in the value of fixed-income securities.

"During the second quarter, 10-year Treasury rates rocketed up from 1.87% to 2.52%," Matt noted. "This is going to make for some serious ugliness on bank balance sheets. In the fixed-income market, the basic math is simple: When rates go up, prices go down. That means that the piles of debt securities on bank balance sheets just took a dive during the past quarter."

The concern was prophetic. In Bank of America's case, despite the fact that the nation's second largest lender by assets earned an impressive $4 billion last quarter, its book value actually declined, albeit by only $0.01 per share. And while the impact wasn't as severe at other lenders like JPMorgan Chase (NYSE: JPM  ) or Wells Fargo (NYSE: WFC  ) , few escaped the second quarter unscathed.

To be clear, this shouldn't happen. Under normal circumstances, a company's net income translates into retained earnings on the balance sheet. And because the retained-earnings line item is situated in the equity portion of the balance sheet, one would expect book value to increase.

The disconnect traces its roots back to the treatment of mark-to-market securities. Namely, when the value of these securities declines, the deterioration gets recorded as "other comprehensive income" on the balance sheet, which, not coincidentally, is also characterized as equity. Thus, to get somewhat semantic, while the fall in market value isn't "realized" on the income statement, it's nevertheless "recognized" on the balance sheet.

In most instances, as the above examples suggest, one only thinks about this accounting peculiarity in terms of banks or other financial companies. But over the last few weeks, we've learned that its impacts are much more wide-ranging.

Yesterday, for example, technology giant Apple announced that its accumulated OCI fell by $1.2 billion in the second quarter. And Microsoft (NASDAQ: MSFT  ) and Google (NASDAQ: GOOGL  ) had similar experiences, watching as their accumulated OCIs fell by $462 million and $754 million, respectively. Although this trend wasn't wholly unexpected, and the losses will only be realized if the companies actually sell the fixed-income securities prior to maturity, it nevertheless calls into question the long-held belief that cash is king -- at least for the time being.


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  • Report this Comment On July 27, 2013, at 1:05 PM, xetn wrote:

    What about the value of the banks' REOs? As I understand, they have been given a pass on having to mark to market on them.

    If the value of collateral backing loans severely declined, as it did following the 2008 collapse, most of the banks would be bankrupt.

  • Report this Comment On July 27, 2013, at 7:55 PM, TurningItBlue wrote:

    If the banks had long term securities which they intended to hold to maturity, they could have accounted for them using amortized cost. They would only be marking securities to market if they are either in trading accounts, or "held for sale" both of which would indicate that they do anticipate actually realizing the losses. These losses (due to interest rates changing) of course could be, and often are, hedged.

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