Fair Market Option Case

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An Oversight in Accounting for the Fair Value Option

CASE

Larkin Bank started as a small local bank in southeastern United States in the early

1900s. Larkin grew through the years and, with approximately $650 billion in total assets at the

end of 2019, is a top five bank in the U.S. Larkin Bank has historically been a healthy, well-

capitalized publicly traded bank listed on the NYSE and has confident and loyal investors who

have enjoyed consistent dividends and attractive stock returns for over a decade. With 2,580

financial centers throughout 35 states, Larkin Bank’s focuses on satisfying retail, corporate, and

institutional customers through its multiple lines of financial services, including retail banking

and brokerage, mortgage lending, wealth management as well as corporate banking products and

services.

The Financial Accounting Standards Board (FASB) issued an accounting standard

permitting the fair value election (FVO) in 2007 (FASB 2007). The FVO allows companies to

fair value (i.e. mark-to-market) certain financial assets and liabilities and record changes in fair

values as unrealized gains/losses in current earnings (ASC 825). Upper management of Larkin

Bank assigned a technical team consisting of managers in accounting policy and securities

traders to initially implement the FVO into its accounting information systems and internal and

external reporting functions for managerial and regulatory reporting purposes. This team also

helped develop internal controls to properly monitor the related accounting and reporting

functions. The technical team researched the proper accounting treatments for financial and

regulatory reporting purposes to avoid errors that may contribute to investor and lender concerns

about reliability of information and financial stability. Management believes their internal

accounting system as it relates to the FVO is therefore operating properly.

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Larkin has a substantial portfolio of investments in debt securities and uses debt

instruments as a funding source. Larkin has elected the FVO for a number of its investment and

debt financial instruments. The following two sections summarize two important topics for

Larkin – regulatory capital and the fair value option. This is followed by the current situation at

Larkin with respect to the FVO and the issues the bank faces.

Regulatory Capital

Regulatory capital enables bank regulators to monitor the safety and soundness of bank

operations in order to identify deficiencies. Regulation of banks is necessary because bank

failures can have systematic effects on the economy due to the prominent role that banks play in

holding consumer deposits and facilitating borrowing and lending activities between consumers.

A bank with low regulatory capital may be turned over to regulators who then pursue a recovery

of the bank or manage a termination in an orderly and timely manner.1 Therefore, banks are

required to report a number of periodic filings with the Federal Reserve and other regulatory

bodies.

Banks classified as bank holding companies (BHC) with consolidated assets of $1 billion

or more must file the FR Y-9C, which includes schedules supporting the determination of Tier 1

capital, a primary measure of the financial health of a BHC. While reported earnings are a

metric for assessing financial performance for both banks and non-banks, Tier 1 capital is a

1 The following website for statutory minimums for categories of various regulatory capital group

descriptions: http://www.fdic.gov/deposit/insurance/risk/rrps_ovr.html. Assume thresholds for Tier 1 capital ratios

set by regulators for “well capitalized and “adequately capitalized” are 6% and 4%, respectively, for this case.

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critical financial reporting objective among bank managers and subject to management influence

and manipulation.2

The importance of equity to investors is well-known but why regulatory capital might

influence investors’ perceptions as well is less clear. Similar to equity for a non-bank entity,

regulatory capital is a measure of residual values representing owners’ claims to bank resources

upon liquidation. What is different about Tier 1 capital is it incorporates the riskiness of assets

held in part because the opacity of bank assets; that is, valuing financial assets is difficult due to

concerns about the fair value and marketability of underlying collateral. Any significant changes

to regulatory capital, especially unexpected changes, influence how investors value a bank’s

future cash flows available to shareholders.

Regulators have established both minimum capital ratio requirements and well

capitalized thresholds for Tier 1 capital for monitoring purposes and because it sheds light on the

ability of banks to offer returns to shareholders through dividends and share repurchases. When

banks approach minimum Tier 1 capital levels and draw concern about liquidity, regulators may

exercise their oversight responsibilities and reduce a bank’s ability to make distributions to

shareholders. In the event of material misstatements and violations of regulatory capital, a bank

may experience additional regulatory intervention including financial penalties, increased

monitoring, being placed into receivership, and eventual seizure. For these reasons, among

others, investors pay close attention to significant events relating to regulatory capital.

Tier 1 capital is measured as the ratio of regulatory capital (i.e. BHC equity capital,

which is similar to total equity for non-banks) to risk-weighted assets (RWA). RWA is a

2 The banking literature explores empirical relations between earnings and regulatory capital management,

firm value, and accounting standards. See Beatty and Liao (2014) for an in-depth summary of this literature.

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measure of banks’ assets and is sensitive to the risk level of each asset category. Risk weights

range from 0 to 100 percent: Assets such as cash (0 percent) and government guaranteed

treasury securities held as investments (20 percent) receive a lower weight than consumer loans

and commercial loans (50 percent), which tend to be riskier. All other assets not assigned to

these categories receive a 100 percent risk weight. The sum of weights multiplied by the balance

of its respective asset category represents RWA.

To demonstrate the application of RWA in a regulatory capital calculation, consider a

bank with Tier 1 capital of $2 million and three assets: Cash of $5 million, Treasury Securities

classified as Available-for-Sale of $15 million, and Consumer Loans of $34 million, each of

which has a risk weight of 0%, 20%, and 50%, respectively. The RWA measure for this bank

would be $33 million ($5,000,000 x 0% + $15,000,000 x 20% + $34,000,000 x 50%) and thus

the Tier 1 capital ratio for this bank would be 9.01% ($2,000,000 / $20,000,000). Due to

estimates and operational decisions motivated by accounting choices (i.e. earnings management),

both the numerator (i.e. regulatory capital) and denominator (i.e. RWA) are susceptible to

accidental or intentional errors and managerial influences through timing of transactions.

Moreover, Tier 1 capital is sensitive to economic risks associated with both regulatory capital

and a bank’s portfolio of assets.

Accounting information is directly linked to regulatory capital. While complex,

guidelines for determining regulatory capital generally follow the accounting treatments under

U.S. GAAP. One exception is the exclusion of some changes in fair value from Tier 1 capital

calculations. Regulatory capital calculations exclude cumulative changes in fair value of

liabilities recorded at fair value under the FVO (see following section on the FVO). Specifically,

any unrealized gains/losses on liabilities elected under the FVO resulting from the bank’s own

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credit risk are excluded from Tier 1 capital. However, upon redemption or maturity, any realized

gains/losses on FVO liabilities are included in Tier 1 capital.3

Fair Value Option

The banking industry drives much of the accounting standards that involve recognition

and disclosure of fair value estimates. Two of the more important fair value standards are those

codified in ASC 320, which provides the accounting for certain investments in debt securities,

and ASC 825, which permits a company to elect the FVO.4 These two standards were originally

approved in part in response to criticisms among regulators and bank managers over the lack of

relevance of accounting for asset securities.

The FVO allows companies to elect to fair value (i.e. mark-to-market) eligible financial

assets and liabilities and record changes in fair values as unrealized gains/losses in current

earnings. This treatment is similar to the accounting for trading securities under ASC 320. Upon

an election to use a FVO starting in the initial adoption period of the accounting standard (first

fiscal year beginning after November 15, 2007), a FVO adopter records a cumulative-effect

adjustment to the opening balance of retained earnings and an accompanying adjustment to the

fair value adjustment account on the balance sheet. After the initial adoption period, the FVO

election is made on the permitted election date (generally, the date the eligible item is first

3 See Schedule HC-R in the FR Y-9C. Forms and Instructions for the FR Y-9C are available at:

https://www.federalreserve.gov/apps/reportforms/reporthistory.aspx?sOoYJ+5BzDal8cbqnRxZRg==

4 ASC 320 for the accounting of investments in debt securities is based on Statement of Financial

Accounting Standards No. 115, Accounting for Certain Instruments in Debt and Equity Securities (FASB 1993) and

ASC 825, the fair value option, is based on Statement of Financial Accounting Standards No. 159, The Fair Value

Option for Financial Assets and Liabilities (FASB 2007).

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recognized). Once the election is made, it may not be changed for that financial asset or liability.

Further, banks that adopt the FVO are in some cases allowed to include unrealized gains/losses

on elected instruments in regulatory capital. However, realized securities gains/losses

recognized under ASC 320 are always included in regulatory capital.

The accounting for the FVO on liabilities is somewhat controversial because of its effects

on the income statement and balance sheet. Fair values of liabilities fluctuate due to companies’

own creditworthiness (i.e. credit risk) and overall interest, liquidity, and market risks. For

example, the fair value of a 30 year long-term note paying a fixed rate will decrease if its market

rate (or yield) increases relative to the fixed rate. The accounting for this fair value adjustment

results in a lower note payable by debiting a contra liability account (e.g., debt valuation

adjustment) and crediting an unrealized gain account that flows through current earnings. The

rational for this treatment is because if the bank were to redeem this note at the current market

rate, then it would pay less than the carrying value of the note. The opposite occurs if the market

rate decreases relative to the fixed rate. In regard to regulatory capital, which aims to serve as a

prudent monitoring mechanism especially in economic downturns or recessionary periods, it is

counterintuitive that a bank’s regulatory capital increase due to a decrease in its own credit risk.

As mentioned previously, regulatory capital calculations therefore exclude cumulative changes

in unrealized gains/losses related to liabilities recorded under the FVO that are the result of

changes in the bank’s own creditworthiness.

Early redemption poses a complication as banks seek to improve their balance sheets

during both stable and volatile times. Like any company, banks monitor economic risks and

make business and accounting choices accordingly. Early redemptions of liabilities may be used

an earnings management mechanism and banks may therefore find it advantageous to pursue

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early redemptions of long-term debt obligations. The effect on earnings and regulatory capital is

contingent on whether the liability instruments in question are accounted for under the FVO.

For non-FVO adopters, the liability is removed at carrying value and a realized gain/loss

is recorded for the difference in the carrying value and the fair value (i.e. redemption price). For

FVO adopters, early redemptions have less an impact on current earnings because the disparity

between the carrying value and fair value of the liability is reduced. Specifically, a realized

gain/loss is recorded for the difference between the carrying value and the fair value, however,

any related balances in a debt valuation adjustment and unrealized gain/loss accounts are

reversed. This treatment limits the net earnings impact to changes in fair value between the last

financial statement reporting date and redemption date.

Larkin Bank and the Financial Crisis

Larkin diversifies its liquidity, credit, interest, and other market risks with portfolios of

financial asset and liability instruments. Like most large banking institutions, Larkin Bank

carries significant amounts of available-for-sale securities ($81 billion or 12 percent of total

assets as of December 31, 2019) and long-term debt instruments ($122 billion or 18 percent of

total assets as of December 31, 2019), representing the bank’s second largest asset and liability,

respectively.

The investing and financing strategy at Larkin Bank follows a traditional banking model

that invests in U.S. Treasury bonds, mortgage-backed securities, and government bonds and

issues notes with fixed or floating rate features for meeting borrowing needs. Larkin Bank’s

steady return on assets of two percent and prudent growth over three decades demonstrates that

its investing and financing strategies are successful even in volatile market conditions.

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Unfortunately, a nationwide financial crisis stemming from high unemployment, rising

inflation, and increasing levels of delinquent loan payments deeply impacted Larkin Bank in

2018 and early 2019.5 As this crisis significantly affected several other multinational banks, the

Federal Reserve Bank, the primary regulator for BHCs, responded with significant reductions to

borrowing rates and providing liquidity assistance. However, the volatile market conditions also

required government intervention in monitoring and maintaining the financial health of

substantially all U.S. banking institutions.

Tables 1 and 2 report preliminary balances pertaining to long-term debt, including fair

value amounts under the FVO election at the conclusion of year 2019 but before considering the

impact of early redemptions. Tier 1 capital and RWA information based on the preliminary

balances is reported in Table 3. Upon further investigation, more than just market factors may

have prolonged concerns about Larkin Bank’s financial condition. Specifically, Larkin Bank’s

Tier 1 capital ratio decreased significantly at the start of the financial crisis, dropping from

10.5% when the FVO was adopted in 2008. While Larkin Bank stabilized after significant

concern about its financial condition and Tier 1 capital ratio, the bank’s Tier 1 capital ratio is

almost below the threshold for a well-capitalized bank at 6.3% as of December 31, 2019.

Epilogue

Since the financial crisis, bank regulators have been closely monitoring Larkin Bank

along with many other large national banks to ensure that proper risk and capital management

decisions allow for a sustained recovery.

5 The micro- and macro-economic factors faced by Larkin Bank in this case are similar to those that

resulted in the financial crisis of the late 2000s.

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On April 18, 2020, Larkin Bank reported to the Federal Reserve a misstatement in

reporting on the early redemption of a bond payable accounted for under the FVO. Due to the

negative impact on Larkin’s regulatory capital, the Federal Reserve not only rescinded its prior

approval of a share repurchase plan, but also restricted Larkin Bank from issuing a cash dividend

to shareholders. On April 23, 2020 Larkin’s market value dropped almost 6 percent - the largest

change since the start of the financial crisis – after publicly announcing the misstatement and the

Federal Reserve’s decision to restrict planned cash distributions to shareholders.

In the following weeks as more details concerning the misstatement were disclosed,

Larkin’s stock price recovered to a level reached just prior to the announcement. Reasons for

this increase include improved investor confidence that Larkin Bank was forthcoming and

transparent about the error, the error was an isolated incident, and no upper-level management in

the accounting and reporting functions have been ousted as a result of the misstatement,

indicating that subsequent internal investigations yield no evidence of fraud or opportunistic

behavior. Moreover, while the error impacted regulatory capital, the financial statements

reported under U.S. GAAP were not affected. Larkin Bank is currently working with the Federal

Reserve to restore future share repurchases and cash dividends.

Requirements

1. Prepare journal entries for the Senior Debt Facility Fixed Rate – Series A bond issued on

January 1, 2005 with a stated coupon rate of 3.75% (payable annually) when the market rate

was 3.97%. This bond matures in 20 years on December 31, 2025. As part of your response,

prepare an amortization schedule for the bond.

2. On January 1, 2008, Larkin Bank elected the FVO for the Senior Debt Facility Fixed Rate –

Series A bond (regular adopter) when the bond’s fair value is $10.302 billion.

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a. Prepare the journal entries necessary to implement the FVO on Senior Debt Facility

Fixed Rate – Series A bond (assume any difference between the unpaid principal balance

and fair value is due to Larkin Bank’s own creditworthiness and ignore tax affects if any).

b. Determine the effect of this election on the bank’s regulatory capital.

3. Assume Senior Debt Facility Fixed Rate – Series A was redeemed on December 31, 2019

when its fair value was $12.662 billion.

a. Prepare the journal entries to properly record the debt valuation adjustment and

corresponding unrealized gain/loss for 2019 (ignore tax affects if any).

b. Prepare the journal entries to properly record the early redemption of this bond after

the annual coupon has been paid and all fair value amounts have been updated

through a debt valuation adjustment account (3a above). Assume this is the only

instrument redeemed in 2019 and ignore tax affects if any. Any adjustments to

unrealized gains/losses and debt valuation adjustment accounts should be made based

on the remaining instruments in the portfolio.

c. What is the effect of this redemption on Larkin Bank’s Tier 1 capital ratio (assume a

dollar for dollar impact of the redemption on any effect on regulatory capital and

ignore tax affects if any)?

d. Assume Larkin Bank improperly accounted for the regulatory capital impact of the

realized gain/loss in (3c above) above as if it were an unrealized gain/loss. How

might this improper treatment impact your answer in 3c?

e. It is possible that the improper treatment in 3d resulting in an accounting error was

motivated by an effort to manage regulatory capital (Tier 1 capital). Do you believe

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management would intentionally misreport realized losses related to debt accounted

for under the FVO? Why or why not?

4. Why might the banking industry motivate the accounting standard setters to continue to

move toward a more fair value oriented accounting framework?

5. Provide insight on why the FASB made the FVO irrevocable.

6. With shareholders and lenders (i.e. investors in bonds issued by a bank) in mind, what are

potential explanations for the FVO requiring the seemingly counterintuitive accounting

treatment for fluctuations in fair values of financial liabilities.

7. Why might bank regulators prevent Larkin Bank from pursuing a stock repurchase program?

A detailed answer will articulate the use of Tier 1 capital in assessing Larkin Bank’s financial

stability.

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Table 1 – Long-term Debt

Aggregate Long-term Debt Balances (amounts in millions) 12/31/2019 12/31/2018 Senior debt

Fixed 86,276 84,550 Floating 21,917 21,697

Subordinated debt Fixed 9,781 9,682 Floating 4,527 4,351

Total(a) 122,501 120,280

(a) Includes $19.567million and $19.456 million of long-term debt accounted for at fair value at 12/31/2019

and 12/31/2018, respectively.

Note: The aggregate long-term debt balances as of December 31, 2019 and 2018 include fair value adjustments

where applicable, but exclude the impact of early redemptions that the bank may undertake at year-end.

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Table 2 – Fair Value Option Information Panel A – Aggregate Unpaid Principal and Fair Value under Fair Value Option Election (amounts in millions) 12/31/2019 12/31/2018

Aggregate unpaid

principal Fair value

Fair value over/(under)

aggregate unpaid

principal

Aggregate unpaid

principal Fair

value

Fair value over/(under)

aggregate unpaid

principal Senior debt

Fixed 14,894 14,811 (83) 14,759 14,348 (411) Floating 2,922 2,447 (475) 2,519 2,655 136

Subordinated debt

Fixed 1,711 1,734 23 1,780 1,763 (17) Floating 409 575 166 532 690 158

Total 19,936 19,567 (369) 19,590 19,456 (134)

Note: The fair value information as of December 31, 2019 excludes the impact of early redemptions that the bank

may undertake at year-end.

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Table 2 – Fair Value Option Information (continued) Panel B – Details of Long-term Debt Instruments under the Fair Value Option Election (amounts in millions) 12/31/2019

Instrument type CUSIP Description

Par Unpaid

principal Fair

value Senior debt facility 9XXXXX101 Fixed Rate –

Series A 12,000 11,882 12,662

Senior debt facility 9XXXXX102 Fixed Rate – Series B 1,600 1,569 1,399

Senior debt facility 9XXXXX103 Fixed Rate – Series C 1,500 1,443 750

Senior debt facility 9XXXXX104 Floating Rate – Series U 1,500 1,498 1,188

Senior debt facility 9XXXXX105 Floating Rate – Series V 1,200 1,355 1,187

Senior debt facility 9XXXXX106 Floating Rate – Series W 80 69 72

Subordinated debt facility

9XXXXX107 Fixed Rate – Series D 1,100 1,108 1,066

Subordinated debt facility

9XXXXX108 Fixed Rate – Series E 530 535 590

Subordinated debt facility

9XXXXX109 Fixed Rate – Series F 70 68 78

Subordinated debt facility

9XXXXX110 Floating Rate – Series X 200 213 198

Subordinated debt facility

9XXXXX111 Floating Rate – Series Y 100 109 277

Subordinated debt facility

9XXXXX112 Floating Rate – Series Z 90 87 100

19,970 19,936 15,567

Note: The fair value information as of December 31, 2019 excludes the impact of early redemptions that the bank

may undertake at year-end.

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Table 3 – Selected Bank Information (amounts in millions) 12/31/2019 12/31/2018 1/1/2008 Total assets 650,967 637,501 630,768 Risk-weighted assets 298,118 288,213 401,704 Tier 1 capital 18, 001 17,544 26,641

Note: The balances include fair value adjustments where applicable, but exclude the impact of early redemptions

that the bank may undertake at year-end.

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References

Beatty, A., and Liao, S. 2014. Financial accounting in the banking industry: A review of the

empirical literature. Journal of Accounting and Economics 58: 339-383.