The strange accounting that tripped up Bank of America is on its way to being changed.
That accounting rule, which has been around since 2007, has vexed investors in financial institutions ever since it began to be applied. The banks greatly enjoyed it at first because it had the seemingly perverse result of increasing their reported profits â€" or at least reducing their reported losses â€" at a time when the banks seemed to be in dire straits in 2008 and 2009.
Since then, the banks have liked it less because it reduced profits as their chances of survival appeared to increase.
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.
People should not hold their breath. Changes in accounting rules happen at a glacial pace. The board has been discussing this change since 2010.
Had the expected new rule been in effect, it appears that Bank of America could not have made the mistake that was disclosed on Monday â€" a mistake that forced it to withdraw its capital plan submitted to the Federal Reserve and suspend a planned dividend increase and share buyback.
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 â€" the loan â€" to current value might make no sense unless the value of the liability â€" the bond â€" 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 â€" whatever the accounting rationale â€" 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 while it got the net earnings right every year, it mishandled the adjustments to its capital.
And how did it err? 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.
Bank of America did not explain how that the error came to happen or how it was repeated year after year. Nor did it explain why the error was discovered when the first-quarter financial statements for this year were being prepared.
The securities in question were complicated ones, known as structured notes. They were originally issued by Merrill Lynch before Bank of America bought the brokerage firm in 2009, during the financial crisis. Those notes had what is called an “embedded derivative,†which means their eventual value at maturity would vary based on the performance of something else, perhaps a currency or a commodity or a stock index.
Under the current rules, any change in value because of a move in the underlying security â€" say a stock index â€" should be reflected in both earnings and capital. So should a change in value caused by changes in market interest rates. But the change in value caused by a change in the credit standing of Bank of America should be reflected only in earnings, not in capital.
If the change in rules tentatively endorsed by the F.A.S.B. were in effect, the latter change would no longer be reflected in earnings. So no adjustment would need to be made in calculating capital levels.
It is clear that Bank of America management should have caught the error. But it is less clear who else should have caught it. It was contained in the bank’s submission to the Fed regarding stress tests, which the Fed said it carefully reviewed. A Fed spokeswoman declined to comment, but it perhaps should be noted that the submissions contained thousands of numbers, not all of which could be checked.
Bank of America’s auditor, PricewaterhouseCoopers, also declined to comment. It is responsible for auditing the company’s financial statements, which the bank says were correct, at least so far as the income and balance sheets go. But the company’s 10-K annual report, which carried the auditor’s letter of approval, also included a footnote regarding capital levels, which the bank now says were incorrect. One measure of capital was reported at $161.5 billion, when it should have been $157.7 billion. Auditors are supposed to review such footnotes, but either number showed the bank to be more than adequately capitalized, and it could be argued that the difference was immaterial to investors.
It was not, however, immaterial to the Fed, which forced the bank to revise its capital plan. And that fact was clearly material to investors. Bank of America stock lost 6.3 percent of its value on Monday, shaving more than $10 billion off the company’s market capitalization.
It will be interesting to learn, if we can, just how the error was caught this year. It might be even more interesting to know which bank officials were supposed to review the calculations, and failed to do so, year after year.
