Peeling away financial reporting issues one layer at a time

How GAAP and IFRS Succeed in Overstating Bank Capital without Really Trying

As I stated in my post on ASU 2015-03, the accounting for debt issue costs is relatively small potatoes. The point was to illustrate that the FASB’s so-called “simplification initiative” was driven by politics, and that actual simplification might, or might not, be the outcome.

That post also raised questions about the nature of “interest,” that are far from small potatoes. Most notably, both the FASB and IASB are in the final throes of their efforts to finalize standards for the accounting for loans, including periodic interest income.

So, let’s talk about “interest.” What is it, really? Does current or prospective GAAP appropriately measure income from lending?  What are the implications for measuring loans?

A Simple Example

Kathy took out a 10-year $100,000 mortgage loan from her local bank at an interest rate of 10%. To keep the problem really simple, but without loss of generality, the loan is not pre-payable; and payments of $16,274.54 are due at the end of each year.

Kathy made the first payment according to schedule.

 Question #1: How much income did the bank recognize for Year 1 under GAAP?

Answer: That’s easy, $10,000 (=$100,000 x 10%).

Further assume that immediately after the loan was made, the bank sold the rights to receive the ten future payments from Kathy to ten separate investors.

Question #2: Did the investor who purchased the Year 1 payment earn a return of: 10%; greater than 10%; or less than 10%? What about the investor in the Year 10 payment?

Answer: The return to the investor in the Year 1 payment would be less than 10%, because it is the least risky of all the investments. The expected return to the investor in the Year 10 payment should be greater than 10%, since the investor is taking on more risk than any other investor.

Does Current GAAP Distort the Earnings from Lending Activities?

You betcha.  Here are four points to consider about the difference between GAAP and the underlying economics.

First, the periodic amounts of income should be no different for the bank than for the ten investors in aggregate. But, under GAAP, it would be.   For example, the ten separate investors would report income of less than $10,000 in Year 1; but the bank will report income of $10,000 — as if each payment had the same discount rate.

Second, stripping away things like reserve requirements, deposit insurance, etc., the banking business is not fundamentally different from other businesses: the objective is to make a return on investment (ROI). If, instead of lending to Kathy, the bank in my example had invested in, say, the first X barrels of oil produced every year by Kathy’s oil well, the financial statements should be identical if the cash flows were identical.

Third, “interest” and ROI are almost always different. ROI is an economic objective, and interest is merely a term of art devised by bankers to facilitate lending transactions. Lenders and borrowers negotiate interest rates, and stipulate to their use in calculations in order to permit the parties to efficiently schedule payments, and as necessary to adjust future payments should a deviation from the schedule occur.   Put simply, interest rates and economic rates of return are not the same concepts.

Fourth, and most important, the simple example clearly illustrates that GAAP accounting for “interest” overstates income in the early years of a loan. This is not mere happenstance. Bankers thrive on these income statement distortions along with the manipulation of their loan loss “reserves” to keep compensation steady and high.

B41AjlizDVpL._SX329_BO1,204,203,200_ut even more insidious than the overstatement of income, premature recognition of ROI persistently overstates bank capital, which makes banks even more risky than their already thinly-capitalized balance sheets portray. I am in the midst of reading The Bankers’ New Clothes, in which professors Anat Admati (Stanford) and Martin Hellwig (Max Planck Institute) patiently and perspicuously explain that we are at risk of yet another financial meltdown because too-big-to-fail banks continue to be over-leveraged. There are many reasons for this, and you should read the book to learn them, but the fact that simplistic accounting would overstate bank capital adds insult to injury for this concerned accountant.

And, how is such simplistic accounting for loans by banks justified by policy makers? The latest excuse goes something like this: for loans that the bank’s management intends to hold to receive the “principal and interest,” current values are supposedly not relevant. But even my simple example shows the obtuseness of that reasoning. To measure income correctly, you have to measure loans at their current value; otherwise, the change in carrying amounts for the period will not produce anything approximating a faithful representation of economic income.

* * * * * * *

The objective of loan accounting under GAAP or IFRS is not to produce economic income. It is to produce the income — and measures of capital — that bankers wish to produce.


  1. Reply profundis August 4, 2015

    How do the offsetting effects of inflation play out in your analysis? It seems that paying back principle and interest over a ten year period – i.e., with less valuable currency in each successive year – would increase the effects of premature income recognition that you describe. On the other hand, borrower income generally increases along with inflation (as well as work experience), so that making the same payment each year does not necessarily mean that collection of a fixed amount becomes more doubtful every year.

  2. Reply Jordan August 6, 2015

    Interesting points here. It’s amazing what you can find when looking at things with a more critical eye. Thanks for sharing your insight!

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