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3.4 Testing for Areas of Interest to the SEC

Table 2 3.4 Testing for Areas of Interest to the SEC

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Although the model presented above identifies some key areas of interest to investors, in practice investors consider additional variables as well. One such additional variable is loan impairment. A loan is impaired when the present value of the loan is below its book value, and occurs when it is probable that loan payments will not be received.° When a loan is impaired, its value is written down to the present value of its expected cash flows or to its market value. Loan impairment lowers net income, which lowers equity cash flows and the continuing value, thereby lowering bank value. Other related variables of interest to investors are loan charge-offs and recoveries. There are additional variables of interest related to bank activities outside the basic model. For example, banks charge fees in addition to interest. Therefore, investors are likely to be interested in net fee income.’ Also, many banks grow by acquiring other banks, so merger and acquisition activity can be substantial and usually has a significant impact on valuation. Finally, banks often use off-balance sheet and special-purpose entities, which are also of interest to investors. Table 1 summarizes the variables of interest to bank investors.
Although the model presented above identifies some key areas of interest to investors, in practice investors consider additional variables as well. One such additional variable is loan impairment. A loan is impaired when the present value of the loan is below its book value, and occurs when it is probable that loan payments will not be received.° When a loan is impaired, its value is written down to the present value of its expected cash flows or to its market value. Loan impairment lowers net income, which lowers equity cash flows and the continuing value, thereby lowering bank value. Other related variables of interest to investors are loan charge-offs and recoveries. There are additional variables of interest related to bank activities outside the basic model. For example, banks charge fees in addition to interest. Therefore, investors are likely to be interested in net fee income.’ Also, many banks grow by acquiring other banks, so merger and acquisition activity can be substantial and usually has a significant impact on valuation. Finally, banks often use off-balance sheet and special-purpose entities, which are also of interest to investors. Table 1 summarizes the variables of interest to bank investors.
Figure 1. Areas of Interest to Investors and the SEC
Figure 1. Areas of Interest to Investors and the SEC
(1) Also includes the topics: loan impairments, charge-offs, recoveries, provision for loan losses, and net loans. (2) Special purpose and off-balance sheet entities. * Significantly different from zero at the 5% confidence level.
(1) Also includes the topics: loan impairments, charge-offs, recoveries, provision for loan losses, and net loans. (2) Special purpose and off-balance sheet entities. * Significantly different from zero at the 5% confidence level.
Areas 16 — 19 in figure 1 generated issues in comment letters, but are of questionable interest to investors. One of these areas (area 16) is derivative accounting. The reason that this area is not necessarily of great interest to investors is that the accounting standard on derivatives, SFAS 133, provides limited, misleading, or no information on the economic impact of derivatives — which is what investors are interested in. There are several reasons for this. First, SFAS 133 allows accounting for hedges only in limited cases. This is a considerable problem for a bank that hedges deposits.'' Second, SFAS 133 allows hedge accounting only for hedging certain risks. Therefore, derivatives used to hedge some economic risks are not accounted for under SFAS 133. Third, SFAS 133 does not account for hedges related to held-to-maturity securities. Consequently, a bank holding a portfolio of securities designated as held-to-maturity, will not apply hedge accounting to derivatives used to hedge these securities. Fourth, SFAS 133 allows hedges to be designated as Fair Value hedges or Cash Flow changes. Financial reporting will vary depending on the choice of designation by the bank, so this allows banks to impact financial statements through their choice of hedge designation. Fifth, disclosures required under SFAS 13: are often at such high-level of aggregation that they are not of much use in gauging their usefulness in hedging specific risks. To sum up, although investors are interested in derivatives, the current accounting treatment of derivatives raises substantial doubts on the value of
Areas 16 — 19 in figure 1 generated issues in comment letters, but are of questionable interest to investors. One of these areas (area 16) is derivative accounting. The reason that this area is not necessarily of great interest to investors is that the accounting standard on derivatives, SFAS 133, provides limited, misleading, or no information on the economic impact of derivatives — which is what investors are interested in. There are several reasons for this. First, SFAS 133 allows accounting for hedges only in limited cases. This is a considerable problem for a bank that hedges deposits.'' Second, SFAS 133 allows hedge accounting only for hedging certain risks. Therefore, derivatives used to hedge some economic risks are not accounted for under SFAS 133. Third, SFAS 133 does not account for hedges related to held-to-maturity securities. Consequently, a bank holding a portfolio of securities designated as held-to-maturity, will not apply hedge accounting to derivatives used to hedge these securities. Fourth, SFAS 133 allows hedges to be designated as Fair Value hedges or Cash Flow changes. Financial reporting will vary depending on the choice of designation by the bank, so this allows banks to impact financial statements through their choice of hedge designation. Fifth, disclosures required under SFAS 13: are often at such high-level of aggregation that they are not of much use in gauging their usefulness in hedging specific risks. To sum up, although investors are interested in derivatives, the current accounting treatment of derivatives raises substantial doubts on the value of
Table 4 shows differences between firms that generate issues in SEC letters and those that do not. There are three main differences between these firms. First, firms with issues are on average larger, are more likely to list their shares on the New York Stock Exchange (NYSE), and are also more likely to be audited by a Big Four firm. Big four firms are KPMG, Deloitte and Touche Tohmatsu, Price Waterhouse Coopers, and Ernst & Young. '© Some bond categories, such as muni-bonds, are often insured, so if an issuer is not able to pay interest or principal, the insurer will step in and make the payments to the investors. Recently, the financial condition of these insurance companies has deteriorated, and insurance payments are now unlikely. The values of these bonds have therefore fallen. Therefore, bank investors would have benefited from knowing what insurance companies provided coverage to bonds held in a bank’s portfolio.
Table 4 shows differences between firms that generate issues in SEC letters and those that do not. There are three main differences between these firms. First, firms with issues are on average larger, are more likely to list their shares on the New York Stock Exchange (NYSE), and are also more likely to be audited by a Big Four firm. Big four firms are KPMG, Deloitte and Touche Tohmatsu, Price Waterhouse Coopers, and Ernst & Young. '© Some bond categories, such as muni-bonds, are often insured, so if an issuer is not able to pay interest or principal, the insurer will step in and make the payments to the investors. Recently, the financial condition of these insurance companies has deteriorated, and insurance payments are now unlikely. The values of these bonds have therefore fallen. Therefore, bank investors would have benefited from knowing what insurance companies provided coverage to bonds held in a bank’s portfolio.
trade in exchanges are less likely to generate issues with the SEC."' ISSUE is a dummy variable equal to one if a company had one or more issues in comment letters and zero otherwise. The independent variables are dummies for the auditor, the exchange in which shares of the firm trade and the amount of assets held by the firm. The equation is estimated using Maximum Likelihood, and the results are in table 5. The LR-statistic tests the joint null hypothesis that all slope coefficients except the constant are zero, and the Probability (LR) is the p-value of the LR test under this null hypothesis. Since the Probability (LR) is 0.006, we can reject the null at the 1% confidence level. In addition, the results show that two coefficients are significantly different from zero. The first one is coefficient B, =1.92 , which indicates that banks audited by PWC are more likely to have issues during the SEC review. The second one is B, = —6.89 which indicates, unsurprisingly, that firms that have shares that do not trade in exchanges are less likely to generate issues with the SEC.'’
trade in exchanges are less likely to generate issues with the SEC."' ISSUE is a dummy variable equal to one if a company had one or more issues in comment letters and zero otherwise. The independent variables are dummies for the auditor, the exchange in which shares of the firm trade and the amount of assets held by the firm. The equation is estimated using Maximum Likelihood, and the results are in table 5. The LR-statistic tests the joint null hypothesis that all slope coefficients except the constant are zero, and the Probability (LR) is the p-value of the LR test under this null hypothesis. Since the Probability (LR) is 0.006, we can reject the null at the 1% confidence level. In addition, the results show that two coefficients are significantly different from zero. The first one is coefficient B, =1.92 , which indicates that banks audited by PWC are more likely to have issues during the SEC review. The second one is B, = —6.89 which indicates, unsurprisingly, that firms that have shares that do not trade in exchanges are less likely to generate issues with the SEC.'’
6. CONCLUSION review. First, firm size matters as larger firms have more issues. Second, firms with shares liste in the NYSE also generate a larger number of issues. Third, filers that use PWC as their audito also show a larger number of issues.
6. CONCLUSION review. First, firm size matters as larger firms have more issues. Second, firms with shares liste in the NYSE also generate a larger number of issues. Third, filers that use PWC as their audito also show a larger number of issues.
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