Question

State Bank has the following year-end balance sheet (in millions):

Assets		Liabilities and equity
Cash	$   10	Deposits	$   90
Loans	$   90	Equity	$   10
Total assets	$ 100	Total liabilities and equity	$ 100

The loans primarily are fixed-rate, medium-term loans, while the deposits are either short-term or variable-rate deposits. Rising interest rates have caused the failure of a key industrial company, and as a result, 3 percent of the loans are considered uncollectable and thus have no economic value. One-third of these uncollectable loans will be charged off.

Required:

1. What is the impact on the balance sheet after the necessary adjustments are made according to market value accounting?
2. Explain the main arguments against market value accounting
3. Explain the main argument that supports the use of market value accounting
4. What is the difference between the economic definition of capital and the book value definition of capital?

Answer 1

Solution:-

i)Impact of charging off in Balance sheet of Banks

When Banks lending money to their customers ,they expect profit on such advance by way of interst from the loan issued.When a borrower fails to repay the loan amount ,the issueing banks will loss money.A series of Charge off can negatively impact the bank's Bottom Line.When a bank reaches the point where it has given up on collecting what it's owed,it can declare a loss and writte off the uncollectable as an expense in the income statement of banks.

When a loan were charge off by a bank,it removes that loans from the balance sheet.in the above case state bank has charge off 3% of loan paid ,ie $2.7 milloin($90*3%) .The same shall be shown in the income statement of bank and the amount charged off shall be deducted from the loan amount.

ii)Argument Against Market Value Accounting

    -Difficult to implement,Especially for liquid assets of assets not traded,estimated market value accounting could carry errors.

-Introduces Unneccessary variability in to Financial instritutions Earnings,Especially,1.Market Price does not reflect fundamental Value.2.Financial institutions intend to hold assets to maturity

-Financial institions are Less willing to take longer term asset exposures due to thire high sensitivity to changes in the interest rate and credit.

iii)Main Agruments supports Market Value Accounting

Market value accounting lists assets and liabilities for thier actual value.Financial statement reflects correct picture of the companies health.This allows investors to take better decitionregarding their investment decition with the company.

iv)Difference Economic Definition of capital and Book Definition of capital

Economic capital is the estimated amount of money that needed to cover possible losses from unexpected risk.A firms Economic capital number can also be seen as a measure of solvency.Book Definition of capital means anything can be a form of financial capital as long as it has a monetary value and is used in the persuit of future revenue.