Show-Me-the-Money, Inc. is a medium-sized bank. The bank’s stock is owned primarily by residents in the city where the bank operates. During the last decade, the bank lent money for numerous real estate developments. Most of the loans went to developers who constructed office space and expected to repay the loans from office rent. Aggressive lending and building practices resulted in overbuilding. A downturn in the local economy drastically reduced demand for office space. As a result, many of the buildings are now largely empty. Rent from the facilities is insufficient to pay interest on several of the bank’s larger loans. The bank has permitted several borrowers to restructure their loans, providing a longer period of repayment and lower interest rates. The market value of the property backing these loans has decreased approximately 40% since its construction. The bank’s proposed year-end balance sheet reports loans in the bank’s long-term investment portfolio at $43 million. This amount is net of a loan loss reserve of $5 million. The balance sheet also includes $18 million of property among the bank’s assets. This property was acquired through foreclosures on several loans. The property is valued at the present value of the original loan payments, including interest the bank expected from the original borrowers. The bank is collecting rent from tenants and expects to sell the property when real estate values return to higher levels. The bank’s total assets are $80 million, and total stockholders’ equity is $10 million. The bank’s proposed income statement for the year reports profits of $6 million. The year-end audit is now underway, and the bank’s auditors are reviewing the proposed financial statements. They have questioned management about its loans and property values. The auditors believe that the current market value of the loan portfolio is about $35 million. They are less sure about the value of the property. The bank’s managers are arguing that the current market value of the loans is not relevant because they do not expect to sell the loans. Instead, they expect to hold the loans until they mature. Also, they do not plan to sell the property until they can recover the amount the bank invested.
Required
Do you believe the investors and creditors of the bank will be well served by the financial statements that the bank’s management proposes to report? Explain. Do you see any ethical problems with the way the bank’s managers want to report its assets? Why? What problems may arise for the bank if it reports its loans at current market value?