Difference between Book Value Accounting and Market Value Accounting

Difference between Book Value Accounting and Market Value Accounting

Book value accounting refers to the practice of valuing assets and liabilities on a company’s financial statements based on their historical cost or the amount recorded when they were initially acquired. This method does not consider changes in market conditions or the current value of similar assets or liabilities.

On the other hand, market value accounting, also known as fair value accounting, involves valuing assets and liabilities based on their current market prices or estimated market values. This method takes into account market fluctuations and reflects the potential gains or losses that would be realized if the assets or liabilities were sold in the current market.

Effect of Interest Rate Changes on Bank Assets and Liabilities under the Two Methods

Under book value accounting, the value of bank assets and liabilities remains relatively stable even if interest rates change. This is because book values are based on historical costs and are not affected by market conditions. However, changes in interest rates can still impact a bank’s profitability through changes in interest income and expenses.

In contrast, under market value accounting, interest rate changes directly affect the value of bank assets and liabilities. When interest rates rise, the market value of fixed-rate assets, such as loans or bonds, decreases because their future cash flows are discounted at higher rates. Similarly, the market value of fixed-rate liabilities, such as deposits or bonds issued by the bank, increases as their future cash flows are discounted at higher rates. Conversely, when interest rates fall, the market value of fixed-rate assets increases, while the market value of fixed-rate liabilities decreases.

Marking to Market

Marking to market is a process used in market value accounting where financial instruments or assets are valued based on their current market prices. This process involves regularly updating the values of assets and liabilities to reflect changes in market conditions. By marking to market, companies can provide more accurate information about the current value of their assets and liabilities.

Two Different General Interpretations of Duration and Technical Definition

Macaulay Duration: Macaulay duration measures the weighted average time it takes for an investor to receive the present value of expected cash flows from a financial instrument. It considers both the timing and magnitude of cash flows and is expressed in years.

Modified Duration: Modified duration is a modified version of Macaulay duration that incorporates the sensitivity of a financial instrument’s price or value to changes in interest rates. It helps estimate the percentage change in price or value for a given change in interest rates.

Difference between Duration and Maturity

Duration and maturity are related but distinct concepts:

Duration: Duration measures the sensitivity of a financial instrument’s price or value to changes in interest rates. It considers both the timing and magnitude of cash flows and provides an estimate of the weighted average time it takes to recoup the investment’s present value through its cash flows. Duration helps investors assess interest rate risk.

Maturity: Maturity refers to the time remaining until a financial instrument’s principal or face value is due to be repaid. It represents the term or lifespan of the instrument. Maturity is typically fixed and does not consider changes in interest rates.

Loan Cash Flows and Present Value Calculations

a. At the end of six months:

Cash flow: Payment of accrued interest ($100,000 * 12% * 6/12)
Cash flow amount: $6,000

At the end of the year:

Cash flow: Payment of one-half principal ($100,000 * 0.5) + payment of accrued interest ($100,000 * 12%)
Cash flow amount: $50,000 + $12,000 = $62,000

b. Present value calculations:

Present value of cash flow at six months: $6,000 / (1 + 12%/2)^(6/12)
Present value of cash flow at year-end: $62,000 / (1 + 12%)^1

c. Proportion of total present value:

Proportion at six months: Present value of cash flow at six months / Total present value
Proportion at year-end: Present value of cash flow at year-end / Total present value

d. Duration calculation:

Duration = [(Present value at six months * 0.5) + (Present value at year-end * 1)] / Total present value

To obtain precise numerical answers for parts b, c, and d, you would need to calculate the present values and perform the necessary calculations using specific interest rate figures provided for discounting purposes.