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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

 
 
Author: Jack Ciesielski Created: 10/13/2006 2:54 PM
The AAO Weblog is a weblog published by Jack Ciesielski , dealing with accounting issues and news topics related to investment and finance.

If I haven't mentioned it lately, I'll say it again: Statement 157 is nothing new under the sun. While those who would like to blame accounting for their mistakes (and that's what it does: the accounting shows their mistakes) continue to bleat about the unfairness of fair value reporting, the fact remains that Statement 157 had nothing to do with changing the measurement of fair values. It changed the disclosures: now we can look at reported values and know how much they were the results of quoted markets or black magic. It was always that way - it's just that until Statement 157, we never had a good idea of the prevalence of black magic in financial reporting. With all the misguided bashing of Statement 157 going on , it's hard to remember that it hasn't even become effective yet . Not until this quarter. Last Friday, the SEC put in its two cents. The Division of Corporation Finance released a letter it had sent earlier in the month to unspecified financial institutions regarding their pending application of Statement 157. The letter is not an amendment of Statement 157; it's an amplification of Statement 157. The FASB cannot tell companies what to include in the "Management's Discussion & Analysis" section of SEC filings: that's the SEC's turf. Therefore, Statement 157 didn't include any mention of what kinds of disclosures to make in the MD&A. That will be particularly of interest to investors when firms have to use "unobservable inputs" (Level 3) to estimate the fair values of assets. This letter fills that guidance void: "If you conclude that your use of unobservable inputs is material, please disclose in your MD&A, in a manner most useful to your particular facts and circumstances, how you determined them and how the resulting fair value of your assets and liabilities and possible changes to those values, impacted or could impact your results of operations, liquidity, and capital resources. Depending on your circumstances, the following disclosure and discussion points may be relevant as you prepare your MD&A:     • The amount of assets and liabilities you measured using significant unobservable inputs (Level 3 assets and liabilities) as a percentage of the total assets and liabilities you measured at fair value.     • The amount and reason for any material increase or decrease in Level 3 assets and liabilities resulting from your transfer of assets and liabilities from, or into, Level 1 or Level 2.     • If you transferred a material amount of assets or liabilities into Level 3 during the period, a discussion of:           - the significant inputs that you no longer consider to be observable; and           - any material gain or loss you recognized on those assets or liabilities during the period, and, to the extent you exclude that amount from the realized/unrealized gains (losses) line item in the Level 3 reconciliation, the amount you excluded.     • With regard to Level 3 assets or liabilities, a discussion of, to the extent material:           - whether realized and unrealized gains (losses) affected your results of operations, liquidity or capital resources during the period, and if so, how;           - the reason for any material decline or increase in the fair values; and           - whether you believe the fair values diverge materially from the amounts you currently anticipate realizing on settlement or maturity. If so, disclose why and provide the basis for your views.     • The nature and type of assets underlying any asset-backed securities, for example, the types of loans (sub-prime, Alt-A, or home equity lines of credit) and the years of issuance as well as information about the credit ratings of the securities, including changes or potential changes to those ratings." Over at "Notions on High and Low Finance", Floyd Norris worries that a sentence in the letter provides the magic weasel words for companies to avoid writing down damaged goods to an estimated fair value:

"“Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability.”

That sounds to me like an invitation to fudge. Some people on Wall Street think that nearly every sale today is a forced sale..." Worth worrying about, but I don't think that's what the SEC meant in the letter. And if anyone tries to use that as an excuse to avoid Level 3 estimation, they should be immediately dispatched to the lowest circle of fair value hell. And anyone who tries to such an excuse in these words will find that hell: they'll be compared to those who don't take the low road. There's only one default position in Statement 157: fair value, whether it's easy or hard to derive. Maybe the SEC needs to clarify that statement.

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So much has been written on the passing of Bear Stearns and its merger with JP Morgan Chase , it's almost impossible to add much worthwhile to the discussion. I would say, however, that the most cogent analysis of the deal-making by the Fed - including the blatant shafting of shareholders - was provided by Andrew Ross Sorkin in his post on the NY Times DealBook blog . And there's a wave of electrons and ink coming your way on the findings of the bankruptcy administrator in the case of New Century Financial, whose 581-page report sent reporters riffling through its pages yesterday. (No, I haven't read it yet. Maybe I'll settle for the executive summary.) There's another story that contains elements of both stories, in a way. Yesterday, the SEC issued a cease-and-desist order to JP Morgan Chase for its negligence in the case of National Century Financial Enterprises, an issuer of asset-backed securities for which JPM had acted as trustee - a role it inherited when it acquired Bank One, which initially had been trustee for the now-failed health care finance outfit. According to the administrative proceedings, during the period of 1999-2002, National Century Financial - whose name is creepily similary to New Century Financial - "offered and sold nearly $3.5 billion in asset-backed notes to qualified institutional buyers. NCFE and the programs collapsed in November 2002 when investors and others discovered that NCFE had made large improper transfers among program accounts and caused collateral shortfalls. The collapse caused investor losses of approximately $2.6 billion." Seems like so long ago now - and so many other asset-backed foibles, it's hard to distinguish them from each other. This one might be memorable for another unsavory reason: the ex-CEO of the firm has been convicted of witness tampering in the fraud trial. How did the fraud take place? In short, NCFE was kiting cash in the reserve accounts of the asset-backed notes: "A principal feature of the scheme that allowed NCFE to hide investor losses was the transfer of huge amounts of Reserve Account funds on or around the first and last business day of every month (“Month-End Transfers”). The indentures required that the programs maintain Specified Balances in the Reserve Accounts totaling approximately 17% of the value of the outstanding notes issued by the program. However, even though the indenture trustees for the NCFE programs had the ability to look at the balances in the Reserve Accounts at any time, the indentures only required the programs to report on the balances in Reserve Accounts as of one day of the month, called the “Monthly Payment Date.” The largest program for which JPMorgan Chase served as asset-backed indenture trustee was reported on by NCFE and tested by JPMorgan Chase as of the last business day of the month. The largest program for which Bank One served as asset-backed indenture trustee was reported on by NCFE and tested by Bank One as of the first business day of the month. As a result of this structure, NCFE was able to kite large amounts of funds back and forth between the programs to make it appear that the programs were maintaining the Specified Balances. In fact, NCFE was consistently and severely depleting the balances in these Reserve Accounts without telling investors." Neither Bank One nor, later, JP Morgan Chase caught on - and that was their undoing: "The Month-End Transfers were large, recurring, and contrary to the requirements of the indentures. In participating in the Month-End Transfers that were contrary to the requirements of the indentures, Bank One and JPMorgan Chase were negligent and should have known that NCFE was misusing the Month-End Transfers." Let's hope that JP Morgan Chase is a bit more attentive to the sensitive details of the far more complicated acquisition of Bear Stearns - and whatever trustee role it will be assuming in connection with Bear's asset-backed obligations. This story should further convince investors that where there's securitized assets, there's bound to be some stink somewhere. And it should also convince investors to run away from investments containing the words "Century" and "Financial" in the name of the issuer. The bard Donald Fagen almost had it right in his "Bright Lights, Big City" soundtrack tune "Century's End": Not "dumb love in the City, at century's end." More like "big hurt in the market, when 'Centuries' end."

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Last week the FASB issued Statement 161, "Disclosures about Derivative Instruments and Hedging Activities." It requires firms to put in their financial statements what should have been in them from the start of Statement 133, back in 2000. Perhaps most notably, it requires this most basic of disclosures:

"An entity with derivative instruments shall disclose information to enable users of the financial statements to understand:
     a. How and why an entity uses derivative instruments
     b. How derivative instruments and related hedged items are accounted for under this Statement and related    interpretations
     c. How derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows."

Simple, eh? If an annual report was really supposed to be an exercise in communicating with shareholders, this would be a natural place to begin. Any illumination on those fundamental issues would help investors - provided they don't wind up being boilerplate. But - an annual report (or an interim report, at that) is not an exercise in communication with the firm's owners. It's an exercise in compliance. It's a shame that it requires a FASB statement to get the most basic communications on derivatives done right.

Of course, it doesn't stop there. The standard also requires much more tabular disclosure about fair values of derivatives positions and the geography of derivative instruments, and gains and losses therefrom, within the financial statement package. For anyone who's ever tried to pick this stuff out of financials, the standard will be a blessing - if proper "compliance" occurs.

We'll have to wait a while to see how effective it is. The standard won't go into effect until years and interim periods beginning after November 15, 2008. While earlier adoption is encouraged, it's not often that firms are fans of increasing their disclosures on most financial instruments. Don't hold your breath waiting for early adopters to pop up in 2008, especially in times of stress in financial markets.




Well, this will be on everyone's mind today. Remember - it shows closing prices through last Friday, when the stock was $30:

  
No doubt, there will be catcalls about mark-to-market accounting because of this. Many critics will say the balance sheet smelled because Bear Stearns held $46 billion of mortgage investments as of the end of November (maybe the last balance sheet we'll ever see for the storied company.) Of those $46 billion of investments, $29 billion were valued using Level 2 inputs and the remaining $17 billion were valued using Level 3 techniques. And with just wild estimates of fair value on their balance sheet, nobody knew what Bear was really hiding and nobody had faith in their balance sheet, and who would dare lend to them without Uncle Sam stepping in, and so on.

One of my early mentors in accounting liked to warn me that "with some folks, a little knowledge is a dangerous thing. And they often prove it." He's so right in this instance. Observers who have learned the fair value hierarchy three-step act as if carrying securities at fair values - even if you have to guess at what they're worth - is something new. It isn't - what's new is that firms now have to tell you how much of the values are mere guesses, and the degree to which they're guessing. Statement 157 didn't require broad new classes of instruments to be reported at fair value - it just required more information about the ones that have been handled that way. For years.

In fact the last accounting standard requiring fair value treatment to be applied to a broad class of financial instruments was Statement 133, "Accounting for Derivative Instruments and Hedging Activities" - way back in 2000. That one didn't seem to touch off any financial meltdowns. Yet  ignorant observers of Statement 157 - which doesn't extend fair value reporting - are blaming it for everything except global warming. A little knowledge really is a dangerous thing.

 I finished up my fifth year on the FASB's Emerging Issues Task Force on TWednesday. My, how time flies.

I've retired, and my financial statement user seat at the table will be more than ably filled by Mark Lamonte, of Moody's. (And a fellow ITAC member, I might add.)

So - a couple thoughts on my time at the EITF. I've said it before: if accounting is considered a branch of microeconomics, then the EITF debates the nano-economics of accounting issues. And I'll reduce all my EITF observations to one analogy: the television program "Lost."

No, that's not a sarcastic or ironic swipe at the EITF. Bear with me, please.

Loyal fans of the show, of which I count myself, look for clues and threads about the show's eventual conclusion in every episode. (Why, if I didn't watch that one hour of TV per week, I'd have a 50% greater output on this blog. That's sort of like the counting of small firms saying that SOX 404 compliance costs would drive them into bankruptcy.)

Back to the "Lost" analogy. I remember reading an interview with the show's creators, where the interviewer was pumping them for any clues or significance attached to a bracelet. The item belonged to an important character that may been connected to another character appearing in one of the show's signature "flash-forward" sequences - the connection being provided by the bracelet. One of the creators threw cold water on that possible connection, saying that "sometimes a bracelet is just a bracelet."

And that is a bit like what I've encountered in my time on the EITF. The EITF spends an incredible amount of time on financial instrument issues. You have a lot of high-powered people puzzling over tiny accounting bracelets, often trying to find a way to see something in a particular financial instrument: is a portion of this promise to pay really equity? Or is it all equity? Or none of it? After puzzling over these issues in the last five years, I believe that sometimes, a liability is just a liability. (Thank you, Damon Lindelof.) 

It'll be interesting to see what happens to the EITF agenda if the FASB and the IASB complete the liabilities and equity project. It might wipe out their agenda; on the other hand, it might sweep in a whole new class of questions accounting for financial instruments. More "Lost" ponderings about the connections to the EITF agenda, if I don't stop here. Have a great weekend!

Required reading for all students of investing: Warren Buffett's annual letter to shareholders. The 2007 version is as witty and entertaining as always. And Mr. Buffett often puts in his two cents on an accounting issue, too - ensuring that investors will take note of it in the year to come. This year's accounting topic: pension assumptions, an issue we've monitored for years at The Analyst's Accounting Observer. Buffett's complaint is that the long-term pension plan earnings rate assumption that corporations use in calculating their expected earnings on pension assets is too optimistic: according to him, in 2006 the relevant S&P 500 companies averaged 8%. Our own work (Volume 16, Nos. 9 & 10, S&P 500 Benefit Plans: Will Pension Panic Resurface?) showed the median return for those companies to be even higher at 8.25% - way down from where it was just five years before at 9.0% and still with some outlandish outliers, but down nevertheless. As Mr. Buffett points out, though, the returns on the different asset classes in the plans don't make sense:      "... The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.     This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.     How  realistic is this expectation?  Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually.  An investor who owned the Dow throughout the century would also have received generous dividends  for much of the period, but only about 2% or so in the final years. It was a  wonderful century." As usual, the man makes sense - including his larger point about the reason for the bias in the assumptions: "What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them report higher earnings.  And if they are wrong, as I believe they are, the chickens won’t come home to roost until long after they retire." Does anyone know what the right rate should be? Well, no - you can argue, as Mr. Buffett does convincingly, that rates are too high. But anyone who really KNOWS the real rate to come over the long term would be, more or less, a supernatural being. I don't know any in Corporate America or Wall Street. (Though I've met a number of pretenders.) Figuring the "right rate" is not the real problem. The real problem is that there shouldn't be any expected rate of return for managers to justify in the first place. The accounting methods in place were developed back in the mid-1980's; while an improvement over the (lack of) accounting for pensions at the time, the benefit reporting standard (SFAS 87) was built with many complicated accounting devices in place to keep pension costs smooth. (We've detailed them over the years; check your back issues.) One of those permitted devices: an implicit assumption that the long-term earnings of the benefit plan would average out to some specific rate and letting managers build those assumed earnings into their net benefit cost - a "rebate," if you will, that allowed managers to report lower pension costs. It also allowed them to manipulate that rate to come up with a net benefit cost that they liked. That "expected earnings" never produced cash for shareholders. In fact, the real returns belong to the pensioners, not the shareholders. Pension contributions are pretty much a one-way street: the company making them can't pull them back unilaterally, at will. (There are instances when they can get back some overfunded balances, but it's not simple or easy. Or common.) If the real returns belong to the pension players, why should even the real returns be reported in the income statement as measure of corporate performance? The expected returns were built into the accounting because the real returns would be quite volatile, something that companies couldn't stomach in the '80's (and wouldn't likely want to stomach in this century either.) The real returns really do matter to the corporate sponsor, because they'll be on the hook for contributions if the plan assets fail to fund the promises made - so they belong in the investor reporting package. They just don't belong in the income statement - where the efforts of portfolio managers get mixed in with the operating performance of the company's managers. Instead of cluttering the income statement with the "expected returns" of asset managers for assets that the firm doesn't necessarily control, the REAL performance of the plans might be better reported in accumulated other income - or some other format than what investors receive right now. The FASB is entering Phase 2 of its benefit reporting plan revamp; with the IASB, it's also tackling the revision of the whole financial reporting package. The "expected return" component of benefit costs might be gone as a result of these projects. Good riddance, I'd say. How about you? I'm curious to know what you think and I've arranged a quick 3-question survey at this link, courtesy of SurveyMonkey ...

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Yesterday, Compliance Week ran an article by Tammy Whitehouse based on an interview with retired Public Company Accounting Oversight Board member Kayla Gillan. (You can access the whole article at Compliance Week for free with a quick registration.) The SEC's recent internationalization tear has left many observers concerned about the SEC's priorities; see for instance, Tom Selling's piece today in his Accounting Onion. Last year, the SEC was all over the rewrite of Auditing Standard 2, because of the uproar over the internal control provisions. It might be interesting to hear what someone close to the process had to say about that particular sausage-making:

“Some people at the SEC wanted the auditors to really only look at the process that companies go through to assess [internal controls] and not actually look at the controls themselves,” she said. “That would have been in my mind not only a much narrower scope of review but potentially even a misleading opinion to investors. At one point they wanted auditors to only look at the denied controls and not whether or not they were actually operating effectively. At one point they wanted to really significantly reduce the amount of information the auditors were required to give to the audit committee on controls that were less than material weaknesses.”

In any of those three paths - look only at internal control process, look only at certain controls, or reduce information to the audit committee - you have to wonder: how does an idea like that improve confidence of the audit committee or investors that the financial statements have been pulled together properly?

The SEC was heavily involved with the development of Auditing Standard 5, the replacement for AS2. In the end, the PCAOB prevailed; while it's more flexible than AS2, the new standard keeps in place much of the original's workings. What's interesting in the interview is the amount of SEC "proactiveness" in the process; it sounds almost as if the PCAOB was at risk of being run over by the Commission. Makes you wonder about the SEC's current internationalization efforts and therelationship between the SEC and the FASB.

On Friday, the SEC released its "Financial Explorer" to the public. It's an interface tool that will let investors manipulate XBRL-published financial statements so they can produce charts quickly. You can access the Financial Explorer tool directly at this link.

I spent a little time with it; interesting displays, fairly quick response time. (For what it does, which is still pretty limited.) Is it going to be extremely useful? Not in its current state, which I recognize is simply "early." It's more than a toy, but way less than a tool. The visualizations of the data are nice, but there has to be more meat to it. The site explains that the Explorer tool is designed for the retail investor (aka John Q. Public). But does that mean all that retail investors want is quick pictures of some data, and some visual representations of changes in metrics? If that's all that the system is going to serve up, there might be a whole generation of "retail" investors that never learns about the good stuff in the footnotes or the MD&A.

The site indicates that more data is on its way to presentation, and in theory, there should be all kinds of XBRL readers available in the after-market that will make data manipulation more custom-tailored. The present state of the art does make one consider, however: what role will the Management's Discussion & Analysis play in the XBRL world? That disclosure is one of the most investor-beneficial requirements that the SEC has ever instituted - and it doesn't seem to lend itself well to "data-tagging" and table-structuring. Let's hope the SEC focuses some its imagination on the MD&A as hurtles itself into the XBRL future. Context counts as well as numbers, and that's long been what the MD&A provides investors. How does one tag that?

In the wake of the surprise laid on the market by AIG on Monday, there’s one casualty: Statement 157. And it was just an innocent bystander.

Plenty of commentary has been spewed on the unfairness of fair value reporting, with blame for perceived inequities being laid on Statement 157. Some pundits are saying that this is an example of what's wrong with statement 157 - that it's forcing companies to come up with ridiculous values that are disconnected from long-term reality. Some express concern that trying to report illiquid assets at their fair value is too subjective and arbitrary. Some argue for keeping illiquid securities reported at their cost on the balance sheet.

Back up. First of all: AIG has not adopted Statement 157 yet. Period. Those estimates of losses aren't due to some forced, new fair value reporting; they're the result of good ol' impairment recognition.

It's a basic tenet of financial reporting: when an asset isn't worth what it cost, it's written down to what it's worth. Illiquid assets like factories and buildings, when they're not being used productively, are not carried at their historical cost: their carrying value is written down to an estimate of what they're worth. Would investors prefer that they remain stated at full cost on balance sheets, even if they producing any results for shareholders? Of course not. But there isn't always a market for them - so, by the logic of those who carp about valuing illiquid securities being "fair valued," those losses should be held in suspended animation until there's a sale of the assets. In a "real" market.

Statement 157 aside: what makes valuation issues like this one unsettling is that investors know that it's a "black box" being used to value things that aren't bathed in sunlight. Who knows how a "super senior credit default swap" should be valued? How can investors be comfortable with reported values when there's "model-switching" is going on? (AIGFP's initial model didn't include the value of "structural mitigants" or the benefit of a "spread differential;" Model 2.0 included them in November; the December values won't include the benefit of the spread differential, which helped to the tune of $3.6 billion. And AIG promises to continue to develop valuation methodologies for the year end figures, so there could be yet another version of their Binomial Expansion Technique black box arriving in time for the year end figures. Not a confidence builder for investors.)

Nevertheless - would investors be better served if managers didn't have to step up and disclose values - and how they got there? Are investors better served by "trust me" statements? I don't think so. Estimates of writedowns due to impairments have always been around. Statement 157 doesn't force anyone to use a "black box" to value anything that they haven't had to value or assess for impairments before. What Statement 157 really does is provide a framework for understanding how much investors have to stomach when it comes to black-box valuations. That fair value hierarchy (Levels 1, 2 and 3, often labeled by critics in full snark as "the three levels of hell") paints a picture of the reliability of the reported fair values. It does not expand the use of Level 3 disclosures - they've been around forever. Investors just didn't know it. How does knowing where the valuation risks exist become a bad thing for investors?

It's funny: fair value reporting under Statement 157 is getting criticized widely while asset values are being written down. Wouldn't the risks be greater if asset values were being revised upwards?

As the world trudges - make that "sprints" - towards a system of international financial reporting, one becomes curious as to how all that international standard setting is going to be financed.

Here in the United States, the FASB had long funded itself by passing around the hat: it relied on contributions from corporations, auditing firms and to a much lesser degree, investors. That funding strategy didn't do much for the appearance of FASB's independence from its constituents. With the Sarbanes-Oxley Act, the FASB's funding came straight from the SEC, eliminating its dependence on well-heeled constituents. As long as the SEC acts in the interests of investors - the intended beneficiaries of financial reporting, by the way - investors would have to feel more comfortable with the SOX set-up than the previous funding mechanism. 

The IASB, torch-bearer for the international reporting movement, still has a funding model that looks a lot like what the FASB had in place, pre-SOX. Last Monday, the IASB released an update on its funding plan for 2008.

The IASB considers its funding plan to be "broad-based, compelling, open-ended and country-specific"; it needs £16 million for 2008 and it believes it has £12.5 million secured. The funding comes from 19 different countries, based on the proportions of a country's GDP to the whole pot. That funding from each individual country is not necessarily coming from investors: it's expected to come from voluntary contributions by preparer companies within the countries, and sometimes from a country's stock exchanges or  accounting standard-setter.

The US is expected to contribute a little over £2 million from 32 companies. They must be expecting to be using IFRS soon; seems a little strange to see contributions from US companies when they can't report under that system yet. At the same time, many multinationals domiciled here have to use IFRS in their foreign subsidiaries, so it's not entirely strange.

Nowhere in the plan is there an indication of funding from investor groups. Perhaps the most interesting thing is that there is also funding from the US Fed of £200,000 - and a lot from the Big 4 international accounting firms. Combined with next-tier accounting firms, they'll contribute about £4.3 million in 2008 - about 27% of the expected budget, and 34% of the funds raised to date. It sure looks like the old FASB model of funding - and a sure-fire recipe for agitation by countries whose constituents might not like standards the IASB develops. And if you think the IASB standards are "principles-based" right now, with this much auditor involvement in IASB operations, there's the opportunity for international standards to become more minutiae-oriented down the road when auditing firms would like to have something in black-and-white for dealing with stubborn clients. Hopefully, the IASB has longer-range plans for funding independence.