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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.

A heads-up: I've written a piece in the Financial Times on standard-setter convergence - and why it's not the good idea that it once was.

It's a subscription-only publication (sorry).

I proposed that the IASB and FASB continue on a path of friendly competition for an indefinite period of time, rather than rushing into a politically-forced pseudo-convergence that resembles a takeover more than a merger. One point I didn't get to make because of space limitations: the US moves made in preparation for convergence should be reversed if the convergence movement is halted or at least postponed. Specifically, the FASB should revert to its seven-person constitution, as it was before convergence appeared imminent. There was never a convincing reason given for the five-person configuration, though it would have certainly been easier to merge fewer people onto the IASB.

I have no particular insight as to where the SEC is going on its convergence roadmap. One must presume that this has moved to the back burner as the events of October, the cruelest month, unfolded. (I don't care what T.S. Eliot said about April. He's wrong.) It would be hard to believe they could resume their magical thinking about convergence without considering the effects on independent standard setting - and what it could mean for US investors. Remember: the SEC is charged with serving and protecting US investors - not stock exchanges or consulting firms who would benefit from accounting standard changeovers. Financial institutions aren't the only ones who need to sober up after the October surprise. 

Last Thursday, SEC Chairman Christopher Cox took his turn on the hot seat before the Committee on Oversight and Government Reform United States House of Representatives. His testimony offered some interesting hints about where the SEC might be going - though they're a bit conflicted.

Cox argued that the SEC's strengths - a mandate for investor protection, rather than a supervisory role for institutions - made it the right regulator for the times. As he said, "if the SEC did not exist, Congress would have to create it." And he defended the SEC's turf against encroachment by others:

"Some have tried to use the current credit crisis as an argument for replacing the SEC in a new system that relies more on supervision than on regulation and enforcement. That same recommendation was made before the credit crisis a year ago for a very different, and inconsistent, reason: that the U.S. was at risk of losing business to less-regulated markets. But what happened in the mortgage meltdown and the ensuing credit crisis demonstrates that where SEC regulation is strong and backed by statute, it is effective — and that where it relies on voluntary compliance or simply has no jurisdiction at all, it is not."

That's a bit startling, in that the SEC has been vigorously pushing for a switch to international financial reporting standards. "Losing business to less-regulated markets" hasn't been cited by the SEC as a reason for the switch, but it's certainly been a concern of the exchanges for years. Now it seems the SEC wants to assert itself as the premier independent regulator. Not a bad idea.

One wonders if the SEC is having second thoughts about the idea of tossing GAAP aside. Nowhere in the testimony did Mr. Cox mention the IASB or international financial reporting standards, and the SEC has been dead silent on their proposed roadmap since the end of August.

Take a Chevy Tahoe, add bling, call it a Cadillac Escalade - and GM improves its survival odds if it sells more Escalades than Tahoes.

It's a trick we've all seen for years: take your basic model, extend it a bit here and there, make options standard and presto! You've got a more exciting version of the same thing that you can sell for a better price. It's not always a winning strategy: Chrysler had an amusing turn with its "Plodges." And for crying out loud, Taco Bell has been using it for years. A Chalupa is a Gordita is a Crunchwrap.

Which is the point: you can put a different wrapper around the same product, but underneath, a Caddy Escalade is a Chevy Tahoe. You can put a Dodge front end on a Plymouth, but a "Plodge" was still a Plymouth and nothing more. And the stuff inside a Chalupa, Gordita or Crunchwrap is indistinguishable from one iteration to the other. (Or just plain indistinguishable.) It's the wrapper that provides the delivery system for what's inside.

Which brings us to the Treasury Department's "Troubled Asset Relief Program." As the Treasury prepares to inject a $250 billion vitamin shot into 10 large banks, investors should ask themselves about how such an investment will appear on the balance sheets of the investees.

Take a look at the term sheet for the injection. The government plans to buy preferred stock, now in vogue. It'll carry a 5% dividend, rising to 9% after five years; it can't be redeemed for at least 3 years; restricts dividends on junior preferred stock or common stock; has no voting rights; and restricts executive compensation to be in accordance with the Emergency Economic Stability Act's requirements.

One other thing: it has a "perpetual life," apparently because the term sheet says so. Realistically, the Treasury is not going to be a longer-term player in these preferreds any longer than it has to be - and there are no restrictions on the transferability of its investment.

Sounds a lot like debt? That's because it is. This is the Treasury's version of a "Plodge" - it's debt with an equity skin around it. Under that equity wrapper, it's still debt. For regulatory purposes, it's considered Tier 1 capital. That's just fine - if the regulators want to consider it to be part of the lending capital base, that's their playground. They can change those capital requirements as they see fit - it's part of the joy of being the regulator.

When it comes to financial reporting to public investors, it would be more realistic to see it classified as a liability. Think of it: how much risk is there to Treasury compared to common equity holders? None - the Treasury is playing the role of a lender, with all the protections a lender requires.

Render unto Caesar what is Caesar's. And report to shareholders what is the shareholders'. The FASB has had a liabilities and equity project simmering for years, and the most recent conclusion they reached was that the only thing that should be considered equity is - common equity. Tomorrow they will be discussing the project once more, and probably will twist themselves into knots trying to come up with some kind of rationale for stuffing this preferred issue into the equity category. Let's hope they stick to Plan A - but don't get your hopes too high.

A note on IFRS/GAAP convergence, a subject that's been somewhat in the background these days. In the wake of the credit/liquidity turmoil, the IASB is seeking to overturn a difference in the two sets of standards: today it is considering the adoption of an exception in US GAAP that allows for the reclassification of trading securities into held to maturity. There's no such exception in international financial reporting standards.

Wait - there's more. the trustees of the IASC Foundation, the IASB's oversight board, is willing to overlook the normal due process of gathering comment and open discussion on such a move.

At a time when the IASB is seeking to become the globe's pre-eminent accounting standard-setter, with the interests of investors at stake, the actions taken by the trustees to bypass due process are bad enough. To do so in order "to seek a level playing field" with US GAAP is even worse; the "held for trading" transfer exception sought by the Board only adds to the complexity and inanity of attempts to mollify critics of fair value accounting for financial instruments. Seeking convergence in this regard may seem like a small matter, when in fact it's a giant step backwards.

Instead of being a global leader, the IASB is appearing to be a quite malleable standard setter. If it goes down this path, it will only be worsening investor concerns over the degree of political influence to which it will be subjected if it is the only accounting standard setter on the planet.

Take a moment away from the financial horror show you've been watching for weeks to contemplate an imaginary one: a coal mine disaster. After the dust settles and rescue efforts are mounted, a canary is lowered into the coal mine - and it promptly keels over. What to do?

Well, if you're Congress the answer is obvious: you launch an investigation of the canary-breeding industry, because there must have been a genetic flaw that made the canary susceptible to the stress induced by the mine shaft's impure air.

That is the kind of logic being shown in the halls of Congress these days when it comes to figuring out the troubles roiling the capital markets. Fair value reporting in the financial system is the canary in the coal mine that informs investors when companies have made poor investment decisions and have dubious capital levels. If it's telling us unpleasant news about the state of things, then it can't be right. Order up an investigation of the canary-breeding industry, and that looks like what Alabama Congressman Spencer Bachus is intending to do in this letter to Representative Barney Frank. It can't be that fair value reporting might actually be saying something about the financial condition of banks; there must be something wrong with fair value reporting. So let's investigate. It's conventional wisdom and political hay-making at its worst.

It's testament to the low regard for investors held by Congress and the firms thirsty for their capital. Don't give them figures in balance sheets that show the state of the economic world as it IS; show investors the world the way we think it SHOULD be. That's a very dangerous idea that will probably be extended to other areas of financial reporting when other financial after-effects of current market instability begin to show.

[One possible area: pensions. While there are plenty of GAAP-permissible ways to minimize the funding level damage being currently wrought by markets, there are bound to be outcries over the fact that firms now show the unfunded balance of plans in their balance sheet more clearly than a couple years ago before Statement 158 went effective. The same kind of illogic applied to investigating and neutering fair value accounting could well be extended to pension and other benefits reporting. Let's hope not.]

To repeat one more time: fair value reporting is nothing new; firms have always had to report assets at what they're worth. Statement 157 did not extend fair value reporting to any new areas of balance sheets; it just gave investors more information about the integrity of fair values reported. And right now, integrity is pretty far out of fashion when it comes to the banking industry and Congress.

* * * * * * * * * *
When the FASB and SEC issued their joint interpretation on Statement 157 last week, I mentioned there would be additional guidance coming from the FASB soon afterwards. On Friday afternoon, the Board issued Proposed FSB 157-d, "Determining the Fair Value of a Financial Asset in a Market That Is Not Active." It's an amendment that amplifies the discussion in the joint clarification by presenting an example of valuing an illiquid security; it'll tack the example onto Statement 157.  The comment period ends Friday, October 9. If it passes (and you have to believe it will), expect it to be the blueprint for valuation of many investments in financial institution balance sheets in coming weeks as third quarter results are prepared.

On Friday, the Financial Accounting Foundation appointed Marc Siegel, leader of the Accounting Research and Analysis Group at RiskMetrics Group, to take over the board post currently held by George Batavick, who will retire from the FASB.

I've known Marc from our membership on the Investors Technical Advisory Committee since it started in January 2007. I think he'll be a fine addition to the slimmed-down board - and he's going to be joining it a pivotal time in the Board's history, as it faces the fallout from the Wall Street bailout bill - including a hostile pushback of fair value accounting. Not to mention the IFRS convergence efforts, which seem to have been forgotten in the last couple of weeks by most observers of the financial reporting scene. (With good reason.)

I'm sure Marc will do a fine job and will bring a keen understanding of the investor's point of view to the table. Good luck to him, and best wishes to George in his retirement.

From the Angry Bear blog (and soon to be in every American's email inbox):

Your Urgent Help Needed

Dear American:

I need to ask you to support an urgent secret business relationship with a
transfer of funds of great magnitude.
I am Ministry of the Treasury of the Republic of America. My country has had
crisis that has caused the need for large transfer of funds of 800 billion
dollars US. If you would assist me in this transfer, it would be most
profitable to you.

I am working with Mr. Phil Gram, lobbyist for UBS, who will be my
replacement as Ministry of the Treasury in January. As a Senator, you may
know him as the leader of the American banking deregulation movement in the
1990s. This transactin is 100% safe.

This is a matter of great urgency. We need a blank check. We need the funds
as quickly as possible. We cannot directly transfer these funds in the names
of our close friends because we are constantly under surveillance. My family
lawyer advised me that I should look for a reliable and trustworthy person
who will act as a next of kin so the funds can be transferred.

Please reply with all of your bank account, IRA and college fund account
numbers and those of your children and grandchildren to
wallstreetbailout@treasury.gov so that we may transfer your commission for
this transaction. After I receive that information, I will respond with
detailed information about safeguards that will be used to protect the

Yours Faithfully Minister of Treasury Paulson





Much political hay will be made this week over the proposed bailout bill. Could anyone have scripted a more bizarre scenario only a month and a half away from the national election?

While the candidates duke it, figuring which way a position will garner them more votes from the other or get thos undecided voters to decide in their favor, there will be another fight going on: the battle to dump fair value accounting.There are rumors of legislative action that calls for a moratorium on Statement 157.

As if Statement 157 had anything to do with the crisis. Understand one thing if nothing else: if a bank or investment firm makes serial horrendously stupid investment decisions, like continually lending money to people having no wherewithal to repay, hiding that fact from investors will not make you whole. It will not resolve a liquidity crisis. Fair value reporting tells investors what assets are worth, and gives investors a heads-up on managements' stewardship of assets.

The problem with fair value accounting now is that it's telling investors that there wasn't much stewardship at all. Go back a few years, when these firms were reporting record earnings: did anyone question fair value reporting then? Of course not. It's a different story when fair value reporting shows culpability.

The current "blame the accounting" mode is like berating the UPS delivery man who brought you a pair of tan Gucci loafers instead of black ones you ordered. What did UPS have to do with faulty goods? Nothing; Gucci screwed up. What does Statement 157 have to do with crummy asset values? Nothing. Managers screwed up.

It's doubtful that many critics of Statement 157 actually ever read it. If they did, they might actually see that this didn't sweep in any broad new applications of fair value reporting. The last standard that required many new applications of fair value accounting was Statement 133 on derivatives - back in 2000. Firms have always been required to write down impaired assets. There's never been a bye to just leave junk on the balance sheet, even before Statement 157.

What's different now? Two things. Statement 157 requires far more disclosure about the nature of financial instruments gracing the balance sheet. Firms always had to take a stab at the value of a security before; now when they do, investors have an idea of how that figure was developed - so they can believe it or not. Hence, the disclosures about Level 1, 2, and 3 hierarchies of fair value. Sunshine on how numbers were developed: that's the biggest improvement in reporting to investors brought by Statement 157.

The second difference: the kinds of financial crud now subject to fair value reporting has never been this plentiful, thanks to the imagination of lenders and investment bankers who concocted CDOs, CDOs-squared, CLOs and all the other alphabet-named implosion devices. Of course they're hard to value; that just might have something to do with why they don't trade. If these things are now nearly worthless, why is it better to delude investors into believing they're worth something more? Just so the firms that made poor decisions can recapitalize themselves from deceived investors?

If there's anything that should have been learned from this fiasco, it's that markets need information to function well. It seems as if the firms that have tanked didn't even have good information INSIDE their own firms about risks, collateral and cash. Taking information away from investors not only puts them at a disadvantage in making investment decisions - it give the advantage to the already-inept. So how can you expect efficient capital allocation at a market level?

Last week, PCAOB member Charles Niemeier addressed a New York State Society of CPAs conference. He spoke his mind about the one-sidedness of the movement towards IFRS adoption in these United States. As reported by CFO.com, Charles raised the valid point: moving to IFRS can "put in jeopardy the thing that gives the U.S. a competitive advantage ... All research shows that the U.S. is unique in its regulation. No [country] is as effective . . . . We have the lowest cost of capital in the world. Do we really want to give that up?"

Apparently, the SEC doesn't buy into the research conclusions showing that the United States has the lowest capital cost on the globe. Although at the moment, with two major financial institutions going into either outright liquidation (Lehman) or de facto liquidation (Bear), and a government takeover of Fannie Mae and Freddie Mac, you'd have to wonder if our cost of capital is still the lowest in the world. If it isn't, it would be a mighty stretch to say our cost of capital rose because we're not on the IFRS train yet. Let's just say there are a few other possible reasons why our capital cost might be strained.

Niemeier goes on to explore myths about IFRS convergence, such as the fact that it's "principles-based," not rules-based.
"IFRS is not more principles-based, it's just younger," said Niemeier. He pointed out that the US once followed a more "principles-based" system - but a 1969 court decision, U.S. v. Simon, spurred the development of many rules because it found that simply sticking to generally accepted accounting principles is not a foolproof defense when charged violating antifraud securities laws. Auditors sought guidance from standard setters, and the house of GAAP grew into a skyscraper.

Another myth Niemeier took on: the use of IFRS will enhance comparability. While it may be that US financial statements might be more similar to those in other countries, there's an inherent contradiction in the "principles-based" dream. If "principles-based" standards allow companies and auditors to exercise more judgment, how can company-to-company financials ever be more consistent? Worse yet: if companies start to exercise "nostalgic accounting" by employing judgment in the application of IFRS that makes their results resemble their prior national accounting system results - and this may be happening already - how can expansion of IFRS make things more comparable?

His speech hasn't been posted on the PCAOB website yet, but when it is, I'll be sure to provide a link. I think he's on to a lot of the concerns that need to be addressed in accounting standards convergence. Investors are not served well if convergence is merely "convergence by decree" - something that happened when the SEC removed the reconciliation of IFRS to GAAP earlier this year. As Charles puts it, we need to "return to a policy of convergence to achieve something noble, not convergence for uniformity's sake. We should strive for comparability, not just say it."

WebCPA.com reports a survey of 535 accounting professors conducted by the American Accounting Association and KPMG showed that only 22 percent of them intend to incorporate IFRS lessons into their plans for the 2008-9 academic year.

Bad enough - but 62% of them "admitted they have not taken any significant steps toward doing so."

Don't they read the papers? You're entitled to wonder. One legitimate excuse offered by the profs: it's hard to fit anything more into the curricula. There's more justification for a mandatory five-year program.

The survey also showed that they didn't expect textbooks to be available on the subject until the 2010-11 academic year. They're probably right - but that doesn't mean they can afford to turn out students who will be facing new accounting challenges the minute they walk onto the job. There is a real opportunity here for schools to differentiate themselves from the pack. The ones that can develop a rugged program that at least teaches students IFRS rudiments - and how to continue learning afterwards - will be able to attract the best students and engender the best relations with the Big Four when recruiting time comes for their graduates.