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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.

There's still time to comment on the FASB's rapid-transit amendment of the impairment model embodied in EITF Issue No. 99-20. To put it in a nutshell: the existing rules will require companies having a decline in value for things like lower-rated securitizations, whether held by issuers as a retained interest or purchased outright, to look at the cash flows a marketplace participant would use in evaluating the cash flows of the instrument. The impairment charge can then be determined. The FASB would like to replace that test with a more judgment-based model embodied in Statement 115, at the request of the SEC. Is it an improvement? I don't believe it is; in fact, I think it would be quite likely for impairments on securities covered by the amendment to be recognized later rather than sooner. Sure, the banks would like that - but I don't think that's giving investors timely or realistic information for investing decisions. I've put together my own comment letter, appearing below. I would recommend that even if you can send just a brief email on the subject to the FASB email-box, you should do so. Avoiding a reckoning on the values of these instruments is not the same thing as a reckoning; you'll be doing yourself a favor in the long run if firms are reporting their troubles honestly in the present.

* * * * * * * * * * * * * *

 

December 28, 2008

 

Russell G. Golden

FASB Technical Director

Financial Accounting Standards Board

P.O. Box 5116

Norwalk, Connecticut 06856-5116

 

Re: Proposed FSP EITF 99-20-a

 

Dear Mr. Golden:

             

              I am writing in regard to the Proposed FSP EITF 99-20-a, “Amendments to the Impairment and Interest Income Measurement Guidance of EITF Issue No. 99-20.” I do not support the issuance of this amendment for the following reasons.

 

              • The existing No. 99-20 impairment model embodies marketplace participant points of view in determining whether or not an impairment exists. The model is consistent with the principles of FASB’s Concept Statement No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements,” and also with those contained in Statement No. 157, “Fair Value Measurements.” The information it provides investors is a faithful representation of current economic values. The impairment model embodied in Statement 115 is far less prescriptive and invokes much more preparer judgment.

 

              This project originated because the banking industry lobbied the SEC for more lenient rules on recognizing losses on  some of the worst-faring securities created during the housing boom.i Moving to a Statement 115 model will not provide better information to investors than the current impairment model, and in fact, could lead to delayed recognition of impairments.

 

              At a time when the American auditor is facing some of its most serious professional challenges since the early part of this decade, the FASB will hobble them in their dealings with clients by replacing an impairment model that currently works with one that leaves plenty of room for management discretion. Ordinarily, that wouldn’t be necessarily wrong - but given the current economic environment and the genesis of this project, it certainly portends a negative outcome regarding the information to be provided to investors.

 

              • I believe the Board has its priorities reversed on this project. If a Level C standard (No. 99-20) produces information more consistently representative of fair values than the Level A standard (Statement 115), then it would seem that there is a problem with Statement 115.

 

              If fair value reporting provides investors with the information they need to make investment decisions, then why should the Board engage in projects that decrease the information provided to investors?

 

              Instead of diluting the information provided to investors by Issue No. 99-20, the Board would do better by investors - whom it is ostensibly serving, rather than preparers - to study the shortcomings of Statement 115. In fact, the whole idea of “other than temporary impairments” should be reconsidered through the expansion of fair value accounting for financial instruments. If full fair value accounting for financial instruments existed, there would be no need for artificial categorizations like “held-to-maturity” and “available-for-sale” securities - and no need for other-than-temporary impairment testing.

 

              • The Board has engaged in a mere facade of a due process. An 11-day comment period for a project with this much potential reporting impact like this one is a mere sham.

 

              Take into account the religious and national holidays during those eleven days and this amendment’s due process takes on the trappings of a parody.

 

              At least the Board went through the motions of a due process, unlike the IASCF and the IASB when they amended IAS 39 last October.

 

              In closing, I would like to support the Board in simplifying the accounting literature in trying to remove multiple impairment models and other possible redundancies in the accounting literature. There is that minor benefit to this project, but at too great a cost to investors.

 

              I would support that notion, however, only if the actions taken were more comprehensive and not on a piecemeal basis that serve to benefit one group at the expense of investors.

 

...

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The SEC will convene a teleconference today of international securities regulators to "discuss urgent regulatory issues om the ongoing credit crisis."

According to the press release, the technical committee will consider "manipulative short selling" and "under-regulated or unregulated products."

With regard to the first, it will be interesting to see if we ever get some case history of what constitutes "manipulative short selling." To see just what the SEC deems to be manipulation, we'll have to wait and see what the enforcement cases show.

With regard to the second consideration, the international confab intends to "develop disclosure principles to promote transparency in OTC markets for derivatives and other financial instruments which will contribute to enhanced investor protection and mitigating systemic risk." Good idea there; late, though.

The interesting thing is the other matter to be considered: international accounting standards. The issue to address for the international regulators is to "ensure that the process of developing international accounting standards continues to take account of the interests of investors." That sounds like it could refer to the lack of independent funding of the IASB - or the dive the board had to take with regard to the fair value exception to achieve a "level playing field" (three of the more dangerous words in standard setting, by the way). In any case - it sounds like the SEC is being more cautious, at least superficially, in its pursuit of international accounting standards in the US. It could be invoking "investor interests" to give it a more graceful exit; it could weigh in the favor of the next administration if they don't like the idea. It's going to be an interesting transition at the SEC.

On Friday evening - the day before the G20 summit began in Washington - the SEC released the long-awaited roadmap for converting the United States financial reporting system to International Financial Reporting Standards. The document will have a 90 day comment period, which will begin ticking once it's recorded in the Federal Register - and that will probably take place in less than two weeks. Say it's in the register one week from the day the SEC released it: that would put the comment period's end at February 19, 2009. It's a proposal that will span two administrations - and we really don't have an idea how the new administration is going to view the proposal. When an SEC chair is named, it'll be clearer - and with the current market turmoil, you'd have to believe that President-elect Obama will not waste time on this choice. A key premise in the 165-page document: the pause for deciding. While it's encouraging companies to take the option and apply IFRS to their own reporting before it becomes a requirement, the Commission has left itself the option to stop the convergence process in 2011. It will depend on the Commission is satisfied with progress toward achieving seven milestones related to: • improvements in accounting standards; • the accountability and funding of the IASC Foundation; • the improvement in the ability to use interactive data for IFRS reporting; • education and training relating to IFRS; • limited early use of IFRS where this would enhance comparability for U.S. investors; • the anticipated timing of future rulemaking by the Commission; and • the implementation of the mandatory use of IFRS by U.S. issuers. If it's satisfied with progress in the next three years, then the Commission will proceed with requiring U.S. issuers use IFRS beginning in 2014. The declarations made at the G-20 summit will likely propel American companies down the IFRS road - so it will be critical for investors to pay attention to the roadmap. They might not like where they are at the end of the road. Some of the  declarations have very strong implications for accounting as we know it. An excerpt: 

Immediate Actions by March 31, 2009:

* The key global accounting standards bodies should work to enhance guidance for valuation of securities, also taking into account the valuation of complex, illiquid products, especially during times of stress.

* Accounting standard setters should significantly advance their work to address weaknesses in accounting and disclosure standards for off-balance sheet vehicles.

* Regulators and accounting standard setters should enhance the required disclosure of complex financial instruments by firms to market participants.

* With a view toward promoting financial stability, the governance of the international accounting standard setting body should be further enhanced, including by undertaking a review of its membership, in particular in order to ensure transparency, accountability, and an appropriate relationship between this independent body and the relevant authorities.

* Private sector bodies that have already developed best practices for private pools of capital and/or hedge funds should bring forward proposals for a set of unified best practices. Finance Ministers should assess the adequacy of these proposals, drawing upon the analysis of regulators, the expanded FSF, and other relevant bodies.

Medium-term actions:

* The key global accounting standards bodies should work intensively toward the objective of creating a single high-quality global standard.

* Regulators, supervisors, and accounting standard setters, as appropriate, should work with each other and the private sector on an ongoing basis to ensure consistent application and enforcement of high-quality accounting standards.

* Financial institutions should provide enhanced risk disclosures in their reporting and disclose all losses on an ongoing basis, consistent with international best practice, as appropriate. Regulators should work to ensure that a financial institution' financial statements include a complete, accurate, and timely picture of the firm's activities (including off-balance sheet activities) and are reported on a consistent and regular basis.

So let's read the tea leaves and see what to expect by March 31, 2009: • There will be more guidance on Level 2 and Level 3 valuations from the FASB or the SEC; • The FASB proposals for modifying Statement 140 and FIN 46R should be turned into completed standards; • The anointing of the IASB monitoring board as "good enough" to ensure independence of the IASB; • Maybe even a staff accounting bulletin from the SEC on disclosures about complex financial instruments. In the "medium-term" - whatever that is - expect the continued convergence process of the US standards with the international standards, along with the continued mutual recognition of the efforts of securities regulators around the world. There was one ominous-sounding declaration, one that didn't name fair value accounting specifically, but read between the lines in this excerpt from "Reinforcing International Cooperation:"

Medium-term actions:  * Authorities, drawing especially on the work of regulators, should collect information on areas where convergence in regulatory practices such as accounting standards, auditing, and deposit insurance is making progress, is in need of accelerated progress, or where there may be potential for progress. * Authorities should ensure that temporary measures to restore stability and confidence have minimal distortions and are...

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The election is over, and the national guessing game has begun about who will be the next Treasury secretary. Of course the attention is focused on the Treasury post: nothing is more urgent than instilling confidence in the financial system at this very moment, if any other post-election promises are to be fulfilled.

Much less focus has been placed on who will be the next SEC chairman, however. It's a given that current chairman Christopher Cox will be gone. His replacement's name, however, hasn't generated the same kind of speculative fervor as the replacement for Henry Paulson. Nevertheless, events continue to bubble at the SEC offices.

Last week, the SEC announced that John White, director of the Division of Corporation Finance, will be leaving the Commission at the end of the year. White has been a prime mover behind the SEC's plans to scrap GAAP and adopt international financial reporting standards (IFRS).

On Friday, Chairman Cox delivered a speech about international enforcement cooperation, and focused on the Commission's international efforts in subprime loan investigations. Though the topic was international in scope, there was nary a word about the forthcoming IFRS "roadmap."

Not everybody is so quiet about the pending arrival of the roadmap. Accountancy Age, a British trade journal, proclaimed that it would be released last Thursday or Friday. Maybe they're just slightly ahead of their time.

No matter - the situation at the SEC bears watching. Whoever is named to the top post may give a significant clue about the future of the Commission: will it be someone who can reinvigorate it so that it's leading those it regulates instead of mopping up a mess after it happens? Or will it be someone who will shepherd it into another agency that takes over its functions? Let's hope for the former and not the latter.

No trick, maybe all treat for financially distressed homeowners. On Halloween, news spread that JP Morgan Chase would work with homeowners holding about $70 billion of mortgages. While JP Morgan Chase didn't step into the subprime swamp when it was percolating, it inherited a large number of subprime loans from its acquisition of Washington Mutual - who wasn't shy at all about making bad loans.

Terrific idea - keep the loans whole, build customer loyalty, keep people in their houses and just maybe, help stabilize the real estate market. In short, do what you can to keep the economy going.

Investors can't help but wonder, though: what are the economic effects on the bank? They're going to give up something to keep the consumers whole. And you have to wonder about the effects that renegotiation may have on the status of any of those loans securitized by WaMu. While it's not a black-and-white area of securitization accounting in Statement 140, a renegotiation of loans in a securitization trust could be considered evidence that a genuine sale of loans never took place. To present a true picture of what exists, the sale would best be reversed with the loans being returned to the bank's balance sheet and the pass-through security being a part of the bank's debt.

There's a bye given by the SEC to such renegotiations however, from the Office of the Chief Accountant early in 2008. No need to worry about shareholder presentation of events as they exist; just move along folks, nothing to see here.

Nothing indicating yet that this is the route JP Morgan Chase is taking. It's noteworthy, though, if they spark a wave of renegotiations among other banks. One would hope that happens - but investors need to exercise skepticism about the genuineness of loan sales in securitizations. In any case, if the additional securitization disclosures proposed by the FASB for this year come to pass, investors would be best off by using them to estimate what leverage would look like in the absence of securitization sale accounting - whether or not there have been loan renegotiations.

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.

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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.