The Accounting Onion

Regulate Derivatives? Start with Better Accounting!

I can usually find enough time to write only one post each week. Consequently, much of what I considered to be high-quality fodder is washed away by the exigencies of my real work. This week, however, had too many interesting news items, and I can't let them go without at least something said about each of them:

• The FASB's own Investors Technical Advisory Committee (ITAC) wrote a strongly-worded letter to the Financial Accounting Foundation decrying that current events have eroded the FASB's independence. Independence indeschmendence -- the most telling aspect of the ITAC letter for me is the reference to the weakening of accounting standards that were "already inadequate." I'd say that taken as a whole, they are woefully inadequate.  That's because the FASB has never acted in an independent manner.  When pressed, it folds like a cheap suit.

• Joseph Nocera and Gretchen Morgenson, both of the New York Times, wrote separate stories (here and here) decrying glaring shortcomings of SEC enforcement activities. Nocera reports that the SEC staff has been measuring itself for far too long by the sheer volume of the number of cases it settles. Over a year ago, I wrote about that here, but I hope to revisit the issue soon again.

• Bob Herz, chairman of the FASB, addressed a broad range of issues in a speech to the National Press Club. Compare his remarks to that ITAC letter, and it should be pretty obvious why they don't appear to agree on very much. (I'm with ITAC.)

Floyd Norris, also of NYT, wrote of the issues facing policymakers ("Derivatives Tug of War Takes Shape") as they struggle to create new regulations and mechanisms for trading derivatives. That's my topic for this week.

Derivatives are Like Butchers' Knives

My father used to say that just because a butcher's knife could be used as a lethal weapon, that doesn't mean butchers should be required to have a license to use them. (Actually, I'm butchering his words slightly to make my point -- sorry, Dad.)

The butcher's knife view of derivatives is that they are primarily used as 'hedging' instruments; and the opportunity to hedge risks promotes investment. But, there is a growing recognition that they have been too frequently utilized as weapons of mass economic destruction; and, unlike butcher's knives, should be regulated. First, they have been used to transfer risks to others who may not have understood the risks, due to lack of sophistication and/or transparency. Second, and to my view the more fundamental problem, is the way that managers "game" the derivatives accounting rules to accomplish personal objectives at the expense of shareholders.

Recent events are rife with examples of management's games, but they can be so complex as to obscure the basic point I want to make. So, here's a case I encountered some years ago during the course of a consulting engagement, which more plainly illustrates my point.

My client, let's call it OilCo, produced and sold oil and gas. For years, OilCo did very well by selling its output at prevailing market prices; shareholder returns were consistently above average compared to its peers because OilCo personnel were good at their job: locating reserves and extracting them efficiently. But, shortly after oil prices reached a level that had not been seen for a number of years, management made the decision to invest in crude oil forward contracts, effectively selling the company's next year's worth of production at a fixed price. Alas, in the first quarter of the ensuing year, crude oil prices continued to rise. Consequently, the fair value of their forward contracts declined, and OilCo's stock price declined as the rest of the industry moved up.

The key remaining detail of the case is that 'special hedge accounting,' which OilCo and other large companies strenuously lobbied for, did its job for management, even while they were destroying shareholder value. Reported earnings (and any management bonuses tied to earnings) were essentially the same as the previous year, even though oil prices were lower at that time. 'Special hedge accounting' worked because it enabled OilCo to defer the losses on those forward contracts until they could be offset by the higher revenue from actual sales.

By entering into a forward sale of its production at a fixed price, was management of OilCo hedging against future adverse changes in oil prices, or were they speculating that oil prices would decline? However you might answer that question (methinks they were speculating), I take it as given that OilCo's management would never even have considered selling the year's production forward without favorable accounting treatment afforded by 'special hedge accounting.' This strongly suggests to me that fixing the accounting rules may well be a precondition for any additional regulation of derivatives to be effective.

Norris correctly observes that even though the Obama administration's heart might be in the right place, the devil will be in the details of any new derivatives regulations; and there will be intense pressure from special-interest groups to ensure they'll be able to make chicken salad from them.  Although I am strongly in favor of enhanced regulation of derivatives, some of those details will be impossible to get 'right.'  Some of the concepts pertaining to derivatives are pretty amorphous; as the OilCo case illustrates, what may seem on its face to be hedging, may in fact be shareholder-value-destroying speculation.

And even stickier issue is determining the scope of the regulations. What, for example, is the difference between 'insurance' and a 'derivative' (especially a call or a put option)? And what the heck is a 'derivative', anyway? For example, is there a derivative when a manufacturer negotiates a 'take or pay' arrangement with a supplier for the delivery in six months of copper wire that it will use to make its product? Answer: 'Yes.' Will such a contract be regulated? Answer: 'No.' 

My point is that there is no principled distinction between financial derivatives and everyday transactions that may have forward and option components embedded in them. I fear that a major result of new derivatives regulation would be the creation of a new 'financial service' to assist clients with engineering transactions solely for the purpose of circumventing the new regulations.

That's why I believe that derivatives regulation should begin with getting the accounting right. Throw away FASB Statement No. 133's hedge accounting provisions and require that all derivatives be fair valued (I prefer replacement cost to fair value, but that's another story) with gains and losses going to earnings. To be maximally effective, the accounting rules should require that all assets and liabilities, especially those arising from insurance contracts, be fair valued with gains and losses going to earnings.

I will readily admit that getting the accounting right will not be a panacea, but given the trouble the Obama administration is having building a consensus on regulation, the accounting is clearly the right place to start. And, it could turn out that little more is needed.  As the OilCo case illustrates, managers generally eschew transactions that place their accounting-based bonuses at risk. So, if taking a derivatives position doesn't promise to sweeten future earnings, then fuggedaboutit. Fewer derivatives transactions will require fewer regulations.

SAB 112: Let the New Earnings Game Begin

In a recent post on business combinations accounting that is related to SAB 112, I criticized the FASB for creating yet another loophole in business combinations accounting that make M&A transactions more attractive than they really should be. To recap, I described how JP Morgan wrote down toxic loans acquired from WaMu so that, going forward, JP Morgan had a built-in stream of future earnings at very high interest rates.

First, a Mea Culpa

I was feeling pretty satisfied with myself until reader Michael interrupted my reverie with several interesting and valid comments. With great reluctance, I began to re-think parts of my screed.

First of all, he found a couple of inaccuracies in my telling, which should be corrected:

"Tom, I think I'm with you on your conclusion (i.e. mark all financial assets to fair value (replacement cost?)) but the area of GAAP causing the inconsistent measurement is not FAS 141(R). FAS 141(R) was first effective for transactions that closed on or after 1/1/09 for calendar year companies. JPMorgan was subject to FAS 141 (no R) for this transaction and disclosed as such. However, you may be aware that even under FAS 141, certain loans were required to be accounted for at fair value, notwithstanding the SAB [Topic 2A-(5)]...those loans that were purchased at a significant discount are subject to the guidance in SOP 03-3, which requires a fair value measurement [at the acquisition date] for such loans. Given the purely awful composition of WaMu's portfolio, it is not surprising that half their loans fell into that guidance. I think most of the focus should be on the criminal allowance put up by WaMu pre-transaction...$2 billion on $240 billion in loans at 3/31/08, $8 billion on $240 at 6/30/08. Yikes." [italics and bolding supplied]

That's a really interesting last sentence, especially coming from an auditor, and I'm betting that even the PCAOB will not want to go near that one. As important as that may be, it's a digression from the mea culpa I now proffer to all who read that post: I overlooked the fact that SOP 03-3 would be applicable, because I mistakenly thought the acquisition of WaMu was accounted for under FAS 141(R).

Michael's comment and my mea culpa notwithstanding, the fact remains that henceforth, FAS 141(R) has taken over for SOP 03-3 in the earnings management toolbox when it comes to making sure that a business combination transaction will be accretive to future earnings. (Note: that doesn't mean that SOP 03-3 has become obsolete. Loan acquisitions that are not part of a business combination are also within its scope.)

Michael also responded to my suggestion that the offending provision of FAS 141(R) should be suspended until loans are fair valued.  He pointed out that should that day ever come, the invitation for earnings management of which I spoke doesn't completely go away:

" … [L]et's assume that all financial instruments were remeasured each period at fair value. While there will be timing differences with loans that are measured at fair value at acquisition, net income over the life of the same loans will be the same...if JPMorgan had to continue to remark the loans, they'd still recognize that accretion into earnings if the loans ultimately perform. I understand your generally well founded skepticism, but I think this is one of the less offensive areas of FAS 141R.

Michael is right (again). I could live with an outcome whereby unbiased fair value measurements will provide a stream of accounting earnings to an acquiree. But, I am indeed more than a little skeptical that two versions of fair value will emerge from FAS 141(R)—if they haven't already from other games that executives will play with earnings. The WaMu's will still have strong incentives to overstate market value, and even Michael implies that auditors are not likely to stand in their way. The JP Morgans of the world have incentives to understate the same fair values.

Enter SAB 112

That's where SAB 112 comes into the discussion. Among other ministerial changes, it deleted Topic 2A-(5) of the SAB codification, which I described in the earlier post and became unnecessary after FAS 141(R) instituted the fair value requirement for acquired loans. The crux of this post is this: if the SEC thought that manipulation of loan loss reserves during a business combination merited an anti-abuse rule, then more than ministerial adaptations were called for.  How can the SEC be so naïve as to think that fair value will fix the problem of loan value manipulation? Instead of merely deleting Topic 2A-(5), they should have re-written it to put the brakes on what will surely become a new recipe for chicken salad. It would have been really simple for the SEC to make the following rule:

Irrespective of pre- and post-acquisition bases of measurement, the new carrying amount of every asset recognized may be no less at the date of acquisition than the carrying amount recognized by the acquiree; similarly, the fair value of liabilities assumed may be no greater than amounts recognized by acquirees.

I know that my suggestion may sound unprinicpled and draconian to some (and I would be prepared to allow for some exceptions), but the reality is that no set of business combination accounting rules will be perfectly 'efficient.' For any accounting rule, it is inevitable that some value-creating transactions will be discouraged, and some value-destroying transactions will occur because the accounting result is too sweet to resist. The key for regulators is to strike an appropriate balance based on broadly acceptable objectives for financial reporting.

In regard to business combinations, there have been no such objectives ever before.  It is clear that the rules have been completely out of whack since the inception of GAAP in the 1930s. As for the last few decades, the evidence is crystal clear that our economy has been administered a nearly lethal dose of value-destroying business combinations to juice executive compensation while killing share prices and wreaking havoc among rank and file employees. That's why I believe it is time to trying something more radical: an acquiror should not be able to create a stream of reported earnings by writedowns to assets or increases to liabilities. Therefore, post acquisition writedowns of assets and write-ups of liabilities would be charged against the post-combination earnings of the acquiror.

Let's see if the 'new SEC' is up to the task. We'll know they're doing it right if the EU and IASB have conniptions over it.

To Catch a Chief Accountant

I received an email from the source I previously dubbed Debit Throat, providing some interesting reactions to my previous post on handicapping the chief accountant 'contest.'

"I agree [with your odds] – I don't think that Neimeier is [no longer] a possibility (although my choice also) for CA.  Frankly – I don't think that Charly even wants to do it anymore although I understand that there has been savage fighting between the Big 4 and the SEC about this.

One thing is for sure – the CA appointment will tell the tale on what happens with IFRS, and I believe that the tide has turned there AGAINST IFRS.  For this reason I don't think that Wayne Carnall will be the pick since he is a big IFRS advocate. 

So my guess: 1) Adams and 2) a long shot in Ciesielski.  I don't see Kroeker getting the nod."

For some reason, DT's email triggered my memory of a 1991 Accounting Horizons article, "The Selective Financial Misrepresentation Hypothesis." It was written by the late Lawrence Revsine of Northwestern University, apparently to lend much-needed perspective on the contributory role that politically-driven financial reporting rules played in the trillion-dollar savings and loan debacle.

Sad to say, very little about financial reporting has changed for the better since 1991, while much has changed for the worse, making Revsine's observations even more relevant to the current conversation.  I would also say that it is directly applicable to the chief accountant selection SEC Chair Mary Schapiro has been putting off, but eventually must confront before the debate on IFRS can continue.  If she can summon the gumption to heed Revsine's message in the face of tremdous pressure to act otherwise, then that would be progress enough for me.

The Seeds of Selective Misrepresentations

According to Revsine, financial reporting originally became necessary as business arrangements increased in complexity; its intended role was to "…summarize events and to provide information for more complex analyses." No surprises there, but Revsine continued, "…managers gradually learned that while events that affect performance often cannot be controlled, the way that people perceive these events can be controlled" by "distorting economic reality." Misrepresentations cannot be too comprehensive lest a complete loss in the credibility of financial reporting should occur; hence, the importance of being "selective."

Many of the selective misrepresentations that have been enshrined in GAAP take the form of "loose" accounting standards. Management exploits them to shift income with the objective of maximizing its total compensation when, as is very often the case, that compensation is tied to reported earnings. To cite but a few examples, management can 'cherry pick' gains, manipulate the timing of revenue recognition, fudge loan loss reserves, etc. In general, managers desire choices among mutually "acceptable" alternatives, "…rather than methods that tightly specify statement numbers under given economic conditions."

But managers are not the only group that can benefit from selective misrepresentation of financial information. Auditors prefer accounting standards that foster client harmony, so as to maximize client retention. The same loose standards that managers prefer generally fit that bill, but standards that are loose and complex at the same time sweeten the deal for auditors. Management should have their flexibility, but detail and complexity should also be present so that auditors can stretch the envelope on billable hours.

Even current shareholders benefit from "loose" accounting standards. That's because, by placing upper and lower bounds on earnings-based bonus payouts, shareholders provide managers with built-in incentives to smooth earnings over time. The resulting appearance of lower earnings volatility induces higher bid prices for shares. Moreover, loose accounting standards also allow shareholders to transfer wealth from creditors and the public by evading debt covenants and regulatory capital requirements.

With respect to those regulatory capital requirements, Revsine asserted that the role of misrepresentation in accounting standards had not been adequately recognized in accounts of the near trillion-dollar S&L debacle; and I fear that the story will not be fully told this time around, either. The moral hazards associated with our subprime mortgage mess – for example, taking on excess risk because bank losses were protected by deposit insurance – were clearly exacerbated by outdated GAAP-based measures of capital adequacy; yet, I feel like a voice crying in the wilderness when I call for a de-linking of capital adequacy measures from GAAP.

Chairperson Schapiro: If You're Out There, Please Read this Part Very Carefully!

After explaining why selective financial misrepresentation happens, Revsine provided a compelling explanation of the how, and it's not a pretty picture: the "regulatees" (managers, auditors and shareholders) banded together out of common interests to "capture" the regulators. This has largely occurred through movement of personnel between the regulatory agencies (e.g., SEC and FASB) and the regulatees:

"… regulatory 'capture' describes a process where the ostensible purpose of regulation—protection of consumers—is eventually reversed and regulatees become the beneficiaries [citation omitted]. …

While it regrettably conjures a pejorative image, the phrase "regulatory capture" is not intended to impugn the integrity of standard setters. Instead, the point is that everyone is influenced by their background and becomes comfortable with familiar perspectives and experiences. This is inevitable and natural. Unfortunately, in the regulatory sphere, it is also antithetical to the intended purpose of regulation."

From today's perspective, I think Revsine was being too kind to the regulators. But in his defense, he did write his article before Chistopher Cox was appointed SEC chair by George W. Bush. Anyway, that's beside the point.

Revsine's main point was that knowledge of the mechanism by which selective financial misrepresentation occurs is the first step towards reversing a process that has given short shrift to investors and taxpayers. Just starting with the savings and loan debacle of twenty years ago, the abject failure of the SEC to insulate itself from the influence of regulatees on accounting standards makes the financial consequences of the Bernie Madoff affair look like a convenience store heist. I'm not just talking about the subprime mortgage crisis, although that would be more than enough. I'm also talking about mergers and acquisitions motivated by accounting results, rust belt pension plans gone bust, executives paid with mountains of stock options they didn't deserve, Enron, Worldcom, and much, much more.

Accounting will never be fully free of misrepresentations, but without significant change, the next financial crisis could send financial reporting, and the SEC along with it, back to the Stone Age. As the SEC Chair faces pressure from the Big Four et. al. over naming a chief accountant, I would urge her to review the current list of candidates for the obvious signs that they have been captured by the regulatees. By the standard of independence that her own appointment by President Obama exemplifies, Charles Niemeier should be the odds-on favorite; Jack Ciesielski should be given serious consideration. And the others, bless their acculturated hearts, should be politely told 'thanks, but no thanks.'

Handicapping the Chief Accountant Contest

A BNA news article [available by subscription only] reported last week that anonymous sources say that Mary Schapiro has narrowed the candidates for SEC Chief Accountant to five finalists: 

• "Jane Adams, a former deputy chief accountant of the SEC and former longtime staff member of the Financial Accounting Standards Board, who worked until recently at Maverick Capital, New York ;

• Wayne Carnall, currently chief accountant of the SEC's Division of Corporation Finance and a former partner at PricewaterhouseCoopers;

• Jack Ciesielski, president of R.G. Associates, Baltimore, a current member of the Financial Accounting Standards Board's Investors Technical Advisory Committee and veteran of several standard-setting panels, who also is publisher of Analyst's Accounting Observer;

• James Kroeker, acting SEC chief accountant and former partner at Deloitte & Touche, who joined the SEC staff in early 2007 as a deputy to former Chief Accountant Conrad Hewitt; and

• Charles Niemeier, a member of the Public Company Accounting Oversight Board and former chief accountant of the SEC's Division of Enforcement."

It just so happens that I am in Las Vegas this week – strictly business, honest! On my way to meetings, though, I have been checking the sports books.  I know it's hard to believe, but nobody here has been handicapping Mary Schapiro's pick. So, I'll have to take it upon myself to supply the odds, as a service to finacial reporting fans who may need to end an argument with, 'put up, or shut up!'.  

The Current Line

I have Adams as the even-money favorite. She has the right background, and may not have staked out a position on IFRS yet. That might make her more broadly acceptable. She would also be the first woman chief accountant. If I were betting, which I am not, I would take Adams against the field.

Ciesielski and Niemeier are both 99:1 long shots. As a PCAOB member, Niemeier may have garnered the most publicity for his anti-IFRS stance, and his general reputation for independence and intellectual rigor. Cieselski, has been an incessant and articulate advocate for investor interests through ITAC and his Analysts' Accounting Observer weblog and subscription service. He has also taken turns on AcSEC and the EITF. Cieselski may have a slightly lower profile than Niemeier, and may be slightly more moderate in his IFRS views, but he is equally toxic to the IFRS adoption lobby.

Carnall is a reasonably possibility at 3:2 odds. I know Wayne from my time at the SEC and from later interactions while he was at the SEC. He may be the single most knowledgeable person on regulatory issues faced by foreign companies listed on U.S. markets; and he has a long and distinguished history as an SEC staff member. He could be a very popular choice with the SEC Staff, but I'm just guessing.

Kroeker is a long shot at 23:2. I do not know much about him, and his role in the Cox/Hewitt era could be a plus (political compromise), or a minus (guilt by association). In the "we can do better" spirit of the new guard in Washington, my sense is that it is more of the latter.

As to my personal preference, I'll keep my own counsel, although I am on record for having supported Niemeier when it was rumored that he was going to be the pick. Some of the candidates I know pretty well, others not so well, and some none at all.

I just hope Schapiro finally gets this overly-protracted process over with soon, and makes a choice that sends a pro-investor message: that she will neither wilt nor compromise investor protection as the political pressure from special interests to adopt IFRS inevitably intensifies. Only a fool would bet against that.

FAS 141(R): Turning Toxic Loans into Star Performers*

From a MoneyNews.com story published this Wednesday headlined "Banks Stand to Reap Billions from Purchased Bad Loans," came an account of a jaw-dropping transaction. It was spawned by FAS 141(R), the latest and greatest standard on accounting for business combinations:

"When JPMorgan bought WaMu out of receivership last September, it used the purchase accounting rule [FAS 141(R)] to record impaired loans at fair value, marking down 118.2 billion of assets by 25 percent.

Now, JPMorgan says its first-quarter gains from the WaMu loans resulted in $1.26 billion in interest income and left the bank within an accretable-yield balance that could result in additional income of $29.1 billion."

Business combination accounting has forever been fertile ground for earnings and balance sheet management for one simple reason: the opportunity to tweak the amounts reported for the assets acquired and liabilities assumed, with the ultimate objective of brightening post-acquisition earnings reports. But, as tiresome as that old game might be, the kind of maneuver that JPMorgan's management has engineered is a novel twist on an old loophole that had once been closed pretty tightly by the SEC.

The Closed Loophole that Would Be Re-Opened by the FASB

Once the "pooling of interests" method of business combination accounting of APB 16 was abolished with the advent of FAS 141 (not to be confused with FAS 141(R)), the most basic surviving principle of business combination accounting became thus: the acquisition of a business should always be reflected on the financial statements of the acquiror by assigning a new carrying amount to each of the acquired company's assets and liabilities. This new carrying amount would be updated, based on current assumptions and estimates regarding the future role of the acquired assets and liabilities in the combined entity. The implementation of this principle had long been known as the "purchase accounting" method for business combinations.

With certain important exceptions, SFAS 141 mandated that new carrying amounts for assets acquired in a business combinations would be based on their fair values. The exception that is germane to the JPMorgan story pertains to loans (i.e., trade receivables, interest-bearing loans and marketable debt securities classified as held-to-maturity). The measurement bases for these items were carried forward from APB 16's version of the purchase accounting method: a gross amount reduced by an appropriate allowance for uncollectible accounts. This exception to loan measurement was important, because it also meant that a 1986 SEC staff position would still be applicable to purchase accounting.

At that time, the SEC saw fit to put a stop to unwarranted increases in the allowance for loan losses as part of the business combination transaction. Increases to loan loss allowances would mathematically transfer future loan losses to goodwill, where they would be deferred indefinitely, with the effect of reporting inflated earnings in future periods as the loans were eventually settled for more than their understated carrying amounts. Staff Accounting Bulletin 61 (Topic 2-A(5)) states that the SEC would not permit any adjustments of the acquiree's estimate of loan loss reserves, unless the acquiror's plans for ultimate recovery of the loans were demonstrably different from the plans that had served as the basis for the acquiree's estimates of the loss reserves.

FASB Amnesia?

FAS 141(R) did away with the "purchase method" and established the "acquisition method" of accounting for business combinations. It apparently did so out of a belief that measurements of assets and liabilities that are based on the most current information available are usually, if not always, preferable to valuations based on less-current information. The JPMorgan case glaringly points to a significant flaw in that belief: inconsistent application of fair value could be more harmful than consistent application of a less desirable attribute. As to the case at hand:

• WaMu, as is quite common, accounted for its loans based on a held-to-maturity model. That is, except for recognizing declines in creditworthiness, the loan carrying amount is based on the original contractual terms; interest is accrued by multiplying the net carrying amount by the yield to maturity as of the date the loan was originated/acquired.

• Even though the market value of these loans had declined significantly as they turned toxic, WaMu apparently was not required to record losses to bring the loans down to their fair values.

• JPMorgan, when acquiring WaMu, was required by FAS 141(R) to mark the loans to market. Subsequent accounting by JPMorgan will continue the WaMu the held-to-maturity model.

It would be a pretty safe bet that JPMorgan was very 'conservative' in their estimates of fair value for the loans; that's because the lower the fair value, the higher the yield to maturity, and the higher the amount of reported future earnings. Of course, there are some limits to JPMorgan's estimate of fair value: auditor pushback, SEC review, increased risk of goodwill impairment charges, and capital adequacy regulations. But, at least in this case, it is possible to become rich without being greedy.

Where is the SEC!?

Maybe there has been more coverage of this issue, but I haven't seen it; kudos to its author, Julie Crawshaw of Newsmax. If we are concerned that bank executives are being overcompensated, especially on the taxpayers' dime, here is a prime example of where insufficient oversight has spawned a new source of moral hazard.

For starters, the SEC should put a stop to this obvious and blatant abuse, immediately. They should issue another SAB, carving out the offending provision of FAS 141(R) and restoring the long-established and functioning status quo. Every company that benefitted from the ill-conceived accounting rule should be forced to retroactively restate their earnings – especially any financial institution on the government dole.

Perhaps the lack of permanent leadership in the Commission's Office of the Chief Accountant is contributing to a lack of attention to this obvious problem, but it is in no way an excuse. Also, this is a problem created by the FASB. Let's be charitable and call it an unintended consequence, but whatever the cause, the FASB should move to fix it forthwith. I'm suggesting that the SEC should act first, solely because they have the demonstrated capability of being able to move the fastest. That's because a SAB doesn't have to be exposed for comment before it can be issued.

But, lacking any actions by either the FASB or SEC to put the cat back in the bag, auditors (perhaps via the PCAOB), and boards should be put on notice of a new potential scheme to inflate executive compensation in the absence of actual value creation for stakeholders. If a single dime of executive compensation comes out of accreted excess earnings from these business combination games, I hope that private securities lawyers will round up the proxies and the lawsuits, settling for nothing less than "a pound of flesh."

A larger lesson is important to briefly discuss in order to understand how this kind of loophole can occur: in accounting for financial assets, the only workable system is comprehensive mark-to-market, all of the time. The current situation is a consequence (intended or otherwise) of the piecemeal approach pursued by the FASB (and IASB) towards fair value accounting.

----------

*Note:  I made a technical correction to this post, that you can view here.