The Accounting Onion

FASB Could Have Easily Stopped the Repo Accounting Games: They Should Explain Why They Haven't

On April 19^th, FASB Chair Robert Herz submitted a letter to the House Financial Services Committee, explaining the accounting standards that applied to Lehman's repo transactions. In desperate hope that the Committee will also ask whether and how those repo accounting rules could be improved, I decided to follow the FASB's letter to the Committee with one of my own. I haven't sent it yet, but the gist of the latest draft is here in this post. I hope you will send me your comments, suggestions, hisses, groans, etc.

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The purpose of this letter is to supplement the information provided to you by Robert Herz, FASB chair, in his letter of April 19^th regarding, among other things, the FASB's accounting requirements applicable to repurchase (repo) agreements. As I will describe further below, I believe the committee should be aware that FASB rules addressing the accounting for repo transactions are based on needlessly complex and subjective criteria, which apparently gave license to the machinations that Lehman Brother Holdings Inc. (Lehman) allegedly engaged in for the purpose of removing liabilities off period-end balance sheets.

I would also like the Committee to be aware of the fact that the accounting rules governing repo agreements need not be based on criteria that invite exploitation by managers who care little about fair presentation of financial information to investors. On the contrary, it would be a straightforward matter for the FASB to promulgate rules governing the accounting for repo agreements that are simple, transparent, representationally faithful, relevant to investors, useful to prudential regulators, and would not provide an open invitation for abuse.

The FASB Should Amend Its Repo Accounting Rules

I am proposing for the Committee's consideration a different approach to repo accounting, the first requirement of which is that transferred securities would be measured at fair value. [Note 1] In fact, the FASB has recently announced its intention to require that virtually all financial assets should be measured at fair value.

Second, the following procedures would apply to securities for which ownership has transferred:

1. At the inception of the agreement, a transferor would recognize an asset for the cash received and derecognize the securities transferred. Any difference between these two amounts would be reflected on the balance sheet as a change in shareholders' equity through net income. [Note 2]
2. To recognize the commitment to repurchase the transferred securities, a receivable for the future return of the transferred securities would be recognized at its fair value; and a payable would be recognized at its fair value for the price to be paid for the return of the transferred securities. In contrast to existing accounting rules, these two amounts must be presented "gross"— i.e., they may not be offset. And again, any difference betwee these two amounts would be reflected on the balance sheet as a change in shareholders' equity through net income.

 

If ownership of the securities does not change per the terms of the repo agreement, then the initial transaction would again recognize the cash receipt, and also a liability to pay it back. The transferred securities would be unaffected. Ultimately the difference between the amount initially recorded as the liability and the cash paid to the counterparty in the repo transaction will be reflected as an increase or decrease to shareholders' equity through net income.

Comparing My Proposal to Existing Accounting Rules

I hope that the Committee will consider whether the standards of accounting that I have proposed are reasonable and would prevent abusive financial reporting practices. In my opinion, they are.

First, unlike the current rules, my proposal is principles-based. The accounting for a repo agreement should easily, given the sophistication of the parties involved, reflect the fair value of each party's obligations and rights.

Second, it appears that the complexity of the Lehman Repo 105 and 108 transactions were not driven by financial considerations, but only by an intent to qualify them for sale accounting treatment. One may debate whether or not Lehman's accounting for its repo agreements complied with existing accounting rules, and like Mr. Herz, I am unable to express an opinion on that without additional information. However, it is inarguable that Lehman's machinations, which were consistently timed to take place near the end of each fiscal quarter, had no other business purpose except for obtaining a particular accounting result. If the accounting rules I am proposing had been in effect, such machinations would have been ineffective for meeting Lehman's apparent financial reporting objectives.

Third, my proposal adds transparency through the requirement to separately report the fair values of assets and liabilities. As a matter of accounting policy, gross presentation should be required when net presentation would be misleading. For example, existing lease accounting rules require that some leases (so-called "capital leases") must be accounted for by the lessee by recognizing representing a right of use of the leased asset, and an obligation for future payments to the lessor. For reasons very similar to the issues raised by Lehman's accounting for repo agreements, the FASB has expressed its intention to require that all leases should be presented on a gross basis, even though the receivable and the liability are with the same counterparty. [Note 3]

Fourth, as Mr. Herz has explained in his letter, the accounting for repo agreements hinges on whether the transferor of securities has maintained "effective control," a condition which is difficult to describe, much less objectively determine. An "ownership" criteria, on the other hand refers to a legal standard, and use of that standard would have thwarted the alleged abuses of repo accounting by Lehman and any other reporting entity.

The Committee Should Investigate Whether the FASB is Responsible for Economic Damages Caused by Its Inadequate Repo Accounting Rules

As Mr. Herz explained, Lehman construed (and their auditor apparently agreed) existing repo accounting rules to permit them to apply sale accounting treatment to its Repo 105 and 108 transactions. As a result, Lehman was able to reduce its on-balance sheet liabilities; because sale accounting treatment calls for the transferred securities to be derecognized from Lehman's balance sheet, and the cash proceeds from transferring the securities was used to settle other liabilities. Under the accounting rules I have proposed, the liability shifting that Lehman had engaged in would not have been possible. This is because the net balance sheet effect, which is to increase assets for the cash received, and to increase liabilities for the obligation to pay cash to the counterparty, does not depend on whether the repo arrangement results in a change in ownership of the transferred securities.

More generally, the Committee should consider whether the existing FASB rules are appropriate for any repo arrangement. In my opinion, they are not. The FASB's rules are based on the simplistic assumption that any repo can be classified, and consequently accounted for, as either a secured borrowing, or a sale of financial instruments; and that a series of subjective criteria will reliably distinguish between these two species of repos. The result of the FASB's approach has predictably been that a small variation in contract language could tip the scales one way or the other toward radically different accounting treatments and portrayals of financial risk and solvency.

Moreover, the FASB should have known that its rules-based approach to accounting for repo agreements would be abused by some issuers to defeat both fair presentation to investors and to corrupt the inputs to capital adequacy calculations relied on by prudential regulators.

I hope that the Committee will see fit to investigate the issue of the FASB's responsibility further. While Mr. Herz did state in his letter that most repo agreements called for treatment as secured borrowings, the Lehman case has made the general public aware that the availability of sales accounting treatment may have contributed in a significant way to the instability of financial institutions, which in turn led to government bailouts of those deemed "too-big-to-fail."

The Committee should ask Mr. Herz whether the abuses of repo accounting that have occurred should have been foreseen by the FASB, and whether he believes that the FASB shares responsibility for the financial crisis that plunged the federal government into further debt, and the economy into recession.

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Note 1: Defining and measuring "fair value" are matters of considerable controversy. For the purpose of these comments, however, it is not necessary to consider this issue beyond acknowledgement that "fair value" connotes any one of various approaches for reporting a current economic value for an asset.

Note 2: Other treatments of the difference are possible, and I do not recommend that the Committee focus on that issue at this time.

Note 3: There is also a strong argument to be made for gross presentation of many other financial arrangements. For example, if interest rate or credit default swaps had been presented on a gross basis by financial institutions, their prudential regulators as well as investors would have been provided with a much clearer picture of the overall risk exposures of those entities. The added transparency provided by gross presentation, might have even discouraged many of the derivatives transaction that are widely believed to have been the root cause of the recent financial crisis.

On IFRS, CA Magazine Publishes what JofA Won't

The April issue of CA Magazine, which is published by the Canadian Institute of Chartered Accountants, has a lengthy feature article provocatively entitled "IFRS: Dead in the USA?". It author is Lawrence Quinn, a freelance writer based in Atlanta. Thus, I would hesitate to say that the article provides a Canadian perspective on our IFRS hemming and hawing, except for the editors having the mettle to publish a refutation of the south-of-the-border party line. You can bet the house that the AICPA's Journal of Accountancy would rather mail out pages of blank T-accounts than an IFRS downer like this one; shilling for IFRS is in JofA's job description.

Quinn reports that, despite the SEC's best efforts to spin the tepid and sparse feedback on its Roadmap proposal, even the erstwhile staunch proponents of IFRS adoption are ready to move on. A Microsoft executive says, "We've followed IFRS for years and have been proactively involved as the process moves forward. Nevertheless, we've finished our initial assessment of what will be involved in conversion or adoption, and we just don't see the savings." [italics added]

A FedEx executive is even blunter: "I sum up IFRS this way: SOX meets Y2K."

If IFRS adoption isn't for Microsoft or FedEx, then from whom is it? Even a PwC IFRS partner, whose job for years must have been to preach the gospel of IFRS, could not bring himself to allay the fear of runaway changeover costs: "I think cost is individual to every company; it's [conversion costs as a percentage of revenue?] not really calculable. I don't think anyone has really gotten their hands around this yet, and if they have, it's from 75,000 feet."

All of this has been reflected in responses to the Roadmap proposal by other credible sources. But, an interesting revelation to come from the article is that even after IFRS goes live in Canada, their public companies may still be able to choose US GAAP for its basis of accounting. After the paranoid EU pooh-bahs shut down Germany's US GAAP option before it could spill over the border to infect France et al, the Canadian option could be the next hope for hard evidence of real differences and similarities between IFRS and US GAAP. For one thing, it will be interesting to see how many Canadian companies currently applying US GAAP will stay with it; and of the Canadian GAAP companies, how many will switch to US GAAP instead of IFRS.

If the SEC were really interested in making an evidence-based decision, they should be waiting at least three or four more years for the mother lode of financial statement and security price data to be delivered to its doorstep. Waiting to learn from the Canadians' eminently reasonable and prudent policies would push off a final decision on IFRS in the U.S. until 2015 or thereabouts, four years later than the current impetuous schedule.  But, just because almost two years of an arbitrary timetable have been frittered away, a headlong rush into adoption does not all of a sudden become a sane or even reasonable thing to do. And, according to the CA article and virtually every other source, few here in the US (except, of course, the Big Four) are clamoring to put IFRS on a fast track anymore. In these trying times, it makes more sense that the SEC should be left alone for a while to repair the holes in its regulatory and enforcement regimes laid bare by the financial crisis, Bernie Madoff, and Judge Rakoff.

For its part, the FASB could be working to close some of the gaping holes in financial reporting, instead of merely "converged" – and very partially at that. Don't forget that some huge differences are not even on the agenda: pensions, asset impairment, and R&D, just to name three off the top of my head.

I'll have more on this in subsequent posts, but suffice it to say for now that many of the joint projects for which it appears that convergence is about to be attained (e.g., leasing, revenue recognition, financial instruments with characteristics of equity, financial statement presentation), are setting up to be real duds. They are hardly what anyone would consider principles-based, as is the SEC's wont, or will have resulted in 'demonstrably higher quality' accounting standards.

It seems that convergence is merely creating new rules, much as the new wavy mirror in the fun house makes one look short and fat instead of tall and thin.  Everybody knows that changes to accounting rules inevitably change management decision making. If the mirror on earnings is distorted, then contorted decision making could actually look good when viewed from that mirror.

The way 'convergence' seems to be going, the demand for managerial contortionists should continue unabated whether IFRS is adopted in the US or not.     

 

EU to IASB: It's Our Way, or the Highway

The EU is simply too committed to pertuating the giddy notion that financial statements can serve investors -- and be smoothed at the same time. That's why I predicted that they would soon respond negatively and vociferously to the SEC's recent statement of support for a brand of convergence that would end up forcing broader application of fair value on unwilling European financial institutions.

But, I could not have predicted that a reaction would come so soon, or so crudely. In an article entitled "Accounting Convergence Threatened by EU Drive," the Financial Times has reported that, "in a tense meeting on future funding for the IASB," the EU's internal market commissioner made its financial support conditional on greater board representation for banks and their regulators.

Is this a credible threat? I think, yes. The EU has already achieved its major objective for beating down US GAAP, which was to browbeat the SEC into accepting financial statements prepared in accordance with IFRS from European issuers without reconciliation to US GAAP. Granted, that objective has only been partially met, because the SEC still insists on the reconciliation of differences between "IFRS as issued by the IASB" and any provincial variation.

Nonetheless, the EU's saber rattling may not resonate well with European companies listed in the US. They could end up facing more onerous reconciliation requirements over time if the EU takes this issue to the brink. What's a bank to do if US GAAP requires fair value for its assets and liabilities, while a future watered-down version of IFRS, permitted in the EU, does not require reporting those fair values?

The bank would either have to break ranks with its European counterparts and reconcile to US GAAP, or terminate its US listing (including ADR sponsorship).* Neither would be an appetizing prospect, but the indications to this point are that the EU would dislike that scenario less than losing its leverage over the IASB should convergence continue—and especially if the US adopts IFRS. It seems that henceforth, the EU will be saying at virtually every new fair value increment that it really, really does not want to see the US adopt IFRS.

For its part, the IASB is boxed in. If it were to make a principled stand against this blatant threat to its independence, it could be quite easy for Europe to abandon the IASB for some alternative standard setting mechanism. Or, if the IASB caves to the demands of the EU, then it will lose the US. So, either way, convergence and US adoption of the IFRS are lost causes; obviously, the IASB cannot afford to be abandoned by the EU.

Some at the SEC may continue to disingenuously insist that convergence is like 'apple pie,' but this recent development should finally make it evident that convergence has become more like an albatross around the neck of the FASB. If the EU had their way, convergence would be nothing more than a race to the bottom, with the interests of investors cast aside in the process.

As one friend who called the FT article to my attention put it, "it appears the independence of the IASB is more a matter of one's imagination than reality." It's time for the SEC to get real.

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*If you are curious to know how a foreign issuer can avoid filing a Form 20-F even though it has US shareholders, you should take a look at Exchage Act Rule 12g3-2(b). 

A Tale of Shorn Sheep, Slaughtered Pigs and Keystone Cops

No One Would Listen: A True Financial Thriller is Harry Markopolos's own story of a futile eight-year quest to expose the $65 billion Madoff fraud. As an SEC alum myself, I was not looking forward to reading a blow-by-blow description of gross incompetence at my alma mater as it were.  I stared at that brown and black book jacket sitting on my desk much as I stared at one memorable dinner plate from my childhood, holding a generous dollop of slimy, similarly colored mushrooms that seemed to dare me to return its limpid gaze.

And, where would the "thrill" come from as the scheme sans apparent motive abruptly came to an end? Madoff himself had effectively written the anticlimax when he turned himself in to the authorities before he would suffer the indignity of being properly caught in the act. I did know that I would be reading about grave mistakes having been made, from which everyone with more than a passing interest in U.S. capital markets would have something to learn. Thusly did I know I would be compelled to read No One Would Listen, much as I knew the two-headed power of our home well enought to predict with absolute certainty that I would be eating those horrible looking mushrooms before TV time.

The mushrooms actually tasted pretty good (my Mom is still a wonderful cook), and much to my surprise, No One Would Listen was might tasty, too. The red meat was, as expected, the SEC's incredible ineptitude; a case of truth stranger than fiction served blood rare. However, the role of "feeder funds" was more complex than simple meat and potatoes aiders and abettors; although to be sure, there was enought of that.

Some feeder funds were managed by third- and fourth-generation rich kids who were as lost as babes in the woods when it came to rigorous financial analysis. All they really cared about was that Madoff had that je ne sais quoi they thought they could trust; to give the blue bloods the excess returns that they were entitled to by their place in the natural order.

A more insidious group of feeder funds portrayed themselves to investors as due diligence mavens, when in actuality they (along with the audit firms involved) did little more than go through the motions. Like the blue bloods, they merely accepted everything Madoff supplied them without any real verification.

All Ponzi schemes raise the ineffable question as to how otherwise intelligent folks turn off their brains when offered the prospect of money without work or risk. But, too little attention seems to be paid to the thinking and actions of those who confidently recognized a true-good-to-be-true offer for what it is. Markopolos writes that for him, one of the most disturbing aspects of the Madoff affair was that hundreds of analysts like him must have been aware of the mass fleecing going on. Yet, only Markopolos and his small group of compatriots apparently tried to do anything about it. I don't know who should feel worse: the suckers who were taken in by Madoff; or those who knew full well what was under foot, yet chose to stand idly by. Ah well, more about that later, when I discuss incentives for whistleblowers.

Can The SEC Do Better?

Markopolos has a number of insightful suggestions for reforming the SEC, and even if you don't care to read the entire book, the lengthy epilogue is worth reading to prime your own pump. I'm going to comment on two of the areas that primed mine: radical restructuring of the SEC staff, and changes to incentives for both staff members and whistleblowers.

With respect to reconfiguring the staff, I agree that there are far too many lawyers, but replacing them with experienced finance professionals, as Markopolos proposes, is a lot harder than it sounds. The problem is that the government can't pay competitive wages to competent and experienced professionals unless it can supplement a paycheck with non-pecuniary benefits, e.g., on-the-job education and 'relationship building.'

SEC lawyers and accountants accept below-market pay sometimes because of lifestyle considerations, but much more often they do so because it creates other options for them. The private sector values the technical and institutional knowledge acquired while at the SEC, and it must be said their tight relationships with SEC staffers doesn't hurt. Such is evidently not the case with financial economists. The best and the brightest are hired straight from school onto Wall Street and soon, if not immediately, command salaries and bonus prospects that are many times greater than SEC staffers of similar vintage. Moreover, SEC experience won't make them any better, brighter or more marketable. The unfortunate reality is that the SEC will have to obtain its financial expertise elsewhere—perhaps through consulting arrangements under which it can pay market rates.

Regarding incentive bonuses to staff, Markopolos suggests that the SEC create compensation bonus pools from collected fines. With all due respect, I think that's an even bigger stretch. If an SEC staffer, who has been working full-time and full-out on a Madoff-size case unexpectedly discovers exculpatory evidence, how will that be handled? If the staffer's family budget depends on getting a bonus out of the case, will she try to bury the evidence? While I would like my government to be highly effective enforcers of the law, I fear much more a government where there is even a slight appearance that law enforcement officers have a personal financial incentive to prosecute and convict the innocent.

Where Markopolos and I agree completely is on the cryingly obvious need to give greater incentives to financial fraud whistleblowers. One of the things I find most pleasing about the securities laws governing financial reporting is that the SEC's enforcement capacity is augmented by private litigants seeking to recover damages and penalties from companies and individuals that violated the securities laws in some fashion or another. Thereby, shareholders and the lawyers who retain them (sometimes in reverse order) are given strong economic incentives to police violations of the securities laws. To be sure, some defendants will be harried by frivolous claims, but that cost seems to pale with the benefits.

So, why not extend this logic to violations by investment advisers and funds? Let's provide an incentive for individuals, be they employees or others, to come forward with direct evidence of financial fraud, and reward them generously when a case is prosecuted successfully. Markopolos points out that a bare bones program is already in place at the SEC for insider trading cases, but somehow the SEC has avoided shelling out much money to its sources. The IRS and other government agencies have much more developed and successful whistleblower programs that the SEC can emulate and/or adapt.

Markopolos also points out that the processes by which whistleblower complaints are vetted needs to be made more efficient, and I would take his suggestions even further. I would require that whistleblowers make their concerns known via a formal, non-public filing process (to be unsealed after a period of time). The instructions to a whistleblower complaint form would set forth the minimum level of specificity of allegations and strength of supporting evidence in order for the SEC to even consider taking further action. The whistleblower could also choose to remain anonymous by engaging a lawyer to handle the filing, and there might be a small filing fee, say $1,000. It would also be specifically established that false filings of whistleblower complaints would themselves be subject to sanctions.

To effectively process the whistleblower allegations and to fairly distribute awards, the SEC would establish and publish its procedures for, among other things, assigning files to teams of enforcement staff members who possess the technical competence to deal with the issues and, if necessary, engage outside consultants. Just as in the Madoff debacle, the inspector general's office would investigate the valid complaints that fell through the cracks, but it would also continuously monitor the handling of all whistleblower filings.