The Accounting Onion

"Vulture" Capitalism, Accounting … and Mitt Romney?

Rabid conservative ideologues believe that everything transacted in a free-market, i.e., unfettered by government involvement or regulation, is by definition a good thing. I presume this is why Newt Gingrich acted like he was between a rock and a hard place when going negative on Mitt Romney's wealth, which was gained largely out of the purview of government regulators.

Gingrich has been desperately trying to besmirch Romney's reputation by any means possible (and I do mean any), but either he has been too lazy to collect facts or he has been unwilling to risk offending too many of the politically conservative oligarchs. Gingrich's excuse for vague assertions and conjectures seems to be that Bain Capital's affairs have been impenetrable.

Before going on, I want to be clear about what this post is not: a direct criticism of Mitt Romney's business dealings. Other than reading one Wikipedia article, I do not have a single fact as to what Romney did or did not do while at the investment firm he co-founded, Bain Capital. My objective is to provide a roadmap to the others for acquiring facts (if they exist) for legitimately evaluating Romney's past dealings. The signposts along that road are mostly failures in corporate governance, but as you might expect coming from yours truly, financial reporting has a little something to do with the story.

Corporate Governance and LBOs

It is well-known that Romney became rich in large part through acquisitions of controlling interests in hundreds of companies. Some of those companies were start-ups, but others were mature; they were transformed in one way or another such that Romney, his partners and the investors in their private investment fund reaped large profits from buying them up.

Many of these companies had been publicly traded before Bain's investment; these are the ones I will be focusing on. Typically, firms like Bain Capital obtain their interest in public companies as part of a "leveraged buyout" transaction, or "LBO." Very simply, an LBO is the acquisition of a company financed by a lot of debt. Sometimes, an LBO is referred to as a "bootstrap" transaction, because the acquiree's future cash flows (either from operations or sale of operating assets) are expected to be sufficient to pay down the debt and provide a healthy return to investors. Very often, and critically so, the top management of the acquiree takes an equity interest in the LBO. That can create a conflict of interest between one's personal ambitions and one's duty to shareholders, and the history of LBOs since the 1980s is replete with shareholder fleecings.  Here's my all-time favorite example:*

On Dec. 6, 1983, the senior management of Metromedia, offered shareholders $720 million in exchange for all of the outstanding shares. The offer was accompanied by a prospectus in which it was stated that by taking the company private, management could more effectively pursue a long-term growth strategy. The offer also followed a series of very negative press releases, which were clearly designed to drive down the share price, and consequently, the cost of the LBO.

Upon consummation of the LBO, John Kluge ended up holding 90% of Metromedia's equity, without having invested a single dollar. Within two years, Kluge realized over $4 billion from the outright sale of most of Metromedia's businesses (so much for that long-term growth strategy!).

In 1986, Forbes identified Kluge as the second richest American, behind only Sam Walton of Wal-Mart fame.

Not coincidentally, I believe, the shakedown of Metromedia's shareholders happened around the same time as Mitt Romney was offered the opportunity to become a venture capitalist – for Kluge's coup must certainly have whetted the appetites of many a high roller. LBOs began to lose their luster as a get-rich-quick scheme starting in the late 1980s, but the ethics still remained questionable. In a nutshell, here's why: If a public company could benefit from shouldering more debt, improving operations or selling assets, why should it take an LBO to get the job done?

The LBO Accounting Story

All of this would be a digression from the main theme of my blog – financial reporting – without this additional accounting twist. LBO accounting was controversial until FAS 141R, Business Combinations, became effective in 2009. Up until then, one school of thought was that if management continued to run the same company, and/or the LBO transaction was absorbed by a brand new legal entity and effected outside of the target company (i.e., through the purchase of shares from existing shareholders), the carrying amounts for the assets acquired in the LBO should not change. Under that view, companies that are taken private could do an IPO a few years later with the same basis for their assets; i.e., without the burden of additional depreciation or amortization expense, and with a higher return on assets.

Is window dressing important to LBO investors? Maybe not to all, but to some (perhaps Bain Capital) it must be. EITF 86-16, Carryover of Predecessor Cost in Leveraged Buyout Transactions and its successor, EITF 88-16, didn't just come from nothing. The special accounting for LBOs structured in just the right way must have been pushed by investors who really needed that type of accounting to make their deals work. Paul Kluge would not have been one (although Abe Briloff called him out for questionable accounting a few years earlier – and Metromedia's stock price dipped 25%), but as deals became more difficult (higher buyout prices and lower leverage), maybe Mitt Romney would have been willing to use an accounting trick to sweeten a deal. EITF 88-16 was finally nullified by FAS 141R, but that was not until 2009, ten years after Romney left Bain Capital for good to enter politics. In the meantime, aggressive use of EITF 88-16 clearly must have played a part in LBO transactions somewhere and somehow.

Whom Do You Trust: Mitt the Vulture or the Newt the Dodo Bird?

Maybe Bain Capital's LBO transactions were pure as the driven rain. I don't know, and all I'm doing is providing a line of inquiry for those like Newt who seem to need a roadmap to validly question whether some or all of Romney's considerable wealth was fairly or ill-gotten. At the very least, those looking to put Mitt Romney's business career under a microscope should be asking whether the equivalent of Bain's brains and money could have been had without: booting shareholders out first; or paying such princely sums to Romney and his partners; or by giving preferential accounting treatment for LBOs. Creative destruction may be essential to economic growth, but vulture capitalism is not.

I don't buy Gingrich's excuse for not having facts to support his claims. There are always two sides to every transaction. Surely, if they exist, disgruntled counterparties and abused former employees of LBO targets should be all too willing to "swift boat" Romney. Come to think of it, since no one has yet to come forward, then maybe he's clean.

I won't speculate any further whether there are skeletons in Romney's LBO closet, but keep in mind that LBO transactions are rife with potential for conflicts of interest. For example, management may sell its own shareholders down the river for a quick buck; board members don't want to become too obstructive to their friends in management; investment advisers with a stake in the transaction may offer bogus "fairness opinions"; and auditors may remain silent even with full knowledge that a fleecing is about to take place. All of this could be happening as an LBO investor writes checks to facilitators and gives them encouraging pats on the back.

If Romney is complicit in a Kluge-type scheme to any degree, then a part of his fortune would have been built not from taking a fair share of value added through creative destruction, but through vulture capitalism – shareholder fleecing and economically unjustified upheaval of the lives of employees, their families and other innocent bystanders.

Ultimately, voters have a right to know.

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 *Adapted from two articles by Benjamin Stein in Barron's, "Where Are the Shareholders' Yachts: But John Kluge Pockets Billions from Metromedia's LBO" (August, 18, 1986); "Shooting Fish in a Barrel: Why Management Always Makes a Bundle in an LBO" (January 12, 1987).

What Should "Investor Protection" Mean to Accounting Standards Setters?

If you were to ask a financial regulator what 'investor protection' means in the context of accounting standards, the textbook response will have something to do with ensuring that investors have enough information to make informed investment and voting decisions.* Indeed, that's what also has been taken as gospel since 1978 when the FASB published its Statement of Financial Accounting Concepts No. 1:

"[F]inancial reporting should provide information to help investors, creditors, and others assess the amounts, timing and uncertainty of prospective net cash inflows to the related enterprise." (¶ 37)

I believe this has been the guiding philosophy of standard setting ever since. It is time to recognize that it is a failed philosophy.

Informativeness is in the Eyes of the Lobbyist with the Most Juice

First, to rank accounting alternatives on the dimensions of their 'informativeness' is deceptively difficult, if not just downright impossible. That's why FASB "due process" takes forever, and is more about politics than reasoned thinking. But, even if the goal of enhancing informativeness were the correct goal for regulators, what can be said about the progress toward informativeness that has been made over the ensuing one-third of a century? Not a whole heck of a lot.

Lawrence Summers gave a speech in 1999, when he was deputy Treasury secretary, which contained this remark about financial reporting:

"If you ask why the American financial system succeeds, at least my reading of the history would be that there is no innovation more important than that of generally accepted accounting principles; it means that every investor gets to see information presented on a comparable basis; that there is discipline on company managements in the way they report and monitor their activities." (source: a 2009 NYT column by Paul Krugman)

I am resurrecting those remarks from an earlier post because they demonstrate how central financial accounting is to the functioning of our economy; and conversely, the vast destruction that can occur when accounting doesn't work as it should. Perhaps, from Summers' perspective in 1999, accounting standards were more or less okay, even though he ignores the S&L debacle and the role played by inadequate loan accounting standards. But from the perspective of 2011, after all that has befallen us in the ensuing 12 years, surely he would have to recognize that accounting has become more a part of the problem than holding out much promise for being a part of the solution. (For a more contemporaneous viewpoint, I suggest you read Floyd Norris's recent column on the utter mess and disgrace that is the accounting for financial instruments.)

Some would say that the mission of the FASB has been to institute improvements to accounting standards, and on a case-by-case basis, there is no disputing that some improvements have been made. But, despite all the new rules and complexities, it's still much too easy to smooth income, and to obfuscate or just plain hide important information about risks and uncertainties. All in the name of informativeness, U.S. GAAP (more so, IFRS) gifts issuers with free choices (explicitly or often implicitly) among accounting treatments, and the privilege to make highly subjective and self-serving estimates. Nowadays, few are surprised at how powerless or unwilling, auditors are to stop issuers from making two plus two seem like something other than four. (Indeed, an important lesson here is that audit reform may not be possible without accounting standards reform.)

Accounting Standards as Weapons of Financial Destruction

Second, there is an aspect of reality that goes essentially unacknowledged in the FASB, SEC or IASB literatures: financial statements issued for public consumption routinely double as convenient, albeit very dangerous, management control systems.

For example, the attainment of a pre-determined amount of earnings under U.S. GAAP can be a surrogate for achieving underlying economic goals. This may ostensibly be the case because of the difficulty in measuring achievement of real targets. I say "ostensibly," because I'm not confident that enough corporate board members sufficiently appreciate the tradeoffs involved; in particular, the difference between reported net income and real profitability. Even granting a genuine willingness on the part of board members to exercise due care, they seem to be too easily won over to the point of view that game-conducive earnings-based compensation is the most effective way to achieve congruency between management's preferences and shareholder value maximization.

In short, "what gets measured gets done." Yet, by fixating on informativeness, the FASB has succeeded in ignoring this self-evident maxim throughout its entire history. And in doing so, the FASB (with the SEC standing idly by) has enabled a national tragedy at many levels: obscene levels of compensation awarded to management, impairment of U.S. competitiveness, mass disruptions of financial markets, shareholder value destruction – not to mention the chaos and misery inflicted on honest, hardworking and capable individuals.

Give Accounting Back to Shareholders

We desperately need to figure out how to make accounting part of the solution instead of a big, big part of the problem.

To start, we need to shift the primary emphasis of accounting standard setting from informativeness to 'stewardship' and 'external control.' By stewardship, I mean economic reality: the identification and valid measurement of the net resources that management has been entrusted to invest and utilize; whether management is taking the appropriate level of risk; and whether management has generated a satisfactory return to shareholders. External control is an outcome of a focus on stewardship in financial reporting, and by stewardship I am referring to the need to explicitly recognize that accounting standards have had, and will continue to have a profound impact on corporate decision making. (Pardon the digression, but this consideration by itself should be sufficient reason to stop all the IASB adoption nonsense.)

Granted, no set of rules can result in an accounting for all of the assets and obligations of an enterprise; and by extension, no set of internal and external controls can be expected to put a complete halt to shareholder value destruction through accounting-based managerial decision making. But, the least regulators can do is to endeavor to recognize a reasonable set of an entity's assets and liabilities, and to measure them in sensible economic terms. For a start, we should be using constant units of purchasing power instead of nominal currency units in comparisons. Even in times of merely low inflation, It is not true that a bank earns an economic profit when it ultimately collects $1,001 on a 10-year $1000 loan; yet, that's the way that bankers appear to think, largely because accounting rules permit them to act like it's okay to think in such naïve terms. And, just like Floyd Norris points out, we don't need about a dozen different free choices and all the subjectivity involved in accounting for stocks, bonds and loans.

* * * * *

My reading of history is more critical than Lawrence Summers'. It tells me that tight regulation of financial markets is necessary, because bad things happen when managers could end up being rewarded for decisions that destroy shareholder value. But, focusing on stewardship and external control does not mean that informativeness gets thrown out the window. In fact, I think the resulting financial statements would be more informative than those prepared in compliance with today's U.S. GAAP or IFRS. If done right, they should also be more auditable, but that's a topic for another post.

If investor protection were a horse, then when it comes to accounting standards the SEC and FASB have spent far too much time looking at the wrong end. (Don't ask me where I think the IASB has been looking!)

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*And also to prevent misleading disclosures, but that's not central to what I am thinking about here.

A Much Needed Accounting Lesson for Two Senators

Nothing good comes from bad accounting, and many of the bad things that happen are easy to predict: excess bonuses to management, negative NPV investments, underfunding of pension plans, etcetera, etcetera, etcetera. Yet, the instance I'm writing about in this post has a special flavor.

Savvy managers may know that the accounting rules they are exploiting fall far short of good, but others, in stark contrast to their status in society and evident sophistication in other matters, take the solemn pronouncements of the FASB for gospel. Recently, two U.S. senators have apparently forgotten or are oblivious to the fact that the making of financial reporting standards is more like the production of sausage than the engraving of the Ten Commandments by Moses on Mt. Sinai. Consequently, they have introduced a bill to model the tax deduction for stock-based compensation after the low-grade pork in a tube known to the accounting cognoscenti as Codification Topic 718 (formerly SFAS 123R).

The senators in question are Carl Levin (D-Michigan) and Sherrod Brown (D-Ohio). A couple of weeks ago, they introduced a bill to eliminate the so-called 'excess tax benefit' from issuing stock options to employees. The two senators note that the amount of expense reported for financial reporting purposes (for example, in SEC filings) is quite often less than the amount of the tax deduction taken per the tax return, and they seem to think that the so-called 'excess tax deduction' amounts to a government giveaway to corporations. If financial reporting measures stock-based compensation 'right' (and it surely does not), then by their logic it's wrong to receive a deduction that's greater than the expense reported for financial reporting purposes.

Bless their little hearts, but Levin and Brown (and surely other senators) are oblivious to the reality that the accounting evils lie in the financial reporting rules, and not the income tax rules. It is the financial reporting rules that are fraught with inconsistencies, for they were designed to systematically understate the cost of compensating employees.

The Economic Measure of Stock Compensation Cost

I'll be the first to admit that, when it comes to taxes, I'm sort of a babe in the woods myself. But, the complexity that is misleading the senators does not lie in the tax rules. The tax rules in this respect are simple, and a review of the fundamentals ought to be sufficient to set the stage for my accounting lesson to them.

There are two kinds of deductible expenses for tax purposes. The first type is the cost of productive resources that are consumed; examples include depreciation of productive assets, rent of productive assets, costs of inventory acquired and subsequently sold, and salaries of employees. The second type, financial cost, was at one time more controversial; and the most straightforward example is interest cost of debt.

Many decades ago, interest costs were seen to be fundamentally different than the costs of using productive resources. They were merely distributions to stakeholders, i.e., more analogous to dividends than costs of production. Eventually, though, in response to political pressure from railroads and other large corporations, taxing authorities adopted a shareholder perspective to tax deductions. In regards to interest costs, they should be deductible since they reduce the maximum amount that could be distributed to shareholders. In other words, from the perspective of the shareholder, expenditures on productive resources and the interest are both costs that reduce the amount of funds available to be distributed to shareholders.

Moreover, the tax law straightforwardly provides for the amount of interest that may ultimately be deducted as the difference between the total amount borrowed and the amount ultimately paid back to the lender. There is nothing magical about this, and it is consistent with the measurement of other tax deductible costs, including the stock-based compensation rules that are being challenged by Senators Levin and Brown.

So, one problem with their bill is that if you believe that the tax deduction for stock-based compensation should be consistent with interest costs, then you should agree that the ultimate cost of stock compensation should be the intrinsic value realized by the employee when the stock options held are recognized. And, in principle, the answer should not change whether the options are net settled, physically settled, or in the form of stock appreciation rights.

The Free Accounting Lesson

The foregoing is so mundane, I feel almost ashamed to have written it. But, I needed to do that to tee up the really interesting part: somehow, these two senators (and probably a few more) are either being grossly disingenuous or are laboring under the mistaken belief that U.S. GAAP on stock-based compensation (Topic 718) must be 'right,' since it was issued by the FASB after a decade of "due process." In point of fact, it is an embarrassing political compromise that was allowed to survive because its most outstanding feature is that it generally reports only a small portion of the full cost to shareholders of such programs (as I explained in the previous section).

Surely, the senators are aware that it was only relatively recently that U.S.GAAP began to require any recognition of compensation expense for stock options. The controversy was intense, and the best the FASB could do against stiff political resistance when they promulgated FAS 123R was to require that stock compensation expense be limited to the value of the options on the date they were granted – as opposed to either the date on which they were earned ('vested') – or most accurately and consistent with the measurement of other expenses, the date the options were exercised.

For example, assume that an employee is granted an "at-the-money" option to purchase one share of her employer's common stock for $8 per share, and she eventually exercises the option when the share price is $20 per share.

The option was granted on January 1, 20x1, at which time it was valued at $2 per share. It vests (i.e., becomes exercisable) four years later, and expires three years after that. The fact that a company's earnings reported to its shareholders is reduced by only $2 (and spread out over the four-year vesting period) while the amount of wealth transferred from shareholder to employee is $12 (i.e., six times greater than the $2 recognized for financial reporting) is one of the most glaring inconsistencies in gazillions of pages that comprise U.S. GAAP (or IFRS, for that matter).

* * * * * *

Bless these innocent children, who happen to be U.S. Senators, and keep them forever. Will they ever come to realize that the so-called 'excess tax deduction' (a financial reporting concept, not a taxation concept), which they have decried with indignation and sanctimony, is a blatant misnomer? A more accurate moniker would be 'insufficient financial reporting deduction', for the failure of GAAP to record the full amount of wealth ultimately transferred from current shareholders to employees.

Dear senators, GAAP is not gospel, and much of the time it is not even good. And, don't just take it from me. As one retired FASB member, David Mosso, now ruefully admits, GAAP (or IFRS – take your pick) is a "garbage truck."

I'm Not the Only One Dissing the SEC's IFRS Fixation

Every time I write a post, I might receive a couple of non-spam comments, and perhaps a few more private emails intended for my eyes only. Most of the feedback is positive, and even encouraging. Nonetheless, I am by nature particularly sensitive to negative feedback, even when delivered in a kindly and constructive manner.

For example, Edith Orenstein thinks I jumped the gun with my assertion that the "fix is in," on the forthcoming SEC Roundtable on IFRS; and Lane suggested that my arguments lack force when I predicted that some panelists would be shills. These comments came even prior to my most irrascible rant on the Roundtable after it took place. In some ways, this post is a response to Edith and Lane: I know that my comments are often unkind and liberally dosed with irreverence and sarcasm; but in my defense, I am not the only one out there letting their frustration with the SEC's IFRS fixation hang out.  Consequently, even in my most untethered moments, it feels kinda OK to know that I'm in pretty decent company:*

Lynn Turner, a former SEC chief accountant no less, circulated this email bearing the incendiary subject line "Stacked Deck":

"I find it interesting that so many credit rating agencies are given slots at the SEC IFRS roundtable when they were the very ones who so shafted investors. And Jonas who was at one of them, now at Morgan Stanley, and who was head of the AA national office is another one of the participants.

Take a look at the panelists on the small-company panel. Bank of the West isn't a public company – it's owned by BNP Paribas. Cuisine Solutions has a subsidiary in France – sort of unusual for a small U.S. company. Viropharma has a European unit. Tandy Leather has operations in Canada and the UK. Are you seeing a pattern here? They specifically aren't having as panelists the kind of strictly domestic small public company that wouldn't benefit from IFRS."

And in a subsequent email:

"The SEC so stacked this deck it is beyond one's imagination as to why they would expect anyone outside their 4 walls would see this as anything short of the typical Washington DC contrived outcome."

Jack Ciesielski, former member of FASAC, AcSEC, EITF and author of one of the most highly respected publications for financial statement analysts, described the upcoming Roundtable as a "railroad job." And he also wrote a must-read comment letter on the SEC staff's paper, "Exploring a Possible Method of Incorporation." Like Gaylen Hansen's remarks from the Roundtable, all of Jack's criticisms are quite devastating, but the one from Jack that resonates with me for its originality and the vividness of the example is the following:

"If the FASB is barred from starting projects independently of the IASB, how are American investors best served? There could be financial reporting issues that are unique to our country, that would never be addressed by the IASB - simply because they are not a problem in the rest of the world.

An example may help make the point. In the United States, many … are troubled by what they consider to be excessive executive compensation. There is only a limited amount of information available annually regarding executive compensation. More comprehensive information about all of a firm's human capital costs (not just executives' compensation), directly displayed in financial statements on a quarterly basis, would be useful for investors to help them assess the value of pay packages on which they vote annually. … There's no cohesive model or set of disclosures for reporting pay information. What gets measured, gets managed - and since there's not much reporting of pay information to investors, it's likely not to be managed too well.

It's a uniquely American problem, not shared elsewhere in the world. The FASB should undertake a project for improving investor information in this area - but it would be barred from doing so under condorsement, unless the IASB deemed it necessary. That's not likely to happen unless it became a problem elsewhere in the world. Is it fair to ask American investors to wait until an American issue that may be resolved by better accounting and disclosure is a problem in the rest of the world? In a word: No." [ first line bold in original, bold italics supplied]

Professors Ed Ketz and Anthony Catanach (Grumpy Old Accountants blog) evidence even less restraint in venting their frustration than yours truly. The title of their latest blog post, "IFRS is for Criminals" is more than sufficient evidence for that.

Floyd Norris, NYT columnist, trenchantly observed that, if the SEC were to follow through on its "condorsement" idea, many "flavors" of accounting would be the result for many years – if not indefinitely. The drive for IFRS to eventually replace U.S. GAAP increasingly appears to be coming from large companies who would like the SEC to give them the option to report using IFRS, just like many of their counterparts overseas.

But, I enjoyed Floyd's column the most for his one-liner response to the latest lobbying by IASB chair Hans Hoogervorst for the EU to endorse its latest pronouncement on the accounting for loan losses. Hoogervorst said straight out that the rule should appeal to the European Commission because it gives banks the free option to ignore economic reality, e.g., Greek bonds trading at junk debt levels:

"But it may not appeal as much to those who rely on financial statements, and would prefer to know when a bank's loans go bad. As a sales pitch, 'Adopt our rules and you won't have any losses' does not sound like a promotion for a superior set of accounting standards." [emphasis supplied]

Gosh, I wish I had written that!

Some say that the same sorts of political machinations are at work on U.S. GAAP. Even granting that point today (which I don't), imagine how things will look if more countried created an EU-like infrastructure for the purpose of lobbying the IASB for just the right IFRS standard to incorporate into its own system. The EU, the US, China, Japan and a hundred other smaller economies would be 'on board' with IFRS, but the IASB chair's head would have to be on a swivel in order to fend off each and every attack from increasing numbers of 'incoporators', 'endorsers', 'advisory groups', etc. The IASB will, in effect, devolve to something awfully akin to its early beginnings when the IASC (the IASB's predecessor) worked as a 90-person committee.

The only "standards" or "principles" back then were that there were none. A new era of balkanized accounting jurisdictions could put the IASB right back to where it started.

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*Some of the comments made were in private correspondence with me. In every case I received permission to reproduce them here.

"Goodwill Impairment" Accounting Could Become Less Costly – and Earnings Management a Lot Easier

When you start with a bogus asset like goodwill (itself a misnomer), it's hard to find quality in the rules that govern its measurement. The root of the problem is that business combination accounting relies on a fantasy: that an utterly ineffable plug to balance the business combination journal entry must somehow be an asset. The initial measurement of that plug is, at its theoretical best (i.e., assuming that management did not overpay; and all other assets and liabilities are recognized and accurately measured), an amalgamation of assets and liabilities that (unlike every other asset on the balance sheet) can neither be separated from the rest of the entity nor measured directly. Among the broad panoply of misnomers in financial accounting, "goodwill" is among the least subtle.

If goodwill is a bogus asset, then testing it for impairment compounds the madness. But, there is at least some method to it. The propensity of management to overpay for corporate acquisitions is one of the most well-documented and uncontroverted phenomena in academic finance: with disturbing frequency, share price movements send a signal that investors believe that a corporate acquisition destroyed, rather than created, value. If goodwill were recognized as an asset, but not subject to either amortization or impairment, then management would be even more inclined to destroy shareholder value without having to worry that future earnings would suffer from its profligate spending. Since 2001 (see SFAS 142), impairment testing, albeit replete with opportunities for earnings management, has been seen as the less silly of two silly charades. As currently set forth in U.S. GAAP (ASC Topic 350), this is how it is choreographed:

• All of the goodwill currently on the balance sheet has to be assigned to "reporting units," another misnamed artifice, invented solely for the purpose of making the goodwill impairment test flexible and palatable.
• The fair value of each reporting unit has to be assessed at least once a year – a costly undertaking.
• The real mayhem begins if, heaven forbid, your estimate of the fair value of the reporting unit turns out to be less than its carrying amount. You must then estimate the "implied fair value" of goodwill, another artifice devised solely for goodwill impairment testing; and –
• Write goodwill down to the implied fair value, if its carrying amount is greater.

Recently, however, the FASB issued proposed Accounting Standards Update No. 2011-180, which if finalized would grant unfettered discretion to elect to avoid these processes altogether – so long as "qualitative factors" indicate that it is more likely than not (MLTN) that the fair value of a reporting unit is greater than its carrying amount. The option to consider qualitative factors applies to any year and any reporting unit.

The existing goodwill impairment ballet can be a very costly production. While I am sympathetic to cost issues, I have a number of concerns with the way the FASB is addressing them:

More management discretion means more earnings management – The Board ostensibly decided to give entities the discretion to skip any qualitative assessment at any time. The stated intention is to save entities the cost of performing the qualitative test in a period when breaching the MLTN threshold could be self-evident. Allow me to illustrate my skepticism for this explanation with a slight digression – an example of a similar impairment test that I got wind of just this week:

I was contacted by an analyst who was concerned about a foreign energy producer that prepares its financial statements under IFRS. In accounting for its oil and gas field development costs, the company capitalizes the development costs associated with both successful and unsuccessful wells. The question I was asked pertained to a very large reported impairment charge from writing off the capitalized costs allocated to one particular dry well, one component of a block of wells comprising a "cash generating unit." The write off took place even though every other well in the cash generating unit was performing well beyond original expectations.

I explained to the analyst that IFRS (see IAS 36) provides the option to assess impairment at the individual asset level at any time – ostensibly to allow an entity to provide more timely information regarding impairments. But, ulterior motives may have been at work: With oil prices (and revenues) so high lately, the entity likely had more than enough accounting profit to absorb impairment losses this year, and still meet earnings projections. Hence, the entity apparently elected to pave the way for higher future earnings by taking an impairment charge in the current year with the main effect being reduced future amortization of development costs.

One of my philosophies of financial reporting – and a major theme of this blog – is that discretion in financial reporting invariably leads to abuse. In criticizing the proposal that entities may use the qualitative assessment at their own discretion, am I being too cynical? Or, is the Board being disingenuous? As you decide these questions for yourself, consider that a qualitative assessment in no-brainer circumstances shouldn't cost that much in the first place. Also, while there are already plenty of opportunity for earnings management in the FASB's extant goodwill impairment standard, there will certainly be times when entities will want to write off goodwill before issuing its financials, but can't because the MLTN threshold prevents it.

The "more-likely-than-not" probability threshold is not auditable – I have conducted seminars on financial reporting to thousands of practicing accountants; and my own impression, which is corroborated by a colleague who has done even more of this kind of work than I, is that CPAs are not well-equipped, nor are they excited about, making probabilistic judgments. Yet, the latest fad among standards setters is to require them to do so (and in some cases – leases, loans, revenue recognition – to generate entire probability distributions). Again, my philosophy that discretion leads to abuse is directly applicable.

Moreover, who shall review the 'reasonableness' of these probabilistic judgments? In the most important cases, it will be the "independent" auditors of large public companies, who are paid millions of dollars via checks bearing the signature of the company's CEO. I can see it now: two weeks before the Form 10-K is due at the SEC, a newly-hired auditor who still takes his job too seriously will question the reasonableness of the MLTN determination. Should the auditor require a re-assessment, the company won't have enough time to conduct its goodwill impairment test. Guess who gets inserted between a rock and a hard place?

Non-existent cost-benefit analysis – Federal law requires the SEC to justify a new regulation with rigorous and transparent cost benefit analyses, generally with hard data and quantitative assessments. I find it strange that both the IASB and the FASB (essentially the SEC's agent when it comes to making accounting rules) can trumpet the rigor and extensiveness of their "due process" without the same. In ASU 2011-180, the FASB is proposing, without even acknowledging any potential negative consequences, to allow reporting entities to side-step a series of rules that clearly were intended to mitigate shareholder value destruction.

More convergence nonsense – The Board mentions that it considered a number of other alternatives for changing goodwill impairment accounting. I won't get into the details here, but some of those alternatives make a lot more sense that the proposed rule changes. Irritatingly, much of the Board's rationalizations are based on their concern that a revised goodwill impairment standard should move U.S. GAAP closer to IFRS. But in point of fact, the goodwill impairment rules under IFRS are already as different from U.S. GAAP (with no plans for convergence) as night is from day. Under U.S. GAAP, the last long-lived asset to be tested for impairment, and written down, is always goodwill; but under IFRS, all long-lived assets are tested together, and the first asset to be written down is generally goodwill (subject to earnings management options that are currently not in U.S. GAAP).

* * * * *

Financial accounting costs too much because it is too darn complex. I am sympathetic towards efforts to reduce the costs of financial reporting, but in most cases, improvements are only slightly incremental and they come with too much baggage. The latest proposal for modifying "goodwill impairment" accounting is a case in point.

 

ASU 2011-2: The Accounting for Troubled Debt Restructurings Still Leaks Oil

I hand-waxed my 1990 Honda Accord last weekend in celebration of its 21^st birthday. Since it still runs like a top, I can take some satisfaction in having 'improved' my car. On the other hand, and it should go without saying, I would have been wasting my time if the engine were leaking oil.

The accounting standards for a "troubled debt restructuring," (TDR) just happened to get its second major wax job recently — in the form of ASU 2011-02, Receivables (Topic 310): A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring. And, unlike my Honda, TDR accounting was a lemon from Day One.

As everybody knows, the Honda brand is associated with very high standards for initial quality. Honda's mission is self-evident from its products: to make a profit from selling cars to misers like me; who are more interested in safety and long-term reliability than high styling, high performance and gadgets that will break and require my attention. But, I don't know how anyone could deduce the FASB's mission from its output, nor its target market. Here's how Leslie Seidman unhelpfully explained it in her recent Senate testimony (and for which I named her my "first goat" of those hearings):

"The FASB's mission is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information." [emphasis supplied]

There may be no better example than TDR accounting for illustrating just how vacuous that mission statement is. Basically, a lousy car will always be a lousy car, no matter how much "improvement" you get from a wax job.

SFAS 15: The Birth of a Lemon in 1977

According to Stephen A. Zeff's must-read 2005 article, "The Evolution of U.S. GAAP: The Political Forces Behind Professional Standards", TDR accounting, as "established" by the FASB was a lemon:

"In 1973, the City of New York was said to be bankrupt, and, with great difficulty, the banks that held the city's debt instruments restructured the debt by modifying its terms. The principal payments were postponed, and the interest rate on the debt was lowered. The banks proposed not to reduce the balance on their books of the loan receivable from the city and therefore not to recognize any immediate accounting loss. FASB began to study the question, and the possibility of recognizing a loss in the event of such restructurings was put to a public hearing. At the hearing, Citicorp Chairman Walter B. Wriston said that if the banks had known that they might be required to recognize an immediate accounting loss from restructuring the city's debt, 'the restructuring just might not have happened.' Furthermore, the prospect of a required recognition of a loss in such cases led Wriston to doubt that such restructurings would be possible in the future. His bombshell testimony put considerable pressure on FASB. In the end, the board [by a 5 – 2 vote in 1977, four years later] said in SFAS 15 that if, after a restructuring, the total cash flows to be received under the new terms were no lower than the balance in the receivable account, no writedown or loss recognition would be required. The standard was heavily criticized because it ignored the economic reality of the transaction altogether." [emphasis supplied, and thanks to Bob Jensen for bringing this portion of Steve's article to my attention.]

The economic reality, of course, was that New York City's new debt contract was worth much less to the bank than the original debt contract when it was issued; yet, not a single dollar of loss would be recognized. FAS 15 was a case of carrying the questionable logic of historic cost accounting much further than intended, while at the same time exposing its soft underbelly: the flawed logic was that accounting profits could be measured as if time, and to a certain extent risk, did not exist; the soft underbelly was the 'principle' that an arms-length exchange should trigger a new basis of accounting for an asset. Does an arms-length exchange take place when debt is re-negotiated? Of course it does, but TDR accounting depends on the pretension that, if played within the rules, no exchange is deemed to have occurred.

The upshot of SFAS 15 is that if it were a car, the engine would have seized soon after being driven off the dealer's lot.  According to Steve Zeff:

"Application of SFAS 15 also prolonged and deepened the financial crisis faced by banks and savings and loan institutions in the 1980s. Many banks and thrift institutions effectively became insolvent because of many bad loans, especially at a time of high interest rates. Federal regulators allowed them not to record writedowns or recognize losses after they had restructured loans to accommodate the debtors. Hence, many of these financial institutions could issue balance sheets projecting an apparent solvency, when many should have been closed. SFAS 15 was used by regulators to justify this policy. As a result, the standard was said by many to be the worst ever issued by FASB. [emphasis supplied]

One might be able to forgive the FASB if only it had learned two important lessons. First, it is not sufficient to merely "establish" any old accounting standard; it should be the equivalent of my Honda Accord -- i.e., built to last and be proud of.  

Second, it is not sufficient to merely state that accounting standards should be 'neutral', but they really do have to be neutral.  Financial statements can only be neutral if they reflect economic reality. TDR accounting was, and still is today, a misguided and biased attempt to obtain a political result by deliberately distorting the process by which loans should be measured and reported. What Walter Wriston was essentially saying is that the 'right' accounting for TDRs is the accounting that results in the proper quantity of loan concessions from banks. But, the question is 'right' for whom — bank executives, or bank shareholders?

The problem is that the 'right' accounting for shareholders is anathema to the Walter Wristons of the banking establishment. If creditors were required to measure loans at fair value as of each balance sheet date and as of each modification of the loan terms, then long-term modifications would only occur if the affect were to increase the fair value of the loan, relative to its fair value just prior to the agreed-upon modification by both parties.  Under SFAS 15, all we might know is that a loan modification did not upset the bank executive's earnings-based bonus arrangement.

Lemon Wax 

The S&L crisis exposed the fact that financial institutions were exploiting loopholes like TDR and vague standards for measuring loan loss allowances (FAS 5) to inflate their balance sheets. So, along came the first wash and wax job in the form of FAS 114. I won't go into the details here, but FAS 114 said that if it became 'probable' that a debtor looked wasn't going to pay what it owed, then the creditor would have to give the carrying amount of the loan a haircut. Not all the way down to fair value, but a haircut nonetheless.

Was FAS 114 an 'improvement'? Strictly speaking, yes. But, it was only just enough to perpetuate the ruse that TDR accounting made any sense at all. The loan-loss allowances recorded from the application of  FAS 114 were but a drop in the ocean compared to the actual losses incurred as a result of the financial crisis of 2008.

Which, finally brings us to the latest wax job, ASU 2011-02. FAS 114 proved to be an utter failure when applied to all loans, but let's for now just focus on the TDR accounting provisions. The ASU has not changed the measurement provisions of TDR accounting one iota, but has purported to firm up that soft underbelly I referred to earlier—maintaining the false dichotomy that some loan modifications are TDRs, and others are exchanges requiring a new basis of accounting.

Yes indeedy, all ASU 2011-02 does is to make it a little more difficult for a creditor to qualify for TDR accounting. But is ASU 2011-02 an 'improvement'? Strictly speaking, yes. But, let me ask the question another way. If the Federal Aviation Administration wrote safety standards like the FASB writes accounting standards, would you fly, or would you drive?

I'd be driving in my Honda.

* * * * * * * * *

The primary reason I dubbed Leslie Seidman "first goat" of the recent Senate hearings on accounting is because we have had more than enough of merely 'improved' accounting standards. The FASB's mission statement is a joke. Either Seidman fails to see that, or she knows how to keep a straight face when reading her prepared remarks. Whatever the case, someone (it's supposed to be the SEC) needs to tell the FASB to stop behaving like petty bureaucrats and acknowledge that after four financial meltdowns in 40 years, it is past high time for fundamental changes to accounting standards.

I have said it before, and I'll say it again: I believe that Bob Herz recognized the problem and articulated a solution. That's why he was fired, and that's why we have Leslie Seidman.

There's No Process Like FASB Due Process

The feedback from my last post, The Myth of FASB Due Process…, was mixed. On the bright side, Edith Orenstein, whose comments inspired my previous post, was flattered to be "venerated," even though we disagreed. And, accounting ethicist author, Michael Pakaluk, sent me this supportive email:

"Once again, you are exactly on the mark, although I would attribute FASB's woes to its being insufficiently a creature of the accounting profession, as a profession, not too much so (but I do not identify the profession of accountancy with the big firms).

Clearly accounting standards, as they are professional standards, need to be determined by expertise and good professional judgment, not by democratic vote. A doctor should stand by his best professional judgment as regards medical treatment, even if 1000 non-doctors disagree. So you are right that FASB's solicitation of comments should be construed solely as due-diligence, that is, to check whether it has overlooked crucial bits of evidence or arguments. (Stakeholder theory I believe is not the appropriate context with which to evaluate it, but rather the conception of profession in the strict sense.) The problem is, as FASB has been divorced from accountancy as a profession, its procedures have taken on something of the character of the political, not the professional, and hence 'due process.'" [italics supplied]

And, speaking of due diligence, here is an internal email that was forwarded to me from the Institute of Chartered Financial Analsysts (ICFA), an investor group that published a prescient fair value manifesto before the latest financial crisis hit:

"There other interesting observations to make about these form [comment] letters [on the fair value proposal]. For example, many of those sending letters don't prepare GAAP financials. The Bank of Montgomery (approximately comment letters 350ish-400ish) sent is 40 plus letters and they don't prepare GAAP financials – just bank call reports – as per my discussion with the bank's cashier. This is a case for many of those smaller institutions sending in letters…call a few in Iowa and you will see this to be true. Further, some of those sending in letters did not know they sent in letters. One guy told me I had the wrong phone number. Another said it did it because the ABA told him to and still another loan officer forwarded me to the accounting department as he couldn't explain the basis for sending in a letter.

It would be interesting to determine what due diligence was done on those sending in comment letters."

But, Denny Beresford, former FASB chair, took me to task on the AECM listserv for my opening swipes at the manner in which changes to the Board's composition appeared to have taken place:

"I was going to add a few of my own comments about due process and the FASB. However, after seeing your opening comments about 'the firing of the FASB Chairman' (nothing could possibly be farther from the truth) and the appointment of three new board members 'who could be reliably counted on to vote as FASF chair John Brennan clearly wished them to' (another silly contrivance), it's obvious that your mind is already made up and wouldn't be changed by any different perspectives. Bob Jensen's forwarded article 'In the Teeth of the Evidence' notes 'It turns out that people who have made up their minds are not receptive to information doesn't support their beliefs,' and your latest piece clearly demonstrates that statement. I actually enjoy reading your opinions about accounting issues but not when you couple them with such outrageous and unsupportable assertions."

In response to Denny's criticisms (whom like Edith, I venerate), I slightly revised my post to clarify that I was expressing personal opinions. But, since these opinions have personal connotations, I now feel compelled to explain them further.

Blogging Standards – Or Lack Thereof

I am not going to defend bloggers in general, or the lack of established standards for blogging, but this seems like a good time to tell you mine: simply to be truthful about what is on my mind.

It may be also be helpful to tell you something about what my blog is not: it is not journalism. I would expect a journalist to make a good faith attempt to represent at least two sides of an issue, and (perhaps most germane to Denny's comments) to corroborate evidence received from one's sources. I sometimes conduct research for a blog post, but it is much more common that I write about what I already learned or inferred from reading, studying and thinking. If I were to hold myself to the same standards as professional journalists are held to by their publishers, then my posts would take me a week to write instead of a day.

Why Do I Think As I Do?

When Denny makes his own unsupported statement that "nothing could be further from the truth" to describe Bob Herz's departure as a firing, he implies that he knows something I don't. He may indeed, but I don't what that would be; but more important, I do not believe I made unreasonable inferences regarding Herz and Brennan from the information that was available to me.

First, Herz's resignation came as a surprise. I had absolutely no inkling that Bob's goals were anything less than to serve out his full second term, or at minimum to shepherd the FASB through the SEC's momentous formal decision on the status of IFRS for public companies.

Second, Bob was a staunch supporter of fair value, and his opportunity to explain his principled views at a congressional hearing did not seem to go well. Third, the vastly divergent views on financial instruments accounting between the IFRS and the FASB (and even within the FASB) were looming as the biggest impediment to convergence. Fourth, the earlier questionable decision of the FAF to shrink the FASB to five members in the face of overwhelming opposition had all the earmarks of a political power play. Fifth, the rapidity after the announcement of Bob's resignation with which the FAF re-expanded the Board back to seven members with hardly a pretense of deliberation or valid explanation. And sixth, there was the appointment of board members with backgrounds leading highly predictable predispositions against fair value measurement.

I, Too, Am Outraged

Notwithstanding my earlier predictions that Bob Herz's departure (however characterized) and subsequent re-expansion of the Board would play out almost exactly as it has, the circumstantial evidence I enumerated above was adequate to convince me that devolution toward convergence was the FAF's unstated agenda. I did not explain the reasons for those views as fully in my earlier post as I have here, because I did not regard them to be central to the theme of due process.

I don't mind admitting that I, too, am outraged – by the politicization of much-needed financial reporting reforms – not just in regard to loan accounting, but in all the many cases where over-represented financial interests have prevailed in the name of "due process." This, more than anything else, explains why I chose to make an exception to my practice of avoiding personal references when discussing policy matters.

 

The Myth of FASB Due Process: And the Fact of Undue Influence

When the FASB announced last month that it was retreating from its proposal to require fair value measurement of all loans, someone identified by various media outlets as an FASB spokesperson (one Neal McGarity, whose name is not listed among the FASB's staff), gratuitously remarked, "The vote today is a reflection of our due process at work and how important input from our constituents is in decision making."

As you can imagine, that's not exactly how I would describe the series of events that redirected the FASB from nigh onto true north on financial instruments accounting back to yet another receipe for random number generation: the orchestrated form letter campaign from irate bankers; the firing (I strongly suspect) of the FASB chairman (a staunch proponent of fair value); and the appointment of three new board members, who could be reliably counted on to vote as I believe FAF chair John Brennan clearly wished them to.

McGarity's comment was the motivation for my own characterization of an FASB "operating behind the façade of democracy and due process," which in turn led to a lengthy comment from the venerable Edith Orenstein of the FEI Financial Reporting Blog:

"Due process can be difficult to examine, and one question to consider is whether a flood of identical comment letters (aka to some people 'form letters') should necessarily be discounted. I personally don't think so. If a point is generally agreed upon by tens, hundreds, or thousands of companies (or investors) I do not believe their choice of using an efficient means of communicating their views, even if the template was developed by a member of a business advocacy group -- or -- an investor advocacy group -- should color the substance of the view expressed, nor should the sheer quantity of responses be discounted just because they arrive as 'form letters.' Importantly, it is the quality of comment letters ('form letter' or not) that should be paramount, in addition to the quantity of comment letters - quantity, for whatever it's worth, is how democracy is determined."

I'll respectfully respond to Edith, but after I make a couple of general observations about due process.

What is FASB Due Process, Anyway?

The term "due process" is obviously much older than the FASB, or even GAAP. Wikipedia describes it as:

"... the principle that the government must respect all of the legal rights that are owed to a person according to the law. Due process holds the government subservient to the law of the land protecting individual persons from the state. When a government harms a person, without following the exact course of the law, then that is a due process violation which offends the rule of law."

All of the other websites I looked at provided similar explanations, which doesn't even remotely describe what the FASB says it is supposed to be doing.

So the first point I want to make is that "due process" as a description of the FASB's policies is a misnomer. The FASB's use (along with that of the monkey-see-monkey-do IASB) of the term is merely another instance of its tactical use of weasel words and phrases to cast an aura of gravitas on a process without having to actually specify that process in any significant detail. Of course, the guarantees of due process in law are highly specified, even though they may be intensely debated. Among other things, they consist of the right to a full and fair trial, governed by rules of evidence, impartiality, burden of proof, etc.

There are no real rules for due process at the FASB, like we see in the law: rules of evidence, decision criteria, etc. All we are provided by the FASB's Rules of Procedure (page 5) are vague statements that pretty much allow the FASB to do what it wants, when it wants. Maybe a new standard will be evidenced-based, or maybe it won't. Maybe a new standard will be consistent with the concepts statements (although those are also like nailing jell-o to a tree), or maybe it won't.

And, in case you're wondering, the term due process is nowhere to be found in the securities laws or in the way the SEC, the main source of the FASB's legitimacy, describes its own rulemaking activities.  The SEC simply states that "the Commissioners consider what they have learned from the public exposure of the proposed rule, and seek to agree on the specifics of a final rule." In other words, SEC evaluation of public comments is not part of a "due process" (or a democratic process) but simply purports to be a learning process.

If Not Due Process, Then What Process?

Actually, I wrote about that here, two years ago:

I have given some thought as to why ... very few [investors] submit comments of their own on SEC/FASB rulemaking proposals. My gut feeling is that analysts tend not to create much value for themselves by taking time to think about what financial reporting should be. To do so would just take time away from one's core activity of decoding the steady stream of dressed-up offal, prepared according to the latest financial reporting recipe book and tastily seasoned by management.

... The policy implication is that, instead of pining for more comment letters from investors, the FASB ... should acknowledge the free rider problem in their 'due process' deliberations. To my way of thinking, investor protection is usually accomplished by the exercise of common sense .... Comment letters from special interests urging some other path are dross, even if they outnumber investor comments by a margin of 100 to 1.

And last year, here:

The Board [should consider] the feedback from non-investor stakeholders – principally auditors, preparers, attorneys and other finance professionals – to the extent that such feedback provides relevant information regarding cost and feasibility of a proposed change to standards. However, the evaluation of a proposed standard's effect on relevance and reliability, [should] be made independent of feedback from non-investor stakeholders.

What the FASB should be doing to evaluate rule changes would be much more aptly described by the term "due diligence" instead of due process. According to Wikipedia, "due diligence" has its origins in the Securities Act of 1933, but has spread to many other applications. The main point, though, is that due diligence connotes comprehensiveness, rigor and reason. I readily grant that the FASB has numerous stakeholders, but (Neal McGarity take heed) the FASB has only one constituency, investors. Therefore, due diligence must involve giving due consideration to investors.

Dear Edith

That brings me to two specific responses to my friend, Edith Orenstein.

First, and as Edith correctly observes in a blog post of her own, the application of a due process concept to standard setting is squishy – but that's the intention. Due process at the FASB is a façade for allowing the Accounting Establishment to call the tune at the FASB. It's not just the big corporations and their trade associations cum lobbyists. The FASB is just not set up to function without the bodies that the Big Four lends to it. Of course, the quid pro quo is influence that goes well beyond their comment letters and those of their clients.

Due consideration of investor input implies that the FASB should not be unduly influenced by the Accounting Establishment, but it is in virtually everything it does. There is pressure on the Financial Accounting Foundation to appoint the right members; and the staff of the FASB and the members of the EITF are stacked with Big Four members.

Second, effective rulemaking needs to consider not only the content of a comment letter, but who wrote it. Unlike a democracy, though, some of the FASB's stakeholders should be treated more equally than others.

FCIC Gives Accounting Standards a Free Pass (Along with Practically Everybody Else)

Darn few, if anyone who wrote about the Financial Crisis Inquiry Commission's 600-page report has  anything good to say about it. Jonathan Weil at Bloomberg may have described its shortcomings as well as anyone, and he also provides a vivid example of how the commission took great care to avoid tread marks on the toes of the rich and powerful:

"To get to the heart of what went wrong with the report released yesterday by the Financial Crisis Inquiry Commission, check out its account on page 254 of how the largest investor in a cash fund managed by Bank of America suddenly pulled out $20 billion of its money in November 2007.

The withdrawal crippled the fund, which had $40 billion of assets at its peak, forcing Bank of America to step in and prop it up. The commission included a note about the episode in the back of its report.

'The identity of the investor has never been publicly disclosed,' it says. The note then referred readers to the source of the information: A couple of stories published in December 2007 by Bloomberg News and the New York Times.

And here I had thought the purpose of the commission's inquiry was to uncover new facts that the public didn't already know. Such as: The identity of the mystery investor that single- handedly kneecapped Bank of America's Columbia Strategic Cash Portfolio, once the largest cash fund of its kind in the U.S. The commission had subpoena power. It should have been able to get this information. It didn't, though." [emphasis supplied]

Thus, it should not have come as a surprise that the loan, derivative, repo and securitizations accounting standards so highly coveted by the members of the American Bankers Association – a lobbying group with political clout fast approaching the NRA's – weren't even discussed.

PwC Couldn't Get Out of the Way

I haven't read the report; and I won't, because I gotta make a living, OK? So I asked Lynn Turner, former SEC Chief Accountant, to confirm for me that the FCIC had indeed turned a blind eye on accounting standard setting. Lynn not only responded in the affirmative, he also excerpted for me a very interesting portion of the report dealing with the accounting by AIG for its now infamous "credit default swaps."

"AIG Financial Products did not have its own model or otherwise try to value the CDO portfolio that it guaranteed through credit default swaps, nor did it hedge its exposure. Gene Park explained that hedging was seen as unnecessary in part because of the mistaken belief that AIG would have to pay counterparties only if holders of the super-senior tranches incurred actual losses. He also said that purchasing a hedge from UBS, the Swiss bank, was considered, but … the head of credit trading … rejected the idea because it would cost more than the fees that the AIG Financial Products was receiving to write CDS protection.

Therefore, AIG Financial Products relied on an actuarial model that did not provide a tool for monitoring the CDOs' market value. The model was developed by [a finance professor who was close to AIG Financial Products' CEO]. The … model had determined with 99.85% confidence that the owners of the super-senior trances would never suffer real economic losses, even in an economy as troubled as the worst post-World War II recession. … [PwC], who were apparently also not aware of the collateral requirements, concluded that 'risk of default … has been effectively removed and … there are no substantive economic risks in the portfolio and as a result the fair value of the liability stream … could reasonably be considered to be zero." [pp. 266-267, emphasis supplied]

Here's some of my reactions:

• These contracts are in a gray area between insurance and derivatives. I'm sure AIG subrogates much of its insurance exposure (i.e., buys reinsurance), so why didn't it even consider 'hedging' its CDS exposure? Surely, the inability to obtain a reasonable price from UBS to take on some of the risk must have been a hint to AIG and PwC that they could be heading for a big tumble.
• How convenient it was to get a friend of the CEO finance professor to tell PwC what it most desperately wanted to hear. Basically, the finance professor was sent on a field trip to look for black swans. Since he didn't see any, he concluded with near 100% certainty that black swans did not exist. 
• Neither AIG's top executives, nor its auditor's actually understood the terms of the contracts they were evaluating!

And Lynn's comments are even more trenchant:

"[T]he FCIC report highlights how AIG did not have any models that would allow it to value its positions in its CDO portfolio. This was a huge multibillion dollar portfolio. Given this, one has to ask how the heck the company could comply with GAAP let alone manage its business. Furthermore, it calls into serious question how PWC did the audit and gave a clean opinion on AIG's internal controls. In court documents it has come out that PWC told AIG in the summer of 2007, before it signed off on the 2nd quarter 10-Q, that the company needed to get better models. Yet there was no public disclosure at the time of a lack of internal controls or problems with the financial reporting.

Even more concerning, is the FCIC report gives no indication the commission questioned or challenged PwC on this."

 

All's Clear. Full Speed Ahead on the Race to the Bottom

So, it seems that except for PwC, the Accounting Establishment escaped scot-free. Yet, just from this one incident should have suggested that accounting and auditing had some underlying issues. We are left to conclude that either: (a) the commission couldn't bring itself to even ask the tough questions about financial reporting; or (b) it didn't know enough to ask the right questions; or (c) all of the above.

If the S&L debacles, and then the Enron-era debacles, and now the 'financial crisis', all in less than 20 years, are not enough to kick start a fundamental re-thinking of financial reporting, then what will it take? Here's just a few of the questions that the commission could have investigated:

• Was S-0X 404 ineffective in preventing at least some part of the financial crisis? What is the evidence that reporting on internal controls over financial reporting is more than a go-through-the-motions boondoggle for auditors (and their bank clients) – unless and until an egregious accounting error has actually occurred and has actually been discovered?
• Does the evidence suggest that auditors lack the training and competency to evaluate the "reasonableness" of management's assertions – especially when it comes to complex contracts that hope to evade accounting rules and auditors' scrutiny? Can we really expect auditors to discover and take into account all of the critical terms of these complex arrangements?
• Do financial institutions, and preparers in general, have undue influence on accounting standards?

FASB Chair Leslie Seidman and accounting know-nothing Mary Schapiro (SEC chair) must be extremely relieved to have escaped the spotlight. Everybody knows that the accounting standards for loans, derivatives, repurchase agreements securitizations and even contingent liabilities all stink, and nothing more than band aids have been proposed thus far.

So, with the FCIC report behind her, and having "reversed course" set by her fired predecessor away from fair value measurement of loans, Seidman and the rest of the carefully selected shills on the FASB are free to focus on the priorities that will no doubt be her legacy: donning goggles and flippers with the EU to see who can take revenue recognition and leases the farthest toward the bottom on only one breath.

The Journal of Accountancy reported: "Seidman said FASB received 'overwhelming feedback' that preparers, auditors and others would prefer to have loans held for collection recorded on the balance sheet at amortized cost with a more robust impairment test." [emphasis supplied]

It seems that the new FASB chair can't even bring herself to utter the word "investors." Message to the FCIC: investigate that.

The FASB's Proposed Repo Accounting: Loopholes Still Abound?

Last November, the FASB issued Proposed Accounting Standards Update 1900-100, Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements:

"During the global economic crisis, capital market participants questioned the necessity and usefulness of the collateral maintenance guidance when determining whether a repo should be accounted for as a sale or as a secured borrowing. …

[The determination of whether sales accounting is permitted] is based, in part, on whether the entity has maintained effective control over the transferred financial assets. One of the relevant considerations for assessing effective control is … whether there is an exchange of collateral in sufficient amount so as to reasonably assure the arrangement's completion on substantially the agreed terms, even in the event of the transferee's default.

The Board determined that the criterion pertaining to an exchange of collateral should not be a determining factor of effective control. … The Board believes that the remaining criteria are sufficient to determine effective control."

Please allow me to translate and remove the varnish:

We were burned by Lehman Brothers, who on multiple occasions dressed up its balance sheet by exploiting a loophole in our repo accounting rules. We allowed Lehman to presume that, because they received 'only' 5 percent less cash collateral than the value of the assets they transferred to an accommodating counterparty, it would be able to account for certain repo contracts as 'sales.'

Our rationale for including in GAAP a size-of-collateral loophole was that even if the counterparty defaults on its obligation to return the securities, the transferor (e.g., Lehman) would be holding sufficient cash collateral so that the transferor could buy replacement securities in the market.¹ We now realize that our rationale completely ignored the basic fact that cash collateral is fully fungible with other sources of cash. The Lehmans of the world would have all sorts of cash hanging around for purchasing equivalent assets in the market, if that's what they wanted to do. So, let's be frank: we totally screwed up.

This proposed ASU is really our admission that collateral considerations had no basis in logic or reality. However, we really, really now believe that the remaining loopholes are sufficient for determining which party to a repo agreement has 'effective control'—whatever that means—over the transferred assets.

Will the Fix Work?

Under the remaining loopholes, a transferor would have retained 'effective control' of the non-cash assets (and have to account for the repo as a collateralized borrowing instead of a sale) unless it can wriggle through at least one:

• The financial assets to be repurchased are the same, or substantially the same, as the ones transferred;
• The repurchase is for a fixed price;
• The repo agreement is entered into at the same time, or in contemplation of, the transfer.

The FASB states in the proposed ASU that "…the assessment of effective control should focus on a transferor's contractual rights and obligations with respect to transferred financial assets," but I can't see how these three surviving loopholes have somehow fundamentally transformed the focus of repo accounting. I am also not sage enough to foretell what new devices issuers will invent, but wriggling through only one loophole is still all that it will take to achieve sale accounting.

Moreover, the logic of an overarching 'effective control' criteria remains, let's say, interesting. Has there ever been a coin flip that turned out to be 'effectively heads'? Sorry, but I can't resist this one: has there ever been an 'effective pregnancy'? Like 'control,' either you are, or you aren't;

A Principles-Based Solution

I described my approach to repo accounting in a previous post, and I'll briefly summarize it in enough detail here so as to add a clarification in response to a question I received.

The following procedures would apply to securities for which legal ownership (as opposed to 'effective control') 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 preferably be reflected on the balance sheet as a change in shareholders' equity through net income.
   
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 between these two amounts would be reflected on the balance sheet as a change in shareholders' equity through net income.

One reader of the post in which I described my proposed repo accounting asked whether I would also show a receivable on the balance sheet of a company that simply has committed to buy an asset under any sort of agreement (i.e., not just a repo agreement). My response is: no – except for financial instruments.

First, I would amend GAAP to require that all commitments or options to purchase or sell a financial instrument (perhaps with limited exceptions such as regular-way security trades) would be accounted for as any other derivative. I will readily admit that I am not an expert on determining whether a particular contract is accounted for as a derivative, but my understanding of the derivatives rules in Codification Topic 815 is that the 'forward' or 'option' aspect of a repo arrangement is scoped out. My proposal would fix that.

Second, I would require gross presentation of all derivatives. In other words, the receivable leg may not be netted with the payable leg – even if the terms of the contract were to permit net settlement.

Taken together, these two changes to GAAP would effectively eliminate opportunities for window dressing with repos. Even more significant, and as I have described in a post dealing with the credit default swap mess, these enhancements to GAAP would also result in more conservative balance sheet indicators of a bank's capital adequacy. By grossing up an interest rate swap, for example, a bank would recognize a receivable for the expected interest inflows and a payable for expected interest outflows. Under the current rules, capital adequacy is unaffected by the swap, whether the notional amount is $1 million or $100 billion.

Wrapping Up

Let's forget and forgive the FASB for the loophole that Lehman wriggled through, even though there was never any good reason for its existence. But, let's not allow the FASB to pretend that all the repo accounting rules need is a slight trim around the edges.

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¹As explained by former FASB chair, Robert Herz, in his letter to the House Financial Services Committee dated April 19, 2010.