The Accounting Onion

First Missive from the New Chief Accountant: Get Ready to Roll with IFRS

It came as no surprise that SEC Chief Accountant James Kroeker's first public foray, since Mary Schapiro deigned to remove "Acting" from his title, was to announce that the IFRS Roadmap has once again become a priority at the SEC. That should please his former employer, Deloitte, one of the Big Four IFRS Cheerleaders. To give you some indication of the goal-oriented culture from whence Kroeker came, here's a couple of examples from recent "surveys" Deloitte has been peddling.

In 2008, Deloitte asked financial professional what they thought were the benefits and costs of IFRS adoption. That sounds reasonable, but the next logical question appears to have been intentionally left off: which was whether respondents perceived that the benefits of IFRS adoption might not exceed the costs.

And, here's a sample question from a survey I received in my email this month:

In your view, what should the IASB's and FASB's approach be to convergence?

• Extend a comprehensive convergence plan over the next 5-10 years
• Achieve as much convergence as possible between now and 2011, and then focus on IFRS conversion at that point
• Wind down convergence efforts at this time, and support IFRS conversion
• Not sure

"Not sure"? What if you're "sure" or just pretty "sure"; but your answer is not one of the three that Deloitte is willing to tabulate? What if, heaven forefend, you are really "sure" that further convergence efforts would be a waste of time and money?

Answer to my questions: Should you dare opine that IFRS adoption is of no benefit, Deloitte doesn't want to have to acknowledge that gazillions of other like you perchance exist amongst the public, whose interests Deloitte has an ethical obligation to serve. These were not surveys; they were charades. They were put together to serve special interests – at the expense of the investors that Mr. Kroeker now is supposed to be working to protect.

Thus far, the text of Kroeker's remarks have yet to appear, as is customarily the case, on the SEC's website. Consequently, my comments will be based on press coverage from the following sources: CFO.com, Reuters and WebCPA.

Be Very Afraid … of a "Race to the Bottom"

Some people took IFRS adoption for dead, but Kroeker came to say that it has returned to becoming a priority at the SEC, in part because the financial crisis may have underscored its importance. It appears, for example, that without a single authority over standards, the U.S. and Europe may get caught up in a "race to the bottom" to set accounting standards most favorable to banks and to the detriment of investors.

While it is true that the EU has made its fears that lower-quality accounting standards in the U.S. will cause its banks competitive harm, more recent events don't comport with a race-to-the-bottom scenario. The FASB (as I have written here) is proposing that all loans should be fair valued. The FASB is clearing saying to the IASB, 'You can take the low road if you want, but we'll take the high road.' (By the way, there's no way that the IASB will follow the FASB's lead on this. If Sir David Tweedy so much as dreamed of requiring fair value for loans, he'd call up Charlie McCreevy the very next morning to apologize.)

Nonetheless, I do concede that, in the absence of SEC intervention, a race to the bottom is at least theoretically possible. But, for at least two pretty obvious reasons, that possibility is remote, if not downright silly to contemplate.

First, as a general matter, it is not clear that competition among jurisdictions inevitably results in a race to the bottom. As one of many possible counterexamples, consider the development of the state laws governing corporations. The Delaware laws are regarded by many to be least restrictive; however, many corporations choose to register elsewhere. There are two lessons from this that I can think of: (1) there is not necessarily one set of rules to suit all tastes; and (2) the stability and longevity of our system of corporate laws indicates that multiple law givers are preferable to giving the federal government a monopoly on that role. Thus, notwithstanding the 99 other reasons (okay, 10) I can think of, it is far from clear that granting a worldwide monopoly to the IASB is the most efficient thing to do.

Second, and this is the biggie, whatever Kroeker might fear about incentives of standard setters to debase their own coinage, his job, whether he likes it or not, is fundamentally to prevent a race to the bottom from even getting past the starting line. Various securities laws clearly state the authority of the SEC to set accounting standards for public companies. It must be said, however, that the SEC has published its policy that, for the most part, has left standard setting to the FASB. (For the rule wonks amongst you, that would be Section 101 of the codified Financial Reporting Releases.) Kroeker weakly assures us that the SEC will always be active in interpreting accounting standards adopted by SEC registrants, but the SEC historically has done much more than that – by judiciously picking its moments to pre-empt or outright reject FASB pronouncements.

Given Kroeker's own stated preference for uniformity in bank accounting and his own view of its significance in the global financial order, no opportunity could be more ripe than for the SEC to take the initiative on loan accounting. All Kroeker need simply do is to endorse the FASB's proposal to measure all loans at fair value, and counsel the IASB that they should get with the program. That oughta eliminate any fears of an accounting standards race-to-the-bottom.

But, alas, world peace is a more likely scenario; fair value for loans doesn't fly in the EU, so it surely cannot fly with Kroeker's former colleagues at Deloitte. Who wouldn't prefer to know what Kroeker's thinks about loan accounting than the Roadmap? But it's a steady diet of Roadmap that we will surely be force fed in the months to come.

Saying So Doesn't Make it So

As was sadly the case when Christopher Cox was SEC chair, I found nothing in Kroeker's remarks to indicate that he cares much about citing evidence in support of his ideology. Take these accounts:

• Reuters – "Kroeker … said … that in the more than 200 comment letters the SEC has received on the proposal, it was 'resoundingly clear' that people agree there should be a single set of global high-quality accounting standards…"
  
• WebCPA – A single set of global accounting standards is "…like motherhood and apple pie."

Given, as I reported here, that the overwhelming majority of investor responses to the Roadmap proposal want to tear it up, I don't know where he comes up with this stuff. And, don't forget about Deloitte's paranoia about even broaching the question in its "surveys." (By the way, Wayne Carnall, former PwC partner, and chief accountant of the Division of Corporation Finance had characterized the response rate as a pittance, and now Kroeker is spinning 180 degrees away from that.)

Ironically, Kroeker delivered his remarks before a meeting convened by the New York State Society of CPAs. It was there that another candidate for chief accountant, Charles Niemeier, trashed the whole notion of IFRS adoption for what it was: a full-employment act for the current chief accountants' former colleagues.

Not only were Kroeker's and Niemeier's positions as different as black and white, but the quality of their inputs and reasoning couldn't be more starkly contrasted. Niemeier's inspiration clearly sprang from a foundation of cited broad-based analyses produced by published rigorous, peer-reviewed, independent research. The source of Kroeker's remarks apparently came from nothing more than his own wishful thinking.

The Lease Accounting Proposal: What Investors Say

In this post, I'll be reviewing two comment letters submitted to the FASB in response to its Discussion Paper (DP) on lease accounting* by the Investors Technical Advisory Committee (ITAC) of the FASB, and the CFA Institute Centre for Financial Market Integrity (CFA).   My original comments are here. 

The lease accounting project is a strong test of the proposition that accounting standards are capable of cutting through the camouflage of legal form to get at the underlying economics of an arrangement. In that respect, FAS 13 has been a dismal failure, with untold amounts of shareholder value being destroyed by management machinations aiming to exploit complex accounting loopholes and bright line rules lacking no conceptual basis.

Almost any new standard will be a significant improvement over FAS 13, so one of the dangers we face is setting the bar too low. For example, since FAS 13 was promulgated over 30 years ago, the field of financial management has progressed well beyond the point where precise measurement of lease value drivers is on the frontier of our knowledge. I'm not just talking about academic theorizing, either. According to the book, Real Options: A Practitioner's Guide, economic valuation of complex lease terms was first undertaken by executives at Airbus, who needed to know the true cost of the flexibility they were writing into their leases to accommodate their customers' risk preferences. That was over twenty years ago! I'm certainly don't consider myself to be at the cutting edge of financial modeling, but give me about a week, and I should be able to write a spreadsheet to value leased assets and lease obligations that can capture 100% of a lease's complexity for more than 90% of the leases out there.

So, given the state of the art of leasing and finance, we should be expecting a lot more from the FASB than the usual medley of incremental piecemeal improvements they are proposing. We should not just expect that: (1) the assets and liabilities arising from leasing arrangements are appropriately measured on the balance sheet; but (2) that they should also be appropriately measured. As I will be describing, below, ITAC and CFA are pressing for (1), but are aiming far too low on (2). Ironically, given the prominence and reputation for integrity of ITAC and CFA groups, one thing that you can take to the bank is that their positions will be regarded as the upper bound on the concessions to investors that will make it into the final standard. Thus, the most to be had is recognition of leases on the balance sheet; but they will be reported as arbitrary numbers based on calculations that hearken back to the relative stone ages of financial management.

I'll now discuss some of the specific issues starting with the ones I have the least qualms about, and ending with the stuff that gets my goat.

Overall Approach to Lease Accounting

The DP proposes to eliminate operating lease accounting, with the exception of "non-core" and short-term leases. While both ITAC and CFA strongly support the elimination of operating lease accounting, they are both against the notion of a "non-core leases" category. Nobody would ever expect that lease capitalization would have to be applied to immaterial items; but whatever "non-core" is supposed to mean, it doesn't always correspond to "immaterial." It's a ridiculously silly notion, but I'll nonetheless award points to both groups for pointing that out—and doing it much more tactfully than I would have.

ITAC further adds that exempting short-term leases would be an open invitation to gaming, which surely must have been obvious to the FASB but somebody needed to mention it.

Scope of a Forthcoming Standard

Without calling out the FASB for the real reason that lessor accounting issues were deferred, CFA reluctantly accepts the FASB's decision to defer consideration of lessor accounting. The real reason for the limited scope goes something like this: 'We're already taking too much heat from financial institutions on loan accounting, so let's not mess with them any more than we have to.' ITAC, for my tastes, is being too conciliatory (perhaps trying to rebuild the bridges it has burned on IFRS and fair value?) when they state that they are content for now to focus on lessee accounting.

My own two cents — If there is any area in which balance sheet accounting standards can (and should be) symmetrical, leasing is it. If the FASB is serious about its commitment to an asset/liability view of recognition and measurement, then the only real revenue recognition issue in leasing is nothing more than how to present the changes in lease-related assets and liabilities on the income statement. I would not object to deferral of income statement presentation issues from the scope of the next major accounting standard on leases, but I'm disappointed that ITAC and CFA are not exhorting the FASB to get everyone's balance sheet right. Let the big boy lessors present their income statement any old way they want; and let's require detailed roll-forward disclosures of the changes in balance sheet amounts.

Measurement

Everything I have written to this point has been little more than caviling, compared to my consternation on the groups' positions regarding measurement. CFA states that discounting at the incremental borrowing rate would yield a reasonable approximation of fair value, even when there is "significant uncertainty." That's the great unsupported statement of their comment letter—probably because no support is possible.

In the years since FAS 13, alternatives to discounted cash flow (DCF) analysis have been sought and developed because one eventually had to acknowledge a truth that is exactly the opposite of what CFA claims to believe: the truth is that picking the discount rate to value contingent cash flows, and coming up with a reliable measure of the fair value** of those cash flows, is nothing more than a guessing game. Ad hoc adaptations of DCF modeling to option-ladened arrangements is so yesterday. That the FASB proposes to go back to the stone ages of financial theory is less surprising to me than learning that both CFA and ITAC are cool with it.

Here's a much more robust way to think about lease valuation. There are three categories of cash flows in leasing arrangements: (1) the unconditional rental payments to be made, (2) required payments whose amount is determined by reference to uncertain future events, and (3) optional payments. We should require that a preparer document and disaggregate the fair value of their leases by each of these components. This can only mean that options must be valued using option pricing models—i.e., nails should be driven with a hammer. Yes, not all of the cash flow elements of a lease are mutually exclusive, but modern valuation models take care of that. Disaggregation in disclosure of interrelated items is challenging, but reasonable assumptions can be made and disclosed.

As to separate measurement of options, the FASB suggests, and both CFA and ITAC don't object to, a version of DCF that truncates the expected cash flows at the "most likely lease term." Given the financial technology nearly everyone has at their disposal, it's a ludicrous suggestion. Therefore, I expect it will be embraced universally by issuers. That alone should cause CFA and ITAC to reconsider their positions.

ITAC supports the most likely lease term rule of thumb (incredibly, they elevate it to "principle" status in their comments), because it seems that everybody should be able to do it. So, not only are they proposing to pound nails with rocks instead of hammers, they don't think it's worth the effort to drive the nail flush. Who are we writing standards for? FASB ought to be thinking first of the Fortune 500, because that's the bulk of the U.S. economy. Simplistic models to accommodate smaller companies no longer make sense from a cost-benefit perspective.

CFA states that one reason they support the expected lease term approach is out of expediency: "…an acceptable alternative in the interim until the use of fair value for non-financial assets is addressed by standard setters." And when will fair value for non-financial assets be addressed by standard setters? Given the glacial pace of standard setting, and the priorities that standard setters seem to have set for themselves, I'm giving even money that we won't have a general standard on that for at least another 20 years; and 2:1 odds that it won't happen before hell freezes over.  Is that really how long the CFA is willing to wait?

The bottom line on the measurement issue is that if the FASB requires some ad hoc discounted cash flow model for measuring leases on financial statements, then one of two things are going to happen: either companies will have to measure leases twice – the approach they use for internal decision-making, and again with the FASB's stone-age approach – or companies will throw out the approach they use for internal decision making and base their decision entirely on how a lease will be portrayed in the financial statements. Neither alternative should be acceptable to CFA or ITAC.

And that brings me to my bottom line on the CFA and ITAC comment letters. Both groups are legitimately concerned about the quality of information that investors will get from a new lease accounting standard, and they evidently believe that getting leases on the balance sheet at any number is as much as they dare hope for without rocking the boat too much. However, both groups virtually ignore the potentially huge value that investors will realize if the new leasing standard leads to better decision making by managers. Assets that should be leased will be leased, and assets that should be bought will be bought. That vision can only be fully realized if lease accounting gets both recognition and measurement as right as it can be. CFA and ITAC need to hold the FASB's feet to the fire, because nobody will do it for them.

Finally, here's my message for the FASB. Elimination of operating lease accounting is a good thing; it will certainly cut into the book of business of financial engineers and lawyers who accomplish little more than helping management mwwt their financial reporting objectives by skirting the edges of arbitrary bright lines. But, if you choose to catapult lease measurement back to the stone ages, all you will accomplish is to invite those same advisors to adapt to a new game at shareholders' expense. You will not be pleased to eventually discover that, once again and forevermore, you will find yourself chasing your own tail to issue fresh interpretations of unprincipled rules, so as to put a stop to some of more egregious ploys; and worse, you will be pressured to issue new interpretations to widen some of the inherent loopholes in stone age valuation. In the process, your policy choices will surely destroy value for shareholders (although you will strenuously deny it).

Alternatively, you can craft a principled and perforce simple standard requiring economic valuation of leases. There will be some work to do in specifying the objectives of the measurement process, but you will actually be able to afford flexibility in the choice of models and parameter selection. If you do that, some managers will pay consultants, but it will be for honest advice from valuation experts; they could also eschew that advice by negotiating less complex lease terms that they can understand and value straightforwardly.  Honest advice is geared toward discovering the underlying economics of an arrangement, and it will cost a small fraction of the FAS 13-style advice. In the process of all this, your policy choices will create value for shareholders.  

But, don't just take my word for this. Credit Suisse analysts recently issued a report entitled, What if All Financial Instruments Were at Fair Value?" [I can't find it on the web, so I don't dare post a link to my own electronic copy]. In it, I discovered a refreshing message that I hope ITAC, CFA and FASB will take to heart:

"With companies paying more attention to the fair values of their financial instruments, behavior could change. The controls that would need to be put in place and the due diligence involved could force companies to better understand their assets and liabilities. If that were to result in better management, companies could be rewarded with a lower cost of capital." [emphasis supplied]

 

Shalom, and L'shana Tovah (Happy New Year!)

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*The IASB also has a DP out on the topic that is about 90% similar to the FASB's. So for simplicity, I just refer to the FASB's version from here on out.

**I am an ardent supporter of replacement cost measurements, especially for leases. For example, I haven't the slightest idea how the FASB is going to come up with an exit price concept for non-transferable leases. But, to avoid distractions from other points, I am going to presume solely for the sake of sidestepping this issue that all leases are transferable. It doesn't cause replacement cost and fair value to converge, but it gets us close enough for my purposes in this post.

Accounting for Economic Earnings: Inflation-Adjusted Replacement Cost

I am going to cap off the topic of loan accounting, which occupied my last three posts (here, here and here), with a 'proof' and further explanation of my solution to the simple problem I introduced in the first post of the series. I am doing this because some of you have asked me to explain my numbers further. Questions may also still remain regarding how the effects of inflation can be incorporated into a double-entry system of accounts. The answer is, of course, that they can, but there are a few new tricks that some might have not seen before. How exciting… new debits and credits!!

Kidding aside, even this simple example contains some mind-expanding elements for both professionals and advanced students.

For your convenience, this is a repetition of the problem statement:

• On December 31, 20x0, Lender Company invested $10,000 in a bond issued on that date with the same face amount $10,000. To keep things really simple for now (and to defer discussing differences between replacement cost and fair value), there are no transaction costs.
• The terms of the bond provide for two payments: $1,000 on December 31, 20x1, and $11,000 on December 31, 20x2. Both payments were made in full.
• Lender Company had only one other asset on December 31, 20x0: cash in the amount of $1,000. It had incurred no liabilities, and engaged in no transactions, except those related to the bond, through December 31, 20x2.
• As a rudimentary, yet sufficient, substitute for real-world measurements of inflation, we will blissfully imagine that there is only one consumption good in the world: beer. As of December 31, 20x0, a keg of beer cost $100. Immediately after the two payments on the bond, the price per keg rose to $110 and $121, respectively. (It would be perfectly legitimate to remove the dollar signs on the keg prices, and imagine that they are values of the Consumer Price Index.)

No matter, which basis of accounting you choose, the December 31, 20x0 balance sheet for Lender Company, stated in units of purchasing power as of that date will be as follows: 

I will now provide you with the T-account entries to derive the balances that are used to prepare the December 31, 20x1 financial statements, stated in units of purchasing power on that date:

 

Here are the explanations (I abbreviate "units of purchasing power" as "UP"):

And, here are the financial statements at the end of the first year:

Notice that the beginning balance sheet has been restated to reflect units of purchasing power as of 12/31/x1 (i.e., multiplied by 110/100)  even though the date of the balance sheet is one year earlier.

Finally, here are the T-accounts, explanations and financial statements as of the end of the second year:

Notice once again the treatment of the comparative periods:  20x0 has been inflated for two years (i.e., multipled by 121/100), and 20x1 for one year (i.e., multiplied by 121/110). 

To close, I'd like to remind you that reliable reporting of the effects of inflation on an entity can materially affect the financial statements, even when the inflation rate is pretty low. But, unfortunately, comprehensive inflation-adjusted replacement cost got an undeservedly bad rap when it was required by FAS 33 on a disclosure basis only. Among other things, very few accountants and analysts took the time to understand the numbers, because the patchwork implementation of some admittedly sticky issues were overly accomodating to issuers; and as a result, did not result in high-quality information.

I am hoping that inflation-adjusted replacement cost can at least begin a comeback as the FASB seeks to improve loan accounting. One thing they should know: substantial progress is possible even if inflation accounting and replacement cost measurements are not applied to all assets and liabilities. But, loan accounting, especially because interest rates are inextricably linked to expected inflation, would be a very good place to start. The implementation issues are much less problematic than, for example, hedge accounting.

Ten Reasons Against Mark-to-Market for Loans – and the Reasons Why They are Wrong (Part 2 of 2)

Continuing my previous post, here's reasons 6 – 10 with my responses.

6. There are also hedge accounting considerations. Paragraph 79 of IAS 39 does not allow interest rate risk hedge accounting for HTM securities. Paragraph 21(d) of FAS 133 similarly precludes hedge accounting treatment for interest rate risk and FX risk, although credit default hedges are permitted. Available-for-sale securities can get hedge accounting relief. Mark-to-market proponents could argue that elimination of HTM designations and valuation of all financial securities at fair value eliminates some of the complexity of having hedge accounting available for AFS securities and unavailable for HTM securities. However, in my viewpoint having hedge accounting for securities that the company pledges will truly be held to maturity causes more problems by having both hedge accounting and fair value adjustments on these securities set in stone for the duration of their life.

Inflation is a real risk, and it is independent of management's free choice in their accounting for that investment. Ironically, the risk of greater-than-expected inflation is greatest in the presence of such a pledge to hold to maturity, yet through existing hedge accounting rules management is discouraged from entering into a hedge to reduce the risk of excess inflation on the purchasing power of its future cash inflows. This is because the gains and losses on the hedging instrument would actually increase the volatility of accounting earnings, while the effect of the hedge would be to reduce the volatility of economic earnings!

If all investments in debt instruments were marked-to-market, then management would choose the economic hedge that best fits the circumstances of the enterprise; they could choose to hedge default risk, inflation risk, prepayment risk, or whatever other risk that concerns them without worrying about silly rules regarding arcane accounting definitions for "macro hedging," "hedge effectiveness," documentation requirements and more. Management would also not feel a push one way or the other toward a particular brand of "hedging instrument."

7. The argument for valuing the right side of a balance sheet on the basis of CLAIMS is grounded in agency theory. Trying to parcel out, in real time, the shift in relative economic fortunes is a pickle of a problem.

Actually, agency costs can occur because one party, usually the agent, is able to observe economic earnings (and take for itself an undeserved share of those earnings) because the principal cannot measure economic earnings as precisely and completely as the agent. Thus, accounting rules that deliberately distort economic earnings create agency costs, and not vice versa.

Exhibit A for the case that historical cost is the real purveyor of agency costs is the thankfully defunct SFAS 76 and related literature on accounting for an "in-substance defeasance" of debt. Basically, managers wanted to report gains upon early retirement of their bonds, which of course were measured at historic proceeds instead of being marked to market. (Obviously, the yield to maturity of those bonds had increased subsequent to issuance for whatever reason.) Those managers were prevented, either practically or contractually, in many circumstances, from retiring those bonds.

So, special interests did whatever they needed to do to get the FASB to permit in-substance defeasance accounting even if the bonds were not actually retired. The process was pretty straightforward: if enough dough were transferred into essentially riskless, irrevocable trusts whose funds could only be used to make payments to the bondholders, management could get their gain accounting upon funding the trust.

The economics, however, effectively transferred wealth from shareholders to bondholders for no other apparent reason, except to juice reported earnings. Essentially, the bondholders received a windfall gain, because their risky bonds on which they were earning a risk premium, all of a sudden were backed by a fully funded, risk-free trust account. In other words, they were still earning a risk premium without being exposed to any risk! Of course, after the FASB rescinded SFAS 76 et. al., the in-substance defeasance game became a lot less interesting.

My point is that agency costs are minimized when accounting reports economic income. Management can use the opportunity to report fictitious earnings to screw anyone they can: bondholders, employees, shareholders, whomever. Other examples include retiree healthcare costs (mentioned earlier) and compensation via stock options. In all of the cases I can think of when bad accounting became less bad, abuses lessened significantly.

8. We cannot report economic earnings to a point where fair value adjustments have errors of magnitude that destroy credibility in the reporting of earnings or assets or liabilities or equity. This is one of the reasons we do not report economic earnings from long-term purchase contracts such as the Dow Jones contract to buy newsprint (paper) from St Regis paper for 50 years. Sure we can build a model to estimate the 2009 $1.3 billion change in net present value over 43 more years of purchasing paper, but no sensible investor would have any faith whatsoever in that $1.3 billion number because of all the contingencies affecting both Dow Jones and St Regis over the next 43 years, including the possibility that newspapers will cease publishing hard copy in the next decade.

It is quite possible that this "purchase contract" could become a derivative within the scope of FAS 133, and thus measured at fair value, if net cash settlement were required or permitted on each delivery date, instead of physical delivery of paper. In other words, it is currently required (and noncontroversial) to report "fiction" for complex derivatives, but not for other complex (and even less complex) debt instruments, or lease contracts, or purchase contracts, etc.

I am not proposing that we abandon FAS 133's requirements to measure complex derivatives at a current value, but rather to say that if we can tolerate "fiction" for derivatives, I'd like to know why we shouldn't tolerate it for other contracts.

Furthermore, I can only conjecture that the two parties to this transaction would not have entered into it, or at least modified it significantly if it actually did fall within the scope of FAS 133 or some other requirement to measure it at current values. Maybe, instead of Regis providing Dow Jones insurance that the price of paper won't go to high, a more appropriate arrangement would be made with a properly funded financial institution.

The only way to fix this sort of agency problem is to require current valuation of all legal obligations to make future deliveries of goods or services. I know it sounds drastic, but I believe it's necessary, and at least in the arena of lease contracts, the FASB is finally acknowledging that ignoring such contracts by calling them "operating leases" has benefitted only management and its "financial consultants."

9. Continuing the previous example, courts of law most likely would not pay any attention to the net present value of paper from trees that have not yet been planted. One of the reasons we do not book long term purchase contracts is that, when broken, the damage settlements are often a miniscule fraction of net present value estimates of full-term contracts.

Again, my response to the valuation problem of the debtor/obligor is to mirror the replacement cost measurement exercise of its counterparty.

10. Mark-to-market accounting makes sense only to a point where the reported numbers have some relevance in estimating future returns and risks. However, when carried to extremes of sheer fantasy and valuation models with enormous missing variables, then we are no longer providing a service to investors. The problem with measuring assets and liabilities at replacement cost (or fair value) is that it is not the goal. If we report earnings with a total loss of credibility, the profession of accounting will become a laughing stock alongside the profession of astrology. Even economists (gasp) will laugh at us. Clients will no longer want to pay our fees --- that's the ultimate loss.

Actually, on an aggregate basis, I am not sure that clients are actually paying audit fees even today. Each year, the increase in the Big Four's liability exposure (including interest) may be outstripping the fees that they are supposedly earning with audits that do little more than provide legal cover for corporate executives to lay claim to as much of the shareholders' money as they can get away with. Shareholder suits are threatening to bankrupt every single one of the Big Four, and ironically, a more stable (albeit less lucrative) future for audit firms can be found in mark-to-market accounting. This may be a stretch, but I read a wonderful quote of Upton Sinclair (courtesy of Paul Krugman) just today: "It is difficult to get a man to understand something when his salary [or, Krugman adds, his campaign contributions] depends upon his not understanding it."

Even in the absence of a change in measurement attribute, the SEC needs to radically think about the kind of assurance services auditors should be providing on financial statements. As just one example, what is the quantum of investor protection that is added when an auditor documents in its workpapers that the management of Bank XYZ has made an estimate of its loan loss reserves that "appears reasonable"? In place of a rubber stamp from auditors who, despite what any law might provide, can be fired by management virtually at will, I would prefer to be furnished with an independent appraisal of the replacement cost of the loan portfolio, prepared without the involvement of management. Auditors should go back to what they most often do well: count cash: test calculations; confirm receivables, payables, debt amounts and inventory counts; and little else.

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That's all, folks. Here's hoping that whatever the outcome of the debate on loan valuation, it will consist of more than pure politics. As the anecdote from Clarence Sampson indicates, capital markets regulators have been pushing for improvements to bank accounting for ages, with improvements being grudgingly conceded in decades-spaced drips and drabs. Now, finally, the FASB is aiming higher. Let's see whether they can score a hit somewhere in the vicinity of the bulls eye.

Ten Arguments Against Mark-to-Market for Loans – and 10 Reasons Why They're Wrong (Part 1 of 2)

In my previous post, I argued that the FASB should require accounting for investments in loans at inflation-adjusted replacement cost.  I have not been flooded with reactions from readers, but I did ignite a lively discussion on the AECM listserv, composed mainly of academics, and which included a pretty comprehensive analysis from Emeritus Professor Bob Jensen of Trinity University. It's hard to say how most of the 700-odd members felt, but I did receive some hard jabs.  That indicates to me that there are some legitimate and broad concerns -- as opposed to merely selfish preferences of big money special interests.   

In this post, I have taken their comments (mostly those of Bob Jensen, but there were others who contributed their own, thoughtful two cents) to synthesize ten comments that I can respond to in an organized fashion.  Well, there are actually two posts, because the whole enchilada is just too much too swallow in one gulp without putting everyone to sleep.  I'll cover five issues today, and five tomorrow. There will shortly follow another post in which I will present a T-account derivation of the financial statements I provided, accompanied by calculational notes.

Why have I decided to make such a big deal out of this? I predict this topic will be debated as vigorously by capital market participants in the coming year as healthcare is being debated by the general public. Also, just as with the healthcare debate, there will be spillover to other issues: such as convergence with IFRS and adoption; measurement of all liabilities; measurement of real assets; and most important, the objectives of financial reporting. Thus, reasonable professionals, academics and students will probably have to do a lot of thinking to distill all the rhetoric and to feel comfortable with their positions on the issues.

As to my own views, it is no secret that am in favor of comprehensive inflation-adjusted replacement cost accounting.  Here’s my fantasy:  put me in a room for a year and pay me my consulting rates.  When the year is up, I will emerge with a set of comprehensive accounting standards based on constant-dollar replacement costs that will cover everything that GAAP now covers—in about 100 pages.  The basis for conclusions might take 50 more, and worked out application examples might require another 100.  Not everybody will like them, but everybody will come to understand them.  After that, I’ll re-write Article 2 of Regulation S-X to specify the roles of auditors and other experts in SEC-filed financial statements.

But getting back to reality and the scope of this post, I am going to limit the scope to debt instruments and liabilities.  I am also going to ignore the effects that changes in financial reporting per se have on regulatory capital, instead assuming that regulators will develop metrics of capital adequacy that are independent of changes in accounting rules and policies.  Indeed, there are indications that this may finally be happening.

The First Five Arguments Against MTM for Loans -- and Why I Think They are Wrong

1.  Some argue that HTM fair value adjustments reflect opportunity gains and losses when evaluating management. But these opportunity gains and losses may be so inaccurate that they remain in the realm of total fiction. [The commenter, Bob Jensen, considers "fiction" in this context to be "something that is either intentionally or accidentally reported as fact when in reality it is entirely made up out of thin air and does not relate to anything in reality."]

We should not allow fiction that we are 99.999999% certain is fiction. Keep in mind that all the fair value ups and downs of earnings totally wash out over the lifetime of an HTM security. Interim value changes are pure fiction, especially under IFRS where the penalties are too severe to turn fiction into cash.

Sometimes in accounting, we have to choose among the lesser of two evils.  As I have written about in a previous post, until FAS 106 was promulgated in 1990, it would be fair to state that a more insidious "fiction" had been fed to investors: that retiree health care cost liabilities were zero, when it was far more likely that the amount was closer to a trillion dollars – plus or minus a few hundred million.  Indeed, the chicken salad accounting (so-called "pay-as-you-go") prior to FAS 106, which inappropriately delayed recognition of those costs until they were actually paid in cash, is in large part responsible for the demise of GM, just to name one of many casualties.  Thus, even when economic values are measured with huge error, unbiased estimates of changes in value are far better than presentations that pretend that such changes are zero.  Despite its flaws, I'm quite confident that most would aver that FAS 106 was a much-needed improvement to financial reporting.  So, if one is against reporting "fiction" as a matter of principle, how can one justify "fiction" in measuring retiree health care costs, but not for loans? 

One might argue that narrative disclosures of changes in market conditions and other factors are preferable to imprecise measurement, but history has proven conclusively that in both the notes to the financial statements and MD&A, little more is provided than boilerplate.  As Pat Walters (Fordham) indicated on the AECM listserv, it would be preferable to measure economic values on the financial statements, and disclose contractual amounts in the notes. 

I also wonder whether those who support HTM because of measurement limitations, also support HTM for investments in bonds with readily determinable market values?   In fact, the two FASB members who objected to HTM accounting when it was promulgated as an allowed alternative were Bob Swieringa and Clarence Sampson.  Swieringa is an academic (whom I'm proud to say was one of my teachers), and Sampson is a former SEC chief accountant who worked at the SEC for 28 years.  The other five came from the Big Six and/or industry, and would have been seen by Lawrence Revsine through his "selective measurement hypothesis" as having been "captured" by the regulatees. 

Speaking of Clarence Sampson, in an interview sponsored by the SEC Historical Society, he provided a gem of a story that could foreshadow the kind of 'feedback' (to put it mildly) the FASB will get to its forthcoming exposure draft.  Sampson was asked about the SEC's decades-long battle to improve the accounting for financial instruments by banks:

"[Accounting by banks] … was by today's standards horrendous back in the '60s … bad debts were not shown as an expense; they determined income before they took out the bad debt …[W]hen the Commission considered this question, the Chairman of the Federal Reserve came over and protested, dragging his feet all the way …" [italics supplied]

I am supposing that the banking industry's arguments against bad debt expense reporting was something like, "We should not allow fiction that we are 99.999999% certain is fiction."  If that kind of reasoning didn't wash then, it shouldn't now, which incidentally leads us to dealing with the second issue.

2.  Suppose a firm borrows $100 million by selling 10-year bonds at 5% with the holding that debt to maturity. Letting earnings fluctuate for 40 quarters for fictional gains and losses of value changes on those bonds is more misleading than helpful investors in my viewpoint. It may be especially fiction if there are cost-profit-volume considerations. Just because a few investors in those bonds are willing to sell at current market (thereby making a market) does not mean that all investors are willing to sell at current market rates. There are issues of blockage costs of trying to buy all the bonds back versus buying only $1 million of those bonds back.

It is indeed true that the earnings fluctuations will wash out IF there is no inflation, AND IF the loan is paid in full.   The problem, though, is that inflation is ALWAYS with us; my example conclusively demonstrates that, when properly measured, the holding gains and losses on debt don't wash out, even when the bond is repaid in full.  The reason for this is that inflation, even when it is low, can have a significant effect on economic earnings.  Thus, it's a pretty safe bet that, if inflation were properly taken into account, managers' preferences for long-term debt as opposed to equity financing would shift towards equity.  And as another consequence of the proper accounting, it would become more common for regulated financial institutions to hedge their exposures to unexpected inflation.  Currently, accounting standards discourage that, even though it may be in everyone's interests to do so.

But, since the FASB is not proposing to measure the changes to loan valuations at their inflation adjusted amounts, I support their proposal to relegate the fluctuations in fair value to other comprehensive income (OCI), and to exclude them from the EPS calculation.  That's because I'm fairly indifferent as to income statement presentation, especially with the prospect that XBRL will allow investors to tailor income statement presentation to their needs.

As to the problems attendant with the valuation of one's own debt, I believe in symmetrical measurement of financial transactions, i.e., transactions that only transfer wealth as opposed to create it (see this post).  This means that a debtor should report its obligation at the lender's replacement cost of its investment (except that the debtor would not include the transaction costs that the investor would incur to replace the investment).  Among the advantages of relative simplicity and clarity of principle, blockage factors would come into play only if there were investors holding relatively large blocks.

3.    But even if we can accurately measure the value of the $100 million in debt, value to financial reporting is not served by booking repeated gains and losses that automatically wash out over the year life of the bonds. This is especially the case in IFRS where severe penalties are incurred for firms that the IASB imposes on companies that renege on their held-to-maturity pledges. How can you adjust fair market value of HTM securities for the penalty clauses of the IASB for reneging on HTM pledges?

Refer to my answer to 2, above, regarding the washing out of gains and losses when measured in nominal dollars, i.e., when adding apples and oranges. 

As to the IFRS "penalties," that comment refers to a provision in IAS 39 (para. 46b) in which a company must essentially cease use of HTM accounting for the current and subsequent two years if they liquidate a bond investment before maturity.  Actually, U.S. GAAP is not significantly different; the two-year penalty provision has been a long-established policy of the SEC staff since virtually the effectiveness of SFAS 115.  The IASC, probably controversially, inserted it in IAS 39 as part of their hasty scheme to appease the SEC and be able to state that it completed  the momentous, five-year "core standards" project one year early (1999).  What a joke. 

As to whether there is a "severe penalty" for breaking the HTM "pledge," absent any regulatory effects that are neither the fault or responsibility of accounting standards setters, I fail to see how changing the location in the accounts of one's debits and credits penalizes shareholders in any real sense.  Call me old fashioned, but cosmetic accounting changes don't affect future cash flows unless they are factored into management's decision making processes.  For example, a change in accounting could affect that portion of management's compensation which is earnings-based, and management could react accordingly; but if the BOD thinks that would be a bad thing, they could certainly make the necessary adjustments.

4.    We might be able to estimate a reliable change in value of a HTM-designated asset or liability, but reneging on the HTM pledge will impact a raft of other past and future contracts that are almost impossible to factor into the damage caused by reneging on a single HTM pledge.

If we require current-cost accounting in any form, then HTM goes away; and absent HTM, I can't conceive of any reason why management would pledge to hold a security to maturity without adequate compensation for giving up their options.  So, let's say that management does make that pledge and debt securities must be valued at replacement cost.  Valuing the security by the replacement cost of the security as an asset to investors should handle this problem.

5.    Debtors could book debt at current call back values, but these call back values often have penalty clauses that make them poor surrogates of current value, especially when penalties are severe.

I don't see this to be a significant factor if, as I stated earlier, the measurement of debt is its replacement cost to the holder. 

That's all for now.  My next post will deal with issues related to derivatives, hedge accounting, what agency theory has to say about the controversy, and complex executory contracts.  I'll give you the issues I'll be responding to, and you can start thinking about your own responses now!

 

6.    There are also hedge accounting considerations.  Paragraph 79 of IAS 39 does not allow interest rate risk hedge accounting for HTM securities. Paragraph 21(d) of FAS 133 similarly precludes hedge accounting treatment for interest rate risk and FX risk, although credit default hedges are permitted. Available-for-sale securities can get hedge accounting relief.  Mark-to-market proponents could argue that elimination of HTM designations and valuation of all financial securities at fair value eliminates some of the complexity of having hedge accounting available for AFS securities and unavailable for HTM securities. However, in my viewpoint having hedge accounting for securities that the company pledges will truly be held to maturity causes more problems by having both hedge accounting and fair value adjustments on these securities set in stone for the duration of their life.

7.    The argument for valuing the right side of a balance sheet on the basis of CLAIMS is grounded in agency theory.  Trying to parcel out, in real time, the shift in relative economic fortunes is a pickle of a problem. 

8.    We cannot report economic earnings to a point where fair value adjustments have errors of magnitude that destroy credibility in the reporting of earnings or assets or liabilities or equity. This is one of the reasons we do not report economic earnings from long-term purchase contracts such as the Dow Jones contract to buy newsprint (paper) from St Regis paper for 50 years. Sure we can build a model to estimate the 2009 $1.3 billion change in net present value over 43 more years of purchasing paper, but no sensible investor would have any faith whatsoever in that $1.3 billion number because of all the contingencies affecting both Dow Jones and St Regis over the next 43 years, including the possibility that newspapers will cease publishing hard copy in the next decade.

9.    Continuing the previous example, courts of law most likely would not pay any attention to the net present value of paper from trees that have not yet been planted.  One of the reasons we do not book long term purchase contracts is that, when broken, the damage settlements are often a miniscule fraction of net present value estimates of full-term contracts.

10.    Mark-to-market accounting makes sense only to a point where the reported numbers have some relevance in estimating future returns and risks. However, when carried to extremes of sheer fantasy and valuation models with enormous missing variables, then we are no longer providing a service to investors. The problem with measuring assets and liabilities at replacement cost (or fair value) is that it is not the goal. If we report earnings with a total loss of credibility, the profession of accounting will become a laughing stock alongside the profession of astrology. Even economists (gasp) will laugh at us. Clients will no longer want to pay our fees --- that’s ultimate loss.

 

FASB Could Finally Get Loan Accounting Right – Well, Less Wrong

One of the most positive financial reporting policy developments in a long time is the FASB's announcement, about a month ago, of its intent to require fair value accounting for nearly all financial instruments. An exposure draft is supposed to be coming out pretty soon, but that will mark only the onset of a protracted battle royal with issuers of all stripes. After all is said and done, it's going to make the IFRS shootout look like a tea party.

In addition to throwing their collective weight around, I predict that opponents will provide nothing new, but will instead be calling their old war horses back into service.  Among the first should be the argument that fair value is not relevant when management intends to hold their investments in debt instruments until maturity; consequently it will inject meaningless volatility in reported earnings in the vast majority of instances as loans are repaid in full. 

I can think of two responses to the argument. The obvious one is that much has changed since 1993, when the FASB voted 5-2 to adopt FAS 115, and acceded to the held-to-maturity camp, to allow issuers to blissfully disregard readily available market values. Granted, in some respects the standard was a small step forward in that some financial assets came to be measured at fair value, but it (along with a previous standard on loan impairment, FAS 114) enshrined the pernicious view that managers' assessments of the future consequences of their own mistakes are superior to readily determinable market values and market-based interest rates.

The FASB's current actions can only be seen as a tacit admission that amortized cost accounting for loans was a serious mistake, to put it mildly. I completely disagree with the Financial Crisis Advisory Group (whose accounting bona fides and independence should be subject to serious scrutiny), when it stated that "…it seems [weasel word] clear that accounting standards were not a root cause of the financial crisis." Nothing is more clear that accounting shenanigans fully licensed by GAAP and IFRS played a huge role in the financial crisis.  They delayed early warning signs to bank regulators regarding capital adequacy, and far too many decisions by managers were driven by the accounting result that could be obtained. 

My second response, however, is more subtle, but much more important because it enunciates a principle that the FASB would do well to consider in its deliberations.

A Simple Example

The following statement of facts and resulting analysis can also be downloaded from an Excel spreadsheet, here:

• On December 31, 20x0, Lender Company invested $10,000 in a bond issued on that date with the same face amount $10,000. To keep things really simple for now (and to defer discussing differences between replacement cost and fair value), there are no transaction costs.

• The terms of the bond provide for two payments: $1,000 on December 31, 20x1, and $11,000 on December 31, 20x2. Both payments were made in full.

• Lender Company had only one other asset on December 31, 20x0: cash in the amount of $1,000. It had incurred no liabilities, and engaged in no transactions, except those related to the bond, through December 31, 20x2.

• As a rudimentary, yet sufficient, substitute for real-world measurements of inflation, we will blissfully imagine that there is only one consumption good in the world: beer. As of December 31, 20x0, a keg of beer cost $100. Immediately after the two payments on the bond, the price per keg rose to $110 and $121, respectively.

If 'wealth' is defined as command over goods and services (in this case, beer) Lender's economic income can be straightforwardly calculated for each year, and in total, as follows:

 

By measuring income in monetary terms, we have a standard against which to measure any system of financial reporting Lender Company might adopt. That standard is correspondence of reported earnings to economic income.

The first set of columns in the table below comprises Lender's financial statements under the current held-to-maturity model. The second set is a sufficient approximation of the change that the FASB is proposing. Although income over the two years is equal to reported interest revenue under both systems, reported net income differs from year to year. Some would argue that the difference is a needless distraction since the loan was paid in full. The FASB will argue that there is information content to the volatility, especially in economic times when an alarmingly high proportion of loans are not actually paid in full; and especially in longer-term and more complex lending arrangements.

  

My argument is that the volatility is a natural consequence of inflation, and has its own economic consequences, even when all loans are paid in full. This can be seen from a third set of financial statements, below. In addition to changing the measurement attribute for the investment (as the FASB proposes), I am also changing the unit of measure—from nominal dollars, whose purchasing power declines over time due to inflation, to 'constant units of purchasing power':

Reported income now matches economic income exactly. So, by this standard for earnings quality, even the FASB's ambitious proposal constitutes only a partial answer.  It's a weak one at that because the FASB will still permit lenders to overstate profitability on loans with fixed interest rates and fixed maturity amounts.   Should banks that benefit from government-provided deposit insurance be making loans that fully transfer inflation risk onto its stakeholders? Whatever your answer, you should know that if the accounting makes fixed rate loans look more profitable than variable rate loans, then fixed rate loans will be on the first page of the playbook. 

It is also important to mention that fair value and replacement cost accounting are the same when dealing with financial instruments, until you add transaction costs to the picture.  Then, replacement cost will be the only system that yields economic income. That's because the transaction costs are properly seen as part of the investment as opposed to the inconsistent and rules-based treatments for them under both GAAP and IFRS.

In summary, if the principle goal of financial reporting is to generate a net income number that reflects periodic economic earnings, the FASB's proposal heads in the right direction, but two elements are missing: (1) adjustments for changes in the purchasing power of the unit of measure, and (2) proper treatment of transaction costs.  The main point is that volatility of earnings should matter, even when loans are paid back in full.

So, congratulations to the FASB for announcing its intention to require fair value accounting for all financial instruments, including loans and debt instruments. Although I know it won't happen, their opponents should console themselves with the fact that their earnings will still be overstated—even if they will be less manageable and more volatile.

Regulate Derivatives? Start with Better Accounting!

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

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

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

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

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

Derivatives are Like Butchers' Knives

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

FASB Amnesia?

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

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

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

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

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

Where is the SEC!?

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

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

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

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

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

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

Mark-to-Market Accounting: Scapegoat for the Failure to Properly Regulate Banks

The congressional hearings on "market-to-market accounting" are scheduled to begin in a few hours. I shudder at the prospect of financially-illiterate congressmen becoming putty in the hands of savvy lobbyists bearing gifts.

My concern was piqued by Steve Forbes' latest error-filled epistle sans data, which the Wall Street Journal rashly deigned to publish last Friday. I fear that it is a microcosm of what will unfold in the hearings: that mark-to-market accounting will become the scapegoat for practically the entire financial crisis.

"Mark-to-market accounting is the principal reason why our financial system is in a meltdown," writes Forbes. But unlike Congress, who will welcome the suggestion of a convenient scapegoat to keep its constituents at bay, I give Forbes credit for being sufficiently informed to know the real reason; and which lately seems to be fading to the background: DERIVATIVES!

The Forbes critique of mark-to-market accounting for banks and other financial institutions goes something like this:

• Writing down investments will reduce a bank's "regulatory capital," which will in turn cause to reduce lending.

• Reduced lending by banks triggers a vicious cycle: lack of investment begets higher unemployment, which in turn begets higher loan default rates, which causes the fair value of bank investments to decline even further.

• The current accounting rules implementing fair value exacerbate the situation by applying an illiquidity discount to "subprime securities and other suspect assets" even if there has been no direct evidence of impairment.

Forbes believes that President Obama should end "the most destructive policy of the Bush administration" (though I find it curious that he's waited until after Bush has left office to say it) by mandating historic cost for bank assets unless and until there is direct evidence of impairment. I am quite sure that FASB Chair Bob Herz, when he testifies at the hearings, will eloquently and fully describe the many shortcomings of this approach as they bear upon the quality of financial reporting, investor interests and public confidence in the capital markets.

But, Bob's testimony on mark-to-market v. historic cost should be no more than a side show compared to the real problem: derivative financial instruments have rendered the current approach to banking regulation obsolete. Capitalization ratios based on U.S. GAAP, if they ever were reliable, were reduced to white noise when derivatives hit bank balance sheets in a big way. Neither Steve Forbes nor anyone else can provide a solution framed as a change in accounting policy to change that critical fact. And, channeling democrat FDR's banking policies during the depression, which Forbes is wont to do even as he holds his nose, doesn't get us anywhere today; FDR didn't have the DERIVATIVES problem.

Take as a simple example, a financial institution (it could be a bank or an insurance company) that holds only one "investment." Let's say that investment is an interest rate swap with a notional amount of $50 billion dollars; the historic cost of entering into the swap was nil, and its current fair value is $1 billion dollars. Further assume that the bank has liabilities of $0.5 billion dollars. With a debt/asset ratio of 50%, is this bank well capitalized? Technically, yes, but effectively, not on your life. If interest rates were to move slightly in the wrong direction, a $1 billion asset could become a $10 billion liability; and the probability of that occurring could be 50% or more.

Forbes also contends that

"…although banks have twice the amount of cash on hand that they did a year ago, they lend only under duress, or apply onerous conditions…. This is because they know that every time they make a loan or an investment there is a risk of a book write-down, even if the loan is unimpaired."

The existence of derivatives suggests a much more plausible reason: the bankers know that they are going to need every penny of their cash if their derivatives positions go south as a result of, say, a slight increase to mortgage loan default rates. Stated another way, even though their cash position has doubled, they are still way short of capital.

The problem that we really want to resolve is how to restore the banks to a sound financial footing. Even granting that financial reporting to investors could play a role (and I don't), tweaking accounting rules that cover a surprisingly small percentage of assets that banks mark-to-market is hardly the job of Congress. Any solution must radically restructure bank regulation. Throw away any notion of capital adequacy based on capitalization ratios. Stress testing of future cash inflows and outflows is where it's at, and that has nothing to do with financial reporting. For a bank without derivatives, a strong correlation between a static capitalization ratio (based on some set of accounting rules) and the probability of future insolvency might be obtainable; but for banks holding loads of derivatives, we have learned through hard experience that Congress should acknowledge, that any correlation must be spurious.

Finally, although I consider this to be out of my area of expertise, I would like to offer one more suggestion. I believe that federal deposit insurance played a significant role in creating a sense of confidence in the soundness of our financial system. Like prudential regulation, however, it needs to be radically restructured.

Financial soundness of our economy is about whether the failure of one financial institution will damage the entire system. Getting back to deposit insurance, the government should not just limit its exposure to an account (e.g., $100,000 per account), but also to a financial institution. Following the example of Japan in its heyday, a conventional wisdom emerged in the U.S. that our banks would not be able to achieve the economies of scale and scope that would allow them to compete with their international rivals unless they, too, morphed into behemoths. Not only has that strategy failed from taking on too much risk, but U.S. banks along with their Japanese counterparts became "too big to fail," which has now become synonymous for "too big to exist."

I do not advocate that we issue a mandate to banks to break themselves up into smaller pieces, but we should reign in the perverse incentives that encouraged them to become too big in the first place.  One way to do that would be to limit the amount of deposit insurance per bank. Any bank that is too large by the new standard will break itself up without any further prompting, and one would hope the result will be more efficient than what would occur via government fiat.

Basically, I think it's a good idea for Congress to hold hearings related to financial reform.  I just hope that they come to an understanding that regulatory modernization that adequately addresses the singular risks to the financial system posed by derivatives must be an integral part of any legislative response to the economic crisis. 

Accounting rules, no matter how you regard the current batch, are purportedly established to benefit investors.  These rules have have nothing to do with what everyone agrees is much needed reform of the rules that regulate the activities of financial institutions.  Fixating on the accounting rules is not unlike choosing to buffing the scratches out of a car that won't start, instead of opening up the hood to diagnose the real problem.

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Note:  I am indebted, as is often the case, to Jim Noel for comments he made when discussing the idea for this post with him.

EITF 96-15: Godzilla and Frankenstein's Love Child

As I was researching a question for a client a couple of weeks ago, I happened upon a love child of two of my pet peeve accounting standards:

• FAS 115 (marketable securities) – especially the part permitting available-for-sale (AFS) classification;

• FAS 52 (foreign currency translation) – practically every word of it makes my blood boil.

I have written a number of posts on FAS 52, and this one here hits the basics, should you feel the need to get canned up on the topic before reading further.

The love child I speak of is EITF 96-15, Accounting for the Effects of Changes in Foreign Currency Exchange Rates on Foreign-Currency-Denominated Available-for-Sale Debt Securities. Based on the title, it obviously deals with an interaction between FAS 52 and FAS 115. But, as to why it was issued three years after FAS 115 is an interesting question. For every crime committed with accounting standards against investors there is some other special interest being served. In this case, I can only guess at what it was, because the EITF issue summaries gave no hint as to how this bee got under their bonnets.

U.S. companies with foreign subsidiaries are generally reluctant to repatriate excess cash from their subsidiaries if negative tax effects attach to the decision. While waiting for a more opportune time to bring the cash back to the mother ship, they have to figure out where to park it; and one strategy is to invest it in marketable securities issued by other companies based in the U.S. From a risk management perspective, at least the money is invested in dollars. However, as I'm about to explain, earnings-obsessed managers might shy away from that choice, even if it is clearly the right thing to do from an economic standpoint.

FAS 52 has many generous elements, but it is relatively demanding in the area of "foreign currency transactions," which, simply stated, are receivables and payables denominated in a currency other than the entity's functional (foreign) currency. Normally, the effect of translating from the subsidiary's functional currency to dollars gets carried into the translation adjustment without affecting income. However, (with certain limited exceptions) the translation of "foreign currency transactions" must be reflected in income. (I have written about this in a previous post, here.)

The question addressed in EITF 96-15 is whether a marketable debt security designated as available-for-sale is a foreign currency transaction. That sounds like a serious question, but it's actually quite ridiculous. Notice that the EITF is not questioning whether marketable debt securities designated as "trading," or designated as "held-to-maturity" are foreign currency transactions – but only those debt securities that are arbitrarily and capriciously designated by management to be AFS. Knowing only that ought to tell you that the fix was in before the first word of debate had been uttered.

The way I thought about the issue before I did my research was, if I must say so myself, perfectly straightforward. First, an AFS marketable debt security is still at bottom a receivable; some arbitrary AFS designation doesn't change that.  Second, FAS 52 is crystal clear as to the treatment of a receivable: it's a foreign currency transaction.

Notwithstanding the obvious, the EITF arrived at the opposite conclusion. By quasi-Talmudic logic that can only be fully appreciated by those ordained to be accounting policy makers, the EITF established a new record for the figurative hop, skip and jump that lead them to conclude that a marketable debt security designated as available-for-sale would not be a "monetary item" – whatever that has to do with the price of tea in China. Anyway, since only monetary items like receivables and payables qualify to be foreign currency transactions, an AFS marketable debt security cannot be one of them.

Eureka! Gold made from copper! In other words, make a loan marketable, arbitrarily and capriciously designate it as AFS to unmake its monetary item characteristics, and presto change-o, you no longer have to worry about income statement exposure. Do you remember the running gag on Late Nite with Conan O'Brien called "if they mated"?  That's EITF 96-15: two wierdos, FAS 52 and FAS 115, matched by a funny guy to beget horrible looking thing that only a CPA could love.

Prior to EITF 96-15, an earnings-obsessed manager might have chosen to invest excess cash in marketable equity securities despite the additional economic risks relative to investing in debt, because the accounting risks happened to be low. That's because marketable equity securities are not receivables; by the perversity of the way FAS 52 converts foreign currencies to dollars, marketable securities might as well be equipment or inventory. Paradoxically, investing in debt would have created income statement volatility, even though economic risks would be lower than by investing in equities.

The clearly evident purpose of the EITF was to create a discretionary safe haven for excess foreign currency. Whether you think that is a good thing or not, it is not my point. What should be clear is that it is for reasons like this the accounting oligarchs deigned to create the grand ole EITF in the first place: to do whatever it takes to spice the sausage we call GAAP to managers' tastes.