The Accounting Onion

Securitization Accounting and Grand Theft Auto

Many books and articles have been written to describe the mishaps that led to the Great Recession of 2008, but few have done so while putting the role of accounting standards and auditing in context. I reported back in January 2010 that Paul Krugman at least was cognizant enough of accounting to acknowledge that we do not presently have honest financial reporting standards that let investors make good decisions and that "… forces management to behave responsibly." But, other than changing the name on the sausage packaging from GAAP to IFRS, detailed suggestions for achieving fundamental change have been exceeding rare.

NC State accounting professor Paul Williams also drew inspiration from Krugman's column and the financial crisis for a brief paper entitled The Wrong Metaphor, which I recently heard him present to the Public Interest Section of the American Accounting Association. Much as I have (but certainly with some important differences that you should read for yourself), Williams has come to the conclusion that a paradigm shift is needed for accounting to re-assume its proper role in society. I wish we could have much more from Williams reagrding what he thinks should be changed and how to make change happen.

A recent paper by S.P. Kothari and Rebecca Lester of MIT, The Role of Accounting in the Financial Crisis: Lessons for the Future, is very strong in its description of flawed accounting and its potential role in the past crisis. These are some of the basic messages:

• The accounting rules provided originators of subprime mortgages (SFAS 140) the opportunity to record economically specious gains on securitization transactions.
• The accounting rules also permitted regulated financial institutions that invested in financial instruments created out of subprime mortgages (MBOs and CDOs) to delay recognition of likely losses; which, in turn, distorted measures of capital adequacy.
• Estimation errors, most significantly estimates of fair value, committed by issuers of financial statements and their auditors exacerbated the accounting misstatements inherent in the accounting rules.

Although, like Williams, the Kothari/Lester did not provide much in the way of "lessons for the future," I would still highly recommend it. Accounting students could, and should, read it if only for its lucid examples and explanations of the arcane and flawed accounting rules that are applicable to securitizations.

The purpose of this post is to distill the analysis of Kothari/Lester so as to further discuss "lessons for the future." Before I do that, however, I want to tell you about an email correspondence I had with S.P. Kothari after I read their paper. Since I was preparing my own remarks for academics on the topic of IFRS adoption and the future of U.S. accounting, I asked him whether he thought it more or less likely that promulgation of more appropriate fair value or securitization standards would occur if the SEC continues to pursue convergence with IFRS. This was the response:

"…I think convergence will harm promulgation of more appropriate standards because a converged standard setting body would become a monopoly that would be pulled in all different directions by its constituencies."

Clearly, whatever the "lessons for the future" may be, adoption of IFRS is not one that he had in mind.

 

Securitization Accounting as Grand Theft Auto (not the video game)?

The process of securitization reminds me of large-scale car theft ring.* To obscure the link to the illegal 'acquisition' of cars, much like subprime mortgage loans, the cars are almost immediately chopped up into parts and re-sold. As a business model, stealing cars works only because the cost of obtaining a car is low; but let's ignore that for the moment and assume that someone actually establishes a legit buy/chop auto parts business – in other words, cars are bought for full price and chopped up for the sale of parts. Here is a representative sent of journal entries:

Day One – buy a car:

Dr. Car (at cost)                               30,000
      Cr. Cash                                                   30,000

Days Subsequent – chop up the car and sell its parts:

Dr. Cash (from sale of parts)            25,000
Dr. Engine (at estimated fair value)   7,000
     Cr. Gain on sale of parts                            2,000
     Cr. Car**                                                    30,000

I readily acknowledge that second entry does not comport with current GAAP.  I am using to illustrate securitization accounting in the context of a highly simplified example.  Having stated that, however, I don't see any reason (although others might) that the accounting for a chopped car should be different than the accounting for a chopped subprime mortgage.  I can't abide mixed-attribute accounting systems, and believe that college-educated professionals should not be adding apples and oranges, much less elevating the error with misleading names like "statement of financial position."

If you can set aside any cavils you might have with respect to my violation of current GAAP, please answer this question for me:  Would you invest in a business whose financial statements were based on journal entries like these? They sure do look legitimate, but common economic sense would dictate that the second journal entry must overstate the real profit on the resale transactions. First, as Kothari and Lester observe in the securitization context, "how is it possible that the sale of an asset originally recorded at one value could generate income and higher asset balances upon merely transferring this asset to another entity?" I suppose one could say that butchering a chicken should add value such that the sum of the parts is greater than the whole chicken. But that's because there's only one way to one way to obtain chicken parts – first, you gotta grow a chicken. However, one doesn't have to manufacture a car just to obtain a spark plug; or to originate a subprime mortgage loan just to create contracts containing a particular pattern of future cash flows.

The second reason indicating that the second journal entry is misleading is that the flawed business model would not be able to earn an economic profit over a full cash-out-cash-in cycle (i.e., buy car Þ chop Þ sell Þ reimburse for defects under warranty). If the engine could actually be sold for $7,000 (and generating an overall profit of at least $2,000), then I'll be a monkey's uncle!

The Lessons for the Future

In order to determine whether a better accounting is feasible, we need to be able to identify the sources of overstated income. With respect to both the car parts example and securitizations, overstated income could be the result of any of the following:

1. Kothari/Lester do not refer to this explicitly, but the most subtle and important aspect of the problem, in my view, is the unavoidable change in the 'unit of account' from the original asset (e.g., car, subprime loan) to the retained portions (e.g., engine; or in the case of securitizations, a servicing asset, and the right to residual cash flows). For example, erroneous accounting will occur because the values of the components of the car will not exactly sum to the pre-chopped value of the car itself; it doesn't matter how one chooses to measure value.
2. The appropriateness of the basis of measurement for the retained assets: such as historic cost, fair value or replacement cost.
3. Given a basis of measurement, biased measurement of the assets retained (which auditors fail to correct). Kothari/Lester surmise that this is the most significant source of overstated income.
4. Unrecognized or understated liabilities (e.g., a warranty obligation on the car parts, or a written put option for underperforming loans).

As to mitigating these sources, I have provided my two cents on #3, the biased estimate problem in a number of posts, the latest of which is here. Regulators have tried over and over again to make incremental improvements to auditing standards, with no perceived help in increasing the public's confidence that auditors can play a significant role in averting a large-scale financial crisis. It is time to abandon any notion that: management can provide unbiased estimates of value; and/or that auditors are intellectually capable or even inclined to provide a independent and knowledgeable assessments of management's estimates.

Therefore, when financial statements require estimates of current values and uncertain future events, these estimates should be produced by third parties – i.e., neither management, nor the auditor. The auditor's role should be limited to:

• Verification of the components of financial statements that can be verified.
• Verification of the inputs to current valuations that can be objectively measured, and hence, verified.
• Verifying that third party experts charged with measuring current values and expectations of future events have performed the procedures they said they would perform.

As to #2, above, the conventional wisdom is that historic cost accounting is fact-based, objective, understandable, and even verifiable. We have learned the hard way that this is a fiction; however historic cost accounting has been practiced. To get to a point where financial reporting can be freed from perverse incentives for management to produce biased estimates, standard setters must dedicate themselves to the establishment of accounting standards that yield financial statements capable of being audited and understood by auditors, investors, credit rating agencies and the like. Securitization/loan accounting standards clearly indicate that historic cost "principles" when applied to financial instruments create nothing but a big mess.

Saving the worst for last, the unit of account issue (#1, above) may defy a principles-based solution, but I still want to take a stab at it. Referring to the sample journal entries, the higher the values assigned to the assets retained, the higher will be the reported gain. This suggests, once again, replacement cost is the most appropriate basis of accounting, for it would require measurement based on the least costly way to replace the asset subject to being measured. For the car example, the business model indicates that the most economical way for the entity to acquire an engine would be to buy a car, chop it up, and sell all of its parts except for the engine. Thus, the marginal cost of an engine might be essentially zero – and the result would essentially eliminate the gain recognized in the second journal entry. Indeed, the loss recognized in the second journal entry by this logic would be the telltale sign of a flawed business model.

The same logic used to measure the replacement cost of the engine could easily apply to securitization assets such as servicing rights and residual interests, and leads to an analogous question: Did the subprime loan origination/securitization business model only work, or appear to work, because of favorable accounting treatment? These are questions worthy of further research, but if the accounting for securitizations had been more reasonable, we would already have reasonable answers.

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*Kothar/Lester address both the accounting for securitizations by the originators of subprime loans and the subsequent accounting by investors in the financial instruments created by securitization. I am only looking at the former in this post.

**I am assuming that costs of chopping the car are negligible or are expensed in a journal entry not displayed. Capitalization of these destruction costs would affect the form of the journal entries, but it would not affect my conclusions.

Stock Compensation, Tax Law, Financial Reporting and Facebook's IPO

Last August, I wrote a post in which I expressed my dismay that Carl Levin (D-Michigan) and Sherrod Brown (D-Ohio) are trying to make tax law based on the premise that FASB rules for stock options are caviar -- when the stark reality is that they are chopped liver (or worse). The senators are oblivious to the fact that the evils they decry lie in the financial reporting rules (hewn from decades of political wrangling, grandstanding and backroom dealing), and not the income tax rules; and worse, their proposal to reduce the deductions available to corporations while keeping the same taxable income for the individual who would exercise options has no precedent in tax policy, logic or fairness.

This current post is in response to Senator Levin's recent speech on the Senate floor in which he pressed the same dubious points. But, the really interesting part are the circumstances he relates regarding Facebook's upcoming initial public offering of its shares:

"According to its filings, when Facebook goes public, Mr. [Mark] Zuckerberg plans to exercise options to purchase 120 million shares of stock for 6 cents a share. Mr. Zuckerberg's shares, obviously, are going to be worth a great deal more than 6 cents, a total of about $7 million; they will apparently be worth more than 600 times as much, something in the neighborhood of $5 billion.

Here's where the tax loophole comes in. Under current law, Facebook can – perfectly legally – tell investors, the public, and regulators that the stock options he received cost the company a mere 6 cents a share – that's the expense shown on the company's books. [This is wrong – see Footnote.] But the company can also – perfectly legally – later file a tax return claiming that those same options cost the company something close to what the shares actually sell for later on – perhaps $40 a share. And the company can take a tax deduction for that far large [sic] amount. So the books show a highly profitable company – profitable, in part, because of the relatively small expense the company shows on its books for the stock options it grants to its employees. But when it comes time to pay taxes, to pay Uncle Sam, the loophole in the tax code allows the company to take a tax deduction for a far larger expense than they show on their books. …

Now, the end result is that a profitable U.S. corporation – a success story – could end up paying no taxes at all for years, even decades." [italics supplied]

To Levin, the Facebook IPO is a dramatic illustration of an inequitable "loophole" in the tax law. As Levin and Sherrod would have it, Facebook's tax deduction for using stock options to compensate executives – as opposed to any other form of compensation – would be essentially zero (that's probably a little dramatic on my part, but the point is the same); yet, Zuckerberg's tax liability when he exercises the options could be somewhere in the area of $3 billion.

When the Levin and Sherrod approach to taxation is compared to other forms of compensation to executives, rank and file employees, vendors and lenders, it makes no sense whatsoever. If the senators want to make stock options more costly to corporations than other forms of compensation, then so be it – but they should just come out and say so, and explain why it's a good idea.

But, most of what I have just written reprises my earlier post (and if you want even more background on the depressing politicis of the accounting question, see Jon Weil's article, here.) I'm covering this topic anew because Levin's Facebook IPO story raises some other interesting questions with implications for financial reporting.

My first question is this: If U.S. GAAP for stock compensation expense were based on the value realized upon exercise, just like the tax rules, how would that have affected Facebook's financial statements?

The strong implication of Levin's narrative is that the extra amount of expenses would have wiped out every dollar of Facebook's reported net income that it had ever 'earned.' On top of that, there could be other outstanding options held by Zuckerberg and other employees extending way down the organization, which are going to have the same effect on future reported net income.

Which brings me to my second question: For all practical purposes, could Zuckerberg be taking Facebook public at this point in time with no history of profitability, perhaps negative shareholders' equity, and perhaps no hopes for earnings for some for years to come?

My inclination is to say "no," but I can only speculate. So, I all answer that question with another question: Since the FASB's rules understate the economic cost of options granted to employees, did the FASB provide a perverse incentive to Facebook to grant more options (or at terms overly favorable) to employees than it should have?

If one accepts the maxim that "what gets mismeasured gets mismanaged," then the answer to that question should be "YES." The stock option problem lies not with the tax rules that eventually recognize the full cost of the options to shareholders, but with the financial reporting rules that allowed Facebook to grant options without recording their full cost.

Surely, the senators can see that different accounting rules would have wrought different compensation policies from Facebook. Senator Levin would not have had a story to tell and Mark Zuckerberg would be a few billion dollars poorer.

But, methinks that Facebook would still be Facebook.

* * * * * *

Footnote: It is my distinct pleasure to provide Senator Levin (and his staff) with yet another accounting lesson. The amount of expense to be reported by Facebook is not, as the senator claims, the exercise price of the options (i.e., 6 cents per share). Assuming that the options were issued without any intrinsic value, then their "grant-date present value" (i.e., the amount upon which periodic option expense is measured) could end up being more or less than 6 cents per share. Although this technical correction to Senator Levin's story it doesn't fundamentally change the message, it once again reveals a lack of understanding that makes one question if Senator Levin has an adequate grasp on the issues.

 

 

Repo Accounting: After Lehman, another Debacle was Just a Matter of Time

Last January, as the FASB proposed closing that 'Lehman loophole' in repo accounting while leaving three other loopy conditions to be met for "sale accounting" intact, I predicted that it would just be a matter of time for history to repeat itself, albeit through exploitation of some other gap in rules-based GAAP. As it turned out, it took less than a year for another major debacle to occur. This is how the Grumpy Old Accountants describe what happened at MF Global:

"MF Global structured the repo so that it matured when the [European sovereign] bonds [being transferred] matured. The assertion is that the firm doesn't control the debt instrument during the repo period, and when the repo matures, the firm will not regain control of the instrument because it matures on that date. Nice try.

MF Global in fact did not relinquish control of the securities. If the firm had relinquished control in reality, then it would not have received those coupons [on the bonds]."

Just as I had concluded, Grumpy Old Accountants (namely, academics Ed Ketz and Anthony Catanach) find that the FASB is not doing its job. "It should have fixed repo accounting ages ago," and they endorsed my suggested change to sale accounting whenever it applied:

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.

Although I still like my solution, I am well aware that others dislike violations of the general rule of not recognizing assets and liabilities related to contracts for which mutual performance must occur – i.e., executory contracts. There are exceptions (capital lease accounting most prominently), but the FASB could spend its time going around in circles debating whether this particular executory contract merits a treatment that is inconsistent with other executory contracts, where to draw the line, etcetera, etcetera.

So, I'll make it even easier for the FASB. It can even keep that silly "effective control" thing if it wants; however, if a transferor were to apply sale accounting for a repo, it must separately and prominently disclose the fair values of the right to receive the security and the obligation to pay cash. With such disclosures present, not even an understaffed government regulator like the SEC could miss the risk implications of an obligation to pay a fixed amount of cash for a security whose future value is uncertain. And, any analyst could easily make pro forma adjustments to published financial statements as it suits one's own views and preferences.

For the most part, GAAP doesn't do a very good job of providing information about risk; and I am not aware that the SEC's requirements to provide qualitative and quantitative information about market risks (see Reg. S-K, Item 305) are very helpful, either. Which leads me to a related suggestion: to require separate fair value information on both the receivable and payable legs of all financial derivatives. Just a very few numbers would be worth much more than thousands of words worth of sleep-inducing narrative disclosures that, even when provided in good faith, are far too subjective and lacking in comparability across companies or time.

In short, the disclosures I am suggesting would be super straightforward, highly informative, and easily enforceable. Consequently, for every future derivatives-based accounting scandal, I'll be asking whether fair value disclosures of the asset and liability legs could have prevented, or mitigated investors' losses and still further erosion in the public's confidence in our capital markets and financial institutions.

 

IASB Tried to Keep its Greek Bond Letter a Secret – But it Leaked!

Two of my favorite columnists, Floyd Norris and Jonathan Weil have put in their two cents worth on the implications of the Greek bond accounting issues brought to the fore by the IASB's letter to the European Securities and Markets Authority (ESMA). I have already written two posts on the issue, and I certainly don't want to beat it to death, but Floyd and Jon have turned up the heat that cooks the IASB's goose to a crisp.

AccountiLeaks

The biggest surprise came from Floyd's column, in which he revealed that the IASB letter was kept secret, until it was subsequently leaked to the Financial Times. Only after it was leaked, presumably, did the IASB post the letter to its website. Here are just a few reasons why this is so outrageous:

Tipping the scales at the SEC – The IASB simply could not bring itself to publicly acknowledge that consistent application of IFRS takes a backseat to politics in the EU. If the SEC were to adopt IFRS in the wake of this debacle, either it or its registrants will be the chumps. The best case scenario is that SEC registrants and their auditors would be forced to behave themselves, while varying degrees of equivocation would be the norm practically everywhere else.

The CYA imperative – My guess is that the IASB feared political reprisals if it were to publicly humiliate EU regulators for their tacit and/or explicit support of bogus accounting maneuvers. Yet, it couldn't completely ignore the accounting misstatements; for if Greek bonds investors actually do get left holding the bag, the IASB would be blamed for promulgating rules that allowed important information to be hidden until it was too late to do anything about it. At a very minimum, the IASB had to create some sort of paper trail that it could pull out of its archives in a doomsday scenario. Its story would be that it wasn't the accounting standards that were faulty; it was the fault of auditors and regulators for not compelling the banks to adhere to those standards.

Busting the myth of investor primacy – Floyd's article documented the fact that the accounting issues being raised are not merely a question of form, but that, in some cases, there is not enough disclosure to permit an accurate restatement. If the IASB were genuinely committed to investor primacy, secrecy would be entirely out of the question. On this side of the pond, for example, it has been my experience that the SEC will require restatements when they could have an immediate impact on investors' decisions.

When evaluating the propriety of a secret communication amongst regulators, it is simply not relevant that the SEC has enforcement power and the IASB does not. Hans Hoogervorst, as a former regulator, surely knew what the right thing to do was, yet he chose secrecy. Going public with the accounting misstatements – including the specifics of each one – might not have induced the needed restatements, but it was the only principled alternative. Shame.

The Tip of the Iceberg

It was obvious that the IASB's letter only addressed the tip of the iceberg – the Greek bonds classified by investors as "available for sale," but Jonathan Weil makes two important observations in that regard. First, a mere 10 percent of the Greek Bonds were not sheltered from fair value measurements through re-classification as "held-to-maturity." Second, the reason why this percentage is so low harkens back to the politics of 2008, when the IASB amended IAS 39, without justification, to permit reclassifications out of the trading and available-for-sale (i.e., fair value measurement) categories.

On that last point, I'll simply conclude with Lynn Turner's (former SEC Chief Accountant) reaction to Jon's column, which I received via email:

"[Jon's article] highlights what fools the European regulators and accounting standard setters now look like. The article rehashes how the Banks and Politicians ganged up together on both the FASB and IASB to immensely water down their rules three years ago, so that banks could prepare misleading financial statements that omitted losses on their investments. At the time, the SEC also failed to defend the FASB and in fact, when questioned, told a congressman they would see to it the FASB got the rule changes done in just 30 days.

Now, … this change has allowed: (1) banks to avoid reporting the losses they have suffered on Greek debt, (2) banks are slowing "dripping" their losses into their financials over a number of years including years to come, much like Chinese water torture, (3) resulting in banks failing to actively manage their problems, [my emphasis] and (4) extending the problem and probably the magnitude of losses incurred.

Back at the beginning of the 1990's, a report from the GAO noted the US government had engaged in similar financial shenanigans until Richard Breeden became chair of the SEC and forced the S&Ls and banks to report their true losses. Unfortunately, the politicians undid his work and the result is noted [in Jon's article], with a very negative outcome for investors."

Ask yourself this: if issuers of financial statements were required to mark all of their investments and loans to market through net income, would the too-big-to fail banks in the EU be in the mess that they are now in?

Repeat the question for the S&L crisis of the 1990s and the financial crisis of 2008.

Peeling the Onion on the Accounting for Greek Bonds

Yesterday, Han Hoogervorst, the IASB chair, sent a letter to the European Securities and Markets Authority (ESMA), in which he expressed concern for the pie-in-the-sky numbers produced by EU banks on their Greek bonds classified as 'available for sale' (AFS). Although I share Mr. Hoogervorst's concerns, they should be much broader than indicated by the scope of his letter. The IASB should be just as concerned with Greek bonds reported in its artificial held to maturity (HTM) category; and it should be profoundly disturbed by the auditor's role in this debacle.

Echoes of Soc Gen

The Greek bond accounting situation is not an isolated event, but merely a flash mob version of the incredible case of Société Générale. To refresh your memory, Soc Gen, a French bank, chose to dump rogue trader Jérôme Kerviel's 2008 trading losses (about $10 billion) into fiscal 2007. The effect of the 2007 makeover was to partially offset his gains of the previous year, and to give 2008 a clean slate so, I presume, management could get its earnings-based bonuses. There is no disputing that the losses occurred in 2008, yet the bank took the outlandish position that application of straightforward and sensible IFRS rules (marking derivatives to market through net income) would, for reasons unstated, result in a failure of the 2008 financial statements to present a "true and fair view."

You might also be interested to know that Soc Gen's financial statements, as is apparently the norm in France, were opined upon by not just one, but two (yes, two!) auditors. Could Soc Gen have been wrong to invoke the "true and fair" exception if both of its venerable Big Four auditors – Ernst & Young and Deloitte & Touche – gave the financial statements a clean opinion? C'est imposible!

Then, as now, the IASB cried foul, and if history is a guide, its sound and fury will again come to naught. In Europe, just as in the U.S. (I am compelled to add), the banks play the tune.

If You Don't Like Market Prices, Just Make Something Up

Getting back to the present, Mr. Hoogervorst's beef with European banks is that trading markets were discounting Greek bonds by over 50%, yet many banks were only giving the bonds in their "available for sale" portfolio a 21% haircut, the amount that the desperate Greek government averred their own bonds should be worth after all is said and done. Hoogervorst did not identify any offending institutions by either example or name, but the Associated Press has helped out with a few: BNP Paribas and CNP Assurances (a French insurance company) took only a 21% writedown on their AFS Greek bonds, but Commerzbank of Germany wrote the exact same bonds down by 51%.

Also sprach Hoogervorst:

"It appears that some companies are not following IAS 39 when determining whether the Greek government bonds that they classify as AFS are impaired. They are using the assessed impact on the present value of future cash flows arising from the proposed restructure of those bonds, rather than using the amount reflected by current market prices as required in IAS 39.

In addition, some companies holding Greek government bonds classified as AFS have stated that they are relying on internal valuation methodologies, rather than on market prices, to measure the fair value of the assets as at 30 June 2011. The reason generally given for using models rather than market prices is that the market for Greek government bonds is currently inactive (and therefore, in their view, does not provide reliable pricing information).

….[However, a ] … company cannot ignore observable transaction prices when it is clear that market participants are regularly entering into transactions for the same or similar financial assets, even if they are doing so less frequently than they have in the past." [emphasis supplied]

Lack of consistent enforcement is just one of the many reasons that the notion of a single set of, high quality global accounting standards is, in this blogger's opinion, a practical impossibility. If the Société Générale debacle has faded to a distant memory for some, then this case should be an additional reminder to the SEC that genuine comparability cannot possibly exist absent rigorous enforcement. In Europe, it seems, even token enforcement is absent.

And, speaking of the SEC, I wouldn't be surprised if some of the financial institutions taking insufficient writedowns also maintain U.S. listings. It will be interesting to see if the SEC tries to put the heat on them. And, if anybody reading this post knows of any such companies, I would appreciate knowing about them.

Other Problems Hoogervorst Might Prefer Not to Discuss

There are at least three other troubling aspects of IFRS that the Greek bond accounting debacle has exposed.

Accounting for bonds that are classified as held-to-maturity — While Hoogervorst's letter only addresses inconsistencies in measurements of AFS portfolios, the Greek bond crisis also makes it clear that HTM accounting exists for the convenience of issuers. This is for two reasons.

First, management has extremely broad discretion in measuring the amount of impairment. This is because the carrying amount of the HTM investments is based on a totally arbitrary calculation: management's subjective estimate of the future cash flows it will receive, discounted by the original yield to maturity. Unlike the AFS portfolio, there is no requirement to refer to current market prices, and so long as an auditor does not object, management can pick pretty much any number it wants.

For example, AP also reported that although Commerzbank took a 51% charge to their AFS Greek bonds, they also have Greek bonds that are classified as HTM; and for these, they only took a 21% charge. There is simply no way that the IASB can justify these internally inconsistent measurements for identical assets, even assuming that both numbers were produced in compliance with the extant accounting rules.

Second, even if management were to actually make a loan impairment assessment in good faith, the result is a completely arbitrary calculation that defies explanation in economic terms. The resulting number can only be described by the calculation that spit it out. There is nothing more that investors can glean from it, other than an acknowledgement from management that it doesn't expect to receive all of the payments the bank is contractually entitled to receive.  In respect to the Greek bonds, that's not much of a revelation.

And, by the way, I wonder how Commerzbank got that arbitrary calculation to come out to exactly that 21% figure the Greeks want everyone to accept – and don't? As I am about to explain, this case (just like Soc Gen) reveals that at least in Europe, getting one's auditor to agree that management's assessment is 'reasonable' may be the least of management's problems when faced with the consequences of an unfortunate investment decision.

The Vast Inconsistency of Audit Judgments — It just so happened that PwC was engaged to audit all three of the companies mentioned in the AP article. It seems impossible to get around the conclusion that PwC found a 51% haircut on Commerzbank's AFS Greek bonds was 'reasonable', and that a haircut of less than half that amount was also 'reasonable' for BNP Paribas's holding of the same bonds. It seems as if the credibility of the numbers reported by some of these European financial institutions are not worth the paper they are printed on; and by extension, the same conclusion would apply to the reports of their 'independent' auditors.

I wonder if Hoogervorst had considered writing to the Big Four instead of, or in addition to, ESMA. To me, anyway, it is more important to have the Big Four justify its acceptance of vastly different amounts of write downs on the same debt held by two or more different banks. At least the auditors are supposed to be gatekeepers; but ESMA, ironically, has absolutely no enforcement authority on any company.

If the IASB will not be asking the Big Four, the hand that feeds them, for answers, who will? What does this say about IASB independence?

Lastly, the the HTM problem is bigger than the AFS problem – And, don't expect it to get fixed any time soon. The IASB's financial instruments project is a bust on many levels. But with respect to HTM loans, the Board's good book/bad book approach to loan loss allowances is being scrapped, albeit not for any accounting that makes more sense. Instead, the IASB is getting ready to propose a three bucket approach whose only apparent purpose is to allow lenders and bond investors even more discretion to manipulate loan loss allowances and earnings.

. . . . . . . .

Hans Hoogervorst's letter has also reminded us that a single set of global accounting standards has no traction without consistent application and enforcement of the rules. The SEC didn't get the message after Soc Gen, but how about now?

A Brief Exchange with an IASB Member on Hedge Accounting

A reader of my post on the CFA Institute's critique of the IASB's hedge accounting exposure draft suggested that I write to the two members of the IASB, Patrick Finnegan and Patricia McConnell, who had a close association with the Institute prior to joining the IASB. So, I did, and Pat Finnegan was kind enough to respond. This post is based on our very brief correspondence.

Why Would I Do Such a Thing?

Writing to the board members was a departure from my modus operandi, which is to limit my sources to what I happen to read as I pursue my nerdy interests, plus other items brought to my attention by readers and others. I simply don't have time to do much more than that. But, in this case, I couldn't resist reaching out to IASB members. Here's why:

• Pat Finnegan was associated with the CFA Institute until relatively recently, and presumably he helped determine, and advocated for, the Institute's positions on financial reporting issues. (Pat McConnell's direct association with the Institute was longer ago.) Hence, I was looking for an explanation of the inconsistency between Finnegan's present endorsement of the hedging ED and the present disagreements on practically all aspects of the ED expressed by his previous employer. Moreover, these disagreements involve core conceptual issues that go beyond hedge accounting (e.g., fair value, comprehensive income, management intent, etc.) 
• The ED also contains a dissenting view, which the CFA Institute supports, and which IASB members could have joined. It happens to have been written by another U.S. member, John Smith, who is reputedly the most informed and technically capable board member when it comes to financial instruments accounting.
• The utter passivity of the SEC with respect to the actual substance of "convergence" of financial reporting standards suggests that it may be using the votes of the IASB "investor" members as justification for remaining on the sidelines.  Finnegan and McConnell must be aware of the significant influence they have, especially as the SEC approaches closure on its own IFRS policy questions; and for this reason alone, providing greater transparency of their views is the right thing for them to do.*

I Got Criticized, but I Didn't Get an Answer to My Question

In my email, I asked only one question: "Given your former intimate connection with CFA Institute, I would like to ask you whether you agree with their comment letter; and if you disagree, kindly explain why."

And, here is Pat Finnegan's response in its entirety:

 

Dear Tom,

Many thanks for your email, and for sharing your recent posting on our work to reform hedge accounting. I am on your distribution list and read your posting last week.

 You will not be surprised to learn that I do not agree with your assessment of our extensive due process as a 'political circus'. I suspect that most of the 250 or so respondents to the Hedge Accounting consultation would also disagree with your assessment. 

It also seems odd to substantiate your arguments based on just two comment letters. If you are interested in investor views, why ignore, for example, the Investment Management Association (whose members manage over £3 trillion of assets) that broadly supports our proposals? There are a range of views expressed in the comment letters received – some supportive, others offering constructive criticism, which is the whole point of having such an extensive due process.

I understand from my colleague Pat McConnell that you have sent her a similar request for opinion. I am copying her on this reply.

The board is planning to discuss the staff's analysis of comment letters and outreach visits during the next several weeks.  Those discussions will inform the Board's decision making (including my own) before determining how to proceed. I believe the key questions and observations raised in the CFA Institute's letter will be addressed during those discussions. I invite you to listen and if you would like to discuss our tentative decisions as we proceed, please do not hesitate to contact us.

Best,
Pat

I am flattered that Pat reads my blog, and I hope he understands why I singled him out. I am going to respond to his concerns, below. But first, I must note that he has declined to respond to my request: to have an explanation for the inconsistency of his vote with the positions of his previous employer.

As to my inferences from only one comment letter and an analysis by E&Y, I should first point out that I have been following the IASB's "due process" for some time. I invite Pat to read my post on the revisions made to IAS 23 (interest costs), and tell me that "political circus" is not a better descriptor than "due process" for the way in which those revisions were made. But, more directly to his point, if that IMA comment letter is the best that Pat could come up with for investor input that I overlooked, then I clearly did not miss very much.

The CFA Institute's letter that I discussed contains almost 40 pages of solid analysis, including numerous reasoned and detailed responses to specific questions that the IASB asked commenters to address. In stark contrast, the IMA's letter is two pages in total, with barely more than one page of substantive comments. The IMA letter contains no responses to the specific questions in the ED, and it provides no explanations for why investors should be supportive of the IASB's proposals. The CFA Institute's letter, on the other hand, is thorough not just for its depth and breadth, but for its lucid explanation as to why the ED is inimical to investor interests.

Hedge accounting is the poster child for rules-based accounting.  It owes its existence to a highly-politicized process in the first place that made an explicit exception to principles-based accounting. But, even if the ED were actually principles-based, how should one weigh the IMA's two-page letter from an organization representing members that manage over £3 trillion of assets with the Institute's letter and its 100,000 members? Evidently, Pat Finnegan thinks the IMA letter is significant in comparison to the Institute's, but I disagree. A staff analysis of comment letters that could consider the IMA's contribution to be in the same ballpark as the CFA Institute's is precisely the kind of "political circus" I had in mind when writing my post that Pat disagrees with.

As to what the receipt of 250 comment letters actually says about "constituents'" perceptions of due process, unlike Pat, I don't see that it says much of anything. For example, commenters could be just as cynical as I am, and still find it in their interests to register their views. And, I wouldn't be surprised if that's the way the signers and drafters of the CFA Institute's letter regard the process – they have no real choice except to participate in a charade.

The IASB would do well to commission an independent survey of "constituents" (most especially, investors, academics and journalists) for their perceptions of the efficacy of the Board's "due process." That such a survey has not already been conducted is, in and of itself, telling. 

* * * * * * *

Unfortunately, accounting reform is turning out just like banking reform: politics and influence, as opposed to economics and principles, are the deciding factors. I see only political reasons for Pat Finnegan and Pat McConnell to decline to explain their votes on the hedging ED. And, the IASB's analysis of comment letters on their hedge accounting ED, under the name of "due process," can be nothing more than pretense.

-------------------------------

*In a previous version of this post I incorrectly stated that hedge accounting was not discussed at the IASB's most recent meeting.  I apologize for the error.  

Hedge Accounting: Convergence Crunch Time

If you want to appreciate the political circus masquerading as "due process" in accounting standards setting, I recommend that you read two recent documents. The first one is the CFA Institute's stinging 39-page comment letter* on the IASB's hedge accounting exposure draft:

"We do not find investors calling for a standard which allows broader and more liberal application of hedge accounting and which permits its use to alter the IASB's classification and measurement of financial instruments. Rather, our research indicates that users find hedge accounting and disclosures to be confusing, difficult to understand and low in quality. We would be interested to hear how the IASB's outreach to users allows them to conclude that this proposal will benefit users." [Emphasis supplied.]*

And second, this equally-detailed publication from Ernst & Young, which hit the internet at about the same time:

"Among the proposals issued by the … [Boards] … to amend financial instruments accounting, the hedge accounting sections were the most favorably received. Both Boards heard support from constituents for attempting to make hedge accounting easier to accomplish with changes that constituents found substantial and helpful."

That much is all you need to get the sense that preparers, as represented by EY's clients, are clearly talking past investors, as represented by the CFA Institute. If you need more evidence, search for the word "users" or "investors" in EY's 26-page document. You'll find "users" once, but not in any relevant context to the point I am making. What you will find is a lot of support for the IASB from EY, buttressed by this kind of client cheerleading: "hedgers like", "valuable to many industries", "entities typically want to match", "many banks and financial institutions have long wanted", "entities … would benefit", etc.

Ask yourself whose views should carry more weight at the IASB (or FASB): the prestigious CFA Institute, which represents more than 100,000 investment professionals worldwide, and whose stated purpose is to advocate for investor protections; or EY – and its clients? Next, ask yourself whose views are actually weighted more by the IASB (or FASB)?

Case closed.

Whither Hedge Accounting – and Convergence?

The FASB has also issued its own discussion paper, Selected Issues about Hedge Accounting, but they are substantially different. While the FASB has proposed incremental liberalizations of their existing approach to hedge accounting, the IASB took a clean sheet of paper – and has drawn a picture of what accounting standards would look like if the U.S. would kindly step aside.

I want to be clear at the outset that if I had my way, there would be no such thing as hedge accounting, and I believe many investors share my preferences. If the probability is 1/x that reasoning life forms reside on another planet, the probability of their adopting more complex hedge accounting standards than ours is 1/x². Hedge accounting is already ridiculous enough; and with that introduction, I present but a taste of the Institute's many concerns with the IASB's further plumbing of the depths:

• Absence of investor primacy – The Institute believes that most investors would prefer broader application of fair value and increased rigor around the permissibility of hedge accounting, not the opposite which is being proposed. The IASB has done nothing to demonstrate how their proposal would benefit investors. If investor primacy no longer exists at the IASB, then it should say so. Moreover, increased use of fair value accounting, which the CFA Institute has consistently recommended, would reduce any "need" for hedging accounting, yet the IASB is proposing to expand hedge accounting, a dubious and anomalous concept. (My strong sense is that, consistent with my own views, the Institute would eschew hedge accounting altogether if it could get the Boards to agree.)

   

• Lack of conceptual basis – The foundation of the ED is a new concept of risk management strategy that is only vaguely specified, and has no foundation in either economics or the conceptual framework definitions of assets and liabilities. Moreover, the ED has been so broadly written and so removed from any conceptual framework that there seems to be no way it can be adequately policed for abuses. Investors would benefit more from the disclosures of the risks that are not hedged, than the (inadequate and vaguely-specified) disclosures of risks that are purportedly being managed.

   

• More ways to management earnings – Especially because of the failure of the financial statement presentation project, the notion of accounting treatments being driven by management intent has become discredited, so now we are being sold other amorphous concepts like "risk management strategy" which really means 'more choices for management.' Global accounting standards are being promoted under the premise that enhanced comparability will be the result. But, no one can seriously argue that the IASB's ED will move comparability anywhere but on a serious jag in the wrong direction.

   

• Hedge effectiveness threshold lowered – Like the FASB, the IASB is eliminating the requirement to assess hedge effectiveness quantitatively. But, the IASB's new criteria is much more amorphous: to minimize ineffectiveness, and to be "unbiased and other than accidental offsetting" – whatever that means. Relatedly, retrospective assessment of ineffectiveness would no longer be required.

   

• Increased use of "other comprehensive income" – OCI has yet to be defined for any other purpose, yet this "principles-based" hedge accounting proposal would run all hedging gains and losses through OCI.

   

• Held to maturity positions can be hedged – Although these will be re-named when IFRS 9 becomes effective, measurement based on amortized costs only makes sense if management is indifferent to changes in the fair value of their investments. Permitting hedge accounting of these investments means exactly the opposite – that management is not indifferent to price changes, which was what had been asserted to allow amortized cost accounting. What a farce!

   

• Derivatives can hedge other derivatives – Don't like the bet you made on a commodities future contract anymore – and don't want to recognize a loss when you sell it? Under the proposal, you can construct a hedged item out of your anticipated purchase of the commodity and your under-water forward contract (which had been designated as a hedge in order to put the gains and losses in OCI). All you would have to do is to find an offsetting derivative that better suits your new view of price movements, and now the gains and losses on both derivatives can be thrown into OCI.

   

• The ability to hedge a portion of an item – This is where the games start to get really interesting.  There is no restriction that requires that the identified hedge portion be unrelated to the unhedged portion.  So, management could identify a portion (such as the copper component of insulated wire) and describe the hedged portion as a perfect offset of the derivative. Even though the "risk management strategy" may be questionable, who is going to question it? And, there need never be any ineffectiveness to report in net income.

 

• The new concept of "net nil positions" – Which in effect says that when assets and liabilities (which may include derivatives) net to zero, both sides are hedged items – and voila all restrictions on what qualifies as a hedging instrument are swept away, because the asset and liability positions qualify as hedged items.   The fair value option and its restrictions (elected only at inception, irrevocable, gains and losses through net income) are circumvented.  Even better (or worse, depending on your point of view), it could be that all aspects of IFRS 9 classifications can be "managed" with the right financial engineering.

   

• Cash instruments to be used as hedging instruments — Currently under US GAAP, cash instruments (such as debt instruments) may be used to hedge the net investment in a foreign subsidiary whose functional currency is the local currency (an utterly stupid concept to begin with) or a firm commitment denominated in foreign currency. Under the proposal, cash instruments that are measured at fair value through net income could be designated in various kinds of hedging relationships. That means, of course, that the gains and losses on those cash instruments would flow through OCI instead of net income.

The Institute has many other gripes, and a lot of it has to do with process; i.e., timeframe, risks, etc. But, I think I have given you enough to convey the impression that the most prestigious association of investment professionals in the world is trying to tell you that the IASB's ED is a HORRIBLE HORRIBLE document. Yet, politics being what they are, there will doubtless be a lot of pressure put upon the FASB to come as close as they can to the IASB's madness as it re-deliberates its own more modest discussion paper.

Who Are These Guys Anyway?

In understanding where the notions in the IASB's ED come from, it is important to remember that circumstances essentially forced the IASC (IASB's predecessor) to swallow US-style hedging accounting with one big bite. Basically, the IASB was thrust from relative obscurity into international prominence when, in 1995, the International Organization of Securities Commissions (IOSCO) tasked the IASC with establishing a set of high-quality accounting standards, within five years, covering all of the core topics IOSCO specified.

Of these core topics, financial instruments proved to be the gnarliest; plus everyone knew that the final arbiter of high quality was to be the US, where FAS 133 was published in 1998. By then, time was running out on the IASC, and an international consensus on hedge accounting was nowhere at hand. In desperation, the IASC essentially made a carbon copy of U.S. financial instruments accounting and dubbed it IAS 39.

I can't say for sure why the IASB has so sharply tacked away from the FASB on hedge accounting at the eleventh hour of the current convergence project. But, it is clear that the Europeans hated IAS 39 from its inception during that eleventh hour of the IOSCO "core standards" project 12 years ago. With the hedge accounting ED, either the EU is trying to tell the US to take a hike, or they realize that the promise of a "stable platform" for accounting standards would effectively wed them to US-style hedge accounting rules forevermore — unless they make a bold move within the convergence timeframe.

In bringing the EY document to my attention, Bob Jensen wrote:

"There's an old saying when cable companies are bringing fiber to households: 'The last mile costs more than all the other miles.'"

To which I will add a sports adage: Crunch time is when you learn the most about your teammates.

Hedge accounting is crunch time for the SEC.

Speaking of IFRS

You may have noticed the advertisement on my website for the Core Concerns Conference in Chicago this June, sponsored by CFO.com. I will be attending all three days of the conference, and I would welcome the chance to meet and share ideas with any Accounting Onion readers in attendance.

You might also be interested in two other things about that conference. First, if you click on the ad on my website to register, you will receive a $300 discount off the standard registration fee.

Second, and apropos to this post, the conference will feature a panel discussion entitled "One Global Accounting Standard — IFRS in America." The panelists are:

• Paul Cherry, Chairman, Standards Advisory Council, IASB; Former Chairman, Canadian Accounting Standards Board
• Brian Fiedler, VP Finance, Canadian Tire
• Christian Leuz, University of Chicago's Booth School of Business
• William Hildebrand, Financial Accounting Standards Board (FASB) Practice Fellow
• Jack Klingler, Director of Accounting Research and IFRS Implementation, Alcoa, Inc.

You can count on me to use the opportunity to ask questions, and I hope to see you there!

__________

* This document was provided to me via email from a member of the CFA Institute. Since neither the IASB nor the Institute has posted it on the internet as of the time of this writing, I am taking the liberty of posting it to my own website. I just wanted you to know that this is where the link will take you.

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.

A Letter from Dennis Beresford

On Monday evening I received an email from Denny Beresford, former FASB chair (once again via the AECM listserv). Although I feel compelled to state that Denny's letter does not change my own views on the key issues, it provides much needed balance to my recent posts on the topic of FASB due process:

Tom,

I read your latest Onion, particularly your reasoning "Why Do I Think As I Do?" You list six factors that support your thinking on the matter and I just thought you might like to consider a couple of additional factors.

1. The two new Board members that were appointed by the Trustees of the Financial Accounting Foundation did not join the FASB until today (February 28). Thus, they were not involved in the discussions on accounting for loans and did not vote on that matter.
2. The vote that was taken on that topic in mid-January was unanimous – including Tom Linsmeier and Marc Siegel, who I believe would be described by most FASB observers as "staunch fair value advocates," probably much more so than Bob Herz.
3. The vote to modify the FASB's exposure draft position on the accounting for loans was taken after extensive due process. This included consideration of comment letters (yes, many of them were form letters, and they were considered accordingly), and five public roundtable meetings around the U.S. that included investors, reporting entities, auditors and other interested parties. More directly to the point of your criticism of the FASB, pairs of Board members and staff members conducted meetings with over 100 investors to discuss the key aspects of the proposals. A summary of those discussions dated September 29, 2010 is available on the FASB website.
4. Most commentators – importantly, including most investors – did not agree with the Board's proposal to recognize loans, receivables, and a company's own debt at fair value in the balance sheet. Instead they supported amortized cost for those items, with a more robust impairment approach for loans, which is the approach that the FASB is currently pursuing.

These comments aren't intended to necessarily change your thinking on Bob Herz' departure from the Board or anything else. But I do hope they might help others see that the FASB's activities aren't quite so close minded or otherwise evilly intentioned as might be inferred from reading only the Onion.

Respectfully,

Denny

The FASB Could Rescue the Financial System – But It Won't

If you want to understand the causes of the financial crisis from 25 pages instead of the 600 pages burped up by the FCIC, then read this: Understanding the Subprime Financial Crisis, by Duke Law professor Steven L. Schwarcz. I also like this paper very much because the final section cogently reduces the oft-recited litany of a cascading series of value-destroying events to four fundamental vulnerabilities. Schwarcz's premise is that awareness of these vulnerabilities provides a framework for thinking about what should be done to avoid future crises.

My premise is that much of what can and should be done involves radical reform of accounting standards. That's why I am disappointed that both the Schwarcz paper and the FCIC report (albeit Schwarcz slightly less so) fail to discuss to any degree how politically-jiggered accounting standards facilitated the financial crisis; and critically, how simpler yet more robust standards could make the future much more secure. Notwithstanding this shortcoming, Schwarcz's paper at least provides little ole me with a foundation for discussing how improvements to financial reporting could be the most significant reform we undertake in response to the third financial crisis in twenty years.

Let's take Schwarcz's list of vulnerabilities one at a time:

Conflicts of Interest

This first category, conflicts, has a number of dimensions, such as information asymmetry issues between mortgage lenders and investors in securitized mortgages. These would seem to be curable by disclosure reforms, and the SEC has been focusing on replacing reliance on credit rating agencies with enhanced disclosures. However, Schwarcz sees another problem, "super large" compensation payouts, to be less tractable:

"[If] an individual's compensation, even if it were to be fully adjusted downward [i.e., clawed back or contingently paid over time], still enables that individual to be financially independent of the firm, then that individual's incentives will not necessarily be aligned with the firm's incentives." [p. 562]

To my view, super large compensation starts at the top, and works its way down. There can be little argument that the accounting, in and of itself, for stock options granted to executives has contributed to the financial crisis, and subsequent events strongly indicate that no reasoned solution has been proposed. So, here's mine.

Relatively recent accounting rules require that at least some of the economic cost of compensation must hit the income statement, but the grant-date measurement rules reveal only the tip of massive payouts to bank executives. Stated another way, the rules provide that "super large" payouts to executives are never matched by super large expense recognition.

The only way for this matching to occur is to treat stock options just like any other derivative written by a company. This would require updating measurements through exercise or expiration, and thereby measuring compensation cost by the actual amount of value transferred. Moreover, exercise date accounting would dovetail very well with the new SEC shareholder "say on pay" rules and the "Compensation Discussion and Analysis" disclosures in proxy statements. Shareholders have a right to know how a particular compensation scheme can be expected to align management's interests with the interests of shareholders when managers have been made financially independent from the firm.

Investor Complacency

"Complacency is a more difficult category because the government cannot change human nature—although it can try to affect behavior." [p. 563]

Complacency exists in part because the certain cost of being anything more than passive is not expected to be offset by the uncertain benefits. The vast majority of investors choose to place their trust in the integrity of the financial reporting regulators – to have put in place a system that clearly signals when financial performance has lagged, or that excessive risks have been taken.

That the accounting standard setters have utterly failed to live up to the trust that investors have placed in them is the overarching theme of this blog. Only the notion of investor complacency can explain why investors have not yet stormed the FASB's headquarters, much as Egyptians demonstrated in Tahriri Square to protest a plutocracy operating behind the façade of democracy and due process.

I have no suggestions for altering the calculus leading to consistent investor complacency. The only solution is for regulators, most especially accounting standard setters, to embrace the reality that investors will not tend to exercise their right to be heard, rather than to exploit that vulnerability. For example, accounting standards should acknowledge that investor preferences dictate that disclosure – even under the best possible circumstances – cannot be an adequate substitute for financial statement recognition. They should also acknowledge that due process is clearly not working even though thousands of comments against a proposed standard have been received from issuers, largely with the objective of drowing out those few investors who care to be heard. 

Complexity of the Modern Financial System

"[T]hings are just too complex to understand. This manifests itself, for example, in the difficulty of achieving transparent disclosure for complicated securities and also in the difficulty of market participants to learn the financial condition of their counterparties (due, for example, to their entering into credit-default swaps). … For the failure of disclosure, investors can partly address this failure by demanding more and better disclosure, including disclosure of contingent liabilities."

I wish Schwarcz and others would also acknowledge that disclosure failures and complexity feed on themselves. To a large extent, financial instruments are complex because they were engineered to be eligible for a particular accounting treatment favored by management: executive stock options, repos, securitizations, credit default swaps – the list can go on forever.

Just imagine how financial reporting would be improved if current values of investments were stated on the balance sheet, all legal rights and obligations were recognized on the balance sheet, and the asset components of contracts (derivatives and otherwise) were presented separately from their liability components. Not only would financial analysis become far less complex due to the add transparency of financial statements, but the financial arrangements themselves would be less complex.

Systemic Risk of Externalities

"[E]ven if [all individual] market participants fully understand that incurring certain risks may contribute to systemic risk, they will not be motivated, absent regulation, to internalize those risks. … [T]herefore, the solution to systemic risk is to impose regulation that internalizes those externalities." [p. 566]

Once again, the accounting standards I have mentioned above could come to the rescue. Mainly, the prudential regulators would have more objective and reliable (albeit extremely conservative) measures of capital adequacy. Though other forms of regulation would still be necessary, we could actually find that we might need fewer regulations than exist currently.

The most generous interpretation of the post-crisis state of financial reporting is that contributions from thinkers like Steven Schwarcz— even though he has little to say about accounting itself—can help accounting standard setters identify opportunities to enhance the safety of capital markets through improved accounting standards.

If only it were so. While the FASB continues to fiddle with convergence ad nauseum, Rome will surely burn ... again.

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.

Executory Contracts: The Root of Most Off-Balance-Sheet-Financing Evils

If I may be permitted to say so myself, my principles-based solution for curing repo accounting abuses is the bomb. The off-balance sheet effects of repo accounting could be obliterated by a simple 'gross up' (i.e., separate presentation) of: (1) the receivable for the return of the securities; and (2) the obligation to pay for the return of those securities.

But, nobody has nominated me for the Nobel Prize just yet – perhaps because I may not have fully explicated the logic of my breakthrough discovery. I came to this realization upon reading the following comment from a friend (and former accounting policymaker):

"I do not understand your reasoning/logic for having the transferor in a repo transaction recognize a receivable and an equivalent payable for the entire/full value of the financial instrument subject to the repo but not having others that make commitments to expend cash to buy other kinds of assets do the same. For example, Chevron commits to buy 100 million bbls of crude oil from the Saudis--no receivable and payable. Walmart commits to buy 100 million T shirts from a vendor in Vietnam--no receivable and payable. Your having the transferor in the financial instrument repo transaction recognize a receivable and an equivalent payable is a low outside curveball."

If I could literally throw a low outside curveball, dear friend and reader, I wouldn't be blogging about accounting!  So, let's discuss your point.

The Sanctuary of Executory Contracts for Window Dressers

Unlike many other topics I have been writing about where the points of contention are approaches to measurement matters, the heart of this matter seems to involve recognition, and most particularly recognition of 'executory contracts'.

Every accountant has been raised to observe two sacred and inviolable commandments: thou shalt not recognize executory contracts on the balance sheet; and thou shalt present on a 'net' basis receivables/payables with the same counterparty. 

While these commandments were once inviolable, leases have become a very notable exception. First came SFAS 13 in 1976, requiring that a very limited number of executory contracts meeting the definition of a 'capital lease' would be grossed up to reflect a leased asset and a corresponding liability. Then, recently, the FASB has finally, finally come to timidly propose that failure to capitalize any lease contract unacceptably distorts financial statements. Even armed with an understanding of the political realities that the FASB operates under, it is hard not to be shocked and awed by the resistance to this simple idea from issuers and the leasing industry en masse.

My point in this an prior postings is that Lehman's repo accounting machinations should be seen as one of numerous clarion calls for the FASB to apply its leasing logic to repurchase agreements and beyond -- at least to all financial instruments. To see why, I'm going to start with a variant of my commenter's Chevron example:

• Company A has no assets and liabilities
• Oil costs $100 per barrel; and for simplicity, interest rates are zero.
• Company A borrows $100 million and uses the proceeds to buy one million barrels of oil from Saudi Arabia. The Saudis will store the oil for free and deliver it one year hence.

The Accounting 101 student can tell you that Company A's balance sheet has $100 million in assets and $100 million in liabilities after these two transactions; and the Finance 101 student should notice that if oil prices were to head south prior to delivery, Company A will have a heck of a time repaying its debt. But, at least investors have a pretty good indication of the risk just from reading the balance sheet.

Now, compare the forgoing example to the equivalent of the Chevron example:

• Company B commits to take physical delivery of one million barrels from Saudi Arabia one year hence, and will pay $100 million upon delivery. A monitor requires that the Saudis have to maintain enough physical inventory of oil at all times to ensure that Chevron will get their delivery.

Again, should oil prices head south over the next year, Company B is in exactly the same kind of trouble as Company A. But, an investor wouldn't have any indication of the risk that Company B is taking from B's balance sheet, which is unaffected by the executory contract.

The only difference between Company A's operations and Company B's operations is the number of counterparties each has dealt with. Yet, the accounting is radically different (one reflects high financial risk and the other does not). I don't think that's right. In fact, I believe it is inevitably harmful for such inconsistencies in accounting to exist.

I actually witnessed the equivalent of Company B a number of years ago during a consulting engagement. The only reason my Company-B-client entered into a contract to sell their oil production forward was because the contract would stay off the balance sheet until settlement – and with no gain or loss to boot! When oil prices went in the wrong direction (up, in this case) my client lost a ton of money because they decided to gamble on future oil prices, which went way up. The off-balance sheet accounting also turned out to be off income statement accounting, because the value-destroying events only resulted in 'opportunity losses'; i.e., reported profits were not as how as they would have been without the forward sale, but no loss was explicitly reported.

I suppose one could argue that all traditions, including inconsistent accounting for executory contracts, are for a good reason, even if one can't put one's finger on it; and that note disclosures might somehow make up for off-balance sheet accounting. But, no serious person believes that mere note disclosure of risks does the trick, do they? It's pretty much a settled fact that no regulator has yet to successfully write disclosure standards that investors are able to read, and that adequately describe off-balance sheet risks.

The Principled Basis for Recognizing Executory Contracts

As I have written here:

• An "asset" is an economic resource to the reporting entity that satisfies at least one of the following conditions: (1) the reporting entity holds legal title to the resource; (2) the reporting entity holds the legal right (conditional or unconditional) to receive the resource; or (3) the reporting entities holds the legal right (conditional or unconditional) to use the resource for some purpose (specified or unspecified).
• Liabilities are legally enforceable obligations (conditional or unconditional) to either: (1) deliver an asset or the common stock of the reporting entity; or (2) permit another party to use an asset.

So, in my ideal world, adherence to these definitions would require that all legal rights and obligations, even if they relate to purely executory contracts, be recognized gross – even receivables and payables to the same party. But, for political reasons having nothing whatsoever to do with my own preferences, I would limit the scope of this policy to: (1) financial instruments; and (2) non-ownership rights to non-financial assets. Thus, (gulp), the Chevron contract with the Saudis would be excluded – unless it allowed for net cash settlement.

As the scope of executory contracts recognized on the balance sheet is expanded, the more understandable, relevant, and less manipulable financial reporting will become. That's why it feels good to have 'solved' the repo accounting problem.

Unfortunately, I haven't come close to solving the thorniest problem of financial reporting: how to get around the fact that not everybody is in favor of greater understandability, consistency and transparency. If I could solve that problem, then maybe I might actually get that Nobel Prize.

 

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.

------

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

A Loan Accounting Problem to Make "Amortized Cost" Proponents Squirm

Some folks can see fine art in a soup can label, or poetry in a user's manual. I don't mean to brag when I state that I have a similar talent.  I seem to have a knack for stumbling upon interesting accounting issues.

Most recently, I tripped over a New York Times article entitled, "Investors Put Money on Lawsuits to Get Payouts," which describes a new and rapidly growing financing trend: lending to plaintiffs to fund the costs of their lawsuits. Interest rates are astronomical, which explains why everybody seems to be getting into the act, from boutique venture capital firms to behemoths like Citigroup and Deutsche Bank. I wouldn't be surprised if bankers see this innovation in lending like a new drug for repeating the intoxicating highs they got from subprime mortgages.

The article doesn't mention this, but it's important to my analysis.  I have learned through experience as an expert witness that neither lawyers nor their clients may convey a contingent interest in the outcome of a lawsuit to anyone except another lawyer. Thus, as the article states, "Law firms are generally obligated to repay loans even if they lose. In reality, however, firms that make less than expected often struggle to make the required payments, and a number of firms … have filed for bankruptcy protection."

 The Accounting Issues

I'm not going to comment on the social issues of placing bets on lawsuits. Those are the focus of the article itself, and you can find a whole bunch of eloquent readers' comments on all sides of the issues here.  You can read an interesting article written from a legal perspective here.

For accounting purposes, these arrangements fall squarely under the definition of "loan" to be found in the FASB's Accounting Standards Codification: "A contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset in the creditor's statement of financial position." The lender accounting issues can be illustrated by a simple example, inspired by one of the cases cited in the NYT article:

• One year ago, a small law firm recruited four hundred residents of one-factory town in Texas to be the plaintiffs for a series of planned lawsuits against the factory owner. A majority of the plaintiffs are being treated for skin cancer, and others for stomach cancer. Scientific research has established a strong link between a chemical used in the manufacturing process (creosote) and skin cancer; the links to stomach cancer are not as strong. All of the lawsuits allege that the cancers are the result of unsafe working conditions. The law firm's litigation strategy is to bring the cases with the lowest probability of success first.
• To date, the law firm has drawn $3 million from its line of credit provided by single investor at a rate of 20% per annum. Interest is payable annually, the principal amount is due in ten years and early retirement of principal is permitted at no additional cost.
• The average amount of the loan outstanding at the end of the first year was $1 million, and the law firm made its first interest payment, $200,000.
• Court filings and other documents made available to the lender indicate that the prospects for awards in the cases have improved since the inception of the line of credit.

Let's consider three accounting alternatives for the lender: (1) current GAAP or IFRS, both of which entail an 'incurred loss' model for measuring loan impairment; (2) proposed IFRS, which is an 'expected loss' model; and (3) proposed GAAP, which would require measurement of outstanding loans at fair value.

Even before we get into loan impairment issues, the first accounting question is the treatment of the $200,000 'interest payment.' As sure as the sun will come up tomorrow, that small law firm must have round-tripped a portion of its drawdown on their line of credit to pay the 'interest,' for it would have had no other source of funds. Yet, current GAAP/IFRS would blithely recognize $200,000 of interest revenue; and it would make no adjustment to the loan balance, since there are no indicators of an incurred loss. If a lender needs short-term earnings -- or a swift kick in the pants to its interest rate spread, litigation lending would be a sure fire way to get it done.  And, as crazy as this accounting is, I wouldn't count on any audit firm or issuer to ask the EITF to fix the problem anytime soon.

Obviously, the 'interest revenue' is pure fiction, but explaining why in logical terms could be a challenge. So, here's my attempt at an explanation that will also prove useful as we march forward through the example. The $200,000 is inappropriately based on the "yield to maturity" of 20%, which is in turn based on the contractual payments. In contrast, the economic return (i.e., internal rate of return) is based on the expected payments. One of the reasons why the NYT article inspired me to write this post is that the capital asset pricing model (CAPM) can be used to estimate the economic rate of return of litigation loans pretty well without any complex calculations: since the future returns from the loan are essentially uncorrelated to returns on the "market portfolio," the "beta" of this investment is zero. Therefore, in order to derive the economic value of the loan at any point in time, the capital asset pricing model would suggest that the expected cash flows on the loan should be discounted at the risk-free rate (say, 4%). (Stated another way, the risks of putting money down on a lawsuit are more like the risks of a casino bet with a positive expected value -- yes, these do exist, but that's another story -- than a corporate investment, because it is fully diversifiable.)

Proposed IFRS would also recognize $200,000 in interest revenue, but then it would give the loan a haircut for the lender's estimate of "expected losses" – despite the known fact that prospects for loan repayment in full had improved during the year. As I have explained in an earlier post, this approach makes no attempt to portray a sensible carrying amount for the loan itself.  Moreover, its ancestors are the secretive income smoothing techniques devised by German bankers that were financially slobberknockered by hyperinflation post WW I. Ich wünsche Ihnen viel Glück, if you are an investor trying to figure out how much the shares of the lender are actually worth from the IFRS financial statements. Good luck, as well, to the auditor risking money and reputation on a lender's biased and unverifiable estimates of the economic effects of unspecified uncertainties.

Proposed GAAP, which has been emphatically rejected by the EU, and consequently the IASB, would require fair value measurement of the loan. There are obvious accuracy issues to be concerned with, but "it is better to be vaguely right than precisely wrong."

At this point, I hope it is already apparent that the only relevant measure of value and earnings under this utterly simple scenario is fair value. And, we haven't even touched on impairment yet. To do that, let's fast forward one more year:

• The law firm makes the second interest payment on schedule (and from the same source of funds); but two of the weakest cases (involving stomach cancer) went to trial with no damages being awarded to the plaintiffs.

The accounting under current GAAP/IFRS for the second year could be even more ludicrous. First, there is the highly subjective issue of whether or not to recognize an impairment. If yes, then take the lender's latest estimates of expected cash flows and discount them at the original meaningless "yield to maturity" of 20%. More than precisely wrong, it's egregiously wrong – yet, the American Banker's Association has stated that this is the method of loan accounting they like the best. Proposed IFRS is no better. Trust me.

 
Defenders of amortized cost approaches to loan accounting will say that these litigation loans are not relevant, because they are risky equity investments masquerading as loans. But, if that's true, then junk bonds are also equity. If you can find it within yourself to agree with anything I have written in this post, I want it to be that it is futile for accounting standards to attempt to distinguish between loans and other financial instruments – except for basic ownership interests like common shares or partnership interests in a law firm. The history of financial reporting appears to have persuaded the FASB, but not the IASB, that rules for creating categories of financial instruments beyond this basic dichotomy are utterly ineffective.  Yet, the political farces (pun intended) behind convergence are pushing the FASB away from their principles.  That's not convergence, it's dysfunction.

It didn't take me long after reading the NYT article to realize that litigation lending could be the best example for exposing the absurdity of any amortized cost approach to loan accounting. And, it's not as extreme a scenario as it might initially appear. Too many greed-is-good-style managers have demonstrated an ability and willingness to test the limits of an accounting rule, and there is no one to stop them from saying, "show me the rule that says I can't do this."  Therein lie the seeds of the next multi-trillion financial 'service.' 

And, finally, we shouldn't fall for the story that IFRS's incurred loss model is an incremental improvement over the current expected loss model of amortized cost accounting. It will do nothing to change loan accounting from rules to principles; and it will give lenders greater discretion to massage their numbers.

There's a 'Fair Value' Elephant in Every Financial Reporting Room

Kudos to The Economist for summarizing in slightly more than one-third of a page the critical issues that will determine the future of financial reporting. Leading off:

"Despite the departures of Sir David [Tweedie, IASB] and Mr Herz [Robert, FASB], big accounting firms and their clients still expect convergence of standards to top the agenda of their successors…"

In other words, investors, small accounting firms and small businesses, not so much, if it all. That's practically a known fact.

Another interesting fact, as reported by CFO.com, is that a panel of experts created by the FASB and AICPA have recommended that a standard setter apart from the FASB should be responsible for setting the accounting standards for private companies – irrespective of their size. The "elephant in the room" is reported to be that private companies don't wish to be burdened by the recent spate of fair value rules.

But, I wonder if the panel's sponsors haven't been double-crossed by the outcome; for such a re-organization provides yet one more reason not to adopt IFRS. The establishment of a separate standard setter for private companies will permit the FASB to focus more closely on the mission given to it by the SEC: to create accounting standards suitable for financial statements contained in public company filings to the Commission. I don't know how the SEC, whose raison d'etre is public companies, will be able to get around the fact that an IASB with a less-focused mission should somehow be expected to do a better job than a more sharply-focused FASB.

All Fair Value, All the Time

"The most controversial issue in that process [of convergence] is how to report financial assets... Mr Herz firmly backed fair value, arguing that doing otherwise made financial trickery easier."

Yes, that's the whole point: if wisely implemented, fair value measurement of loans deprives management of the opportunity to manipulate their earnings and measures of financial solvency. I give The Economist full marks for stating it so bluntly, because few other publications seem capable of tackling the issue even tangentially. One of the reasons I so enjoy reading The Economist is that their broad readership permits them to provide independent views without concern for biting the (banker's) hand that feeds it.

"[However,] opponents think that revaluing seldom-traded assets during market meltdowns makes banking crises more likely and more severe."

As I have stated often, the FASB made a critical error by specifying that "fair value" should be an "exit price" as opposed to an "entry price." Exit prices are indeed very difficult to estimate when markets suddenly become illiquid, because you can't "command" somebody to purchase some toxic financial instrument at your asking price, even though you might think that it's a "fair" price. On the other hand, it should be much more straightforward to estimate how much someone would be willing to sell an asset for, even in an illiquid market.  It's always easier to buy something than to sell it.

 Stacking the FASB Against Fair Value

"Mr Herz's empty seat at FASB will be filled by an insider, FASB's technical director [Russell Golden]. … Mr Herz broke a 2-2 tie to vote for the reporting-standards proposal that leant heavily towards fair value. … The "big four" accounting firms … not to mention companies of all types with international reach, are on IASB's side [i.e., amortized cost accounting for loans and debt]. Many think, therefore, that Mr Herz's departure may allow for a consensus-seeker to emerge as his replacement."

How Bob Herz came to be fired remains a mystery. The Economist reports that he resigned for "undefined personal reasons," but CFO.com conducted a lengthy interview with Bob, and discussion of the circumstances that led to his departure from the FASB were clearly out of bounds for the interviewer. So, I say he was fired for reasons we can only guess at – and that's what I'm going to do. Unless I'm told otherwise, I am going to assume that his handling of the congressional flap over financial instrument accounting and his pro-fair value stance must have exasperated the trustees of the Financial Accounting Foundation enough to fire him.

And, lest you conclude that the FAF is not attempting to stack the Board against fair value, here are a few more things you should know about Herz's replacement, Russell Golden.

First, "insider" doesn't fully describe the culture from whence Golden comes. As with far too many FASB staff members, Golden came to the FASB straight from the Big Four, where he was a technical partner who presumably lobbied the Board and its surrogates for the accounting rules his firm, Deloitte, proponed. Until the Board expands to seven members from the current five, he will join two other former staff members on the Board, Leslie Seidman and Lawrence Smith. These two, not coincidentally, are also the two dissenting members to the FASB's fair value exposure draft. If Golden votes with Seidman and Smith on fair value, as I fully expect he will, all pretense of an investor-focused FASB will be abandoned, as the Board's position on fair value will have turned on a dime.

Second, Golden has a track record of catering to the Accounting Establishment. Notwithstanding, CFO.com reports that "Golden says he considers his point of view to be less that of an auditor and more of someone with an 'open mind' about improving financial reporting, which includes balancing investor concerns with the cost of improvements to prepares and auditors." –  I simply don't see any evidence of that in Golden's past actions.

To take just a couple of examples that I have written about recently, Mr. Golden presided over the EITF and its agenda when that Big-Four-dominated group came up with consensuses on Issues 10-D and 10-F: both are unapologetic sops to special interests, and shouldn't even have been put on the EITF's agenda. Then, there is the infamous FASB Staff Position that broadened the use of other comprehensive income for keeping declines in market value off the income statement. The Board's meeting minutes indicate that the Board was leaning toward limiting the new 'get out of jail free card' to debt securities, but the Golden-led Staff recommended that equity securities be included in its scope. The Staff ultimately prevailed on the three Board members who voted for the FSP.

Third, and this is the whopper, one Tracey C. Golden is a highly-placed partner at Deloitte. I had heard that Russell Golden's wife works for the Big Four, and I guess this is she. The conflict of interest for Mr. Golden must be obvious, but since the Financial Accounting Foundation seems to have not given it much consideration, I'm compelled to spell it out:

• If (as The Economist reports) Deloitte wants the FASB to converge with the IASB on loan and debt accounting, it is highly probable that this is also what Mrs. Golden wants;
• If Deloitte wants to augment its book of business by assisting US companies in a mandated conversion from US GAAP to IFRS, then it is highly probable that Mrs. Golden wants IFRS and GAAP to converge wherever possible;
• If Deloitte gets what it wants out of the FASB, then Mrs. Golden stands to become significantly wealthier, and so does Mr. Golden.

It may be no small thing for the Technical Director of the FASB, who has no formal vote, to be in a position to gain from the outcome of an FASB vote; but one might conceivably take comfort in the belief that voting members of the FASB will mitigate both the fact and appearance of a conflict of interest on the part of its Technical Director. It's quite another thing, however, when the fate of the most consequential exposure draft in the history of the FASB has a nontrivial probability of being decided by the single vote of Tracey Golden's husband.

 So Far, So Bad

I'll concede at the outset that I was not in possession of the inside skinny on Russell Golden's imminent appointment to the Board until after I wrote my post, but his appointment certainly feeds into my concern that the FAF might do whatever it takes to ensure that fair value would be defeated, and in so doing put IFRS adoption back on track – despite the many voices against it.

At the same time the FAF announced the Golden appointment, it published a Q and A with chair John Brennan to address the process by which the FAF would fill the remaining Board positions. Mr. Brennan was 'asked' only three questions; and I will dare to venture that his response to the last question was the entire motivation for issuing that document:

Q. What are the selection criteria for the new board members? Some internet bloggers [emphasis supplied] have recently speculated that new board members could be selected based on their views about "mark to market" accounting as it pertains to current proposals out for public comment.

A. Let me state unequivocally that FASB members are not selected based, in whole or in part, on their views on any technical accounting issues. In fact, it would not only be inappropriate to select FASB members based on those views, it is against the very core and spirit of the FAF. I would also add that such behavior would be against our by-laws, which emphasize the independence of the FASB with respect to standard-setting matters.

That said, we are looking for some very special qualities in our FASB members, and that includes a strong passion for the mission, great depth of experience and demonstrated knowledge of financial accounting and reporting, and an appreciation of the varying needs and interests of all the FASB's constituents. …

Since I could find no other "speculating" bloggers besides yours truly, I am going to assume that Mr. Brennan was responding to my post.

Mr. Brennan, despite what you have stated "unequivocally," I don't believe it is possible to select Board members without regard to their views on "technical accounting issues," especially at this critical juncture. Do you mean to say, for example, that just because some trustees may have read my blog posts, which express my point of view on numerous current financial reporting issues, I should be automatically disqualified from consideration? Or, do you mean to say that the trustees have both the intellectual capacity and purity of motive to utterly disregard what they actually know of my views? Or, to take another example, if you were to offer a Board seat to a current technical partner of one of the Big Four, could you possibly disregard her firm's formal position on fair value, which she might have drafted herself?

Mr. Brennan, financial reporting has become a huge mess. Even former Board members say so (see here and here). Untold amounts of wealth and the livelihoods of innocent, hardworking Americans have been destroyed by the self-serving actions of executives managing to the rules of GAAP instead of the long-term interests of their shareholders. The FASB should have foreseen, on numerous occasions, that recipes for made up numbers would be abused; and if they did foresee abuse, they must have rationalized that problem away somehow. If you don't believe me, I can provide you with the name of an FASB staff member (originally from a Big Four firm) who told me that value-destroying abuses of accounting rules should be of no concern to the Board.

Restocking the Board from the pipeline of Accounting Establishment candidates will not fix the many problems with GAAP and the inexorable erosion in the public trust in financial reporting coming from the waves of accounting scandals that have rocked our economy in the decades since the FASB was formed. Moreover, the situation is not helped by high-minded assertions that every reasoning person knows cannot be anything more than a pretense for obscuring the real agenda. Reasonable people understand that the views of potential Board members are, and should be, important to you and your FAF colleagues – no matter what may be set forth in the FAF's by-laws. I am simply asking the FAF to recognize that more convergence with IFRS will not fix the mess that accounting is in; it will only make matters worse.

Finally, Mr. Brennan, you will have my application for one of the open Board seats by the end of the week. Each of the four former Board members whom I am privileged to know well enough to ask, have graciously given me permission to use them as references. Three members of ITAC, and two former SEC chief accountants have done the same, and one volunteered that it was a privilege for him to serve as a reference.

I hope that you will give both my views and my application serious consideration.