The Accounting Onion

Is Money Market Fund Accounting Fair to Investors?

The purpose of this post is to review a recently published monograph authored by former FASB Chair Dennis Beresford. To summarize, it supports the status quo for money market funds, and I want to explain why I think the reasoning and analysis leading to that conclusion is flawed, and hence potentially misleading.

With no disrespect intended, I'll be referring to my subject as Denny. And, without wishing to lay it on too thick, I want to state at the outset that I consider him to be a friend whom I greatly respect for both his intellect and integrity.

Speaking of which, Denny told me that he refused compensation from the monograph's publisher, the U.S. Chamber of Commerce, so as not to have to deal with anyone questioning his true motivations. I was not the least bit surprised to learn of his refusal to take nothing (except perhaps a couple dozen golf balls). However, it must be stated just the same that the Chamber is a conservative and large-scale lobbyist that raises millions in large chunks from anonymous donors, who themselves keep a low profile as the Chamber uses their millions to sway political elections and policy deliberations. To give you some idea as to the nature of the Chamber's 'support,' consider this from a New York Times investigation:

Prudential Financial sent in a $2 million donation last year as the U.S. Chamber of Commerce kicked off a national advertising campaign to weaken the historic rewrite of the nation's financial regulations.

I think it's safe to assume that if Denny's positions were not congruent with what some have referred to as the banking oligarchy, his monograph wouldn't have seen the light of day.

* * * * *

To understand the nature of the policy issues, and my misgivings, let's start with a couple of basic questions – having nothing whatsoever to do with accounting:

Question #1:

If someone had invested $1 million in a mutual fund yesterday, could she withdraw the full $1 million today – even if the fund's investments have declined in value? (For the purpose of your answer, ignore any dividends earned.)

Interpretive Response – No, unless said mutual fund is a "money market fund" conducting its business in accordance with SEC Rule 2a-7 under the Investment Company Act of 1940. Paragraph (c) of the rule provides that, with certain qualifications, a "…money market fund shall limit its portfolio investments to those United States Dollar-Denominated securities that the fund's board of directors determines [emphasis supplied] present minimal credit risks …" and the average maturity of the investment portfolio should not exceed 60 days.

Question #2:

Should money market funds, unlike other mutual funds, be allowed to redeem shares at $1/share (i.e., a constant net asset value, or NAV), even if the net market value of the fund is less than $1 per share?

This is the crux of the matter. The current legal response to this question is 'yes,' provided it is 'safe' to do so. It may be safe today, and revisions in 2010 to Rule 2a-7 have tightened things up somewhat; but not everyone believes it will be safe for long. Denny, however, avers that adequate security measures are already in place. Notwithstanding, kindly refer to the part about the BOD's discretion in the interpretive response to Question #1, above.

In contrast to Denny, SEC Chair Mary Schapiro certainly doesn't think it's safe. She has gone out on a limb to make money market fund reform a centerpiece of her legacy, but thus far has been frustrated – reportedly to the point of tears – by special interests.

And Ms. Schapiro is not alone. Arthur Levitt, the longest serving SEC chair in history and by my estimation a moderate not given to hyperbole, had this to say to Bloomberg Radio about the current status of money market funds:

"There's clearly a need to do something about money-market funds. Everything else [other mutual funds] is marked to the market. This should be marked to the market in the interest of investors. The fact that Mary Schapiro couldn't get her three members of the commission to support this is really a national disgrace….

"We've had a number of instances where funds have broken the buck, and the funds have made up for it because they know that the whole faith and confidence in the fund market would be damaged. Today, the margin of error is narrower than it's ever been."

The sponsors of money-market funds simply don't want this regulation." [bold italics supplied]

Question #2a:

As an aside, even if it is safe from a systemic perspective to maintain a constant NAV, does it do right by investors?

To answer that question, think about where the money comes from when the investor with the $1 million redeems her shares. If you happen to hold shares in the same fund, the difference between $1 and the market value per share has to come out of your pocket. And, what if she should invest her $1 million in another money market fund whose market value is greater than $1? If you're an investor in that fund as well, then more money comes out of your pocket.

On its face, a constant NAV is an open invitation to arbitrageurs.  Yet maybe, as Denny argues, the provisions of Rule 2a-7 ensure that these windfall transfers of wealth are insignificant when spread out over all of the investors in a fund; but couldn't the same be said about insider trading? And, over time and with automated trading strategies (perhaps yet to be invented) this kind of thing could run into real money.

Given that marking to market probably entails fewer record keeping costs than maintaining a constant NAV, I don't see how this constant barrage of individually small rounding errors can be ignored.

Question #3:

How should a money market fund account for and report the value of its investments: at 'amortized cost' or at 'market value'?

The title of Denny's monograph, Amortized Cost is "Fair" for Money Market Funds, clearly indicates that this is the accounting question he is answering. For one thing, placing "fair" in quotes can only indicate that Denny is simply referencing an accounting term of art, and not broader questions of fairness as commonly understood. If his monograph were entitled, "Is Money Market Fund Accounting Fair to Investors?," without the quotes surrounding "fair," then very little of Denny's analysis could have been salvaged.

The bulk of the monograph is an interpretive response to an accounting question that is derived from the consideration of accounting concepts, precedents and even accounting materiality. However, the questions for policy makers regarding money market funds are perforce grounded in economic considerations, and not the form of the accounting. Those policy questions are the ones I have already posed in this post.

As Arthur Levitt implies in his criticism of the status quo, how one answers the economic questions determines the answers to the accounting questions – and not the other way around. Stated another way, the answer to an accounting question should depend on the purpose an accounting purports to serve. Regarding money market funds, I believe there is broad consensus as to the predominant purpose of an accounting: to serve merely as the basis for determining how much money will be distributed to investors when they redeem their shares. Once the basis for distributions is determined, the accounting question solves itself.

I believe that Denny realizes this. Even though he emphasizes the accounting aspects, he must eventually come around to considering the economics. But with all due respect, Denny's background as an accounting standard setter does not particularly qualify him to address the potential economic consequences of Rule 2a-7 as it is currently written. My biggest gripe is that from a couple of pages of cursory analysis, Denny is willing to confidently state that money market funds are subject to sufficiently prudent regulation under Rule 2a-7; but Mary Schapiro and Arthur Levitt, who have lived and thought about these issues for much longer, say differently. I think Denny has stuck his neck out too far.

It also doesn't help that when Denny attempts to ameliorate concerns over the limitations of amortized cost accounting, they are hedged in practically every case with qualifying language. Here are three examples from just a single page (9) [italics supplied]:

• "The … restrictions in SEC Rule 2a-7 ensure that the difference between market value and amortized cost generally is immaterial."
• "Further, money market fund investments are often held to maturity and any discount or premium in the purchase price is realized by the fund."
• "Gains and losses tend to be immaterial."

Take out those qualifiers (which I have highlighted with italics), and were are left with unsupportable generalizations. But leave them in, and we have very little to take away from the analysis except for this: amortized cost as a basis of accounting and for administering money market funds works fine – except for when it doesn't.

A Lesson in Loan Accounting from an Unexpected Source: Oil and Gas Companies

[This is my fourth consecutive post on loan accounting. Here are the first, second and third.]

I love finding accounting lessons buried in stories that on their surface seem to have little to do with accounting. See, for example, my post on the appalling politics of joint replacement databases, "No Escaping the Politics of Information." The example I'm going to describe here is a little bit closer to home than body parts: an August 11th, WSJ article headlined, "For Chesapeake, a Question on How it Counts Reserves."

Some background: in January 2004, Royal Dutch Shell announced that it would have to reduce its "proved" oil and gas reserves by 3.9 billion barrels, which was about 20% of their reserves. Another 2 billion barrels were written off in the ensuing months.

The gist of the WSJ article is that ever since the Royal Dutch Shell writedowns and the ensuing securities fraud claims, reserve quantity reporting practices evolved to obtaining some level of outside assurance from independent experts. Consequently, Chesapeake's share price may be discounted by investors because, "[Only] seventy-seven percent of the reserve estimates … reported for 2011 were produced by independent engineering firms, while the rest came from a growing team of in-house reservoir engineers. A survey of nine of Chesapeake's competitors in the same year showed third-party involvement in 89% of reserve estimates, on average."

Chesapeake challenges the claim that its share price is depressed by the possibility of unreliable reserve estimates. While "third-party involvement" could take the form of audits of in-house estimates, or independent estimates, a Chesapeake spokesman claims that its use of third party estimates is more heavily weighted toward independent estimates, while its peers go the other way.

 

An Analogy to Accounting for Loans

But, whatever the particulars of the facts and circumstances surrounding Chesapeake, there are interesting comparisons to be made about loan loss reserves and oil and gas reserves.

The first thing to consider is that accurate estimates of future loan defaults are extremely critical to any evaluation of the financial health of banks, just as "proved" oil and gas reserve quantities are to energy companies.

Second, I would argue that estimates of oil and gas reserves are inherently more reliable than estimates of loan loss reserves. Even though oil and gas reserves could be thousands of feet underground, they are tangible, and they can be sampled and probed. Please don't ask me to cite any of it, but there must be scads of theoretical and empirical scientific studies to support the validity of the methods employed.

In contrast, estimates of loan loss reserves are ineffable; and methodologies for predicting future losses are, to say the least, controversial.  It's a paradox that oil and gas managers engage outside experts to estimate reserves for financial reporting purposes; yet bank managers, who have the more subjective task, think they know enough to estimate loan loss reserves all by themselves.

Third, the SEC requires a financial statement audit of every public company, including banks and energy companies; however, it doesn't require an audit of oil and gas reserves [see Regulation S-K Item 1202(a)(7) and (8)]. Largely in response to the Royal Dutch Shell debacle, managers of oil and gas companies have voluntarily engaged independent experts, whose reputations must perforce depend on their track records, to provide a higher level of assurance to investors than required by law. Obviously, the same can't be said for banks' measures of loan loss reserves.

Fourth, estimates of loan loss reserves are much more critical to the global economy than estimates of energy reserves. Given the market forces that moved oil and gas company managers to act, it seems that another debacle like Royal Dutch Shell is unlikely; but if it did occur, it probably wouldn't shake up the markets as much as a major restatement from a too-big-fail bank.

And what's the likelihood of a bank having to correct its loan loss reserves? There are whole countries in Europe whose banking systems could be on the brink of collapse!

Are financial statement audits of banks helping to allay your fears? Not mine!

Consider as well that audits of loan loss reserves are at the top of the list of deficiencies uncovered by the PCAOB. Even setting aside the question of whether auditors are capable of evaluating bank managers' clairvoyance, all too frequently, it seems, auditors have not even adhered to their own protocols.

 

The Moral of the Story

If you buy into the analogy, and I believe it is quite compelling, then, just as energy companies employ independent scientists, banks should be required to obtain estimates of loan loss reserves or market values (I would much, much prefer the latter) from outside financial experts. Maybe then, market prices of bank stocks and book values would converge. As it is now, investors don't believe the banks' "audited" numbers. Investors surely understand that auditors can and should verify facts, but they are not qualified to predict the future, or even to merely offer an opinion that management's prediction of the future appears reasonable.

In the case of oil and gas companies, the vicissitudes of capital markets led to higher quality financial reporting. But alas, vested interests in entrenched and outdated regulations are preventing it from happening at banks. I am a strong proponent of securities regulation, but sometimes it can get in the way of needed improvements to the information available to investors.

This is one of those times.

The Faulty Reasoning of the IASB's Three-Bucket Loan Loss Model

This is my third consecutive post on the perils of loan loss reserves (first here; second here); and a fourth is going to follow very soon. My fourthcoming (I couldn't resist the pun J) post will be based on recent coverage of Chesapeake Energy Corp's natural gas reserves reporting; I believe there are lessons to be learned about how to do a better job of measuring loans from the experiences of energy exploration companies with estimates of their reserves.

But, let's not get ahead of ourselves. The motivation for this current post comes from an anonymous* reader of my previous post, who took umbrage with the following:

Dare I now hope that the FASB will ultimately rediscover the wisdom of measuring loans at market-based values? I would be more optimistic that reason might prevail if the newest three board members hadn't been specially chosen by the powers that be at the Financial Accounting Foundation to be dependable opponents of market values for loans.

That last bit in italics was what set my reader off. He suggested that I would think differently about at least one newbie Board member, R. Harold Schroeder, if I were to read the comment letter Mr. Schroeder submitted (before joining the Board, of course) to the exposure draft on accounting for loans, derivatives and hedging.

So I did.

On a Dual Statement Approach for Loans

Even though Mr. Schroeder and I disagree on a many aspects of loan accounting, we agreed on at least two things:

• The current loan accounting model is broken;
• Amortized cost proponents are wrong to claim that measuring market values for loans is impracticable.

Before addressing the portion of the comment letter that I take the most exception to – a mistaken rationale for the expected loss model – I need to discuss Mr. Schroeder's main recommendation: the FASB should explore a dual (or "side-by-side") financial statement presentation, whereby one full set of financial statements for a bank would be based on an expected loss model, and a supplemental balance sheet would be based on fair values.

Some kind of dual statement approach merits consideration, but I have two general concerns.  First, as Mr. Schroeder stated, the SEC would probably have to amend Regulation S-X to set forth requirements for the new financial statement that Mr. Schroeder envisages, just as it sets forth the requirements for all other financial statements filed with the Commission. But, could the SEC handle the implications for the standard audit report of two balance sheets – that both could constitute a "fair presentation" of financial position? Also, which balance sheet (or "column") should articulate with the income statement?

(A slight digression—attaining resolution to any of these questions would require a collaborative approach to standard setting among the SEC, FASB and PCAOB, which hardly ever takes place. For this and other reasons, I have come to the conclusion that the FASB – like the PCAOB – should be directly responsible to the SEC, cutting the Financial Accounting Foundation out of the picture. Since S-OX took care of the funding of the FASB, I see no reason why, in regard to financial reporting for public companies, there needs to be an FAF.)

My second concern in regard to dual presentation is that Mr. Schroeder, as is typical of analysts, focuses on the 'information content' of financial statements and the effort it would take to recast a set of financial statements to his liking:

"The current proposal suggests a single-column, reconciliation approach that starts with amortized cost and follows with various fair value adjustments to arrive at fair value for each asset and liability covered by the proposal … [W]e find this format cumbersome and time consuming." [italics in original]

The letter does not address how analytical adjustments could be facilitated by appropriate XBRL coding; or more important, how dual reporting would affect decision making by managers, and consequently, shareholder value creation/destruction. Given the conventional wisdom (embraced by many corporate board members and executives) that the 'market' is fixated on earnings and financial leverage as portrayed in the financial statements as issued, information content should not always be the primary policy consideration. And surely, analysts are facile enough to recast the information to suit its tastes – so long as the data is available.

 

A Mistaken (and seemingly common) Rationale for the Expected Loss Model

Regardless of Mr. Schroeder's view of the role of fair (or market) value in financial reporting, his comments on the expected loss model contain a grievous error:

"Our long-held view is that there is an inherent risk of loss from the moment every dollar is lent. Some of those losses will result from a lender's initial underwriting or judgment errors, while others will result from subsequent changes in the economic environment, competitive landscape and other factors. We do not believe losses from any of these factors are 'unforeseeable.' Nor do we subscribe to the view that a lender would not make a loan unless they believe it will be fully collectible. Therefore, given the inherent nature of lending, all loans have some loss potential that should be given upfront recognition. …" [bold italics supplied]

To see the error in this reasoning, imagine that a bank lends $1,000,000 to a business at an interest rate of 10%, and that the interest rate charged by the bank corresponds to what any other bank would have charged for the risks that the loan presented.

Question: At origination, what should be the carrying amount – and market value – of the loan?

Answer: $1,000,000, which corresponds to the expected – i.e., not contractual – future payments from the borrower, discounted at 10%.

For some reason, everybody understands this logic when it comes to a traded bond, but it is not always carried forward to loans negotiated on a bank-to-borrower basis. Coincidentally, I had recently corresponded with a former Board member on just this question. Consistent with Mr. Schroeder's reasoning, he wrote this to me:

"I think an expected loss model makes sense logically. I always go back to the very simple example I was faced with in practice …. A bank client was getting into the credit card business and sent out a large number of applications with little credit checking. They said they were expecting a certain level of loss (say 3%) but were willing to take that in order to get into the business and begin earning what were then quite large interest fees on account balances. So when they made initial "loans" of, say, $10,000,000, they thought they should record a loss reserve of $300,000. But we told them that FAS 5 [Contingencies] didn't allow that and they had to wait until the balances aged sufficiently that they could demonstrate that there were losses actually incurred. This seemed to the client to lack common sense and I actually had to agree with them. But that was what GAAP said (and says)." [italics supplied]

I agree that a haircut to the principal amount of credit card loans is economically justified when the loans are specifically priced as a loss leader. In this case, the losses are associated with gains to be made on future business relationships with the 97% of new customers who are creditworthy. Even though the interest rate may be high, it may still be a windfall for some borrowers; thus the market interest rate could be even higher than the stated rate in the credit card contract.

But, the general case is my earlier example: a loan issued at the 'market' interest rate. I grant that bankers sometimes misestimate the market rate, but if one does, how could we expect that the same banker to be capable of producing a 'reliable' or 'reasonable' estimate the loss reserve for that same loan?

(And by the way, I also agree that a loan loss allowance on Day 1 could be justified for trade receivables, but that's only because the measurement basis is undiscounted expected future cash flows.)

* * * * *

I want my readers to know that I don't blog just for the thrill of being outrageous or to bash policymakers. I am passionate about accounting, and I write in the hope and expectation that my readers are willing to change their minds. Although I disagree with Mr. Schroeder on numerous points, I found that the views he expressed in his comment letter were the product of thoughtful analysis, which suggests that he will be considering other points of view on loan accounting with an open mind. So, thanks to the reader who suggested that I read it.

And, here's hoping that the extra time that the FASB is taking to contemplate the three-bucket approach to loan loss measurement will ultimately help them see the folly of the expected loss model.

______________________

*My longstanding policy is to not publicize private correspondence or conversations without permission. In contrast to a journalist, I take everything to be 'off the record' until I am told otherwise.

Can Auditors Help Save Spain's Banks? Nuts!

Less than a day after posting my critique of the FASB and IASB loan loss allowance proposal, I happily learned that the FASB may be backtracking. According to a PwC In Brief:

"After considering the results of outreach efforts and constituent feedback, the board unanimously agreed with concerns that aspects of the "three bucket" impairment model are complex and difficult to understand. As a result, the FASB will not move forward with an exposure draft on the "three bucket" impairment model …

The FASB's decision to explore a revised approach could result in an impairment model that differs from the IASB's model. During today's discussion, certain IASB members indicated that they have heard much less concern about the "three bucket" impairment model and therefore, plan to move forward with that approach. ….

It is unclear at this time whether the IASB will move forward with an exposure draft in the near term, or whether the IASB will first consider any revised proposals from the FASB." [bold italics supplied]

Dare I now hope that the FASB will ultimately rediscover the wisdom of measuring loans at market-based values? I would be more optimistic that reason might prevail if the newest three board members hadn't been specially chosen by the powers that be at the Financial Accounting Foundation to be dependable opponents of market values for loans.

In an unrelated event, but telling nonetheless, the Wall Street Journal published a few days later a very perceptive and perspicuous article, by Gabriele Steinhauser, discussing the approaches the EU might take for bailing out Spanish banks. The gist of the article is that "a team of private auditors is rummaging through the books of the 14 largest Spanish banks to determine…" the amount of the loan losses. Nuts.

I recommend that you read the full article, but for the points about the auditors' role that I want to make, it is sufficient to know the following, which in any case is somewhat oversimplified:*

• The European Financial Stability Facility (the bailout fund that is backed by guarantees from the Eurozone member states) will lend €100 billion to Spain for a bank bailout.
• An uncertain amount of the investment, perhaps €25 billion, will be used to capitalize a 100%-owned "bad bank," which will purchase the junkiest of junk loans from the banks.
• The amount not invested in the bad bank will be contributed to those pretty-awful Spanish banks, probably in exchange for some form of TARP-like equity.
• "Each lender's needs will depend on how much it is likely to lose on its part of some €200 billion in loans the banks made to property developers and other boom-time real-estate investors." Presumably, the audits are supposed to help determine these amounts.

I Said "Nuts"

First, whether new capital comes from private or public sources, the valuation question pertaining to an investment should be the same. An investor should want to know how much one could pay for identical or similar assets if they were acquired some other way. Yet, the auditors it seems are not being asked to provide an answer to that question. Instead, they are tasked with estimating: (1) how much cash could be scavenged when (or if) the Spanish economy rebounds within a reasonable time period; and/or (2) the current sales value of the banks' portfolios of loans and abandoned development projects.

Some months ago, I was amused to watch Angela Merkel and Nicolas Sarkozy debating on TV an accounting question: the size of the balance sheet haircut that EU banks should take on their holdings of Greek bonds. Such discussions of paper losses or sale values for asset positions that won't be sold can make for interesting political theater, a play which seems to have been remounted in Spain.

Unfortunately, the real economics of the situation facing Spain and its fellow EU members is much less like theater and much more like surgery without anesthetic. Time marches on and risk is high; hence a simplistic cash-in-cash-out view of gains and losses is far from the transparency that taxpayers, or any other investor, need and deserve before committing one's money to a risky venture that is perilously close to a hopeless cause.

Second, whatever the measurement objective, auditors have no demonstrated competence to produce estimates that policymakers/investors can rely on. If you want a valuation, ask a valuation expert. If you want to understand future cash payment scenarios, then ask an economist. Very simply, and with absolutely no disrespect intended, auditors don't possess the depth of training in asset pricing methodologies or econometrics to do this critical job right – which if not done right could spell the end for the euro.

* * * * *

I see a pattern here. Both the ECB's bailout plan of Spanish banks and the IASB's three-bucket approach to measuring loan carrying values are misguided and inappropriately dependent on the competencies of auditors -- who even with the best of intentions lack the requisite training to evaluate a market value much less an ineffable reserve estimate.

Maybe this is the case study that can convince the FASB that it should leave the IASB and the EU to its own devices when it comes to loan accounting.

It's Crunch Time for Loan Accounting – and Convergence

Once one chooses to ignore market values and to account for loans on the basis of "amortized cost" – as the IASB has "tentatively" concluded and the FASB may now be starting to question once again – the inevitable and ineffable question then becomes how and when to recognize losses on bad loans. Let's examine the alternatives.

The current rules constitute what is known as the 'incurred loss model.' Its only defender in the U.S. is the American Bankers Association, and that should be sufficient to put it to bed. But, if you would like to have the gory details, click here.

The proposed rules are based on the 'expected loss model.' Europeans have taken up its cause, but with apologies to the French and Yogi Berra, it is nothing more than déjà vu all over again. It means that bankers and other financial statement issuers will be required to predict future losses over the lives of loans even in the absence of evidence that a loss has incurred.

As Denny Beresford, former FASB chair once explained in an email to the AECM listserv, one of the important reasons the FASB issued SFAS No. 5, Contingencies, way back in 1975 was to eliminate the practice of accruing "catastrophe losses" in advance of the catastrophe itself. Loans and casualty losses are not the same, but the principle is; and setting aside that principle for loans would not improve the quality of accounting reports from banks any more than that 'cookie jar reserve' accounting was contributing to high quality financial statements from insurance companies before the practice was abolished.

Thus, it warmed the cockles of my heart to read that the FASB and IASB were falling out over the expected loss model. Here is how NYT columnist Floyd Norris called it:

"This week — days after the United States Securities and Exchange Commission made clear it was not going to move toward adoption of international standards anytime soon — the two boards found themselves in angry disagreement over one of the most contentious issues to emerge from the financial crisis: how banks should account for loans that may be going bad [i.e., the expected loss model].

… Leslie Seidman, the chairwoman of the American board, told a joint meeting of the two boards that bank regulators and others had voiced concern about the rules and that she wanted more time to work out guidance and details.

'This is deeply embarrassing,' responded Hans Hoogervorst, the chairman of the international board, which was meeting in London and was linked by videoconference to the American board's meeting in Norwalk, Conn. He said he feared 'this whole thing is going to unravel' after three years of extensive effort." [bold italics supplied]

I hate to be such a spoilsport, but I really hope it does unravel. Very simply, the expected loss model is an even worse solution to the loan accounting problem than the incurred loss model.

Auditing Loan Loss Reserves is a Bigger Problem than Measuring Them

But, the reason I am writing this post is to point out an even bigger problem than the loan accounting rules themselves. The problem I am referring to is that neither mode for measuring loan loss reserves is auditable. Moreover, the problem extends beyond the well-publicized findings of PCAOB inspectors: that many audit firms are incapable of consistently following their own audit programs (see poster children McGladrey, Crowe Horwath and Deloitte).

The mother of all loan loss accounting problems is that, even when auditors do check all of the boxes in their audit programs, they cannot be relied on to make consistent audit judgments.

For example, among the embarrassments to come out of the Greek bond accounting debacle, was the revelation that PwC audited three major financial institutions in Europe that held identical Greek bonds and purported to account for them the same way. Somehow, PwC found a way to conclude that a 51% haircut was reasonable for one client, but a 21% haircut on the exact same bonds was reasonable for another client. Please.

The root of the auditability problem is that management has extremely broad discretion in measuring the amount of impairment, and that auditors are reluctant to challenge those judgments – especially if the client is a too-big-to-argue-with bank. Making matters even more dismal, there is no accounting requirement to refer to current market prices, or even a specific methodology for estimating future defaults. The reality is that so long as an auditor does not object, management can pick pretty much any number it wants. So it does.

 

But, Market Value Alone is Not the Answer

By now, and especially if you are a regular reader of this blog, you are probably thinking that I am going to state that estimated market values can be the only reasonable approach to measuring loans on the balance sheet. Actually … not quite.

In theory at least, estimates of a loan's (or a pool of loans') market should be more "auditable" and "reliable" than loan loss reserves measurements, because an auditor could compare estimated market values to actual market values of traded assets that have similar characteristics. But, my confidence in that theory's applicability to practice was tempered by an observation from Hossein Nouri, when I floated this idea on the AECM listserv.  Hossein wrote, "[T]here are practical limitations to it [i.e., my theory]. For example, for mortgage loans, the banks have hundreds of thousands of loans, if not millions, in different states at different locations. Even within the same city, from one location to another location prices change drastically. In addition, each property has its own criteria, which makes it different from the other properties in the same neighborhood. In sum, there is no easily market value for these properties to come at the fair market value." [italics supplied]

I agree with Hossein that estimates of value are difficult, but it is hard for me to see that they should be more difficult or less accurate than estimates of loan loss reserves. I see the fundamental problem to go beyond the degree of subjectivity in making estimates, to whom is making them.

So, in addition to supporting market value measurement for loans, I go a step further to recommend that loans should be measured by an independent expert – i.e., not management. We need to get beyond the simplistic idea that financial statements should be prepared by management; that's like a student grading herself.

It is time to abandon any notion that management can provide unbiased estimates of value and/or future cash flows, and that auditors are equipped to produce independent and knowledgeable assessments of management's self-interested estimates. The auditor's role in loan accounting should be limited to:

• Verification of the components of financial statements that can be verified (such as contractual amounts and existence).
• Verification of the qualifications of third-party experts charged with estimating market values; and that those experts have performed the procedures they said they were performed.

* * * * *

Loan accounting may well prove to be the demise of IASB and FASB convergence. But whatever the outcome of this project, convergence should take a back seat at the SEC to achieving greater harmonization between accounting and auditing.

Getting the Accounting for Derivatives Right -- to Get Rid of Financial Regulations and Regulators

This may be a little hard to explain, but my thoughts went to lease accounting after reading Jonathan Weil's Bloomberg piece about the JPMorgan derivatives debacle. And, it happened again after I read Floyd Norris's piece in NYT about the misleading accounting produced by MF Global. Anyway, here goes nothing.

First, My Lease Accounting Ruminations

A few weeks ago, as I was trying to think of ways to add a dose of economic logic to the FASB/IASB's leasing project, which increasingly reminds me of a game of hopscotch for all of its contortions and jumping around, it came to me that a plain-vanilla lease is fundamentally nothing more than a series of forward contracts. For either a lease (or a series of forward contracts), there is a series of future cash payments; and these more or less coincide with the right to use an asset for a period of time (or deliveries of the underlying commodity). If there is any economic distinction to be made between leases and forward contracts, it is that forward contracts are often subject to net cash settlement provisions, whereas a lease generally permits only 'gross' settlement through cash in exchange for a right to use an asset for a period of time. Although U.S. GAAP hinges on the distinction between gross and net settlement, for analytical purposes I don't see that the manner of settlement should matter.*

I also have a theory as to why the accounting for leases is so controversial:

• On one side of the debate, there are the 'accounting purists' (and piggybacking special interests) who argue that leases or any other so-called 'executory contract' would not give rise to a liability until performance under the contract takes place. Stated another way, the right to use an asset in the future is not an asset today; therefore, no obligation exists to pay for the right of use until some future point in time.
• On the other side of the debate, are the 'accounting pragmatists' who would respond that the principle of non-recognition of 'executory contracts' poses problems in practice. Imagine this hypothetical: FedEx leases 100% of its planes and vehicles, and accounts for those contracts as operating leases. There is no arguing that its balance sheet, and any measures of risk and operating performance that relied on it for inputs, would be useless at best, if not downright misleading.

The pragmatist view is why the only workable solution for lease accounting is to require capitalization – as both the FASB and IASB have essentially recently concluded. And, some might also judge that the issue of fair value measurement takes on much less practical importance when leases are capitalized on the balance sheet by any ballpark measurement.

But, before going on to the financial institutions of concern to Messrs Weil and Norris, I want to take the argument for capitalization beyond the pragmatist approach against abuses of operating lease accounting to present for your consideration the notion that the principle of non-recognition of executory contracts has become outmoded. The far better principle to embrace would that all contractual rights and obligations must be recognized as assets and liabilities – without offsetting – unless an exception is provided. (I would indeed make exceptions, which I discussed here.)

The general principle borne out of the leasing lesson brings me to derivatives and financial institutions. Let's start with another, yet similar hypothetical: Imagine if JPMorgan had on its balance sheet just $10 million in loans receivable and $9 million in liabilities – that's it. Next, imagine that it enters into an interest rate swap (or a credit default swap if you'd prefer) with a notional principle amount of $10 billion. Like the FedEx hypothetical, there is no arguing that JPMorgan's balance sheet as of the date of entering into the derivative (and probably beyond) would also be useless and misleading. And again, the effects of recognition under any reasonable measurement method pale in comparison to the sunlight added by putting both the contractual asset and liability on the balance sheet.

The accounting policy lesson I want to convey is that a lease is both an executory contract and a forward contract – just like an interest rate swap, a credit default swap, or any other 'financial' derivative you can think of. If the FASB wants to capitalize leases, than why won't it capitalize financial derivatives in the same manner? I don't know if it's because board members would disagree with my logic, or whether they lack the gumption to argue for what's right and necessary. But, whatever their reason might be, the consequences of inaction are the same – which finally brings me to the pieces by Jon Weil and Floyd Norris.

What Floyd and Jon Got Me to Thinking

Regulators Snooze While JPMorgan Lights the Fuse – Jon Weil observes that JPMorgan incurred $2 billion (and counting) of 'hedging' losses in a derivatives screw-up that took place right under the noses of more than 100 federal regulators sitting right next to the traders in the bank's Manhattan headquarters. Weil also said that Federal regulators were in situ and implicitly blessing Lehman's missteps, which according to him might explain why the SEC has been reluctant to take up enforcement actions against individual executives for violating securities laws. "We have come to expect … ineptitude from the … agencies charged with keeping large banks safe. They failed to prevent the last banking crisis; their policies even helped cause it."

My own reaction to Jon Weil's story is to focus less closely on the armies of regulators on the ground as it were, and more on the makers of the regulations. These makers of the regulations should have at some point come to see that nothing – not JP Morgan's or Lehman's CEO, not any other human being, or a so-called "value at risk" simulation – is capable of understanding, much less anticipating, all of the threats to profitability and solvency posed by these overly complex institutions and their contractual arrangements.

My point is that if the banks were forced to present a balance sheet that separately recognized the assets and liabilities arising from their participations in these derivatives contracts (just like lease capitalization), a different and far more accurate picture of the banks' future prospects would have been apparent to everyone. Simply put, better (and virtually costless) accounting regulations would have rendered superfluous a great man financial regulations and regulators; and far better outcomes would have been obtained.

Accounting Backfired at MF Global – Floyd Norris tells the story how flawed repo accounting rules – basically, the same failure to recognize a liability arising out of a derivative contract – distorted the financial statements of MF Global. But, rather than express outrage, like Jon, Floyd timidly states, "It would be wrong to say bad accounting caused MF Global to fail. But it did both encourage and obscure risk-taking that ended in collapse and scandal."

It would have been more salient of Floyd to ask whether better accounting for MF Global's repos (which I described in greater detail in previous posts here and here), would have prevented its management from taking those risks in the first place. For me, the answer is obvious, along with the implication that the FASB has been complicit in the banking disasters – mainly through their procrastination and sputtering about convergence with IFRS. The undeniable effect has been to acquiesce to the big banks demands that they continue to follow their favorite recipes for accounting chicken salad. Even if the FASB can deny that they couldn't have anticipated how its repo accounting rules would be abused, it should have known from past experience that abuses of one kind or another were inevitable.

* * * * * * * *

Jon Weil says that the first thing we need to do is break up the too-big-to-fail banks. He's right, but an accounting requirement to gross up derivatives would add needed discipline and transparency to financial institutions of all shapes and sizes.

The reasons for grossing up leases and derivatives are exactly the same; only the politics is different.

---------------------------- 

* By the way, the view of a lease as a series of forward contracts also has important implications for the measurement of periodic expense associated with lease contracts. I've worked out some of my thoughts on that and hope to post them in the near future.

 

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.

---------------------------------  

*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