The Accounting Onion

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

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

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

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

Conflicts of Interest

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

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

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

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

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

Investor Complacency

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

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

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

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

Complexity of the Modern Financial System

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

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

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

Systemic Risk of Externalities

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

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

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

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

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

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

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

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

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

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

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

PwC Couldn't Get Out of the Way

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

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

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

Here's some of my reactions:

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

And Lynn's comments are even more trenchant:

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

The Sanctuary of Executory Contracts for Window Dressers

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

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

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

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

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

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

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

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

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

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

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

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

The Principled Basis for Recognizing Executory Contracts

As I have written here:

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

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

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

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

 

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

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

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

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

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

Please allow me to translate and remove the varnish:

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

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

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

Will the Fix Work?

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

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

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

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

A Principles-Based Solution

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

The following procedures would apply to securities for which legal ownership (as opposed to 'effective control') has transferred:

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

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

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

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

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

Wrapping Up

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

------

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

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

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

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

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

 The Accounting Issues

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

All Fair Value, All the Time

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

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

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

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

 Stacking the FASB Against Fair Value

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

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

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

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

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

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

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

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

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

 So Far, So Bad

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

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

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

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

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

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

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

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

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

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

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

 

The FAF Trustees Hold the Fate of Fair Value and IFRS Adoption in Their Hands

This is one thing of which I am certain:

If finalized, the fair value provisions of the FASB's financial instruments exposure draft (file no 1810-100) would be the most significant change to financial reporting since the founding of the FASB in 1973 – or perhaps even since the passage of the securities laws in 1933 and 1934. 

The volume of comment letters already posted to the FASB's website only tell some of the story – there are already 250 of them and the comment period still has a month to run. But, it's hard to find the good ones, as a lot of them go something like this one:

"Dear Director, as a Director and Shareholder of a small community bank, I wanted to voice my opposition to the "Mark-to-Market" accounting proposal. We as a small bank were affected greatly by the FASB 166 change. It has wrecked [sic] havoc with not just our capital levels, but it has also distorted numerous performance ratios. The last thing we need now is another change to current accounting practices.

Sincerely,

[Name omitted]

Sent from my iPhone"

One reason I am writing this post is because there is also some really good stuff buried under the chaff. Ed Trott, former Board member wrote two letters. Trott's first letter strongly supports reporting financial instruments at their fair value, and here's a taste of it:

"I hope that the FASB (and ultimately the IASB) will act with true independence to develop accounting guidance for financial instruments for the benefit of the capital markets. Unfortunately I believe IFRS 9 was developed based on not threatening the IASB's franchise with the European Union rather than the opportunity to develop a high quality standard that could be used globally….

I served as an FASB Board member for 8 years [and before that, 7 years on the EITF and a few more on AcSEC.] In the final 7 years of my service the weighting of my auditor experience [appropriately] became secondary to the weight given to providing useful information to the users of financial statements. …

… My concern about being second-guessed with respect to using fair value measurements for [financial instruments] was overwhelmed by information that could be captured and communicated using a fair value measurement. With continued observation of financial reporting and enforcement, I believe fair value estimates, done objectively, are less likely to be second-guessed than many other parts of financial reporting. …

Although I believe all financial instruments should be reported at value using a fair value measurement and that using a "business strategy" to determine where to display the changes is suboptimal, my comments will accept this approach."  [emphasis supplied]

Trott's second letter thoroughly debunked the "alternative view" expressed with the ED, which for convenience I'll refer to as an historic cost approach:

"The writers raise concern about 'subjective' data being included in financial statements…. I believe the subjectivity introduced in the proposal on recognition and measurement of credit impairments (which the writers seem to agree with) will dwarf the fair value measurement subjectivity. I believe [fair value measurement] is is much less subjective, and many more observable inputs are available, to determine a debt instruments [sic] overall fair value than the impact of only one factor….

Although I am not sure world leaders speak for financial statement users, I would love to see a high quality accounting standard for Financial Instruments that was used globally. However a less than high quality standard, even if converged with the IASB standard, should not be the goals of the FASB. I don't believe a convergence effort starting with two non-high quality approaches can end up with a high quality standard. " [emphasis supplied]

That's really good stuff.

David Mosso also wrote a comment letter, and it was completely consistent with his book, which I recently reviewed, but this excerpt at least will give you a flavor for the strength of his convictions:

"I am dead certain that no matter how many new regulations are written to prevent future financial crises, crises will recur periodically until the GAAP system … are given a revolutionary overhaul to adopt comprehensive mark to market accounting with emphasis on diagnosing companies' financial health."

I have to contrast that with the steady drone of the IFRS adoption machine in the U.S., which too much like those inexorable vuvuzelas at the World Cup irritatingly drone: "inevitable." Mosso is saying that if we fail to adopt IFRS in the U.S., our economy will go to hell in a hand basket. Someone please tell me why, after all we have gone through, that we should really care about IFRS adoption? 

Sorry Guys, But The Fix Is In … Maybe

As I stated above, one purpose of this post is to do my part to ensure that Mosso and Trott don't get buried by the whipped up hysteria of the banking lobby. The other reason is to point out the real threat that their voices will be rendered moot by political interests trumping user interests on the board of trustees of the Financial Accounting Foundation.

The Financial Accounting Foundation (the group that oversees the FASB and the GASB) announced last week that it would be expanding the FASB from five members to the original seven. It was only about a year and a half ago that the FAF shrunk the board from 7 to 5 members. Commenters on the proposal to shrink the Board were almost uniformly against doing so, but the FAF ignored the feedback and did what they said they were going to do in the first place, and in the name of faciliting IFRS adoption in the U.S.

Last week, the FAF announced it has taken another tack: without requesting comments from the masses, it would put the FASB back to seven members forthwith. Yet the stated reason was the same: to facilitate IFRS adoption. Go figure.

Actually, if the FAF wants to completely ignore the protestations of users, and practically everybody else except the largest audit firms and corporations on the topic of IFRS adoption, then re-inflating the Board to seven members makes sense.

The math is as simple as it gets. With one of the three members voting to issue the financial instruments ED, having announced his retirement (Bob Herz), four Board members continue to serve. Two of them favor fair value and two, like the IASB, support some new historic cost-based concoction. By expanding the Board to seven, the FAF can cherry pick enough new historic cost-favoring Board members, so as to overwhelmingly defeat the ED. Convergence and ultimate adoption of IFRS would be, as the horn blowers drone, "inevitable." And, at this juncture, I would have to agree.

Next, let's look at the FAF voting math, which is a little more complicated, albeit just as crucial. There are 14 voting trustees. I'm going to put the three from the audit firms plus the securities lawyer, investment banker and Microsoft executive firmly in the 'historic cost' camp. That's six already, and I am going to assume that only eight are needed to approve a new FASB member.

The three investors and the two academics ought to be 'fair value' folks, but I feel more than a little bit on shaky ground here. Neither academic appears to have big accounting chops—although they both have very strong credentials in finance.

I am also concerned about the three investors, because it is difficult to predict whether they will vote with their conscience or their wallets. It is not always clear that investment managers care for transparent financial reporting, as it could threaten opportunities to create a competitive advantage with proprietary analysis and modeling techniques that can cut through the haze emanating from low quality accounting standards.

The three trustees from government/not-for-profit are huge question marks. I readily grant that it is right and proper for NFPs to have their say on many of the issues addressed by the FAF; but, this ain't one of them. How ludicrous would it be for the NFP bloc to determine such a significant issue -- one noe less that much, if any, impact on their constituencies.

So, that's the math that makes me fearful that the fix is in. I am just as fearful that a 'historic cost' bloc of trustees will control the appointment of two like-minded FASB members. And, since that will be enough to control the FASB via simple majority (which I am against), the third appointee will be nothing more than a $500,000 per year lamp post.

Whatever the ultimate scenario, if there is only one though that you will take from this posting, I hope it is this: 

The fate of the most significant financial reporting initiative in the history of the FASB will not be decided by the Board. It will be decided by the 14 trustees of the FAF.

The timing of the FAF's decision to increase number the size of the FASB, and their control over the new appointments, has rendered it thus; and for or all I know, that's the reason why Bob Herz, the current chairman, chose to retire early. If I were in his shoes, that exactly what I would have done.  Moreover, unless the FAF does the right thing, resign in protest is what Tom Linsmeier and Marc Siegel (the two remaining fair value guys on the Board) should do.

On the other hand, I have not a single shred of direct evidence as to how any individual FAF trustee will vote. Perhaps, they will appreciate why three bright stars of the accounting firmament, David Mosso, Ed Trott and (soon) Walter Schuetze have spoken out and appoint new Board members accordingly. But, the stated purpose of the Board expansion, and the arithmetic of Board voting strongly suggest otherwise--which leaves us with little to do, except to wait for the banks to fail us yet again.

Loan Impairment: A Made-Up Number By Any Other Name …

According to the American Bankers Association's August 5^th letter to Treasury Secretary Timothy Geithner, the banking industry will be fundamentally changed if the FASB were to require banks to account for its loans at fair value. Everybody who thinks that banking practices should be fundamentally changed, please raise your hand.

"The FASB's proposal will … decrease the ability of investors, regulators, and bank customers to undertstand the business of banking, due to the focus on estimates of the market's perception of value rather than the cash value to the bank." (italics supplied)

Let's break this passage from the ABA's letter into two parts: what the ABA appears to be for—reporting loans at the "cash value to the bank;" and what they are against—a "focus on estimates of the market's perception of value."

"Cash Value to the Bank" – Old Rotgut in New Bottles

My inspiration, such as it is, for this post came from a discussion of the ABA letter with a friend (who must remain anonymous). My friend was first to ask what the phrase "cash value to the bank" was intended to mean. As the letter offered no hint of possible alternatives to the FASB exposure draft that the ABA would support, we initially surmised that the phrase in question was the ABA's oblique way of stating that it actually wanted no change to existing GAAP, without actually uttering those preposterous words -- for in these trying times, it is hard to say with a straight face that GAAP's loan impairment rules are anything but utterly disconnected from reality.

So, we asked the ABA; and, we were right. Here's the gist of my email correspondence with Donna Fisher, ABA's senior vice president of tax, accounting and financial management.

My Question: "Does the term 'cash value to the bank' refer to existing U.S. GAAP as it applies to a bank's loan portfolio?"

Ms. Fisher's Response: "Yes, we are referring to current accounting, in which the amount of principal to be received is the amount that is reported. As in current GAAP, this would not include interest income, but would include fees and discounts. Loan impairment would continue to be shown as a contra-asset on the face of the balance sheet." (italics supplied)

I suppose there is still some uncertainty as to the intended meaning of the term in question. Is Ms. Fisher referring only to the carrying amount before or net of impairment charges? Methinks she must be referring to carrying amounts for loans net of impairment charges; for if she were not, then the ABA shouldn't object to reporting fair value as the net of the principal amount (taking into account fees and discounts) and an adjustment to bring the principal amount to the fair value of the loan. I'm 100% certain that the ABA would not be happy with that!

I think I'm on pretty solid ground when I state that most everyone except for bankers and their auditors have eventually come to realize that extant accounting for loans is a dog's breakfast of wishy-washy criteria and made-up numbers. But, I haven't reached my self-imposed 1000-word quota yet, so let's review the lowlights of what investors and bank regulators are currently being fed.

Residential mortgages—The accounting standards for "large groups of smaller-balance homogeneous loans," including residential mortgages and credit card receivables are about as squishy as accounting can be. All banks will perforce make some accrual for defaults, but GAAP contains no guidance whatsoever for measuring the accrual, other than it must be capable of being measured reliably—whatever that means, and especially since we are told nothing about what the net loan amount is supposed to portray.

The bottom line for loans evaluated on a portfolio basis is that GAAP is an open invitation to bankers to make up a number. Even before the financial crisis, bankers were exploiting with virtually impunity these gaping gaps in GAAP via what former SEC Chairman Arthur Levitt famously referred to as "cookie jar" or "rainy day" reserves. I recall that the SEC staff in 1999, under Levitt, questioned specific banks about loan reserves that were as high as 8% during periods when actual loan loss experience was under 1%. Golly, I wish we could have those days back again, but the point is to show that even after being chastened by the S&L crisis, many bankers were defiantly back to their old accounting tricks, and with nary a peep from their auditors.

Loans identified for individual evaluation—The protocol for recognition and measurement of impairment goes like this:

• Recognize an impairment when it becomes "probable" (helpfully defined as "likely to occur") that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.
• The amount of the impairment is to be measured as the difference between the carrying amount of the loan and the present value of the expected cash flows (as estimated by management, of course!) to be received from the borrower.
• The discount rate used for making the present value calculation is the loan's original yield to maturity (referred to as its "effective rate," in order to avoid explicit mention of the apples-multiplied-by-oranges arithmetic).

First, the definition of "probable" is as clear as mud, and intentionally written so that each bank can have its own special way for determining when that "probable" threshold has been crossed. In practice, "likely to occur" is interpreted to mean significantly more likely than not, and that by itself should speak volumes. Why must investors wait for the bad stuff to be just inches from hitting the fan? By the time investors learn about collectibility problems, there is no getting out of their way.

Second, I probably don't have to explain to anyone how ludicrous it is to discount lower expectations of cash flows with the originally-expected rate of return on investment. Can this be what the ABA refers to as "cash value to the bank"?  Evidently so. 

I'm sorry to have to have to inform the ABA that a made-up number by any other name is still a made-up number. I'm dying to reproduce a Dilbert cartoon here, but with copyright laws what they are, I had better not. So, here's the gist of what those scruffy mutts were saying:

Boss: Your report is nothing but a bunch of made-up numbers!

Subordinate: I know, but studies have proven that made-up numbers are better than real ones.

Boss: How many studies say that?

Subordinate: 58.

(Thanks to Bob Jensen for bringing the cartoon to my attention.)

Third, the requirement in GAAP to consider most loans individually plays even further havoc with the specious "probable" threshold for impairment recognition. Let's say, for example, a bank holds 10 commercial real estate loans, and due to the occurrence of some event after the loan was made, the probability of default for each loan increased from 1% to 5%. Even though the probability that at least one of the loans will default in the future is roughly 60% (= 1 - .95¹⁰) no impairment charge will be recognized. I surmise that only bankers and auditors think that' makes for "fair presentation."

Don't Trust Markets: Only Real Bankers Know How to Value a Loan

The ABA's position is that when it comes to accurate estimates of a loan's value to the bank itself, investors and regulators should rely on ABA members to make those valuations. This we should accept even though two recent banking crises and a cursory reading of Freakonomics tell us otherwise in no uncertain terms.

I certainly don't want to belabor the obvious here, but what is there about a banker's character that makes them different from the rest of us? Yes, they are the ones on the ground working with the entire loan portfolio, but asking them to grade their portfolio is like asking a college student to grade her own work. Surely, we have progressed far beyond the naive view of bankers and their auditors as belonging to some sort of priesthood whose solemn vows place them a cut above the rest of us mere mortals. If we are to accept the ABA's premise that market "perceptions" of the value of financial contracts are structurally flawed, then the problems with our market-based economy run much deeper than deciding how to make the debits and credits.

It's one thing for the ABA to be against fair value accounting, but it's quite another to support the status quo. For that, the ABA decided to invent a high-minded sounding term of art that has no actual meaning except for the dog's breakfast that is current GAAP for loan impairments.  Their motivation is to hide their support for continuing to allow bankers to pretty much decide on their own what made-up numbers they deign to report to shareholders.

And, wherefrom comes the basis for presuming that a banker can divine value more accurately than a market of buyers and sellers (or a neutral valuation expert) possessing essentially the same information that the banker has? Certainly, recent history provides no basis. A huge factor that brought about the financial crisis was that the Big Five investment bankers (supposedly the smartest of the smart), stupidly ate too much of each other's cooking—those overrated tranches of securitized subprime mortgage loans. They all could have fallen on themselves like victims of a Ponzi scheme of their own making had the taxpayers not picked up a large portion of the tab.

Now, the ABA wants us to believe that the old recipe their members followed for cooking their own books is still tried and true, just because they have given it a shiny new name – 'cash value to bank.'

The name I have for that is chutzpah.

Sweet Little Nothings from the IFRIC

In researching an IFRS question recently, I stumbled across a whole new (for me) source of stealth guidance put out by the IASB's International Financial Reporting Interpretations Committee (IFRIC). I am referring to official descriptions of issues that were presented to IFRIC, but not taken onto their agenda.  Notwithstanding that rejection strongly implies insignificance, the IASB has seen fit to compile IFRIC's stated reasons for rejection, going so far as to update references when changes are made to them.  Even so, these compilations are all prefaced by a disclaimer that each snippet (by my count there is a about two hundred of them) is for "information purposes only" and does not "change existing IFRS requirements."  Right.

What follows is the story of just one "information purposes only" comment that clearly was meant to be more than that -- most likely a gift to a highly-valued stakeholders.

A Little Revenue Recognition Question*

During an IFRS course I was teaching to practicing accountants last month, one of the attendees asked me how discounts for early payment should be treated. His company, for example, offered terms of 2/10 net 30, and 99% of the customers took advantage of the discount. However, not all customers actually paid within the discount period; as is common in practice, a significant proportion of customers claiming the discount did so after the discount period lapsed.

If you have studied U.S. GAAP accounting at even a basic level, you would be aware of at least one method for treating early payment discounts, despite the fact that no specific provisions in GAAP dictate the accounting treatment for them. I couldn't even find an answer from a search of PwC's own GAAP accounting and reporting manual--normally a rich source of information that I use frequently. Thankfully though, practically every intermediate accounting textbook covers the basics of the 'generally accepted' alternatives treatments of invoice payment terms. Before we delve into IFRS for its requirements, kindly permit me to stipulate that there are two generally accepted approaches under U.S. GAAP:

• The 'gross method' calls for, assuming a $100 nominal price, recording $100 of revenue upon delivery of goods/services offset by accounts receivable. Before the financial statements are issued, however, two accounts receivable allowance accounts are established: one for future exercises of early payment options granted during the period (with an offset to a contra revenue); and as with all sales on account, another for uncollectible accounts (with an offset to bad debt expense).
• The 'net method' will record the initial sale at $98. If the company collects $100, the difference will be credited to financial revenue – usually interest income. The allowance for uncollectible accounts is handled in the same way as per the gross method.

Neither method is completely satisfactory for reasons that I won't go into here, but they are useful benchmarks against which to judge what I found from researching IFRS. As you will see, IFRS was crystal clear—until the IFRIC made one of its "information purposes only" comment about an issue they decided not to comment on.  Go figure. 

I initially focused my investigation of the IFRS treatment on the initial recognition aspect, because that was what my questioner was concerned with; also, the appropriate subsequent measurement would likely suggest itself from initial measurement. International Accounting Standard (IAS) 18, Revenue, provides as follows:

"The amount of revenue arising on a transaction is usually determined by agreement between the entity and the buyer or user of the asset. It is measured at the fair value of the consideration received or receivable taking into account the amount of any trade discounts and volume rebates allowed by the entity." [IAS 18.10, italics supplied]

Stripping out some of the qualifying language, the core of paragraph 10 is about as clear and principled as one could ask for: revenue is to be measured at the fair value of the receivable.

As to that qualifying language, I don't know for sure what "usually" means in this context, but since early payment invoice terms are so common, it should be safe to assume that the general rule enunciated in IAS 18.10 is applicable without alteration. The last phrase of IAS 18.10, "…taking into account the amount of any trade discounts and volume rebates …", also does not appear to pose a problem, although I have to admit that I don't have any firm grasp on its function. A fair value measurement should comprehend all potential economic consequences; why two specific factors are mentioned may be an artifact, which would have become outdated when fair value was formally defined by another accounting pronouncement.

IAS 18.10 is not fully consistent, however, with IAS 39, Financial Instruments: Recognition and Measurement, which provides guidance on accounting for financial instruments for initial recognition at fair value. However, I should note that IAS 39's application guidance does provide a materiality exception for measuring trade receivables at fair value:

"Short-term receivables and payables with no stated interest rate may be measured at the original invoice amount if the effect of discounting is immaterial."  [IAS 39.AG79]

I'm going to proceed for now as if discounting would be material, and deal with undiscounted receivables separately.

Which brings us to subsequent accounting for the receivable. For that, we need to stay with IAS 39, because, trade receivables are within its scope. Specifically, IAS 39.46(a) provides that receivables are to be subsequently measured on the basis of amortized cost using the effective interest method.

A key difference between U.S. GAAP and IFRS relates to recognition of impairment. Under U.S. GAAP, the receivable may be reduced for an allowance for bad debts on Day One. However, this is not appropriate under IFRS because an allowance for bad debts should have already been taken into account when initially measuring the receivable at its fair value. Subsequent recognition of impairment losses may only be made if there is "…objective evidence of impairment as a result of one or more events that occurred after recognition of the [receivable]." (IAS 39.59)

So, the answer that I was going to send to my questioner was going to go something like this:

IFRS requires that the receivable be initially measured at fair value and subsequently measured at amortized cost until the invoice is paid or becomes past due. The receivable would be considered to be impaired if not paid within 30 days (or perhaps at some earlier date if an event occurs that provides objective evidence of impairment). The difference between total cash received from the customer and the initial valuation of the receivable should not be presented on the income statement in the same manner as revenues from the sale of goods.

However, for reasons of materiality, it is common practice to disregard the effect of discounting in the initial measurement of trade receivables. When that is the case, then the net method appears to be most consistent with the principles enunciated in IFRS.  Accordingly, the liberal discount terms would indicate that the original amount of the receivable and the revenue to be recorded would be $98; any amount collected in excess would be financing revenue.

Finally, I must note that IFRS does not address the measurement of impairment if the receivable is measured at its undiscounted amount.  Therefore, I believe it must be presumed that no impairment may be anticipated until a subsequent event provides objective evidence of impairment.

IFRIC the Fixer

Then, this little blurb from the July 2004 edition of IFRIC Update (and as I mentioned above, subsequently compiled with other similar snippets) was brought to my attention:

"Items not taken to the IFRS agenda…. Prompt settlement discounts ... IFRIC members agreed that prompt settlement discounts should be estimated at the time of sale, and presented as a reduction of revenues. ..."

In other words, IFRIC has 'agreed' (without putting the issue on their agenda – and in the absence of a quorum, I should add!) that IFRS calls for the gross method of accounting. Whatever their answer, it sure would be nice to know how they got there!  Cynical me thinks that's precisely why this common question, for which IFRS is clearly not clear on, was not put on the agenda.

One of the criticisms that supporters of IFRS adoption in the U.S. make of U.S. GAAP is that the utterances and scribbling emanating from SEC staff members without due process become de facto rules. Notwithstanding disclaimers like the one that IFRIC employs for its snippets, these and similar sources are considered authoritative by issuers and derogatorily referred to by many as "speech GAAP."

But, a critical difference between SEC speech GAAP and IFRIC's version is that the SEC's interpretations almost invariably constrain the accounting possibilities;  issuers don't like them.  But, it seems pretty clear that issuers would appreciate those otherwise gratuitous comments from IFRIC, which make chicken salad out of even the most principled of international accounting standards.

Perhaps one can also criticize the various promulgators of U.S. GAAP for allowing diversity in practice to persist for such a basic and common question as early payment discounts. But let's suppose for argument's sake that the EITF formally considered putting the issue on its agenda, and then chose not to.  In announcing their decision, would they proffer an opinion as to what the appropriate accounting treatment should be?  That would be inconceivable.  At the very most, IFRIC could publish a statement that they were not going to address an issue because, perhaps, they viewed it as already being settled – or that the existing standards are sufficiently clear. Anything beyond that is merely poorly-disguised "speech GAAP."

One of the many reasons why I am so opposed to IFRS adoption in the US is that I trust the IASB even less than the FASB to stick to its principles or to focus on the needs of investors. Chicken salad speech GAAP from IFRIC is just one more reason to feel that way.

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

*My analysis of this question was enhanced by contributions from two contributors to the AECM listserv: Pat Walters of Fordham University and Carla Carnaghan of the University of Lethbridge.  An earlier version of this posting omitted reference to IAS 39.AG79; sincere thanks to S. Ramachandran for pointing this out to me.

Also, I have slightly altered the circumstances under which I received this question in order to maintain the confidentiality of a client relationship.

A Simple Solution To Standard Setters' "Control" Issues

In the good old days, you recognized the assets you owned. For the reasons why things eventually became a lot more complicated than that, there is plenty of blame to go around. Blame the banks and their minions of financial engineers for arcane securitization transactions that transferred legal ownership of those assets, but not much else, to work the accounting wonders that have now become closely associated with the most recent financial crisis. Blame Enron for trying the same scheme with power plants and such.  Blame lots of companies like Enron that were able to keep a lower profile. 

From the perspective of the rampant abuses that occurred, I suppose you can't find too much fault with the FASB and IASB for taking another tack for asset recognition/derecognition. But, the fact remains that "control" (notwithstanding the difficulty the boards have had in pinning down an abuse-proof definition) as a recognition criteria has problems of its own. Take, for example, lease accounting, one of the more high profile issues of the day. As in my previous post, I'm going to use some recent remarks on the topic attributed to Jim Leisenring by Simon Brown as a jump off point. Before we get to that, however, I am once more compelled to provide a few caveats.

First, I incorporate by reference the caveats as to Simon Brown's reporting of Jim Leisenring's remarks concerning "high quality accounting standards" (HQAS) . Second, I'm really glad I issued that caveat when I did. Soon after I sent that post hurtling into cyberspace, I received a credible email claiming that Brown's reports on Leisenring's remarks as regards to HQAS were inaccurate and misleading. My source claimed that Leisenring had not even referred to any discussions of the characteristics of high quality accounting standards amongst the IASB members.

Although I regret any inaccuracies that may have found their way into my commentary, I only used the information from Brown to establish the existence of an active discussion among IASB members as to what "high quality accounting standards" meant.  I do not believe that any mischaracterizations of Leisenring's remarks, although highly regrettable, should call for alterations to my own personal comments.

As to the current post, I shall with newfound trepidation once again rely on Brown's reporting of comments made by Leisenring – this time, however, concerning lease accounting. I have inquired from my sources as to whether Brown's reporting on this topic was substantially inaccurate; and so far, I have received neither a confirmation nor a denial. As is always my policy, if I should subsequently discover any inaccuracies, I will make disclosures to that effect.

What Brown Said Leisenring Said About Lease Accounting

[Leisenring said,] The boards "have no idea what they're doing collectively, including me," …. [he] said the boards have been arguing about the issue for two months. Some members have argued that lessors should derecognize the portion of the asset they gave up by right of use, which he called "extraordinary accounting." He said the [sic, their?] derecognition model would suggest that every time a hotel rents a room, for example, it should account for the loss of the part of its building that it gave up, then reverse it the next day when a guest checks out.

I Can Fix That Problem!

The hotel example is clearly what one gets by taking a "control" criteria for recognition/derecognition to its logical extreme.  I can think of no other way to fix the problem than to restore "ownership" to its rightful place as the principal criteria for asset recognition; to wit, only legal entitlement to an economic resource may trigger recognition of an (as opposed to "the") asset.

By "legal entitlement," I am referring to one of the types of circumstances: (1) ownership of an asset; (2) a right (conditional or unconditional) to receive an asset; or (3) a right (conditional or unconditional) to use an asset. But unlike any other "traditional" accounting models, I would also need to define a liability symmetrically as an obligation to a holder of (2) and (3), above.

This revised asset/liability criteria makes lease accounting very straightforward, although I want to take this opportunity to remind you that I am severely critical of the measurement aspects of its proposals as well -- they are truly terrible.  Anyway, as regards to recognition only, the lessee (i.e., hotel guest) should recognize an asset for its right to use the property being leased (i.e., hotel room); and an obligation to pay the lessor (i.e., hotel owner) in exchange. The lessor, for its part, recognizes an asset for the right to receive payments from the lessee and an obligation to provide access to the hotel room. Thus, the accounting for the hotel property itself is unaffected by the lease arrangement as no change in ownership occurred.

Does My Fix to the Leasing Problem Create Other Problems?

You may already be thinking of potential shortcomings to my "legal entitlement" approach. So far, I have thought of two – but I can easily live with them.  In fact, I vastly prefer them to the results that come out of the control approach.

First, legal entitlement could put all executory contracts on the balance sheet, not just leases, the pioneer of on-balance-sheet recognition of an executory contract.  That's because it was rightly seen by many as an essential exception to close one of the most popular off-balance sheet loopholes. Years later, a forward contract meeting the restrictive definition of a "derivative" became another form of executory contract that was put on the balance sheet (SFAS 133).

So, I suppose, that standard setters can continue to pick and choose which executory contracts to scope in or out of its rules no matter whether "control" or "legal entitlement" is the asset recognition criterion.  As for my own preferences, except for limited practicability and materiality considerations, the ancient prohibition against recognition of executory contracts has become obsolete.

Second, the "legal entitlement" criterion for liability recognition as I have stated it would not result in recognizing "contingent liabilities" such as pending lawsuits (unless, of course, the case had been adjudicated). It would also not comprehend constructive liabilities. With respect to contingent liabilities, all sorts of regulators have been trying for ages to come up with consistent accounting for contingent liabilities and the results, to be kind, have been inconsistent if not just plain ineffectual. With respect to constructive liabilities, they are merely tools for earnings management.

I'm most happy to get both contingent and constructive liabilities off the balance sheet, although disclosures of contingent and constructive liabilities have their place, and arguably should be strengthened. There is nothing wrong with expansive narrative and quantitative disclosures in notes or in MD&A.

I should also note that my criterion would comprehend contractual warranty obligations and any other similar obligation to stand ready to perform in the future.

Control as a Presentation Criteria

Finally, I should point out that the notion of "control" can still be useful, even though it has done little more than to bollix things up. For another recent example, see the infamous Repo 105 mess.) Its role would be limited to determining the presentation of financial assets. If legal entitlements over financial asset(s) convey the power to control another entity, then consolidated presentation would be appropriate. Other circumstances could also indicate that consolidated presentation is appropriate, too, such as whether an entity is a "primary beneficiary." If the investment(s) confer "joint control," then proportionate consolidation would be appropriate; but, that's certainly fodder for another blog post.

Fair Value for Financial Instruments: It's Now or Never

I don't watch TV very much, except for sports – lots of sports. I nonetheless tore myself away from ESPN for thirty minutes last week when a friend strongly suggested that I watch an interview of Paul Volcker (former Fed Chairman) and William Isaac (former FDIC Chairman) on the Kudlow Report. Among other things, these gentlemen were supposed to explain why they were staunchly opposed to mark-to-market accounting for bank loans.

As expected, I didn't learn anything new from watching a superficial discussion amongst voices singing in unison. However, I did come away with a new appreciation for how much public pressure is being brought to bear on the three FASB members who boldly voted to issue proposed revisions to financial instruments accounting.  If finalized, they would require reporting nearly all financial instruments at their fair values, so it's a safe bet that the ultimate disposition of this proposal will be a watershed event in the history of U.S. accounting standards; not just for what it says about the future of fair value accounting, but for what it portends for adoption of IFRS in the U.S. This one is for all the marbles.

There are, to be sure, many aspects of the FASB's proposal to debate, but the flashpoint is whether any version of mark-to-market (MTM) accounting is appropriate for bank loans. The conventional hue and cry is that market-based valuations induce "procyclical" behavior with the ultimate effect of blunting or even defeating other economic policies. The story goes like this:

1. The market value of a bank's loan portfolio must decline during an economic downturn, even if there are no specifically identifiable problems with any individual loan. This is because the market will assign a higher probability to future bad news and impound it in the price.
2. If the decline in market value is recognized on the bank's financial statements, then regulators, whose policy it is to utilize balance sheet ratios for determining the capital adequacy of banks, will require those banks either: (a) to raise new equity capital (not an attractive option in down times), or; (b) to cut back on their lending—the more likely outcome, since equity values would be depressed.
3. If the banks were to cut back on their lending, the economic downturn would become worse.

In other words, the cornerstone argument of the anti-fair value camp goes thus: truth hurts; therefore, we must repress it.

Volcker and Issac recommend a head-buried-in-the-sand accounting standard, which allows management to disregard any possibility that a loan will not be repaid in full unless and until direct evidence to the contrary bites them in the rear end.  And, when reality can be ignored no longer, we should prefer estimates of uncollectibility produced by self-interested management (under the watchful eye of their "independent" auditor), and ignore the collective opinion of disinterested market participants.  

Here's just two of many reasons for casting one's lot with the markets.

Reason #1: Current GAAP is Procyclical, Too

One can argue just as forcefully as the MTM naysayers that the existing accounting standards are also procyclical, and that it was the flaws in the existing standards that brought us the S&L failures of twenty years ago, not just the bank failures of two years ago:

1. During periods of economic expansion, accounting rules that permit delayed recognition of loan losses encourage bankers to make inappropriately risky loans. It doesn't help that auditors are prone to accept management's head-in-the-sand versions of loan loss allowances.
2. When economic expansion ceases, banks will continue to lend to inappropriately risky candidates, and perhaps, to even riskier candidates in a desperate attempt to meet unreasonable earnings expectations. Bankers can do this with apparent impunity, because they are permitted to ignore market valuations of their existing loan portfolio.
3. When bank financing is needed to reverse the economic downturn, it won't be available, in large part because the banks have dug themselves a hole, jumped in, and can't climb out.

In other words, it is also bad economic policy to base measures of capital adequacy on fictional loan portfolio valuations, especially when that fiction is the cause of underfunding government-sponsored deposit insurance programs.

I would regularly tell my students that sound banking policy means that you only lend money to people who don't actually need it. Everybody else must seek to issue equity, thank you very much. Similarly, it may be unrealistic for policy makers to expect even healthy banks (never mind the ones in that aforementioned hole) to increase their lending during a downturn. Lacking sufficient appetite for risk on the part of potential equity investors, that leaves only the government to take up the stimulus mantle. (Yes, dear reader, I'm a Keynesian).

Current GAAP has clearly encouraged banks to make loans they shouldn't have made, and if that's not exactly what Bob Herz, FASB chair said in his testimony to Congress, it's pretty darn close:

"The fact that fair value measures have been difficult to determine for some illiquid instruments is not a cause of current problems but rather a symptom of the many problems that have contributed to the global crisis—including lax and fraudulent lending, excess leverage, the creation of complex and risky investments through securitization and derivatives, the global distribution of such investments across rapidly growing unregulated and opaque markets lacking a proper infrastructure for clearing mechanisms and price discovery, faulty ratings, and the absence of appropriate risk management and valuation processes at many financial institutions." [italics supplied]

Reason #2: Fair Value Doesn't Have to Be Procyclical

If an economic policy can be defeated by putting a truth on the balance sheet, then there is something fundamentally wrong with that economic policy. Bob Herz, FASB chair, is now calling for severing the linkages between financial reporting and bank regulations, and I've also made that suggestion here. I don't want to sound like a broken record, but there must be a better way to regulate banks than to rely on made-up balance sheet numbers.

Getting back to TV and sports, while lying sleepless and jetlagged in a Chicago hotel room a couple of days after the Volcker and Isaac show, I woke to Jimmy Kimmel's monologue. What I think happened is that I dozed off during the stupefying game seven of the NBA finals, and Kimmel followed. Here, as I paraphrase it, is perhaps as close to an accounting joke as Jimmy may ever get:

"It seems like every week, the estimate of the amount of oil spewing into the ocean from that underwater well doubles. We have to stop these estimators: they're destroying the Gulf"

Get it?

Accounting for a Sweet Co-Co

Prof. Robert Bloomfield of Cornell University posted an interesting accounting question on the FASRI (FASB Research Initiative) blog. I'm taking the liberty of repeating it here in its entirety:

A policy proposal floating around these days is to require banks to issue contingent convertible debt:

My [Mankiw's] favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance.

A lawyer asks how these might be structured.  This accountant asks:  how would you account for them?  Note that unlike many contingent convertible securities, the event on which conversion is contingent is a regulatory action.

I am attracted to the accounting question because I think the policy proposal itself is a brilliant idea; and because it dovetails nicely with my last post on the FASB/IASB deliberations on liabilities/equity classification. For the sake of the points I would like to make, I'm going to make three questions out of Rob's single question:

1. How would the contingent convertible debt (known in the trade as a Co-Co) be accounted for under current GAAP?
2. Would the answer change if current FASB proposals became final rules?
3. How should the Co-Co be accounted for?

Current GAAP

I could not find specific GAAP for a Co-Co, but I can't be sure that none exists -- in part because the FASB's Accounting Standards Codification is so darn hard to read! There are many redeeming qualities of the Codification; however, it seems to sacrifice readability for systematic presentation. I used to think that some of the pre-codification Original Pronouncements read like gibberish; but now, alas, I pine for them.

So, here goes nothing.  I surmise that GAAP does not make a distinction between regulatory events and other events triggering conversion.  Thus, it would require that this particular Co-Co be accounted for as straight debt until conversion actually occurred. That accounting actually seems reasonable until we have a bank whose financial condition may actually be getting to the point where the regulator would flip the switch to convert the debt to equity. For simplicity, let's assume the debt was issued at par. Upon conversion that entire amount would have to be transferred to shareholders equity (probably through net income) in one fell swoop as of the date of conversion.

A big one-time credit to equity smacks of a rule devoid of any intent to provide timely information to investors. The economic value of the debt would have been declining as conversion inexorably approached, and current GAAP wouldn't have cared less. So, in the period that the regulator flips the debt over to equity, the huge cumulative catch-up adjustment to the debt could swamp the operating losses of the current period, which surely must be occurring. If the debt had been marked to market whie the bank was heading toward its nadir, the trends in the earnings available to the pre-conversion equity holders would have been reflected in a more timely and relevant fashion.

Future GAAP

Of the accounting that would occur if certain current FASB projects came to fruition as planned, I am more certain.  Starting with the fair value project, the debt would be fair valued each period. That's a good thing, but the Co-Co also exposes yet one more (see my previous post) hole in the rules-based liability/equity project.

Let's take a bank that has the following components to its capital structure: (1) the Co-Co, (2) call options on its common shares (which may only be settled by issuing common shares), and (3) common shares. According to the FASB's current position, the options will be classified as equity; but the Co-Co, which also contains a conversion option) will be classified as debt unless converted. Although the Co-Co would be fair valued each period, such treatment will be inconsistent with the treatment of the call option, the opening value of which will sit in the equity section of the balance sheet like cream cheese on a bagel forevermore. The economic events that could cause a change in both the fair value of the Co-Co and the option would be ignored as to their impact on the option, but the impact on the Co-Co would be recognized.

The accounting treatment for the option and the Co-Co would differ for no good reason.  Both would affect the economic position of the current shareholders, but only the effect caused by the change in the value of the Co-Co would be recognized.  This is just one of many reasons why the FASB should revert to its recently abandoned principled stance: it should classify all financial instruments as either assets or liabilities, except for common stock.

Accounting Onion GAAP

Rob Bloomfield correctly observes that lawyers would have to be consulted to precisely specify the Co-Co that Mankiw and others have envisaged. When considering current or future GAAP, I risked putting the cart before the horse by not anticipating key terms of the arrangement. That's because one of the huge problems with rules-based accounting (especially for financial instruments) is that the standards promulgators must ever be on the ready to publish new rules as those pesky financial engineers devise clever ways to circumvent the fences that have already be erected to keep them at bay.   But, as I will demonstrate, there is no danger that a new financial instrument will threaten the sufficiency of truly principles-based standards.

First, the Co-Co liability –and for that matter all other financial instruments other than common shares—would be measured at an investor's replacement cost. (Thus, no inactive markets problem for determining the exit price; even if there are no current buyers, there are always sellers for the right price.)

Second, any changes in replacement cost are to be reported through net income.

Third, upon conversion, I would derecognize the Co-Co, increase paid-in capital for the market value of common stock immediately prior to the conversion, and record any difference in these two amounts in equity through net income. That's the amount that the holders of basic ownership interests gained or lost when the government pulled the trigger on its conversion option.

Any questions? I have one: when is the FASB going to adopt some principles? Also, any and all changes that would make the Codification easier to read would be much appreciated!

Off Topic  -- Tom on the Hot Seat

I had the honor of responding to questions from participants in a recent hour-long FASRI Roundtable dubbed "Perspectives on Standard Setting."  You can listen/watch a Second Life recording of my being grilled by some really smart folks slinging some really tough questions here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Saying So Doesn't Make it So

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

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

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

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

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

The Lease Accounting Proposal: What Investors Say

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

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

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

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

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

Overall Approach to Lease Accounting

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

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

Scope of a Forthcoming Standard

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

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

 

Measurement

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

Accounting for Economic Earnings: Inflation-Adjusted Replacement Cost

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

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

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

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

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

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

 

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

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

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

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

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

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

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