The Accounting Onion

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

 (Click here for Part 2)

 

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

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

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

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

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

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

A Simple Example

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

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

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

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

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

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

 

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

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

  

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

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

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

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

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

Regulate Derivatives? Start with Better Accounting!

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

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

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

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

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

Derivatives are Like Butchers' Knives

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

FASB Amnesia?

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

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

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

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

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

Where is the SEC!?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Forbes also contends that

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

FSP EITF 99-20-1: Dissenting Board Members Hit the Nail on the Head

Do you think that stable funding could allow the IASB to divorce itself from the influence of the EU? If so, consider the example the FASB is setting under similar circumstances, and think again.

The U.S. standard setter was granted its own legal separation papers from special interests six years ago by S-OX; yet it continues to play the henpecked spouse. Take, for example, that seven-years-and-running financial statement presentation project, which I wrote about in my last three posts (here, here, here). That project is moving slower than a one-legged turtle because the FASB chooses to debate and procrastinate, rather than give investors what issuers don't want them to have.

But, a brand spanking new example, which I am about to relate, illustrates a corollary: if Wall Street needs the FASB to make a quick fix, they're Johnny-on-the-spot to service the big boys.

EITF 99-20, which the new FSP amends, concerns itself with the once-arcane question of accounting for the impairment of 'retained interests in securitized financial assets' – you know, remnants of contracts or portfolios considered "junk" at the time the better parts were securitized for the consumption of sane investors. The problem became a front-burner issue to the holders of those junk retained interests as they proceeded to devolve into "toxic."  So, already, you may be getting my drift: the capital of financial institutions were about to get hammered, yet again, by fourth-quarter write downs unless they could get a rule change through the FASB – fast. Basically, what happened was that the financial institutions got their wish via an amendment to an impairment methodology that shouldn't have existed in the first place -- and investor interests were further trampled upon in the process.

The Rest of the Story

Before I describe the new FSP, we should review the salient provisions of its progenitors: SFAS 115, sired out of holy wedlock by the prince of accounting gibberish; which in turn begat EITF 99-20.

SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, requires that investments with a readily determinable market value be measured at fair value. Mandating fair value for some assets was a landmark achievement, but beyond that, SFAS 115 is a charade: an exercise in hiding legitimate unrealized losses from view, solely to appease those who can't handle the truth. Unrealized holding gains and losses on marketable securities classified as "available for sale" (weasel word) are reported in other comprehensive income unless and until they are deemed by management to have become "other than temporary"  (a worse weasel word). Of particular relevance to the issues I am discussing here is this: an other than temporary impairment of a debt security within the scope of SFAS 115 would be recognized only if the holder (i.e., management) determines it is "probable" (the worst weasel word) that it will be unable to collect all amounts due according to the contractual terms.

EITF 99-20 arose from two differences between debt securities covered by SFAS 115 and the retained junk of which I ere did speak. First, junk retained interests do not have a readily determinable market value. Second, it is indeed "probable," by any way one chooses to interpret that weasel word, that the investor will be unable to collect all amounts due according to the contractual terms of retained junk remnants.

If I (or any reasonable investor) had my druthers, there would be no such thing as an available-for-sale financial asset. Retained interests in securitizations, junk or otherwise, would be measured at fair value through the income statement. But, that's not how the EITF works its magic.  Its job is to blithely analogize to some extant rule, no matter how ill-conceived it may be, and presto change-o, out pops a new rule for auditors to lean on, even if that rule is the accounting equivalent of sausage made from leftovers.

So, similar to SFAS 115, EITF 99-20 provides that an impairment of junk retained interests is considered "other than temporary" (with a resulting charge to earnings) only if there has been an adverse change in estimated cash flows. But, at least the EITF took care to specify that estimates of cash flows must be equivalent to those that a market participant would use in determining the current fair value of the investment. In fact, you could say that the EITF foreshadowed the approach to fair value that the FASB would take in SFAS 157.

Notwithstanding whether EITF 99-20 was a well- or ill-intentioned adaption of SFAS 115, the EITF's intentions were clear; and unlike the new FSP that undid those two little words, "market participant," the original choice of them made EITF 99-20 better than having to rely on inherent management bias.  The fact that the implications of using market-based assumptions grew to monster proportions as junk retained interests turned to toxic in droves only serves to highlight the need to de-link financial reporting from the overly sanguine projections of management. 

But that's not the way the Wall Street crowd wants the FASB to see things.  Nobody has been buying toxic loan remnants at anywhere near their original valuations, so the financial institutions would prefer to say that there is no market for them, and hence no "market participants." Therefore, instead of writing down their toxic assets, EITF 99-20 needed to be 'fixed.'

Here is the gist of the way EITF 99-20 was:

"If, based on a holder's best estimate of cash flows that a market participant would use in determining the current fair value of the investment, there has been an adverse change in estimated cash flows… [then an OTTI has occurred, and the investment should be written down to its fair value, and a loss recognized in earnings]."

And here is the 'fix' FSP EITF 99-20-1 made:

"If based on current information and events it is probable that there has been an adverse change in estimated cash flows… [then an OTTI has occurred, the investment should be written down to its fair value, and a loss recognized in earnings]."

If you look at them closely, one could argue that there is no difference in princple between those two mandates.  But obviously, in practice there must be a pretty significant difference.  Though I suppose that the three FASB members who voted for the FSP would vigorously disagree, the effect of the 'fix' is to permit management to ignore the input of the indifferent and dispassionate for management's estimates, whose compensation may be directly effected by the reported earnings for the year ended December 31, 2008.  Obviously, there will be a lot of investments that market participants consider toxic and management, in its infinitely biased wisdom, will persuade the auditors that they hire and fire are just fine.

If there is a silver lining to this debacle, it can be found in the eloquent and forceful dissent of two board members.  Here is just the beginning of what they wrote (names hidden, for the sake of more fun to come!):

"[X] and [Y] dissent from issuance of this FSP because they believe this short-term project does not provide sufficient improvements to financial reporting to support its issuance on an expedited basis with limited due process. [X] and [Y] believe that accounting standards should be focused on serving the needs of investors, who did not request this urgent change. They note that the majority of investors who responded strongly opposed the FSP. Investors are exhibiting a current lack of confidence in financial statement information prepared in conformity with current GAAP, as demonstrated by the high percentage of bank stocks that have market valuations below their tangible book values. As a result, these investors favor valuing all financial instruments at fair value through net income and believe this FSP represents a step away from that goal by failing to require that all changes in the reported fair values of Issue 99-20 assets be recognized in income." [bold italics supplied] 

These are damning words to which I would add that the FASB has deliberately ignored key findings of the SEC in its recent report to Congress. On December 30^th, the SEC issued its 211-page Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-to-Market Accounting. As mandated by the Act, the report addresses, among other things, the adequacy of the processes used by the FASB in developing accounting standards. Among its conclusions, the SEC found that while the existing FASB process works well, additional formal measures to address the operation of existing accounting standards in practice should be established in order to be responsive to the information needs of investors in a timely fashion. Most important, the report states that accounting standards should continue to be established to meet the needs of investors. General-purpose financial statements may be utilized by others, such as prudential regulators of financial institutions; however, GAAP should not be revised to meet the needs of other parties if doing so would compromise the needs of investors.

So, less than a month after the SEC issued its unequivocal views, in FSP EITF 99-20-1 the FASB flaunts those views by short-circuiting due process and diminishing the quality of information provided to investors.

About Those Brave Dissenters

And, who were those masked men (or woman)? If I give you a list of the current FASB members along with a brief description of their backgrounds, I'm betting you can guess correctly, even without knowing anything else about them:

• Robert Herz -- former senior partner of PwC and part-time member of the IASB.
• Thomas Linsmeier -- former academic whose research has explored the role of accounting information in securities markets and consultant to the SEC on market risk disclosures.
• Leslie Seidman -- former consultant to corporations and accounting firms, and former VP of J.P. Morgan.
• Marc Siegel -- a recognized expert in forensic accounting and financial statement analysis.
• Lawrence Smith -- former senior partner of KPMG and chair of the EITF.

The lone rangers are Tom Linsmeier and Marc Siegel, of course -- the only two who did not spend the bulk of their careers serving corporate clients. And incidentally, they are the two most recent additions to the FASB.

The likes of Linsmeier and Siegel give me some hope for the future of standard setting following the second major financial reporting crisis of the decade. If we could somehow get just one more on the board like them, the SEC's recommendations to the FASB could become a reality.

The "Preliminary Views" on Financial Statement Presentation: Seven Years of Deliberation for This?

This past October, the FASB and IASB issued a joint discussion paper with their preliminary views on financial statement presentation:

"[The IASB and FASB initiated the joint project on financial statement presentation to address users' concerns that existing requirements permit too many alternative types of presentation and that information in financial statements is highly aggregated and inconsistently presented…" [¶ S1]

Both boards commenced work on separate projects in 2001, and seven years later have barely anything to show for it except for this five-page document, which amounts to little more than a proposal to re-arrange the living room furniture. For the sake of completeness, I should also point out that the IASB did also make a few minor alterations to IAS 1 that mainly catch up IFRS to GAAP in respect to reporting dirty surplus – whoops, I meant "other comprehensive income."

To give you some sense of the nature of these deliberations, such as they have been, I can draw on a personal experience. After the Enron debacle, the lack of transparency afforded by the indirect method of presentation for the statement of cash flows rightly became a focus of critics. In Enron's case, it would have been kinda sorta nice to be aware of how little cash Enron was getting from its customers. Six months following Enron's implosion, I attended the annual reunion of alumni from the SEC's Office of the Chief Accountant. At a presentation to our group, the erstwhile Chief Accountant assured us that the direct method of presentation of cash flows would soon become required. Supposedly, there was a clear consensus that this was the right thing to do.

That was more than six years ago, and nothing whatsoever has changed, other than that we're knee deep in another financial debacle. The preliminary views document disingenuously continues to spout the party line in support of the direct method, and even for further disaggregation of cash flow information. If this were solely an FASB decision, and if President-Elect Obama appoints a non-partisan SEC Chair (I'm rooting for Charles Niemeier), then I might have some reason to hope. But, there's no way this sort of change will find its way into IFRS. EFRAG (European Financial Reporting Advisory Group), and perhaps China, will contrive some sort of excuse that it would harm the ability of companies in their part of the world to compete; and the proposal will fade to black yet one more time.

Another proposal that would have some merit if it weren't watered down with weasel words is, "An entity should further disaggregate its income and expense items by their nature within those functions to the extent that this disaggregation will help users in predicting the entity's future cash flows." [¶ S11, italics supplied] For example, cost of sales would be disaggregated into materials, labor and other components. But, who would decide what "will help users"? Answer: management, of course, because that is the consistent theme of IFRS – trust management to do what is right. If this were an FASB-only project, I'd bet that the document would include examples and illustrations of the principle functional categories to be disaggregated, together with the principle components of the disaggregation.

Separating Financing from Everything Else

No presentation format can be satisfactory unless it assists readers in assessing the performance of a company, independent of any decisions regarding financing that management made. That's why I am so strenuously opposed to the capitalization of interest costs in any way shape or form: assets values should be reported independent of how they are financed, and financial items affecting profitability should be separated from all other revenues and expenses.

Thus, the cockles of my heart warmed as I read these noble words:

"The proposed presentation model requires an entity to present information about the way it creates value (its business activities) separately from information about the way it funds or finances those business activities (its financing activities)." [¶ S4]

But, then, reality intruded upon my reverie as I read the following:

"The classification decision would reside with management…. The Boards support a management approach to classification rather than a prescriptive approach because they believe it will result in financial statements that reflect how management views and manages the entity and its resources." [¶ S6, italics supplied]

In other words, what constituted financing or "business activities" would be subject to the discretion of management. That's not quality financial reporting, it's farcical financial reporting. But perhaps the boards saw no other way to protect interest capitalization, that sop to the oil and gas industry. Also, don't count on management to disaggregate the interest component of cost of sales, or the cost of anything else.

The main point of this post is to demonstrate that the choice between a "prescriptive approach" and a "management approach" is a false choice. A third alternative, as always, is a principles-based approach.

The Principle of the Largest Possible Entity

The late Tom Burns, one of my mentors, once remarked that the most fundamental problem of financial reporting was choosing the entity of account: in other words, the boundaries that marked the affairs of the entity, and the affairs of others. I didn't fully appreciate that statement until too many years later. I was trying to think of a way to explain to my students in a managerial accounting course how the topics for such a course were selected. I eventually decided that managerial accounting explored decision making scenarios in which managers would decide which "real", or "productive" resources a business should acquire, and how best to put them to use. Questions of financing the resource acquisitions would be explored elsewhere in the curriculum.

That was fine and good, but I needed to have a way to explain what was "real" versus merely "financial." This is when, and I can't explain why, I came back to Tom Burns' observation. I asked myself, what would financial statements look like for the largest possible entity (LPE) – as if the universe were one big happy family? In other words, what if all the entities that existed, personal, corporate, government, etc. were consolidated/combined? This is my depiction (units of measure are arbitrary and only for purposes of illustration):

The Largest Possible Entity
Consolidated/Combined Balance Sheet
December 31, 20x1
Inventories	$   100
Plant and equipment	200
Natural resources	300
Knowledge	400
Total assets	$1,000
Equity	$1,000
Consolidated/Combined Income Statement
Year ended December 31, 20x1
Production revenue	$ 500
Utilization of resources in production	400
Net income	$100

 

The most important lesson from the balance sheet is that all of the assets that remain upon elimination of reciprocal accounts are the "real" assets. Therefore, financial assets and liabilities are distinguished by their absence on the balance sheet of the LPE. For example:

• There is no cash on the LPE's balance sheet. The entity already owns and controls all of the goods and services in the economy, so cash is of no use, except perhaps for the paper it is printed on.
• There are no receivables, derivatives of any kind, or liabilities. They all offset, or eliminate, as "intercompany" transactions.
• There are no investments in other entities, because the LPE can't recognize an investment in itself as an asset.

The only categories of revenue and expense that can appear on the LPE's income statement are revenues from the production of real goods and services and expenses from the use of the assets as inputs to the production of those goods and services. Like all receivables and payables, financial revenues and expense are reciprocal items that cancel out.

From the above, I derive the following simple principles that can be the fundamental basis for a financial statement presentation standard:

• Only those assets that are not eliminated in the consolidation/combination process to arrive at the balance sheet for the "largest possible entity" (LPE) are "real," or call them "operating" if you want. All other assets and liabilities are to be reported as financial in their own separate categories.
• Operating expenses are the utilization of real assets in the production or real goods and services. All other expenses are financial.
• Operating revenues are either (1) the measure of the assets (real or financial) that an entity becomes entitled to for having transferred real resources or for having provided real services; or (2) the measure of the reduction in liabilities that an entity is entitled to from having transferred real resources or provided real services. All other revenues are financial.

Thus, the fundamental distinction to be made in financial presentation is between those items on financial statements that are, or are derived from, real versus financial assets and liabilities. If the boards want to give management the discretion to decide what is "operating" and what is "non-operating", that would be fine with me, just so long as financial items are not conflated with real items in any financial statement. Especially after this latest financial debacle, the potential usefulness of this fundamental distinction should be more apparent than ever.

The day may yet come when we will be freed from the eccentricities of financial statement presentation foisted upon investors by managers who have no interest in giving shareholders more information about their actual performance. Sad to say, after seven years of waiting for a five-page, joint preliminary views document, that day will be no closer if the next generation of SEC leadership doesn't give the accounting standard setters a swift kick in the pants.

On that note, I even sent the gist of my LPE principle to a senior staff member of the IASB a number of years ago, not long after the IASB announced the commencement of its financial statement presentation project. His initial reaction was positive, but after I offered to help develop the idea further, I received no further response. I now invite you, kind reader, to be the judge.

IASB: The Rules of Arithmetic Are Suspended Indefinitely

"The London Symphony played Beethoven last evening, and Beethoven lost." That quotation, which my father attributed to George Bernard Shaw, leapt into my mind as I read Marie Leone's CFO.com report of remarks made by Thomas Jones, vice chairman of the IASB:

"… in general, he [Jones] and other IASB members support fair value accounting for financial instruments, but 'don't believe in fair value for the factory or production machinery.' Jones observed that leaving aside the issue of mark-to-market accounting in an illiquid market, 'I think that fair value does capture reality.' The only thing historical cost captures regarding financial instruments is an 'accurate' but 'meaningless' number, he opined." [italics supplied]

Principles-based accounting didn't just lose, it was assassinated. "O, pardon me, thou bleeding piece of earth, that I am meek and gentle with these butchers!" (The Bard's Mark Antony to Caesar's corpse.)

It appears that Jones' position (and that of the other board members Marie Leone reported him to have spoken for) is that fair value measurements should be restricted to financial instruments that can be sold in a liquid market. If fair value has such limited application, and historic costs are meaningless, then perhaps neither one of these measurement attributes belongs in a principles-based system of financial reporting. Of course, as many of you may realize from reading previous posts, I believe I know which attribute does belong: replacement cost.

Mr. Jones evidently is of the opinion that fair values for "factory or production machinery" yield illusory measures of profitability – and I agree. To make the larger point as simply as possible, let's consider the implication of fair value on inventory. One does not simply make a profit by producing inventory; it has to be sold. That's because real wealth is "command" over goods and services, and no one can be commanded to buy what you produce. Perhaps somebody can be convinced to buy a car from GM (although it appears to be getting harder by the day), but having a car in inventory in no way represents command over anything – except for that car in inventory. (By the way, nobody can be commanded to buy your junk financial instruments from you either.)

The sense of the word "command" in economics is that every owner of an asset has their price; offer a high enough price, and at least in theory, anything that is legally salable is available for sale. That's why replacement cost of all of the assets at one's disposal is the economist's standard choice for measuring wealth.

Replacement cost as the attribute of an asset to measure also resolves both of the problems I have with Jones' positions. First, no number reported for an asset will be "meaningless." Replacement costs of financial instruments and producing assets is the money equivalent of already owning a resource instead of having to expend cash to acquire or produce it.

Second, the problem of illiquid markets for financial instruments goes away. A financial instrument is fundamentally a stream of risky cash flows. It is always possible to estimate how much it would cost to acquire the financial asset, and circumstances will dictate the most reliable method for making that estimate. The illiquid markets caveat is nothing more than code for "I can't find someone to buy my junk asset for the price I want to sell it."

I learned to write my name on my first day of elementary school. On day two, I learned that one plus one only makes two when we add two like things. Does anyone else see a problem with ceding accounting standards to a single group whose putative leadership sees no future for accounting except for one that violates the most basic rule of numbers and logic we all learned by the first grade?

Amended IAS 39: Exploding the Myth of an Independent IASB

Although the FASB's record as accounting standard setter is far from spotless, I can't think of a single action taken where the quality of information provided to investors unambiguously diminished. That's what makes the IASB's amendments to IAS 39 so remarkable: the august body that is supposed to take over the FASB's role as principle standard setter for the U.S., the putative adherent to principles, the preacher of "true and fair view," just took a huge step down a very steep slippery slope.

By way of background, IAS 39, Financial Instruments: Recognition and Measurement, requires financial assets to be classified in one of the following categories, which determine how a particular financial asset is recognized and measured in the financial statements:

• Financial assets at fair value through profit or loss (FVTPL);
• Available-for-sale financial assets (AFS) – fair value through other comprehensive income;
• Loans and receivables (L&R) – measurements based on contracted-for amounts;
• Held-to-maturity investments (HTM) – measurements based on investment cost.

These categories are more or less the same as U.S. GAAP, so I should start by observing that everyone's accounting for financial assets could easily be a lot simpler all around: all financial assets should be measured at fair value (or preferably replacement cost) through profit or loss. The exceptions to FVTPL for equity and debt securities are the FASB's invention in SFAS 115, the original fair value standards.  Such a political compromise was made necessary to get the buy-in of issuers (who funded the FASB) fearful of the havoc that mark-to-market accounting of even some investments would wreak on their earnings (and presumably, executive compensation).

The IASB's press release announcing the IAS 39 amendments reminds me of the politician (everything reminds me of politics on this day) who will say anything with a straight face, no matter how false, just so long as it can possibly win votes:

"In responding to the crisis, the IASB notes the concern expressed by EU leaders and finance ministers through the ECOFIN Council to ensure that 'European financial institutions are not disadvantaged vis-à-vis their international [read U.S.] competitors in terms of accounting rules and of their interpretation.' The amendments today address the desire to reduce differences between IFRSs and US GAAP in a manner that produces high quality financial information for investors across the global capital markets." [emphasis supplied]

Taking these two sentences together, it appears that the IASB must have performed a miracle. Somehow, it has allayed concerns of the European financial institutions, while in the process, has come up with a new accounting treatment that still "produces high quality financial information for investors." I admit they didn't actually say that the quality of financial information has increased by their actions, but a diminishment in quality is the unambiguous and unprecedented result. In stark contrast to the press release propaganda, there is not even a whiff of consideration of investor needs in the document amending IAS 39; nowhere is the word "investor" to be found.

I don't have to deal here with all the ins and outs of the amendments to make my point; just two examples will suffice. First, loans (think mortgages) and receivables that were heretofore measured at fair value may be transferred to the HTM category. As explained above, this is a place where fair value measurement takes an indefinite leave of absence. Today, fair value; tomorrow, who knows.

Second, the effective date of the IAS 39 amendments is retroactive to July 1, 2008, i.e., before the proverbial you-know-what hit the fan. While permitting loan reclassification to HTM may be said by some to undo any "disadvantage" because the same accounting was already permitted in U.S. GAAP (though more narrowly than IAS 39 now permits), even an undergraduate student will immediately understand that the European banks are being given a mulligan. With the unprecedented benefit of hindsight, issuers will cherry pick financial assets with accumulated gains since July 1 to remain in AFS, and the loss securities will be transferred to HTM as of July 1. In other words, the accounting will look like the crash in value didn't happen—in fact, winners count and losers don't. That's not leveling the playing field, it's picking up your marbles and going home. Will any auditor in Europe challenge a client's statement of intent and ability to hold a toxic loan for the "foreseeable future," whatever the heck that means? Vive le Société Générale!

As to any "disadvantage" that may have existed prior to the IAS 39 amendments, the IASB is mute as to what it is, why it is, or how it works.  I have never understood the argument that real competition in business should be presumed to be affected by financial reporting. Take business combinations, for example. In order to eliminate pooling of interests accounting, the FASB had to overcome the objections of its constituents who argued (whether they believed it or not) that recognition and amortization of goodwill would put U.S. companies at a competitive disadvantage when making acquisitions of other companies. When I was at the SEC for just one year, at least one registrant per week would spend shareholders' good money machinating and politicking to get to the point where the SEC staff wouldn't object to pooling of interests accounting for an acquisition. One of Abe Briloff's most famous essays was about how MacDonald's Corp. (I think it was in More Debits Than Credits) would systematically pay far too much of its own stock to underperforming franchisees to reacquire their restaurants (if that's what you would call a MacDonald's), while qualifying for pooling of interests accounting. There was even one case where politicians must have leaned on the SEC to look the other way when AT&T used pooling of interests to account for its acquisition of NCR. AT&T overpaid, of course.

The point is, as I have made repeatedly before, that bad accounting, especially when lobbied for by management, begets decision making that may be good for management in the short-run, but will eventually destroy (lots of) shareholder value. The amendments to IAS 39 will be no exception. Will the toxic loans on the books of financial institutions be managed with a desired accounting result in mind? You betcha (more election blues)! Auf wiedersehen, shareholder value.

The distinctive feature of this story, however, is the blatant pandering to issuers by the IASB, without any pretense of due process and nary a flinch of concern for having robbed investors of current information at a time when they need it the most. If there ever was any notion of an independent IASB, it has now vanished.

SFAS 157: Is the Government a "Market Participant"?

Last Thursday, a new reader (who prefers to remain anonymous) wrote:

"Have you considered addressing the hotly debated issue of how assets sold into the TARP [Troubled Asset Relief Program] will be accounted for by banks, and whether the prices [offered by the government] should be considered market prices for other banks to use in valuing their holdings?"

What an interesting question!  The events of the last couple of days indicate that the U. S. government, prodded by Europe, is moving to a strategy of buying equity (non-voting, preferred).  But, the NYT reports that Treasury Secretary Paulson still wants to go forward with his plan to spend hundreds of billions of dollars on junk assets.  

Uncovering Yet Another Loophole in SFAS 157: What Else Can you Expect from a Rules-Based Standard?

The TARP accounting debate centers around a choice among two treatments: (1) purhcases/offers by the government are not relevant for valuation of unsold loans; or (2) it is appropriate to use the pricing information from government purchases to measure the fair value of unsold loans.

It seems that the debate exists because a reading of SFAS 157 indicates that both alternatives are within the rules; paragraph 11 of SFAS 157 states as follows:

"The fair value of the asset or liability shall be determined based on the assumptions that market participants would use in pricing the asset or liability. In developing those assumptions, the reporting entity need not [but presumably may] identify specific market participants." (my additional language is in brackets)

Whaddya know, another loophole for banks to dive through in this rules-based standard: the "need not" escape clause. The banks would prefer that the government should be considered a "market participant", while others may see the government as merely a safety net.

Treasury Secretary Paulson, would doubtless chafe at the suggestion that the government's 'bid' offers would be anything less than legitimate value-based propositions; and as such, a cure for our economic woes would be had. But, the stock market's negative reaction to his plan, and subsequent partial recovery after it was modified, may refute anything but the notion that Paulson's brainchild would only serve to re-fill the pockets of the Wall Street types that got us into this mess in the first place.

Whatever the view, the clear implication is that SFAS 157 did not anticipate these circumstances; and yet another 'interpretation' is about to be thrown onto the woodpile to keep the fair value light burning bright.

A Principles-Based Solution

This may be one of the clearest and cleanest case I have found in the realm of financial instruments to demonstrate that replacement cost accounting (entry prices) is principles-based; and fair value accounting (exit prices) is rules-based.

Imagine, if you will, that U.S. GAAP requires financial instruments to be measured at the 'ask' price (entry price) as opposed to the 'bid' price. A requirement to measure the toxic loans at replacement cost ('ask' price) takes TARP right out of the picture; because the government will not be indicating a price at which it would be willing to sell toxic loans -- just to buy them.

Thus, the accounting procedure that follows from the replacement cost principle is simple and straightforward: a gain (or markup to the asset valuation) may be recognized only under two circumstances: (1) replacement cost of the asset increased; or (2) it was sold for an amount higher than current replacement cost. Whether the government is a "market participant," whatever that is supposed to mean in SFAS 157, is a non-issue.

In contrast, who can tell what the proper answer should be under SFAS 157? I sure can't, and that's the main lesson of this case. When policy makers get arround to providing its 'authoritative interpretation,' hard experience should inform us of the real principle at work: which interest group has the biggest checkbook.

Suspending Fair Value: Some Congressmen are Suspending Their Principles

While most politicians in Washington were trying to figure out how to solve the current financial crisis with real cash, my congressman*, John Shadegg (Rep. - Arizona), and a few of his colleagues have been fiddling with accounting rules while Rome burns. Flying in the face of the vast majority of investors, the AICPA, the FASB and financial commentators like Floyd Norris and Jonathan Weil, Shadegg and his cohorts made their entire case to the SEC in a three-paragraph letter, to take the significant step to "immediately suspend Mark to Market rules."

The first paragraph of the letter to the SEC Chairman, Christopher Cox, reads thusly:

"We are writing to urge that the Securities and Exchange Commission (SEC) immediately shore up the capital of the nation's banking system by suspending the use of fair value accounting or 'mark to market,' and replace it with a form of mark to value that more accurately reflects the true value of the asset. Although the mark to market accounting method can raise important red flags, in an illiquid market it has become counterproductive and is simply making the situation worse."

Are we to believe that out of the thin air of the financial crisis, these lawmakers somehow acquired the wisdom to know that some other form of "mark to value" (whatever the heck that means) "more accurately reflects the true value of the asset" than estimates based on available market data? Setting aside the question of where they get the chutzpah, I find it ironic that so many Republicans can so quickly cast aside their putative free-market principles just when efficient financial markets are trying to tell them something very important they evidently don't want to hear. 

To be as generous as possible, the only way their argument that a more accurate valuation of toxic loans can exist is to make the heroic assumption that a financial asset is somehow worth more when held by its current owner then by the market participant who values it highest.  This is nothing more than a variation on the greater fool theory: if a bank can't find anyone who is foolish enough to take a toxic loan off its hands at the loan's "true value", then doggone it, these lawmakers trust that bank management (who incidentally got us into this mess) can show us how to get water from a stone.

The second paragraph gets even worse.

"In periods of market turmoil, financial institutions are forced to write down the value of long-term, non-trading assets below their true economic value. The 'mark to market' rule, while well intended, has the unintended consequence of exacerbating economic downturns by hamstringing the ability of banks to make loans to consumers and businesses."

Shadegg and his cohorts are trying to make the argument that the accounting rules have gotten us into this mess, and "more accurate" (read "fudged") valuations will get us out.  Or, perhaps they are saying that sound capital adequacy rules should be suspended when they are breached.  Either way, the false premise they promote is that changing the picture painted by accounting somehow changes the financial institution itself. As Lynn Turner put it in his ft.com editorial, the banks and their political agents want us to believe we can make the situation better by shooting the (accounting rules) messenger.

If banks are not currently lending money, it can only be for one of three reasons: (1) they don't want to, (2) they don't have any, or (3) they are legally prevented from lending by the existing capital adequacy rules. If the correct answer is (1) or (2), there is nothing that the Shadegg group or anyone else in Washington can do – except to do what they have already done: give the banks taxpayer money to lend.

But, if the answer is (3), then I suppose you could induce banks to lend more money by allowing them to fudge their accounting numbers so as to get around the math of the capital adequacy constraint they currently face. Alternatively, and this is the crazy part, lawmakers could actually do something real—like passing a law that permits banks to blow past their capital adequacy limitations. That's obviously not politically acceptable, but somehow fudging the numbers to do exactly the same thing is quite acceptable for the SEC petitioners.  Permitting banks to fudge the value of their assets not only is shooting all the messengers (accountants and market traders), it is the functional equivalent of throwing away capital adequacy standards to double down after having already lost billions through lax regulation.

As a final aside, Shadegg's office issued a press release trumpeting the initiative as coming from a "bipartisan group of more than 60 lawmakers." In fact, 58 Republicans signed the letter, and only 7 Democrats did so. Fuzzy press releases, fuzzy accounting… what's the big deal?  If hyperbole and fudged accounting is permissible in press releases and bank financial statements, then branding oneself a man of principle in campaign ads could very well be more of the same.

Congressman Shadegg, if I were you I would drop the "man of principle" shtick and give "accounting maverick" a shot.

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

*Full disclosure: I have contributed some of my time and money to the campaign of Shadegg's opponent, Bob Lord.

The Credit Default Swap Mess: Did U.S. GAAP Play a Role?

A member of the AECM listserv reported that today's episode of "60 Minutes" explained that a credit default swap (CDS) "was actually an insurance instrument, and perhaps fraudulently sold as [a] financial instrument to avoid insurance regulations and insurance regulators." It is hard for me to challenge that assertion, as I am certainly no expert on insurance regulation, I do know that many financial contracts that meet the definition of a "derivative financial instrument" contains elements of insurance. 

But, even though one can easily point to instances where our financial markets lacked adequate regulation in recent years there is some danger in blaming the lack of regulatory oversight for the entire mess. The regulatory pendulum invariably swings too far back when pushed by politicians seeking a quick fix to the financial malaise of the moment. Therefore, I want to propose yet another accounting fix that might obviate some of the more extreme actions being contemplated—like broadening insurance regulation beyond its historical boundaries, or even scapegoating Wall Street executives (there is already just cause for much abuse of that crowd).

At the outset, I should also state that as is often the case lately, my thoughts in this area were catalyzed by – you guessed it – Jim Noel. He really needs to have a website that I can link to.

Thou Shalt Mark (Some) Derivatives to Market

Statement of Financial Accounting Standards No. 133 requires derivative financial instruments within its scope to be measured at fair value. No exceptions. It sounds like a principled-based standard so long as everyone understands what a "derivative financial instrument" is. In fact, so many things can be seen to be derivatives (insurance contracts not excepted) that FAS 133 could have altered the entire landscape of accounting if the phrase "within its scope" were omitted from the previous sentence.

For example, ordering pizza for delivery has all the economic earmarks of a forward contract. I realize that I'm being a little bit silly here, but I hope you get my point: one of the FASB's objectives in promulgating FAS 133 was to curb abuses from reporting really important zero-value-at-inception financial contracts, like interest rate swaps with notional amounts in the billions of dollars, the same as a pizza delivery order. If the price of pizza changes before delivery takes place, that's not such a big deal unless you're a poor college student (not bad grades, no money … get it?). But if LIBOR declines by 10 basis points, you went from neutral to a big transfer of wealth on a $10 billion swap contract.

CDS's and FAS 133

Among other things, a derivative within the scope of FAS 133 has to have an "underlying" (para. 5a), which is defined in the glossary of the standard as:

"A specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable (including the occurrence or nonoccurrence of a specified event such as a scheduled payment under a contract). An underlying may be a price or rate of an asset or liability but is not the asset or liability itself." [bolded italics supplied]

Can you see that some of these "other variable[s]" may overlap with events that might otherwise be dealt with via insurance? The FASB certainly realized this when they specifically excluded certain types of insurance contracts from FAS 133 (para. 10c). With specific exceptions, however, financial guarantees (think CDS's) are within the scope of FAS 133 if they also meet derivative criteria set forth in paragraphs 5 – 9 of the Standard. I certainly don't want to criticize the FASB on this point, because I think that whether or not you call CDS's insurance or a derivative financial instrument, these are contracts that need to be marked to market. The FASB's intentions were, I believe, well-reasoned, but there is no avoiding rules-based accounting when you have a multi-attribute accounting model.  There is only one way to distinguish between which assets will be marked to market, and which will be valued otherwise: rules.   

Put This in Your Capital Adequacy Pipe and Smoke It!

The point is that even well-intentioned and well-crafted rules can come back to bite you.  One problem is an arcane practice in accounting dubbed "offsetting" by the cognoscenti. It happens all the time, not just involving financial instruments, and it's stealthy: gains and losses on disposals of long-lived assets (offsetting the cost and revenue components); operating lease accounting; pensions. There are all kinds of pronouncements, major and minor, that either explicitly or implicitly bless offsetting, but with derivatives it has come back to bite us real hard. So hard, that I think the practice of offsetting any asset with any liability should be declared streng verboten.

To see why it can be so problematic with derivatives, take a financial institution with $9 billion of liabilities covered by $10 billion of assets. Next, assume that said financial institution enters into a CDS (or any sort of derivative – I don't care) with a notional amount of $10 billion.

FAS 133 would yield a value of zero for this derivative investment at inception because the receivable leg of the 'insurance coverage' (or interest receivable in an interest rate swap) on the $10 billion would be exactly offset by the liability leg: i.e., the 'insurance premium' (or interest payable). Even though we have an accurate report of fair value, we have no idea of the exposure to risk of changes in fair value.  

For purpose of illustration, let's say the present values of those asset and liability legs are both $7 billion.  The balance sheet picture would be altered by reporting $16 billion in liabilities ($9 + $7) covered by only $17 billion in assets ($10 + $7), as opposed to offsetting the two and ending up with zero. You don't need Basel II to figure out what's going on here: FAS 133 does a good job of measuring the value of derivatives, but disclosures notwithstanding, provides nada to help understand the risk of future changes in value. 

Simple Would be Nice for Once

Congress just passed a bailout bill that went from three pages to over four hundred in about of week of deliberations. Requiring the asset and liability sides of derivatives to be separately measured and reported seems like an amazingly simple fix that could simplify regulation of the financial and insurance industries, reduce the need for the disclosures in financial statements written so as to discourage one from reading them, and help investors more easily assess risk.

What I am proposing is certainly not a panacea, because there is still much that is wrong with financial reporting—but do see my earlier post on wiping out securitization accounting (FAS 140). Nevertheless, I'm willing to bet that much of the accounting-driven financial engineering, excess investment and speculation with derivatives that has brought our economy to its current sorry state could be derailed: if we take the simple steps of eliminating offsetting in derivatives reporting, and wiping FAS 140 off the face of the earth.

The Anti-Fair Value Lobby Has a Point (Even if They Don't Know It)

In the current environment, I am an ardent supporter of those who would resist calls to suspend fair value accounting rules. But, when I was at the SEC, I had a front-row seat on what was perhaps one of the most brazen abuses of fair value accounting in history. I was reminded of it by Joseph Stiglitz's recent commentary on CNN.com, in which he characterized the mortgage securitization craze as just another pyramid scheme. Keep that in mind as I tell you the story of Stephen Hoffenberg's $400 million fraud.

Hoffenberg controlled Towers Financial Corporation whose business ostensibly was to purchase junk receivables for just a few cents on the dollar from hospitals, credit card companies, phone companies, etc. Claiming to be able to draw water from stones, Towers would blithely write up the value of the receivables (not strictly 'fair value,' but functionally the same) to create the illusion of collateral and earnings. Investors would be enticed by high interest rates, stellar financial results, apparently healthy cash flow, and a successful track record of paying off prior investors. But like all pyramid schemes, the returns to investors came from only one real source: new investors-cum-victims. The collection operations themselves were pretty much a sham.

All of this occurred in the late '80s and early '90s before business journalists could no longer allow themselves to remain ignorant of accounting matters—save, perhaps the occasional exposé in Barron's. The Justice Department was even worse, eschewing the drudge work of explaining complex financial fraud charges to juries in favor of prosecuting drug pushers. Hoffenberg also flew under the SEC's radar for years by avoiding (perhaps, evading) registration of its debt and equity offerings (think hedge funds).

Hoffenberg might have been able to actually get away with his scheme if he had only known when to quit. But, as is often the case, greed and ego knew no bounds for him. He eventually accumulated enough of other people's money to buy the New York Post from its bankrupt owner, and was practically knighted by the state's governor, Mario Cuomo (by coincidence, the father of the guy whom John McCain now says should be the next SEC chairman). Being on the verge of obtaining permanent financing of his acquisition of the Post by using his ill-gotten gains as collateral finally lit a fire under the regulators; if Hoffenberg were allowed to close the deal, the government's case could turn into an "investigation of a citizen above suspicion" in the eyes of the public.

Less known about the case, but adding to my own deep sense of injustice was that Hoffenberg was able to successfully parry the SEC for a time by trotting out all manner of exorbitantly paid 'expert witnesses' to bless his accounting and business model. Exhibit A was Sidney Davidson, an emeritus professor of the University of Chicago's business school and former member of the Accounting Principles Board. Was Davidson also taken in by Hoffenberg? I think not; Davidson was also allegedly (my information is second hand here) on the payroll of Charles Keating's Lincoln Savings and Loan, one of the great implosions of the S&L era. One of Davidson's 'consulting assignments' was to convince Ernst & Young that the partner who smelled a rat should be taken off the engagement.

Back to the Present

The point of dragging Davidson into this is to show how big money can talk; and it is doing a lot of talk about fair value accounting lately. Invariably, it seems, a very ugly side of human nature seems to come out as a pyramid scheme inevitably starts to lose steam. Those whose investment may be hung out to dry curse the doubters for 'ruining it for everyone else.' That's how I see the proponents of suspending, or even doing away with, the current set of rules we have in place for recognizing certain financial assets at fair value, and taking the gains losses to income.

But, how could fair value accounting be the device by which one scheme was kept alive, yet could have prevented another? Like the Hoffenberg case, there is no question that the two main ingredients of the current fraud were lack of transparency into what was going on, and accounting tricks to give the illusion that all was well. The difference is that in the case of our present extreme unction, it was the ability to hide actual losses (as opposed to create fictitious gains) by not using fair value accounting for junk assets. The answer for the apparent paradox lies in a significant flaw in 'fair value' accounting.

Fair Value is Not Perfect, But It Replacement Cost Would Have Been a Lot Better

First, the limitation of fair value. As I have long argued, I believe in comprehensive application of some form of 'current value,' but 'fair value' ain't it. Fair value is based on exit prices – the highest amount something could be sold for in some market, and there may well be more than one, or even no market to choose from. But 'current replacement cost' is based on the lowest amount that you would have to pay to replace the thing you already have. If the standard for measuring bad loans were current replacement cost, there would have been no way that even Sidney Davidson could have defended a higher replacement cost than the price Hoffenberg had just paid, no matter how much he, the putative master collector, thought he could extract.

The logic of replacement cost also, I believe, takes out the critics of current values at the knees, and also gives them a little something--a higher valuation than fair value. In illiquid financial markets, the question of how much it would cost you to replace a stream of risky cash flows with another contract(s) that provide the same flows with the same risk could be a lot greater than what you could sell them for. Replacement cost relies on the proposition that there will always be a seller if you offer enough money. Stated another way, replacement cost accounting would say that the point on the bid-ask spread to value a security would be the lowest accepted 'ask' price from among all sellers, which in illiquid markets could be significantly higher than the 'bid' price.

Even the proponents of fair value measurements would have to admit that FAS 157 equivocates on where fair value lies on the bid-ask spread. Under replacement cost accounting, the answer is unequivocal. If you want more information on the logical superiority of replacement cost, see here and here for two earlier posts in which I explain the correspondence between replacement cost measures and economic concepts of wealth.

But setting aside the differences between fair value and replacement cost, there are other important observations to make about the mess we are in, and who is proposing what to get us out. First, those who would argue that fair value rules should be suspended during this economic crisis are no different to me than the first potential investors in the pyramid scheme who express concern that there might not be a seat for them when the music stops.

Second, if fair value accounting had been more comprehensively applied, and not less as some would like to see, than at least the bubble would have burst before it became as large as it did; financial institutions would have been forced to take more losses earlier for fair valuing loans and held to maturity investments. For this, the FASB has to take much of the blame for the loopholes they permitted when crafting FAS 115.

Third, it appears that the fair value debate, no matter how cynically one may regard the critics, is finally making it clear that we have to de-link regulatory capital measurement from reporting to investors. If regulators want to rely on a fair value balance sheet, fine. If not, they should make their own, thank you very much.

And another big difference between Towers and the current crisis is that Hoffenberg got 20 years. Today's CEOs are smart enough to take their money and run.