The Accounting Onion

Why Nothing Sticks to Auditors when Loans Go Bad

I read numerous news sources this week echoing the SEC's announcement that it finally has a case it thinks it can win against auditors stemming from the 2008 financial crisis. One journalist, Jon Weil of Bloomberg, takes it a step further to ask, 'What took so long'?

"It has been frustrating to look at the SEC's own highlights of the lawsuits it has filed in connection with the financial crisis -- and to see that none of them had been against an auditor. Now the SEC will have one case to cite, albeit against a couple of small fries. It also should be stressed that the agency hasn't proved any of its allegations against these two accountants. Surely the SEC can find some bigger targets out there in the auditing world if it wants to. [emphasis added]

Actually, Jon, it can't.  The paucity of enforcement actions against auditors surely has not been for lack of trying. But, just as surely, auditors have not been doing much lately to protect investors and to promote economic stability. The topic of audit reform in response to the financial crisis has been everywhere in both the U.S. and Europe (except perhaps where it counts the most – at the SEC).

The SEC announcement comes coincidentally right on the heels of the FASB's proposal to make changes to loan accounting. Which adds another question to Jon's: would better loan accounting standards beget higher quality audits? But more on that later. First, let's discuss why auditors have been to financial reporting as Teflon is to frying pans – nothing sticks.

 

The Problem of Auditing what Managers See through Rose-colored Lenses

I've explained this before, but it bears repeating. Several financial elements are capable of being determined objectively (e.g., cash and contractual amounts for receivables and payables). Auditors are trained to verify these financial statement inputs by counting, reading, confirming, etc., and they generally do an outstanding job at this kind of work – for which any CPA is eminently qualified.

However, dozens of financial statement elements depend on management's subjective estimates of unknowable future events and myriad scenarios based on complex contracts that are often engineered solely to confound. The problem of audit reliability is almost entirely due to requirements for the auditor to state that management's judgments (in which they often have a direct interest) and mere representations of intent "appear reasonable." The impossibility of auditing the ineffable cuts to the heart of any bubble-induced banking crisis – past, present or future.

As Jon Weil observes, even if the SEC prevails in its modest quest to hold at least a couple of auditors accountable, the message value will be minimal. Moreover, for the reasons I've just stated, there is reason to fear that the SEC won't get its case past an administrative law judge (ALJ).

The SEC's case reads well. The auditors allegedly should have seen that internal controls were inadequate, they had reason to know that management's estimates were biased, and they ignored important information concernin the value of loan collateral. But, there are at least two sides to every story; and the SEC may have to meet a very high standard for its side to prevail.

If the auditors don't settle, then (follow me on this one) the SEC will have to convince the ALJ that the auditors acted "unreasonably" by not concluding that the numbers fed to them by management were themselves "unreasonable." Basically, the SEC has two shots, and I have feeling that neither one is a slam dunk. Under Section 4C of the Exchange Act, the SEC can show either one of the following: at least one instance of "highly unreasonable" conduct; or "repeated" instances of merely "unreasonable" conduct that together indicate "lack of competence."

I don't want to get into a lot of details here, but these particular standards are less than 20 years old; and they have not been tested in court very often. What is important to know (and the irony to appreciate) is that in an audit engagement or in a court of law, determining what is reasonable in the context of financial reporting is a quixotic venture. It may not matter that in this case, according to Jon Weil, the bank regulator – and not the auditor – caught the accounting errors; and the auditor resigned only weeks before the bank failed in 2010. As a matter of law, none of that may speak to the question put before an ALJ.

My guess is that the auditor is willing to put the SEC to its proof because they estimate that there is a good chance of prevailing. If they do, it will be helpful in defending against all sorts of civil litigation, where the real money is involved. (By the way, Section 4C which was added by Sarbanes-Oxley in 2002, does not permit the SEC to seek monetary damages from accountants. Maybe it should?)

 

The Only Way Forward

If I am right about the reasons why auditors have avoided SEC sanctions for their shoddy bank audits, then one must also conclude that the FASB's and IASB's proposals will accomplish nothing. Readers of financial statements will continue to be at the mercy of management wearing rose-colored lenses in bad times and creating rainy-day reserves in good times; and auditors will look on with impunity.

The facts are that holding management ultimately accountable for the accuracy of financial statements doesn't work anymore (if it ever did). Different auditing standards won't make the audit more reliable as a deterrent to financial manipulation, so long as management has the license to do the estimating – and to hire and fire the auditors.

Fundamental change is required, and that can't happen by simply leaving the IASB and FASB to their own devices. Beginning with the premise that investors want information from reliable sources that are independent of management, the only way forward is for reporting of loans to be based on fair values, which are produced by independent valuation experts. If that can be made to happen, then auditor involvement can be limited to things that every CPA already knows how to do:

• Verify the inputs to fair value measure that can be objectively measured;
• Attest to the adherence of professional standards by the independent valuation experts;
• Verify that the independent valuation experts performed the procedures they were supposed to perform.

Auditors might make less money on audits, but there are benefits.  There are arguments to be made that some services that are now prohibited, should not be seen as threats to auditor independence. They won't be spending their profits defending against civil litigation and the SEC. 

They'll sleep better.

FASB Pretends It Never Voted to Mark Loans to Market

I will have a lot to say about the FASB's recent publication of its proposed revisions to the accounting for loans over the next few months. In particular, I'm going to vivisect the horrendous "basis for conclusions" section of Proposed Accounting Standards Update 2012-260. To give you a preview of the issues I'll be covering, however, nothing in the proposed ASU's basis for conclusions even acknowledges that the FASB once considered measuring all loans and most other financial instruments at fair value.

At least it proves my point that "due process" at the FASB is a myth.

Bless the Journalists, for They Know Not (Enough) of Accounting

For now, though, I want to get something else off my chest.  As I began to gather my sources, and even before I reviewed the proposed ASU itself, I read the article that reported its issuance in the New York Times.

Let's begin with the good part. The author of the article, respected long-time columnist Floyd Norris, wrote:

"The international regulators [IASB] privately argued [to the FASB] that the pricing of loans reflected the degree of loss expected, therefore there was no need for an initial write-down." [emphasis added]

Kudos to Mr. Norris for pointing out that the IASB was initially on the right track – until it got sidetracked. The FASB even concedes that point – albeit very briefly in the proposed ASU before a clumsy finesse around this economic reality in paragraph BC21. (More on that in a later post.) The IASB's view also corresponds to the reasoning that I set out in a post this past August – see the section "A Mistaken Rationale for the Expected Loss Model."

The bad part of the article is that, instead of just sticking to the facts, Mr. Norris somehow somehow has seen fit to bestow upon us his own two cents worth of accounting logic:

"As a practical matter, it seems likely that any bank making a loan would almost immediately have to write down the value of the loan, even though nothing indicated that particular loan was likely to go bad, simply because experience would indicate that some percentage of similar loans do wind up defaulting." [emphasis added]

I'm not a journalist, but it seems to me that if Mr. Norris felt that his reporting would not be complete without a justification for the proposed "expected loss" approach to measuring loan losses, he should have found an independent expert to do the deed. For surely he knows plenty of them. Or, he could have actually referred to language in the proposed ASU itself. (Did he read it?)

One would hope that any expert without a dog in the hunt would have reminded Mr. Norris that the FASB had decades before explicitly rejected the kind of rationalization that he has made (SFAS No. 5), when it was clearly more concerned with establishing accounting standards that were consistently based on sound principles.

As to any "practical matter," I would suggest that the most salient might be the Board bucking the wishes of the American Bankers Association. Indeed, there are many reasons to believe that auditing the expected loss approach will prove to be impractical, if not downright ineffectual.

The expected loss approach in whatever form it may take is purely a political gambit to give the appearance that accounting is reforming itself after the latest financial crisis, while continuing to avoid providing investors the information they deserve – marking loans to market (which the big banks do every day for their own internal purposes). For evidence of who is actually pulling the strings at the FASB, see the ABA's press release that came out almost simultaneously with the proposed ASU. They're like a parent to a child coming home with a 3.7 GPA: 'very good, but not yet good enough.'

"FASB's proposal is a move in the right direction for both bankers and investors as it seeks to simplify many areas of impairment accounting. However, we believe additional work is needed to ensure that the model better reflects how banks manage credit risk."

It's okay to set up a Day 1 allowance for loan losses, but it shouldn't be too much, and don't ever second-guess management's estimates!

I believe (based on reading his columns and reporting over the years) that Mr. Norris made a good faith effort to be "balanced." However, in doing so he made a grievous error that resulted in misleading his readers to believe that policy makers are undertaking a good faith effort to fix a weakness in accounting standards. The real story is that the deliberations of the FASB amount to little more than constructing lame excuses for avoiding marking loans to market at the behest of the ABA. The "expected loss" approach is a red herring; it's nothing more or less than a long-ago discredited relic of German accounting.

The Opinion of a Real Expert

Subtract the gratuitous sarcasm from the forgoing critique, and you will pretty much have the gist of an email that I wrote to Mr. Norris soon after publication of his report.

I also cc'd that email to a couple of true experts on loan accounting, to solicit their reactions to my concerns. The irony did not occur to me at the time, but one of them, Lynn Turner (former SEC Chief Accountant), has been quoted by Mr. Norris on numerous occasions. Anyway, this is what Lynn wrote (with minor redactions by me) in response:

Tom - I agree with you that fair valuing a loan is the best way to go. The FASB proposed this while Bob Herz was chair, but that notion was dropped after Bob was pushed out at the FASB.[*] ...

I note with interest that Floyd discussed that the proposal would require a write down when the expected cash flows would no longer be equal to those required in the loan agreement.  Quite frankly, that is very much like the current standard.  And of course, during the S&L and banking crisis of the late '80's and early '90's, banks did not take their write downs.  A GAO report at the time issued while Chuck Bowsher was the US Comptroller and head of the GAO did favor going to fair value for loans.

During the most recent financial crisis banks again did not take timely writedowns, despite the accounting standard requiring them to do so when the cash flows from the loan was no longer expected to be equal to the loan agreement.  In addition, SAB 102 and substantially the same guidance from the Banking regulators did require writedowns when economic conditions changed, as they did in '06 and '07.  Yet the banking regulators, well aware of the problems with the subprime portfolios, did not require writedowns.

I was doing work for OFHEO [Office of Federal Housing Enterprise Oversight – later subsumed into FHFA] at the time and it was clear the subprime loan markets had major problems, including with respect to portfolios at Citi, Freddie and Fannie, and yet the regulators sat on their thumbs and did nothing.

What the banking regulators want quite simply is "cookie jar reserves" that can be used and drawn down when times get bad.  This is typically done in a bank by building up the cookie jar and setting aside a portion of earnings each period, for the rainy day to come in the future, as it always does.  The problem with this approach is it still requires the banking regulator to step in a make sure enough is being set aside, and is solely based on a safety and soundness approach.  Yet I cannot recall a single instance of bad economic times when the federal banking regulators have actually been tough enough with their exams, to make sure the banks were safe and sound, and their allowances for loan losses sufficient.  "Safety and Soundness" is a dream - a figment of imaginations emulating from the swamp lands of Washington DC.

I began my career as a CPA in 1976 auditing banks.  I have audited both big and small banks, including as an audit partner.  Twice I have also dealt with banks and their regulators as a member of the SEC staff.  I have also done projects for OFHEO, the FHLBB, and IMF.  And two things have been constant throughout all the years.  First, Banks hate transparency, hate to report anything other than "smoothed" earnings, which in turn helps them deal with capital requirements. And their banking regulators, including the banking examiners, are pretty much worthless when it comes to ensuring banks comply with basic sound banking business practices, compliance with laws, and the establishment of adequate internal controls.  In fact, many a CEO I have dealt with viewed the bank's balance sheet as "his" money more than the money of depositors or stockholders.

As a result, I have little to no faith in financial statements issued by these institutions.  …  The proposal by the FASB, which is worse than the one proposed by the IASB, but both of which are pretty bad, only convinces me more that financial statements are slowly evolving into a mediocre medium of value. [emphasis added]

* * * * * *

As Mr. Norris's colleague, Paul Krugman, has pointed out on more than a few occasions, balanced reporting is appropriate only when the arguments on both sides of an issue are balanced:

"News reports portray the parties as equally intransigent; pundits fantasize about some kind of ‘centrist’ uprising as if the problem was too much partisanship on both sides. Some of us have long complained about the cult of ‘balance,’ the insistence on portraying both parties as equally wrong and equally at fault on any issue, never mind the facts. I joked long ago that if one party declared that the earth was flat, the headlines would read 'Views Differ on Shape of Planet.'

My point is that rather than trying to defend the indefensible "logic" underlying the "expected loss" approach to loan accounting, the article that I would hope to read would provide the following information:

• Just how politicized the issue of loan accounting has become;
• Why it has become so politicized;
• The enormous stakes involved for economic stability; and
• A fulsome explanation of the choices (Mr. Norris, following the cue of the FASB, didn't even mention the possibility of marking to market in his article).

As a model of this type of reporting, there is the recent and ongoing coverage that NYT has recently devoted to the problem of gun violence in the U.S. It shows why NYT is the greatest English-language newspaper in the world.

But, unlike gun violence, which frustrates everyone on every side of the issue, accounting that can lead to prudent bank regulation and investor protection is straightforward and eminently feasible. If there is a special role in a free society for 'traditional' media, it must be to recognize its responsibility to communicate such facts.

* * * * * *

Happy New Year. My father and his twin brother would have had their 95^th birthdays on New Year's Day. Sometimes I think that this blogging obsession with which I am afflicted is my homage to them.

Like the biblical Jacob and Esau, they were as different as night and day. With no disrespect to my dear mother, and with tongue only slightly in cheek, I'm about 50% Dad, 30% Uncle Leo and 20% a reaction to being ridiculed by other children (whose names I have forgotten).

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

*Readers who have accused me of inferring without adequate evidence the actual (opposed to 'official') cause of Herz's departure from the FASB, kindly take note.

Is Money Market Fund Accounting Fair to Investors?

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

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

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

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

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

* * * * *

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

Question #1:

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

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

Question #2:

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

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

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

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

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

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

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

Question #2a:

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

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

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

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

Question #3:

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

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

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

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

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

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

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

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

Bigger than Loan Impairment – Adjusting Bank Profits for Inflation

We have been covering loan impairment for the past few weeks, and the FASB's proposals leave me with the feeling that we will be discussing it for a long time to come. Once the FASB shoves its post-WWI-Germany-derived "Current Expected Credit Loss Model" through the meat grinder that it refers to as "due process," the banking oligarchs will be mollified, and financial results will hum right along again … for maybe a decade. After the next tsunami of bank insolvencies will hit without warning; my best hope is that accounting standards setters (it might not be the FASB that far out) will finally adopt a credible process for marking bank loans to market.

Now that I'm finished with loan impairment, as long as we're on the topic of the accounting for banks, let's move on to another topic that could prove to be even more important between now and the next balance sheet bubble. In this post, I'll be discussing the accounting for inflation – or rather the lack of accounting for inflation. Only for the sake of whetting your interest, let me state that if you believe the conservative naysayers, imprudent monetary policy is raising the inflation specter. But, what I really want to show is that reflecting the effect of inflation on bank financial statements is important even now.

The Effect of Inflation on Accounting in a Nutshell

When a bank originates a fixed-rate loan, monetary inflation inevitably erodes the purchasing power of the contractual cash flows to be received in the future. Even if the bank were repaid in full at some point (i.e., setting aside all impairment concerns) the return of its principal is worth less 'today' than in the past, when the loan originated. Bankers realize this, of course, and should charge a rate of interest that is commensurate with the expected loss of purchasing power of its future cash inflows.

But, despite the straightforwardness of the problem, there is a huge accounting disconnect between economic reality and what is actually reported.  The lessons I intend to convey by a representative, yet simple example, are the following:

• Reported bank profits are always overstated by U.S. GAAP (or IFRS) by the absence of any rules requiring banks to recognize the declining purchasing power of the value of loan portfolios.
• Reported bank profits are always less volatile than their economic profits.
• If you believe, as I do that what gets measured gets done, then shareholder value destruction occurs: loans are mispriced because the full of effect of a manager's lending decisions are not reflected in management's scorecard, i.e., net income for the period; and dividends may unintentionally shrink a bank because they are greater than the banks true (economic) earnings.

Here's the example – and I hope you'll bear with me because I'm going to need more than a modicum of words, numbers and pictures to demonstrate the above points:

• NewBank was established on January 1, 20x0, on which date it engaged in the following transactions:
  • Shareholders contributed $20,000 in cash;
  • The bank borrowed $80,000 in the form of a bond paying interest at 4% at the end of each year for five years.
  • The bank originated a $100,000 loan with terms identical to the bond, except the interest rate charged was 5%.
• New Bank made its bond payments as scheduled, and its borrower did the same.
• Annual dividends were $1,800. (Note that this is the amount of net interest received each year. Also, since the bank has no other revenues or expenses, it is the amount of income reported in U.S. GAAP each year.)
• Inflation for each year was as follows: 2% in the first year, followed by 4%, 6%, 4% and 2% for each succeeding year.

Below are the financial statements for the each year, but I want to first focus on 20x1. (By the way, you can access my full spreadsheet here.  Among other things, it will show you to the purchasing power loss item is calculated.)

The first thing to notice is that the bank's inflation-adjusted income in the first year (and every other year), which henceforth I will refer to as economic income, is lower than its GAAP income. In the presence of inflation, this will almost always be the case, because there is nothing the bank can do about the fact that it holds more monetary assets that are exposed to inflation than monetary liabilities. I have displayed the effect of loss of purchasing power on economic income in a separate line item.

A couple other things to take note. First, that revenues and expenses were inflated. More generally, all measurements are made in "constant" units of purchasing power, which simply means that we are adjusting (i.e., remeasuring) past revenues, expenses, assets and liabilities to reflect their purchasing power as of the end of the most recent period.

But, for a bank, these remeasurements are not as consequential as for an industrial company that would, for example, have to remeasure depreciation expenses from long-ago capital expenditures in the dollars of today.

Second, the inflation adjustments made in the financial statements only require actual inflation as inputs; no assumptions about the difference between expected versus actual inflation are made. In fact, we have no way of directly knowing how much inflation was impounded in the interest rates charged by the bank as a lender, or to the bank as a borrower.

To get a sense of the long-run effects of remeasuring for inflation, the chart below displays the time series of GAAP income versus economic income over the full five-year terms of the loan and debt:

The biggest takeaway here is self-evident: that changes in inflation will add an element of volatility to reported earnings. Conversely, ignoring inflation makes reported earnings quite easy to predict. Even when inflation runs amok, NewBank's reported earnings misleadingly appear to be like a rock of consistency.

The $64-K Question

Should the FASB require banks to adjust for inflation? The reasons why they should are:

• Bankers can be expected to make better decisions if better information is provided to shareholders, i.e., their putative bosses. If you believe that adage 'what gets measured gets done' then you have to believe that shareholders are losing value every day that a clearly inferior accounting standard is in place.
• Making inflation adjustments to a bank's accounts is simple (I'm setting aside other industries here, also mainly for the cause of simplicity). As I demonstrated in my worksheet, inflation adjustments are not rocket science; they are easy to program, and are a lot easier to explain than, say, the CECL model or hedge accounting.
• When banks choose a dividend payout ratio based on GAAP earnings (the ratio is 100% in my example), it is impossible to tell whether the dividend exceeds economic earnings.  Stated another way, a portion of the dividend will be merely a return of investment, as opposed to a return on investment. Among the consequences are that bank executives own shares in their banks, so GAAP-based dividends risk that the executives will be receiving the invested monies of shareholders instead of an earned share of investment income. In the extreme case, when inflation is high, we can expect bank executives to seek a raise in their compensation – even while economic income is surely negative.

As far as I can tell, there is only one reason why inflation-adjusted financial statements shouldn't be required. You guessed it: bankers will throw a fit.

It will make their recent protestations to the FASB against marking loans to market feel like a book club debating 50 Shades of Grey.

Marking Loans to Model is Far Easier and Better than Estimating Loan Loss Allowances: It's Time to Hear from the FASB Members who Changed Their Minds about That

Tom

I'm [Osman Sattar,] a relatively new reader to your blog and I understand that you favour market values in accounting. In this article, you say that:

(1) "[B]oth models [the current incurred loss model and the proposed CECL model] are terrible because they both require estimates of future cash flows over a loan term of 5, 10 or even 30 years out".

(2) "How can the value of a loan at its inception be anything different than the net proceeds to the borrower?"

But, in arriving at a market value for loans (which are not generally traded in a market), surely there would be a need to use models, using estimates of future cash flows over the loan terms? And isn't it likely this would result in a value that is different from the net proceeds to the borrower?

Hi, Osman:

Thanks for reading my blog, and I hope that you will become a regular reader and correspondent. I want to take the opportunity of your comment to introduce you and other relatively new readers to my philosophy of financial reporting that leads to the conclusion you have noted.  Specifically, that some form of "market value" – inflation-adjusted "replacement cost" being my strong preference – is the most appropriate basis of measuring assets and liabilities.

Accordingly, here is my plan for the next three posts:

• I'll respond below to your specific questions about the value of loans at their inception and the use of models for estimating a market value. I'll also have something to say about the FASB members who switched over from market value to the dark side.
• In a post to follow in a few days (hopefully, by the end of this week), I'll list what I see to be the fundamental topics that standard setters must address; and the principles to which standard setters should hold themselves accountable.
• The current controversy is over current measurement of loans, and I am going to demonstrate that even low levels of inflation affect bank profitability. I am choosing to raise this issue at the present time because I believe it is much more important than the present back and forth over the formal details of that exercise in futility known as the accounting for loan impairment. (Impairment models in general are exercises in futility.)

Valuing a Loan at Inception

Osman, you ask, "Isn't it likely [that utilization of models to estimate loan market values that are not generally traded in a market] … would result in a value that is different from the net proceeds to the borrower [at the inception of the loan]?

The short answer to your question is "yes." Notwithstanding, it has no effect on my view that the only reasonable method to account for loans that are not generally traded is to have them appraised by an independent appraiser and/or to mark them to model.

To see this, let's assume that the only alternative to current practice or the boards' proposals is to mark to model. I want to step back from loans for a few sentences to consider first the well-established standards of accounting for forward contracts – which also are generally not traded in a market. Notwithstanding the absence of an active market for trading such a contract, both U.S. GAAP and IFRS specify that these derivatives must be marked-to-model at each balance sheet date; and consistent with my position for loan accounting, both sets of standards provide that if no consideration other than future promises to perform are exchanged, the value of the forward contract at its inception should be set to zero. Management will always believe that they negotiated a fair (or perhaps even better than fair) deal for the company, but according to the standards, that, or the output of any model that would support such a contention, may not be taken into account.

Moreover, in assessing the practical consequences of a disconnect between the economic value of a loan at inception and what any particular model has to say about that, we need to remind ourselves that the first point in time when a loan or a derivative must be "marked to model" would be at the first balance sheet date subsequent to the inception of the contract. However, good practice should validate the model being used at the balance sheet date by testing it against the conditions that existed at the date of loan/derivative inception. If the model yields a valuation that is significantly different from the value dictated by standard economic principles, then such a difference should raise questions concerning model choice and/or inputs used at the balance sheet date.

Is Marking to Model a Reason not to Measure Loans at Market Value?

I know that this is not a question you have specifically asked, Osman, but I sense that you believe it is worth asking.

Any expected loss approach will require estimates of future loan losses at every balance sheet date – an exercise which I have already taken pains to point out as being highly subjective, subject to manipulation, and not amenable to being audited. My view is that marking to model would be a lot simpler and more accurate.

But, I am not asking you to take my word for it. For starters, a perfectly good and reasonable methodology for marking loans to model has already been set forth in U.S. GAAP – albeit for disclosure requirements only:

"For certain homogeneous categories of loans, such as some residential mortgages, credit card receivables, and other consumer loans, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities." [ASC 825-10-55-3 (originally SFAS 107), bold italics supplied]

Here again, the principle I have cited that the value of a loan at inception must be equal to the net proceeds is germane. The last sentence in the forgoing quotation needs it to form the conceptual basis for measuring the fair value of any loan. Specifically, the contractual cash flows, when discounted by the effective interest rate will yield the net proceeds – equivalently, "entry value" or "replacement cost" – of the loan at inception. Thus, at any subsequent point in time, discounting the remaining cash flows by the rate at which loans would be made to borrowers with similar credit ratings should yield a reasonable measure of that version of market value.

But, if the boards would recoil from my favored approach to market value, replacement cost, they should also consider the views of an FASB member on precisely the question I am pretending you have asked. Before his appointment to the Board, Hal Schroeder authored a comment letter to the FASB wherein he stated:

"… [B]anks have existing systems that can also be used to fair value loans. We know from our own experience that with the right systems, loans can be marked to market every day. In fact, within two hours after the US markets are closed our entire debt and equity portfolios are marked daily."

Mr. Schroeder was not on the FASB when it voted by a 3-2 margin to require fair value measurement for loans. The series of events that redirected the FASB from fair value back to yet another recipe for accounting sausage was an orchestrated comment letter campaign from irate bankers; the sacking of the FASB chairman (a proponent of fair value) by the Board's overseers; and the appointment of three new board members (including Mr. Schroeder), who could be reliably counted on to resoundingly overturn the vote for fair value.

And that, boys and girls, is how the anything-but-fair-value movement at the FASB got its start. If Mr. Schroeder and the other two Board members (Tom Linsmeier and Mark Siegel) who previously supported fair values for loans are continuing to act on their principles, it sure would be nice to know how they now came to sing in close harmony with the bankers on such short order:

• I see nothing in the current proposals that reflect Mr. Schroeder's views from before he became a board member.
• In the case of Mr. Linsmeier, I do know something about his background, but I haven't looked at his academic publications; but I can't imagine that the expected loss model looks anything like the views he would have come to independently as an academic. I am also compelled to point out that Mr. Linsmeier changed his vote only a short while before his re-appointment to the Board was announced.

The accounting for loans is important enough so that we should hear all seven board members express their views on all major aspects of the proposal. For starters, Mr. Schroeder should explain why, if fair value accounting for loans is as straightforward as he claims, he continues to align himself with the anything-but-fair-value bloc. Mr. Linsmeier should provide a justification for changing his views in a manner that is consistent with academic standards of intellectual rigor; and as a model for that, I would suggest that he examine the writings, dissents and speeches of Bob Swieringa while he was a board member.

FASB "due process" should not be used as an excuse to duck the hard questions.

 

Pick a Number: Anything but Market for Loan Accounting (Part 2)

In response to my previous post, Edith Orenstein (author of the FEI blog and fellow Ohio State alum) asked me whether I preferred the status quo "incurred," or the proposed "expected" loan loss model (CECL).

Also in that post, I stated that I would have more to say about how the FASB defined "expected" in the CECL model. As it turns out Edith's question makes for a good lead in, so I'll take on both of these questions here.

The Expected Loss Model is a Move in the Wrong Direction

Actually, Edith, both models are terrible because they both require estimates of future cash flows over a loan term of 5, 10 or even 30 years out. It's ridiculous to presume that these numbers are much better than seat-of-the-pants guesses – even for the plainest vanilla loan contracts.

But, I'm not going to evade your question: the proposed "expected" loan loss model is worse.

CECL is worse because it violates basic economic logic and reasonable accounting conventions. How can the value of a loan at its inception be anything different than the net proceeds to the borrower? This was the logic for the incurred loss model; but under the CECL model not only can the carrying amount be different than economic reality from the get go, but it must be different – and that difference must be recorded as an expense on the income statement.

When a cash outflow does not give rise to an "asset" as defined by applicable accounting standards, it is perfectly understandable that a corresponding expense must be recognized. But, this CECL contrivance is different: the cash outflow to the borrower clearly gives rise to an "asset," and there is no precedent I can think of to justify recognizing only a part of that asset.

There is also the matter of discount rates in both models. I discussed in my previous post how the CECL approach is discounting numbers that aren't actually cash flows; at least the current model at least purports to discount cash flows, but with an arbitrary discount rate. What approach is worse? Let's just say that they're tied for last in a two horse race and we'll leave it at that.

So, on a scale of 1 to 10, I rate the CECL model a minus 3, and I give the incurred loss model a solid zero. As I am about to explain, the proposed CECL model will not provide relevant information to investors and regulators. It is merely another iteration of the "anything but market values" movement driven by bankers and auditors.

Pick a number … pretty much any number.

As Edith pointed out, I was pretty "acerbic" (her word) in my criticisms of the CECL model. But, I actually saved the most insidious aspect of the FASB's loan impairment proposal for last:

"The estimate of expected credit losses is neither a 'worst case' scenario nor a 'best case' scenario, but rather reflects management's current estimate of the contractual cash flows that the entity does not expect to collect.

That helps a lot; it's management's estimate, and just like that old accounting joke about two plus two, management can pick pretty much any number it wants.*

The FASB's boilerplate approach to defining expected losses will not fix the problem of overstated loan balances during a financial downturn. But, there is a method to the madness. To see what that could be, let's tryout a saner solution: how about requiring management to provide its best estimate of future uncollectibles – i.e., the number the bank CEO would bet her own house on instead of the shareholders' and taxpayers'?

The 'problem,' with this solution is that it would put even the best intentioned auditors on the hook to do something they are not qualified to do. If management must estimate in good faith the expected loan losses (i.e., the number that is just as likely to be too high than too low), then how is an auditor supposed to provide reasonable assurance that management actually did what was required of them? Perhaps the auditor could re-perform management's task, but given its complexity and the number of judgments required, it would be unlikely to come reasonably close to management's estimate. Then what?

Alternatively, the auditor could simply review management's estimation methods and parameters, check a few calculations, and then in their infinite wisdom pronounce to the world that management's estimate "appears reasonable." The problem with either of these audit approaches is that when then next financial crisis hits, auditors' judgments will be second-guessed – and if history is any guide, rightly so.

But, if the FASB's boilerplate is finalized, auditors' lives will be improved. For starters, they will finally be able to get those persnickety PCAOB inspectors off their backs. Management can throw out the number it wants investors to behold, and auditors can keep themselves relatively protected from litigation merely by devising some rote procedures that must inevitably find that the number management picked was neither the best nor the worst case.

My point, Edith, is that the question of an expected or incurred loss model is a distraction from the real issue. By whatever model, the numbers won't mean anything – and neither will the auditor's report.

There is a better way.

These are the reasons why I have repeatedly maintained that it is essential for the carrying amounts of loans to be estimated by independent third parties and not management – regardless of the measurement basis for those carrying amounts.

Neither auditors nor management are qualified to provide unbiased and reasonably tight estimates of loan loss allowances; but even if you want to dispute that, it is indisputable that auditors can much more reliably provide assurance as to whether a third party is independent, competent, and that it did what it was supposed to do.

Which brings me full circle back to market value. If an independent third party is going to measure the carrying amount for bank loans, why should it be estimating anything other than market value?

The real question is not incurred versus expected loss models. The real question is why the FASB, despite every common sense indicator, is sticking to its mantra of 'anything but market value.'

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

*As an aside, I don't know what "current" is supposed to mean – as of the balance sheet date, or date of the issuance of the financial statements? It's an important distinction.

"Anything But Market" is the FASB's Mantra for Loan Loss Accounting

At its August 22^nd meeting, the FASB came to some significant tentative conclusions regarding the recognition and measurement of loans:

"The Board decided that the model [of loan loss measurement] should utilize a measurement objective of "expected credit losses" and there should not be an initial recognition threshold that must be met before an entity recognizes a credit impairment. Expected credit losses are defined as the estimate of contractual cash flows not expected to be collected…"

Withholding judgment for a teensy moment, let's begin with a simple example. Let's call it Exhibit A in the case against the FASB:

• On December 31, 2007, Bankco (calendar fiscal year-end) originates a bunch of 20-year, fixed-rate mortgages for a total principal amount of $10 million.
• Under the "Current Expected Credit Loss Model" (CECL) proposed by the FASB, Bankco must not only be able to estimate the total amount of contractual cash payments expected to be uncollected, but also the timing of the non-collections. That's because the estimated non-collections are to be discounted at the "effective interest rate" to "reflect the time value of money."
• The application of the CECL model yields the following journal entry: Dr. Loan loss expense, $50,000; Cr. Allowance for loan losses, $50,000.  

OK, here comes the judge. This court finds the FASB guilty on the following counts: (1) misappropriation of the term "measurement objective"; (2) time value of money malpractice; (3) manslaughter of basic accounting principles; (4) reckless endangerment of auditors; and (5) obstruction of accounting justice.*  

Misappropriation of "measurement objective" — To establish motive to commit a crime, we begin by first noting that the FASB has not stated a measurement objective for the right of use asset to be recognized by lessees under its proposed lease accounting model; nor has it stated a measurement objective for performance obligations recognized under its proposed revenue recognition standard. We find the inconsistency suspiciously manipulative.

With respect to the charge of misappropriation in the instance of loan accounting, the term "measurement objective" is commonly understood to apply to measuring assets and liabilities in their entireties, and not merely the contra accounts that capture a component of the asset or liability. For example, the measurement objective for trade accounts receivable under U.S. GAAP is to produce the expected undiscounted cash flows to be received from customers. Accordingly, the allowance for doubtful accounts, adjusts the undiscounted contractual amounts such that the net balance meets this measurement objective.

But, by focusing only on estimations of amounts that are not expected to be collected, the CECL does not actually accomplish a legitimate measurement objective. The resulting net balance from this process ($9,950,000 in Exhibit A) cannot possibly be described in any systematic manner other than by the arithmetic that yielded the result. Thus, it cannot be said that loans are being measured with any particular objective in mind.

Time value of money malpractice — The aforementioned misappropriation of the term "measurement objective" is compounded (no pun intended) by time value of money malpractice. The FASB states as follows:

"…because the amortized cost basis of a financial asset represents the principal and interest cash flows discounted at the original effective interest rate, measurement approaches that estimate expected credit losses based on historical charge-off rates are an acceptable method of estimating expected credit losses in a manner that reflects the time value of money."

We honestly don't profess to understand the FASB's logic. What is clear, however, is that the FASB is discounting "for the time value of money" something that isn't money: i.e., contractual cash flows not collected are neither cash inflows or cash outflows.

The FASB could have required a reporting entity to determine the carrying amount of loans by discounting the expected cash flows to be collected using a rate of interest that reflects both the time value of money and the 'risk' that the actual amounts collected will be different than the actual amounts collected. But, to discount only the portion of the contract that won't be collected is a crime against finance. If it were left unpunished, then we shudder to think how condoning this kind of violation will be explained to future innocent accounting students who seek knowledge of principles and abhor being drowned by arbitrary rules to spit back on the CPA exam.

Manslaughter of basic accounting principles – Not only has the board not explained what the initial measurement of the loan could possible represent, they have not provided any defense for the crime of recognizing a Day 1 expense ($50,000 in Exhibit A), even before there has been any opportunity to generate earnings from the borrower.

In finding the FASB guilty on this count, we recognize that a loss on Day 1 could be justified for a trade receivable that arose from a product sale on which an operating profit is earned; however, that is not the facts of this case. It is impossible to make the argument that cash transferred on Day 1 to a borrower, in what is purely a financial arrangement, could exceed the value on Day 1 of the borrower's promise to make future contractual payments.

Reckless endangerment of auditors – Isn't it already enough that auditors put themselves at risk simply by attesting to the "reasonableness" of management's estimates of the allowance for doubtful accounts on short-term trade receivables? The CECL method is orders of magnitude more complex than that. It would require management to estimate expected losses for multiple periods extending out for decades.

Even under the best of circumstances (which the PCAOB has demonstrated through its inspections is far too often not the case), providing a reliable audit of the present value of expected loan losses under the CECL method will be an impossible task – for which auditors will no doubt be called to account should (or when) another financial crisis occur.

* * * * * *

As regards to the charge of obstruction of accounting standards, this court finds that inadequate accounting standards for loans and related financial instruments contributed to the Financial Crisis of 2008. Consequently, the FASB knew, or should have known, that loan accounting is the most urgent item on its agenda; and that it should have been prioritized above all else, including convergence. It is unconscionable for the FASB not to have a final standard that is clearly and straightforwardly crafted to protect investors from further overstatement of loan portfolios, or even just an exposure draft.

We note as a potential mitigating factor that the FASB has taken the step of disassociating itself with the IASB's "three-bucket" artifice; however, this is far from sufficient to justify an acquittal on any of the counts. The motives for the FASB's actions were clear: to ensure that bankers should be spared from having to measure their loan portfolios with current market-based information over which they have no influence.

Shame on the FASB for continuing to put investors at risk in order to serve bankers. And, most important to this judge, for insulting our intelligence.

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

*An additional count of failure to adequately define "expected" will be adjudicated at a later date.

 

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

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

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

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

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

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

 

An Analogy to Accounting for Loans

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

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

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

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

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

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

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

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

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

 

The Moral of the Story

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

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

This is one of those times.

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

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

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

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

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

So I did.

On a Dual Statement Approach for Loans

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

* * * * *

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

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

______________________

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

Can Auditors Help Save Spain's Banks? Nuts!

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

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

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

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

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

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

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

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

I Said "Nuts"

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

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

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

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

* * * * *

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

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

It's Crunch Time for Loan Accounting – and Convergence

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

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

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

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

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

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

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

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

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

Auditing Loan Loss Reserves is a Bigger Problem than Measuring Them

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

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

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

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

 

But, Market Value Alone is Not the Answer

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

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

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

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

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

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

* * * * *

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Boss: How many studies say that?

Subordinate: 58.

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

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

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

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

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

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

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

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

The name I have for that is chutzpah.