FASB Reversal a Major Step Toward International Convergence

The FASB has made a major compromise in the area of impairment of financial instruments. Full details will be released later, but this is a major concession to U.S. and European banks. It is also a major step toward convergence of U.S. accounting rules with IFRS and the end to what what previously called a "religious war" over fair value accounting. As well, political influence over accounting may be resolved by the compromise.

This new FASB approach is similar to the International Accounting Standards Board’s model in IFRS 9. FASB has agreed that at least some assets should qualify for cost accounting, whereas banks were forced to use a fair value model for all loans under the new rules. Existing rules forced fair value on portions of banks’ loan portfolios.

The FASB’s original proposal was opposed by the banking industry as being pro-cyclical (making problems worse as business cycles worsened). Banks say that proposed the fair value approach is a danger to the survival of marginal financial institutions that could have their capital called by bank regulators because the rules have and would continue to force banks to take large and inappropriate write-downs on temporary market declines. They also lobbied that the rules would hurt lending and unfairly reduce banks' book value. They argued that banks would not make loans if the value of the loan could be written down immediately due to temporary market fluctuations.

Supporters of the FASB fair-value proposals say it would have improved transparency and unmasked potential weaknesses at banks. Proponents of fair value accounting, including the CFA Institute, argue it is what is needed to make the financial statements of banks reflect their true financial positions and operations more clearly to investors.

FASB said that financial statement users, including preparers, auditors and others would prefer to have loans held for collection recorded on the balance sheet at amortized cost, but with a more robust impairment test.

The FASB will go back to users for input toward an impairment model for loans. The original proposal required a fully fair value-based approach that the banks have lobbied against for years. The new approach would recognize a portion of the estimated loan losses over time unless greater losses are expected in the foreseeable future, in which case that larger floor amount would be recognized currently. Some loans, including loans traded actively by banks instead of held to collect payments will be valued at market prices.

The changes are partly the result of a fierce lobbying campaign by the American Bankers’ Association and others and seen as a major victory for the banking industry. However it was not solely the banks in opposition to the proposals. The FASB reported an overwhelmingly negative reaction to its proposal from companies and investors, who wrote more than more than 2,800 comment letters.

Accounting World Does not Need Convergece with U.S.: Major UK Regulator

A major UK regulator said that US attempts to adopt international accounting rules could result in unnecessary complexity.

Adair Turner, chairman of the Financial Services Authority, Regulator of all providers of financial services in the UK, said that the International Accounting Standards Board (IASB) risks adding complexity to its fair value accounting rule, if it continues converging with US standards.

“It is not so much that they are in danger of compromising (international standards), it is that, in the process of trying to reconcile them, they make it more complex,” he said.

He went on to say the world didn’t need the US to adopt international standards.

“We have had a capitalist system without full convergence in the past, it can be a complete pain in the neck… it hasn’t stopped the system working,” he said.

Turner’s comments add to growing concern surrounding the convergence project. In July the Fédération des Experts Comptables Européens said there were “diminishing returns”, from further convergence. Two months later Nigel Sleigh-Johnson, head of financial reporting at the ICAEW, said the process needed to be kept under “close review”. More recently, Stephen Haddrill, chief executive at the Financial Reporting Council, said the process should not be about “translating American standards into an international shape”.

Lord Turner’s concerns centre on the boards’ divergent approaches to fair value. The rule forces companies to value assets at market price and was blamed for exaggerating the effects of the downturn.

In the months following the downturn, both boards, under pressure from world governments, sought to revise their fair value standards. FASB’s approach would result in all assets valued at fair value. The IASB exempted banks’ loan books.

The issue has proved a sticking point in negotiations.

Within the IASB there is little appetite for steering away from convergence. US adoption is a key reason driving other nations to adopt international standards. Walking away from convergence might also embolden Europe, especially German and France, which have attracted criticism for politicizing accounting standards. Haddrill said the IASB was “walking a tightrope” but had made progress addressing inter­national concerns. “Because of the politicization of differences in view in the continent, people are failing to see just how far the IASB has moved towards recognizing some of the concerns that Europe has had, whilst at the same time preserving the principles of fair value.”

“The IASB is again facing that inherit trade off between what are the divergent, and in a sense, incompatible demands.”

FASB, IASB Agree on Something!

The Financial Accounting Standards Board and the International Accounting Standards Board finally agreed on something after a number of public differences of opinion over the last year. They have agreed to define fair value as an exit price, as a result of a recent joint meeting.

Both the FASB and the IASB have been controversial recently as they have come under pressure to revise fair value and “mark to market” standards to give financial institutions more flexibility in valuing assets that became difficult to trade during the crisis.

The two boards have decided to meet on a monthly basis, to resolve outstanding issues in areas such as fair value, revenue recognition, leases and consolidation.

The agreed-upon definition provides that when markets become less active, the two boards tentatively decided that an entity should consider observable transaction prices unless there is evidence that the transaction is not orderly. If an entity does not have enough information to determine whether the transaction is orderly, it should perform further analysis to measure the fair value.

The boards also decided (tentatively):

• that a transaction price might not represent the fair value of an asset or liability at initial recognition if, for example, the transaction is between related parties, the transaction takes place under duress or the seller is forced to accept the price in the transaction, the unit of account represented by the transaction is different from the unit of account for the asset or liability measured at fair value, or the market in which the transaction takes place is different from the market in which the entity would sell the asset or transfer the liability.
• to confirm that a fair value measurement is market based and reflects the assumptions that market participants would use in pricing the asset or liability. Market participants should be assumed to have a reasonable understanding about the asset or liability and the transaction based on all the available information, including information that might be obtained through due diligence efforts that are usual and customary. A price in a related-party transaction may be used as an input to a fair value measurement if the transaction was entered into at market terms.
  

Simpler Accounting for Financial Instruments

Accounting for financial instruments will be simplified from previous methods according to the recent IAS 39 Exposure Draft.

A reduction in the number of different categories from 4 to 2 and the elimination of the messy ex guidance around embedded derivatives and some of the impairment requirements, significantly streamlines this area.

The classification is an attempt to replicate the business model in FI acconting. This means that where a loan portfolio is held to generate income from interest and principal cash flows, it will be measured on that basis and not on one that looks at fair value at a point in time.

The exposure draft draws on input from the March 2008 Discussion Paper Reducing Complexity in Reporting Financial Instruments and discussions of the Financial Crisis Advisory Group.

There are still some major issues to deal with. Amortised cost measurement will be available only for instruments with ’basic loan features’ which are managed on a ‘contractual yield basis’. The latter of these is hard to define for financial instruments that sit in the middle ground between those to be held for their entire term to generate income and those to be traded for profit in the short term; that is going to be a particular concern for those who invest surplus funds temporarily. The IASB itself has not yet concluded on this point and that it’s likely that additional guidance will be required.

There’s also the question of whether equivalent changes will be made to US GAAP. The FASB is currently reviewing the requirements of its own financial instruments standards, but is at a less advanced stage of its project than the IASB. Indications are that the FASB is in a different place to the IASB and their proposals may well require more instruments to be measured at fair value.

The IASB has indicated that if the FASB does reach different conclusions, then these will be exposed for comment to the IFRS constituency.

Old model:

Held for trading
Available for sale
Amortized cost
Held to maturity



New Model:

Politics and Accounting

This article, from an anti globalization rabble-rouser, does contain some interesting stuff.

The Obama administration’s good offices have encouraged the big banks to launch a multi-front offensive to block any measures that would limit their profit-making, and to weaken already existing regulations.

Last February, for example, financial firms and banking organizations launched a multi-million-dollar lobbying drive to change mark-to-market accounting rules that forced banks to report losses or write-downs totaling $175 billion in 2008. Mark-to-market essentially requires banks to value their assets according to prevailing market prices. The banks have balked at this standard, demanding instead the right to assign their own values to their bad debts, using "internal models."

With the aid of $286,000 in campaign donations to the 33 members of a key House subcommittee, the Fair Value Coalition, the lobby group set up by the banks, succeeded in getting the industry rule-making body, the Financial Accounting Standards Board, or FASB, to give the banks immense latitude in suspending mark-to-market rules.

The Wall Street Journal on June 3 published an investigative report detailing the banks’ use of campaign fund monies to get their way. The Journal reported that the banking coalition spent a total of $27.6 million in the first quarter of 2009 on its lobbying effort.

It focused its drive on a House Financial Services subcommittee chaired by Rep. Paul Kanjorski, a Pennsylvania Democrat. Kanjorski received $18,500 from Fair Value Coalition members in the first quarter. Over the past two years, Kanjorski has received $704,000 in contributions from banking and insurance companies, the third-highest among members of Congress.

Barney Frank of Massachusetts, the Democratic chairman of the Financial Services Committee, received $8,500 from the coalition.

Kanjorski and other recipients of the bankers’ largess from both parties grilled the head of FASB, Robert Herz, at a committee hearing on March 12, demanding that he expedite a review of mark-to-market rules and threatening him with a bill to broaden government oversight of his board if he failed to comply.

Herz got the message, and on April 12, in advance of the stress test results and early enough to enable the banks to pad their first-quarter financial reports, FASB announced the changes demanded by the lawmakers.

According to the Journal, the American Bankers Association was the biggest contributor to the campaign funds of committee members in the weeks before the March 12 hearing. The newspaper quotes ABA President Edward Yingling as boasting, "We worked that hearing. We told people that the hearing should be used to talk about the big problems with ‘mark to market,’ and you had 20 straight members of Congress, one after another, turn to FASB and say, ‘Fix it.’"

The Journal notes: "The change helped turn around investor sentiment on banks.... Wells Fargo & Co. said the change increased its capital by $4.4 billion in the first quarter. Citigroup Inc. said the change added $413 million to first-quarter earnings." The newspaper cites a tax and accounting analyst, who estimates that the accounting changes will increase bank earnings in the second quarter by an average of 7 percent.

The Journal quotes Lynn Turner, the former chief accountant of the Securities and Exchange Commission and a former FASB member, as saying "he doesn’t think the banking industry will be satisfied until mark to market accounting is dismantled completely. ‘Despite efforts by FASB to give ground to the banks, enough is never enough, he says."

Watering Down Fair Value Accounting is "Crazy"

Moves by Wall Street lobbyists slammed

Excellent article from the Financial Post

Bank lobbyists and politicians are damaging the credibility of corporate reporting and hurting the interests of investors around the world by pulling back on mark-to-market accounting, one of the world's top international accountants warned.

The comments from Tom Jones, vice-chair of the International Accounting Standards Board (IASB), come after U.S. standard-setters unilaterally decided to dilute the controversial accounting rule earlier this month.

In an interview with the Financial Post, Mr. Jones warned of "a loss of credibility" and said the rationale for watering down so-called fair value accounting is "crazy." He also cited concerns about political interference that could undermine the independence of accounting rule setters.

These fears were echoed by other senior accountants, who urged Canadian authorities to resist pressure from big banks to follow the American lead.

In early April, the U.S. Financial Accounting Standards Board pledged to backtrack on fair value accounting under intense pressure from Wall Street and demands from Congress. U.S. lawmakers had even threatened to take the matter into their own hands rather than leave it to the accountants. The resulting FASB rule changes allow banks to use judgment rather than market prices, to value financial instruments.

Despite the urgings of Bay Street, the oversight council of Canada's standards board opted not to move to align with the U.S. when it met earlier this month, though the organization will weigh the matter again after the international accounting board meets this week.

The Canadian stance has received significant backing from the accountancy profession. Chris Clark, chief executive of PricewaterhouseCoopers Canada, said his firm does not support rushing to imitate the Americans and urged authorities to "balance" the demands of banks with "the needs of the investor".

Nouriel Roubini, the New York University economist nicknamed "Dr. Doom" for his prescient forecast of the global economic downturn, yesterday called the U.S. rule changes "a big mistake" that has allowed Wall Street banks to "fudge" their latest set of quarterly accounts.

The changes circumvent capital rules set by bank regulators and would, if adopted, weaken Canada's banking system, said Wayne Landsman, a professor from the University of North Carolina who will speak on the topic at the Rotman School of Management in Toronto on Thursday.

Proponents of fair value, or mark-to-market, accounting say it is the most accurate and independent way to price assets. But bankers say fair value accounting has exacerbated the current financial crisis by unfairly forcing them to take huge writedowns. They say illiquid markets for certain securities have led to fire sale prices that do not represent appropriate valuations, and they have lobbied to be allowed to value certain troubled securities based on their own estimates.

The idea that banks have been forced to write down assets beyond any rational level is "actually crazy," said IASB's Mr. Jones. The market price for troubled financial instruments has probably not even hit the bottom yet, he added.

Mr. Jones insisted there are better answers to the current problems in the banking sector than tinkering with fair value rules. One possibility would be to change the amount of capital that banks are required to set aside by bank regulators, he said.

Politicians and lobbyists in the U.S. seeking to further weaken fair value are having the effect of pressuring global standard setters to follow FASB's lead, Mr. Jones said. European finance ministers, for instance, have already called standard setters outside the U.S. to "level the playing field" on fair value accounting.

The IASB has reacted by urgently cutting short a consultation period on changes to its rules on financial instruments.

The London-based IASB uses a different rule book to the FASB. In recent years, most countries outside the U.S. have adopted or pledged to adopt the IASB rules. At a meeting in the U.K. this month, G20 leaders called for significant progress towards a single set of global accounting standards. Some observers say a single set of rules would make it easier for investors around the world to make informed decisions.

Mr. Jones said the integration plans have not been derailed by the U.S.'s decision to back away from fair value accounting. Full adoption of IASB standards by the U.S. seems unlikely, but some form of convergence is expected in the long term.

"We are going to try to ensure the difference isn't as great as it seems," he added. Mr. Jones noted that IASB rules on fair value also allow companies to exercise judgment in some cases, like the amended U.S. rules.

Separately, members of a joint committee formed by the two accounting organizations to deal with the financial crisis also complained about political interference in their work.

At a London meeting of the Financial Crisis Advisory Group, that was broadcast on the Internet, senior industry experts expressed concern about the politicization of the process of revising accounting standards.

Harvey Goldschmid, the group's joint chair who is a former commissioner of the Securities and Exchange Commission, and IASB chair Sir David Tweedie, were among those who warned of the dangers of political pressure that could weaken the independence of accounting standard setters.
By Duncan Mavin and Eoin Callan
Financial Post

The Economist to Banks: Back Off Accounting Rules

The Economist recently ran a piece titled “Messenger, shot” calling for standard-setters to defend accounting rules that are under attack and for politicians and banks to back off.

To set the scene--bankers are apologizing all over the place in public, but behind the scenes they are blaming accounting rules for their problems. There is a fierce lobbying effort going on with bankers and their associations/lobbyists/political backers attacking accounting standard-setters.

The banks moan that accounting rules have forced them to report gigantic losses that are not justified. The banks complain that the rules force them to value some assets at the price a third party would pay (the markets), not the price managers and regulators would like them attain.

Recently the banks’ lobbying has affected accounting standard setting in both the U.S. and internationally. How much impact does this have on the capital markets? Independence of accounting standard-setting is essential to the proper functioning of capital markets. It is being compromised.


In April, Congress beat up the chair of the U.S. Financial Accounting Standards Board (FASB), with the result that they rushed through rule changes giving banks more freedom to use models to value illiquid assets and more flexibility in recognizing losses on long-term assets in their income statements.

European ministers moved in lock step with the U.S. and demanded that the International Accounting Standards Board (IASB) make identical changes. Shortly thereafter, they announced word-for-word changes as in the U.S.

Quotes from the article:
“It was banks that were on the wrong planet, with accounts that vastly overvalued assets. Today they argue that market prices overstate losses, because they largely reflect the temporary illiquidity of markets, not the likely extent of bad debts. The truth will not be known for years. But banks’ shares trade below their book value, suggesting that investors are skeptical. And dead markets partly reflect the paralysis of banks which will not sell assets for fear of booking losses, yet are reluctant to buy all those supposed bargains.”

“To get the system working again, losses must be recognized and dealt with. Japan’s procrastination prolonged its crisis. America’s new plan to buy up toxic assets will not work unless banks mark assets to levels which buyers find attractive. Successful markets require independent and even combative standard-setters. The FASB and IASB have been exactly that, cleaning up rules on stock options and pensions, for example, against hostility from special interests. But by appeasing critics now they are inviting pressure to make more concessions. “

“Standard-setters should defuse the argument by making clear that their job is not to regulate banks but to force them to reveal information. The banks, their capital-adequacy regulators and politicians seem to dream of a single, grown-up version of the truth, which enhances financial stability. Investors and accountants, however, think all valuations are subjective, doubt managers’ motives and judge that market prices are the least-bad option. They are right. A bank’s solvency is a matter of judgment for its regulators and for investors, not whatever a piece of paper signed by its auditors says it is. Accounts can inform that decision, but not make it.”

“Banks’ regulators have to take responsibility. If they want to remove the mechanical link between drops in market prices and capital shortfalls at banks, they should take the accounts that standard-setters create for investors and adjust them when they calculate capital. They already do this to some degree. But the banks’ campaign to change the rules is making inevitable a split between two sets of accounts, one for regulators and another for investors. The FASB and IASB can help regulators to create whatever balance-sheet they want. But in doing so they must not compromise their duty to investors.”

Investors vs. Bankers--Who will Win?

Recently the IASB and the FASB issued for comment changes to accounting rules that would allow looser mark to market accounting. This has sparked opposition to the changes from consumer and investor groups that who are advancing their previously expressed arguments that the rules give management (banks?) too too much freedom in valuing assets in distressed or illiquid markets.

Opposition comes from such places as the Consumer Federation of America, the CFA Institute and the FASB's Investors Technical Advisory Committee. The opposition may also have an impact on proposed changes to financial institutions' regulatory capital levels, which the banks claim are needed to ease the existing credit crunch and to avoid future credit messes like we have had in the past year.

Banks have claimed for years that mark-to-market rules force them to place unrealistically low values on illiquid or otherwise difficult to trade assets (known in mark-to-market accounting terms as "Level 3 Financial Instruments".)

The FASB/IASB proposals require "significant judgment" on the part of management in determining when a market isn't active. Once determined inactive, it would effectively allow management to ignore trading prices when coming up with a value for a security.

Those who have recently voiced opposition to the proposed rules say that they make it too easy for companies to reduce write-offs on impaired assets and make it easier for banks to keep their regulatory capital at unrealistic levels, allowing unstable financial institutions to make bad credit choices.

Mark-to-market accounting is under increasingly fierce attack by bankers who are lobbying hard for U.S. Congress to suspend or repeal mark to market rules. Bankers blame the rules for the current financial crisis.

Those who oppose the rules are against the banking industry's ability to make the statutory and regulatory regime work in their favour. They claim that the banks want accounting rules to change to fix irresponsible banking activity. While they agree that mark to market rules are not perfect, they do provide transparency in valuing assets and that such transparency helps investors.

FASB Fast Tracks Fair Value Changes

The FASB has opened the door to modifying rules on determining the fair value of assets that are not actively traded.

FASB has fast-tracked its comment period to 15-days in response to pressure from Congress and by bankers and regulators to modify fair-value accounting rules. The new proposal for comment guides companies on how to determine whether an asset's market can be considered not active, and whether a transaction being used to estimate an asset's value is not distressed. FAS 157 states that fair value of a financial instrument cannot be based on distress sales.

FASB chairman Robert Herz was was repeatedly asked at Congessional hearings last week to “fix” mark-to-market accounting in three weeks. At the same time, Congress stated that they did not want to “interfere with accounting standard setting," Herz stated that that the FASB is preparing some material and that due process is necessary. The members of Congress present threatened Herz with legislation that would “fix” mark to market.

Members of Congress present at the hearings seemed to be of the opinion that changes in accounting rules would suddenly turn the economy around. Herz stated that changes to accounting guidance would not guarantee economic changes.

The emphasis is on FAS 157 Level 3 judgements. Such judgements on measurement of financilal instruments require the most judgment, and are designed for thinly traded or untraded assets that have a value derived from "unobservable inputs." Measurements at Level 3 seem tainted by some readers of financial statemetns. Potenmtitally , the FASB’s new guidance will remove the stigma attached to Level 3.

Level-3 measurements are based on inputs that require more judgment. More judgement means more attention from auditors and regulators and more work on the part of accountiants and possible the need for outside valusators. Approximately 9 percent of financial instruments measured at fair value were classified as Level 3 under FAS 157. Level 1 is at 76 percent and Level 2 15 percent (per SEC study).

Herz stated that "There's not much accounting can do other than help people get the facts and use their best judgment," he said.

FASB expects companies to use "significant judgment," in determining when assets were not trading in active markets or were distressed. This could result in different valuations for the same asset by different companies.

The new guidance requires a two-step approach to determine whether a company is justified in not using observable prices. First is assessing indicators that a market is inactive, i.e. too few transactions to determine prices or the prices are out of date.

Second, if the firsrt step indicates an inactive market, companies will look for indicators of distressed pricing of transactions. If a price is made under distress, then the price cannot be used for estimating fair value and other valuation techniques are required.

The comment period ends on April 1 for adoption for interim and annual periods ending after June 15, 2009.

Here is the actual text of the decision from the FASB web site:

Fair value measurement. The Board discussed the following issues:

Determining when a market for an asset or a liability is not active and determining when a transaction is not distressed. The Board decided to provide additional guidance to help an entity in determining whether a market for an asset is not active and when a price for a transaction is not distressed. The Board meeting handout described the proposed model the Board agreed to.

The Board decided that the changes would be effective for interim and annual periods ending after March 15, 2009. The proposed FSP would be applied prospectively and early adoption would not be permitted.

The Board directed the staff to proceed to a draft of the proposed FSP for vote by written ballot and plans to issue that document for public comment on March 17, 2009, with a comment deadline of April 1, 2009. The Board expects to discuss the comments it receives at its meeting on April 2, 2009.

Other-than-temporary impairments. The Board discussed proposed changes to the guidance for other-than-temporary impairments. Currently, an entity is required to assess whether it has the intent and ability to hold a security to recovery in determining whether an impairment of that security is other than temporary. The proposed FSP would change that guidance as follows:

1. If the entity intends to sell the security or it is more likely than not that it will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an other-than-temporary impairment.
2. If the entity does not intend to sell the security and it is not likely that the entity will be required to sell the security before recovering its cost basis, only the portion of the impairment loss representing credit losses would be recognized in earnings as an other-than-temporary impairment. The balance of the impairment loss would be recognized as a charge to other comprehensive income.

For securities within the scope of FASB Statements No. 115, Accounting for Certain Investments in Debt and Equity Securities, and No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, an entity would determine the impairment charge representing credit losses by using its best estimate of the impairment amount arising from an increase in the credit risk associated with the specific instrument. One way of estimating that amount would be to consider the measurement methodology described in FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan.

For a debt security within the scope of EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets,” an entity would estimate the amount of the total impairment charge representing the credit losses in accordance with that Issue.

The proposed FSP would result in a new category within other comprehensive income for the portion of the other-than-temporary impairment that is unrelated to credit losses for held-to-maturity securities. The impairment recognized in other comprehensive income would be amortized over the remaining life of the debt security in a prospective manner based on the amount and timing of future estimated cash flows unless there is an indication of additional credit losses. That amortization would be recognized in other comprehensive income with an offset to the asset and would not affect earnings.

The Board decided that the guidance would be effective for interim and annual periods ending after March 15, 2009, and applied prospectively. The Board directed the staff to proceed to a draft of the proposed FSP for vote by written ballot and plans to issue that document for public comment on March 17, 2009, for a comment period of 15 days. The Board expects to discuss the comments it receives at its meeting on April 2, 2009.

Politics and Accounting

CTLR View: Accounting Politicization and Fearmongering - A Dangerous Trend

In Blog at the Controllers Roundtable, Joey Borson writes about the increasing interest of politicians in accounting--quoted verbatim below.

In a Congressional hearing today, Representatives spoke out strongly against 'mark-to-market' accounting, and called for the FASB to suspend or significantly change FAS 157 and the associated standards. When combined with simplistic calls in the popular business press for mark-to-market's suspension (or worse), this represents a disturbing trend which combines populist ignorance about accounting with heavy-handed attempts to involve Congress directly in setting accounting policy.

Ignorance: FAS 157 is not Mark-to-MarketIn most cases within the popular press (and Congress), fair value accounting and mark-to-market are synonymous—and the assumption is that companies must always mark the value of their assets to whatever market prices they can find—even if those markets are completely illiquid, or if the only transactions are fire-sales.

However, the FASB has repeatedly said (and emphasized again today), that FAS 157 and existing fair value provisions within US GAAP do no such thing. Instead, the three tiered hierarchy set out by FAS 157 creates criteria for what to do when there are not liquid, perfectly comparable equivalents—and in those cases, companies are expected to use their own judgment about the best method of valuing those assets—including using internal assessments of cash flow and other financial valuation techniques. Companies are explicitly told not to use fire-sale prices. Indeed, fair value standards already require a 'mark-to-model' approach (combined with clear disclosures about what models and assumptions are used) when a 'mark-to-market' approach is no longer appropriate.

Though the FASB can be (and has been) criticized for not providing enough guidance around determining when there is a "fire sale", and what "illiquid" really means, they have, to their credit, been clear about emphasizing the need for judgment—not just mechanical application—in these valuation exercises. This distinction has been lost by parts of the popular business press (and some legislators).

Politicization: Do We Really Want Accounting To Be Congressionally Defined?The last two weeks have seen the dangerous trend of politicians wanting to involve themselves actively in accounting standards—a sea change from what has been the generally accepted policy of having a very independent standard setting process; the hallmark of US GAAP for many years. At the hearing today, many Representatives implied (or in some cases, overtly stated) that if FASB did not "correct" fair value, they would take matters into their own hands, and set accounting policy through legislation.

This comes on top of a legislative proposal that would strip the SEC of their exclusive power to oversee US GAAP, and turn it over to a new committee which would "approve and oversee accounting principles," and would be chaired by the Head of the Federal Reserve, and include the Chairs of the SEC, PCAOB, and FDIC as well as the Treasury Secretary. This board would be required to consult with the Comptroller of the Currency, the Director of the Office of Thrift Supervision, the Federal Housing Finance Agency, the Administrator of the National Credit Union Administration, the President of the National Association of Insurance Commissioners, and the Chairman of the Commodities Future Trading Commission, but would only be encouraged, not required, to consult with the FASB or IASB on setting accounting standards.

In both cases, it is unlikely that accounting will be stripped away from the standard-setting bodies—but even the threat is disturbing. US GAAP depends on the fact that it is a public process, set forth with clear due process periods, and an effect to work with all stakeholders in a clear and transparent manner (hence the long period of exposure drafts, comment letters, and discussion documents which forms the modern accounting standard setting process).

But if GAAP can be set by legislative whim (or legislative "encouragement"), then imagine the accounting standard-setting process resembling the earmark process—with no transparency, provisions set in place for favored industries and constituencies, and a complete lack of due process or cohesive planning. Investors won't stand for that—and accounting, and public companies, in the US will be worse for it.

What's Next? Fair value standards clearly needs (marginal) improvements, and the process-oriented fixes that the FASB and the SEC have recommended are probably the right step in that direction—and when they are not, users should (as they always have done) suggest changes through a formal, public process. But changes should not be put in place by legislative fiat—at least not if we expect the US to maintain a tradition of high quality accounting standards that attracts investors to its capital markets.

Bernanke: Keep, Improve Mark-to-Market Accounting Rules

U.S. Federal Reserve Chairman Ben Bernanke has supported accounting rule makers in their efforts to determine how to apply mark-to-market rules in illiquid markets such as the recent financial crisis. The banking and investment community has blamed accounting rules that they feel are too strict for worsening the global financial crisis. At issue are valuations for assets previously traded as liquid assets that suddenly become illiquid when markets freeze up.

The mark to market rules (“MTM”) require companies to write down assets every quarter to reflect market value. Bernanke doesn’t fully agree completely with the banks, who have always rejected fair value.

In testifying before a U.S. Congressionsl Committee this week, Bernanke said:

MTM is “a good principle in general” and shouldn’t be suspended completely.
“Accounting authorities have a great deal of work to do to try to figure out how to deal with some of these assets, which are not traded in liquid markets,”
“I don’t see a suspension of the whole system as being constructive, because there is a great deal of information in valuing many of these assets.”

Bankers hold strong and long-standing views that mark-to-market accounting has harmed banks and the economy. They say that harm comes from rules that require banks to state investments at fair-value, and that that accounting doesn’t work in illiquid markets because there isn’t enough market data to determine the real value of assets. Treasury Secretary Geithner, the SEC, the FASB and the international Accounting Standards board (IASB) all have stated that the rules should stay because they enhance transparency of corporate reporting.

The SEC wants to keep fair-value accounting, despite calls from the banks to suspend the fair value rules until the financial crisis is over or until the rules can be sorted out. An SEC report released in December advocated that the fair value rules should be improved. They also countered bank claims, saying that “[fair value] did not appear to play a meaningful role” in bank failures last year. The FASB is currently engaged in a study to clarify how the mark to market rules apply when markets are inactive.

Got Goodwill? Part 5

Impairment Hall of Fame

Tough times mean write-downs of assets including goodwill and intangibles. Following are write downs announced recently.

ConocoPhillips – oil and gas: $25.4 billion in goodwill impairments-- $7.3 billion before- and after-tax impairment related to ConocoPhillips' investment in LUKoil and additional after-tax impairments totaling $1.3 billion

Royal Bank of Scotland: $U.S. 20 to 28 billion goodwill impairment charge.

Regions Financial: $6 billion goodwill impairment in its banking reporting unit.

AMD – technology: $3.2 billion impairment to goodwill and intangibles

OfficeMax -- $1-billion impairment in goodwill and trade names

United Rentals: $1.1 billion goodwill impairment relating mostly to goodwill arising out of acquisitions made by the company between 1997 and 2000.

Brunswick Corp.--consumer brands: $1-billion goodwill impairment

JDS Uniphase: up to $744 million goodwill impairment


McMoRan Exploration - oil and gas exploration: $291.8 million impairment charges on oil and gas property, plant and equipment

Celanese – chemicals: $100 million impairment of fixed assets

Fulton Financial – banking: $90 million goodwill impairment charge

H.B. Fuller Co. - adhesives and specialty chemical products: $86.9 million goodwill and asset impairment charges mostly related to the company's 2006 acquisition of Roanoke.

Mattson Technology: $18 million against goodwill, $7 million against intangibles and $3 million against fixed assets.

SEC Issues Report on Mark to Market Accounting

The Securities and Exchange Commission recommended against suspending fair-value accounting rules, instead suggesting improvements to deal with illiquid markets and reducing the number of models used to measure impaired assets.

In a 211-page report to U.S. lawmakers, as expected, the agency's staff Tuesday definitely recommended that fair-value and mark-to-market not be eliminated or suspended. "The abrupt elimination of fair value and market-to-market requirements would erode investor confidence," the report said.

The banking lobby has argued that financial institutions have been forced to write off as losses still-valuable assets because the market for them had dried up, creating a spiral of write-downs and asset sales.

The report said that staff found no evidence to suggest that the accounting rules had played a significant role in the collapse of U.S. financial institutions. "While the application of fair value varies among these banks...in each case studied it does not appear that the application of fair value can be considered to have been a proximate cause of the failure," the report said.

Additionally, the SEC suggests that the Financial Accounting Standards Board narrow the number of accounting models firms can use to assess the impairment for financial instruments.

Michael R. Crittenden at the Wall Street Journal

See:
SEC press release

Full Report: Report and Recommendations Pursuant to
Section 133 of the Emergency Economic Stabilization
Act of 2008: Study on Mark-To-Market Accounting

PricewaterhouseCoopers' Survey: Bank, other Financial Services Board Members Say Mark to Market is Not to Blame for Crisis

Pricewaterhouse Coopers recently completed a survey of 300 board members, two-thirds of whom sit on the audit committee of financial institutions, taken between September 22nd and October 4th at the 2008 PricewaterhouseCoopers Financial Services Audit Committee Forum.

Respondents were surveyed about mark to market accounting: Nearly two-thirds (65%) of financial services board members surveyed agree that mark-to-market accounting, also known as fair valuation, creates volatility in the markets. However, 83 percent disagreed with the statement that mark-to-market accounting is to blame for the current credit crisis.

About the current financial crisis:

• 30 % view the situation as a reminder of the need for more disciplined risk taking during periods of growth
• 20 % say it is a reflection of too much focus on the short-term (investing, reporting, compensation).
• 13% found the positive in the tumultuous economic climate and regard the situation as an opportunity that will eventually strengthen the financial services industry.
• 25%sees this as an example of the urgent need for modernization of the financial services regulatory framework to reflect today's global, integrated capital markets system.

Other findings:

• 96 percent of board members said they think that financial institutions that retain risks to off-balance sheet entities should in the future publicly disclose aggregate information on a regular and timely basis, including the quantity and sensitivity to credit, market and liquidity risks and any changes to those risk exposures over time.
• 65 percent of respondents feel that corporate boards lack the tools and transparency to properly assess risks and exposure.
• 88 percent said the scope of risk management for financial institutions does not adequately account for their exposure to off-balance sheet entities.
• 80% feel they could do more to reduce the chance of future industry instability, according to findings of a survey released today by PricewaterhouseCoopers' Financial Services Industry Group. However, the survey also revealed a desire for greater transparency to accurately measure exposure to risk.
• More than 95 percent of the board members asked said they believe greater clarity is required as it relates to what is and what is not reported on an organization's balance sheet
• 77 percent said existing valuation tools are not robust enough.
  

When asked to rank their four top priorities over the next twelve months, audit committee board members ranked them as follows (in order of importance):

• Transparency and financial reporting
• Internal controls and tightened margin/collateral controls
• Enterprise-wide risk management and buy-in from business lines
• Systematic risk management across the industry

Accounting Mayhem at the Wall Street Journal

After a couple of weeks of singing from the investment banks’ songbook on mark to market/fair value accounting, the Wall Street Journal now does a gigantic triple backward flip flop and says accounting is meaningless:

Mark to Mayhem?
Because of all this, the regulatory state finds itself in a somewhat absurd position -- its own rules could render many financial institutions insolvent in a manner inconvenient to the state.
We choose the adjective advisedly. These institutions are guaranteed by the federal government, implicitly or explicitly, so questions of solvency are largely academic--except as to the value of their equity. In fact, much of the ferocious argument over mark-to-market really is a political battle between CEOs and short sellers for control of the stock price. Washington wishes they'd just shut up before savers and lenders join the argument -- because, in present circumstances, we'd call that a "bank run."

Then there's a third group on the sidelines who attribute religious or ethical superiority to mark-to-market. Their sentiments are simply misplaced. Mark-to-market and its alternatives all have their uses -- a rose by any other name. A savvy analyst looks at them all with the same gimlet eye.

But usefulness is not what we're talking about here -- we're talking about a regulatory trap for equity, created as an unintended consequence of a well-meaning accounting rule. Short sellers see this trap and try to exploit it. Uninsured lenders and depositors see it and worry about not getting paid back. That fear is why banks have all but stopped lending to each other -- and why Henry Paulson launched his plan, and why the SEC made its move yesterday.

Accounting straddles the real and unreal, so it's hard to guess how much difference getting rid of mark-to-market might really make. The only way to find out is to try.

A mere accounting rule change won't reduce foreclosures or raise home prices -- then again, if spared drastic writedowns, banks might be more willing to lend, raising home prices and reducing foreclosures.

A mere accounting rule can't alter the underlying economics of a lending business -- then again, no longer worried about insolvency-by-accountant, investors might discover new confidence to inject capital and improve the underlying economics of a lending business.

No accounting rule is worth $700 billion. Then again, the essence of the Paulson plan was to raise the value of bank assets to help banks escape the regulatory equity trap. Does that mean we can change an accounting rule and save Congress from having to appropriate $700 billion?

Other views—
In the mainstream media
The accounting rule you should care about
A New Rule Change That Could Hurt Taxpayers
Why get a bailout when you can massage the books?
Clarification of accounting rule sparks debate
In blogs
Moving The Foul Pole: The Mark-To-Market Scandal
Changing the rules on bank accounting, the fix is in
Fair Value Follies
Fair Value Follies 2
FASB and SEC Make Nice-Nice
SEC: Why Don't You Just Tell Us What You Want The Value To Be?

SEC, FASB Clarify Fair Value Accounting

SEC Office of the Chief Accountant and FASB Staff Clarifications on Fair Value Accounting

This seems like just plain common sense and a standard application of the rules. But it serves the purpose of starting the process of reconciling GAAP to the recently expressed views of investment bankers and politicians.

Excerpts:

Can management's internal assumptions (e.g., expected cash flows) be used to measure fair value when relevant market evidence does not exist?
Yes.

How should the use of "market" quotes (e.g., broker quotes or information from a pricing service) be considered when assessing the mix of information available to measure fair value?
Broker quotes may be an input when measuring fair value, but are not necessarily determinative if an active market does not exist for the security.

Are transactions that are determined to be disorderly representative of fair value? When is a distressed (disorderly) sale indicative of fair value?
The results of disorderly transactions are not determinative when measuring fair value.

Can transactions in an inactive market affect fair value measurements?
Yes.

What factors should be considered in determining whether an investment is other-than-temporarily impaired?
In general, the greater the decline in value, the greater the period of time until anticipated recovery, and the longer the period of time that a decline has existed, the greater the level of evidence necessary to reach a conclusion that an other-than-temporary decline has not occurred.

Commentary:

S.E.C. Move May Relax Asset Rule
How to Start the Healing Now
Financial crisis: SEC cheers finance companies with mark-to-market ...
Focus turns to 'mark to market' accounting rules
Understanding the Significance of Mark-to-Market Accounting
Stop Treating Wall Streeters Like Villains and Resolve This Crisis

Thirsty for Changes to Mark to Market?

Would suspending mark-to-market rule solve the financial crisis?
Kevin Kersten at bloggingstocks provides this amusing example:

Let me give a silly but simple illustration. If you have 20 one dollar bills in your wallet, we would all agree you have a net worth of $20. Thirsty Bob also has one dollar bill in his wallet and walks into the break room and wants to buy a Coke. Soda in the machine costs 50 cents, but it only takes quarters. Thirsty Bob asks if anyone has change and they all say no. Sam says he has only two quarters and will trade Thirsty Bob -- who is really thirsty -- two quarters for a dollar. Thirsty Bob quickly agrees to take Sam up one his offer in order to get the Coke now. Bob knows that two quarters for a dollar is a bad deal, but he is takes the deal anyway.

According to mark-to-market accounting, you, with your 20 dollar bills, now have a net worth of $10. Even though you are still holding the exact same 20 one dollar bills you held in your hand when you entered the room and even though you did not trade with anyone else in the room, the current public market in the room for $1 bills is 50 cents. If each of those $1 bills is worth two quarters, your net worth is only 40 quarters, or $10. You must evaluate your net worth based on the current market. You are smart enough to know that the one dollar bills are really worth four quarters at the bank down the road, but mark-to-market accounting will not allow you to use this "long term" evaluation method.

This, in essence, captures the problem of the current loans crisis. One dollar bills are the mortgages nobody is willing to buy. Banks must evaluate them at the depressed rates they occasionally trade at and everyone is feeling poorer.

Mark to Market...the Song that Never Ends

More and more on mark to market accounting. Some controversial views are expressed by various writers in the sources noted below and in other sources quoted in earlier postings. But as an accountant in the post-Enron world, it's tough to understand why anyone would want less informative or less transparent accounting disclosure. It seems counter-intuitive that less conservative accounting would help financial markets. None of the arguments made so far present a clear picture as to why any financial institution has been harmed by mark-to-market rules--what we have seen is mostly dubious scare tactics along the lines of "mark-to market is the next plague, so we need to get rid of it." We need bankers to be more specific about this if they want to justify new or different rules.

Suspend Mark-To-Market Now! By Newt Gringrich
Reform or Bust: Because existing rules requiring mark-to-market accounting are causing such turmoil on Wall Street, mark-to-market accounting should be suspended immediately so as to relieve the stress on banks and corporations. In the interim, we can use the economic value approach based on a discounted cash flow analysis of anticipated-income streams, as we did for decades before the new mark-to-market began to take hold. We can take the time to evaluate mark-to-market all over again. Perhaps a three-year rolling average to determine mark-to-market prices would be a workable permanent system. It is not widely understood that the adoption of mark-to-market accounting rules is a major factor in the liquidity crisis which is leading companies to go bankrupt. But it is destructive to have artificial accounting rules ruin companies that would have otherwise survived under previous rules. Also:The Congress should repeal Sarbanes-Oxley, which failed to warn of every single bankruptcy!!

Mark to Market Accounting: Kill It Before It Eats Us Alive
However, mark to market rules distort financial results and business decisions under the false cloak of conservatism. The rules make little sense, produce inconsistent results, lack a basis in reality and provide lots of room for abuse.

FASB, SEC Discuss Fair Value-Standards
The FASB is in discussions with the U.S. Securities and Exchange Commission about whether additional guidance on fair value accounting rules is needed, according to a person familiar with the matter. SEC spokesman John Nester said the SEC is "working closely with U.S. and international regulators and standard setters on the issues related to fair value." It was unclear whether the SEC and FASB would issue guidance before the end of the third quarter, which ends on Tuesday.

Mark to Market Accounting Consequences of Bailout Explained

Excellent article here on how mark to market accounting affects the current investment bank bailout proposal.

Also, in a reaction to the financial crisis, the International Accounting Standards Board has called a special meeting to discuss the IFRS rules on accounting for financial instruments, which is where the fair value and mark to market accounting rules exist.

Former SEC Bosses: Keep, Expand Fair Value Accounting

In an editorial "How to Restore Trust In Wall Street" in the Wall Street Journal, Arthur Leavitt, a former SEC chair and and Lynn Turner, a former SEC chief accountant make the case for more and better, not less, fair value accounting .

• Banking and financial services trade groups are aggressively lobbying the SEC to suspend the mark-to-market, or fair-value, accounting standards, claiming that fair-value accounting standard has distorted banks' balance sheets, and has contributed to the market volatility.
• On the contrary, that gets things backward--it is accounting sleights-of-hand that hid the true risk of assets and liabilities these firms were carrying, distorted the markets, and caused investors to lose the confidence necessary for markets to function properly.
• Restoring public trust requires better quality, accuracy, and relevance in financial reporting and expanding, not reducing fair value reporting of the securities positions and loan commitments of all financial institutions.
  Only fair value accounting brings transparency to the market and determines whether or not a financial institution has sufficient capital and liquidity to justify receiving loans and capital.
• Contrary to what the critics claim -- fair value is not liquidation value. It does not reflect ultimate settlement amounts, but the current value in arms-length transactions. It is an accurate reflection of the value of an asset or cost of a liability, and what taxpayers should pay for assets.
• Those who blame fair-value accounting for the current crisis are shooting the messenger. Fair value does not make markets more volatile; it just makes the risk profile more transparent.
• Blame lies with Lehman, AIG, Fannie Mae, Freddie Mac and others who made poor investment and strategic decisions and took on dangerous risks--blame should not be placed on the process by which the market learned about the them.
• Tough medicine must be taken in order to vastly improve financial reporting, bring transparency to the markets.