Tuesday, March 31, 2009

Levitt Speaks to the SEC; Defends Mark-to-Market

Artheu Levitt, former chair of the SEC recently testified to Congress and vigorously defended mark-to- market.

Statement of Arthur Levitt, former Chairman, Securities and Exchange Commission
Before the Senate Committee on Banking, Housing, and Urban Affairs

March 26, 2009

Core Principles

Regulation needs to match the market action. If an entity is engaged in trading securities, it should be regulated as a securities firm. If an entity takes deposits and holds loans to maturity, it should be regulated as a depository bank. Moreover, regulation and regulatory agencies must be suited to the markets they seek to oversee. Regulation is not one size fits all.

Accounting standards serve a critical purpose by making information accessible and comprehensible in a consistent way. I understand that the mere mention of accounting can make the mind wander, but accounting is the foundation of our financial system. Under no circumstances should accounting standards be changed to suit the momentary needs of market participants. That principle supports mark‐to‐market accounting, which should not be suspended under any condition.

The proper role of a securities regulator is to be the guardian of capital markets. There is an inherent tension at times between securities regulators and banking supervisors. That tension is to be expected and even desired. But under no circumstance should the securities regulator be subsumed – if your goal is to restore investor confidence, you must embolden those who protect capital markets from abuse. You must fund them appropriately, give them the legal tools they need to protect investors, and, most of all, hold them accountable, so that they enforce the laws you write.

And finally, all regulatory reforms and improvements must be done in a coordinated and systemic way. The work of regulation is rarely done well in a piecemeal fashion. Rather, your focus should be to create a system of rules that comprise a complete approach, where each part complements the other, and to do it all at once.

Specific Reforms

Mark to market or fair value standards should not be suspended under any circumstance. Some have come forward and suggested that these are unusual times, and we need to make concessions in our accounting standards to help us through it. But if we obscure investor understanding of the value of assets currently held by banking institutions, we would exacerbate the crisis, and hurt investors in the bargain. Unfortunately, recent steps taken by the FASB, at the behest of some politicians, weaken fair value accounting.

Those who argue for a suspension of mark‐to‐market accounting argue this would punish risk‐taking. I strongly disagree. Our goal should be to make sure risk can be priced accurately.
Failure to account for risk, and failure to present it in a consistent way, makes it impossible to price it, and therefore to manage it. And so any effort that seeks to shield investors from understanding risk profiles of individual banks would, I believe, be a mistake, and contribute to greater systemic risk.

I would add that mark‐to‐market accounting has important value for internal management of risk within a firm. Mark‐to‐market informs investment bank senior managers of trading performance, asset prices, and risk factor volatilities. It supports profit and loss processes and hedge performance analyses, facilitates the generation and validation of risk metrics, and enables a controlled environment for risk‐taking. If treated seriously by management, mark‐to‐market is a force for internal discipline and risk management, not much different than a focus on internal controls. Yes, valuing illiquid or complex structured products is difficult. But that doesn’t mean the work should not be done. I would argue that it has to be done, both inside the firm and by those outside it, to reduce risk throughout our system.

And so I agree with the Chairman of the Federal Reserve, and the heads of the major accounting firms, that the maintenance of mark‐to‐market standards is essential.

Supporting all these activities will require an appropriately funded, staffed and empowered SEC. Under the previous administration, SEC funding and staffing either stayed flat or dropped in significant areas – enforcement staff dropped 11 percent from 2005 to 2008, for example. We have seen that regulators are often overmatched, both in staffing and in their capacity to use and deploy technology, and they can’t even meet even a modest calendar of regular inspections of securities firms. Clearly, if we are to empower the SEC to oversee the activities of municipal bond firms and hedge funds, we will need to create not only a stronger agency, but one which has an adequate and dedicated revenue stream, just as the Federal Reserve does.

My final recommendation relates to something you must not do. Under no condition should the SEC lose any of its current regulatory responsibilities. As the primary guardian of capital markets, the SEC is considered the leading investor representative and advocate. Any regulatory change you make that reduces the responsibility or authority of the SEC will be viewed as a reduction in investor protections. That view will be correct, because no agency has the culture, institutional knowledge, staff, and mission as the SEC to protect investors.


These actions would affirm the core principles which served the nation’s financial markets so well, from 1933 to 1999 – regulation meeting the realities of the market, accounting standards upheld and strengthened, regulators charged with serving as the guardians of capital markets, and a systemic approach to regulation. The resulting regulatory structure would be flexible enough to meet the needs of today’s market, and would create a far more effective screen for potential systemic risks throughout the marketplace.

Financial innovations would continue to be developed, but under a more watchful eye from regulators, who would be able to track their growth and follow potential exposure.

Whole swaths of the shadow markets would be exposed to the sunlight of oversight, without compromising the freedom investors have in choosing their financial managers and the risks they are willing to bear.

Most importantly, these measures would help restore investor confidence by putting in place a strong regulatory structure, enforcing rules equally and consistently, and making sure those rules serve to protect investors from fraud, misinformation, and outright abuse.

These outcomes won’t come without a price to those who think only of their own self-interest. As we have seen in the debate over mark- to-market accounting rules, there will be strong critics of strong, consistent regulatory structure. The self-interested have reasons of their own to void mark-to-market accounting, but that does not make them good reasons for all of us. Someone must be the guardian of the capital market structure, and someone must think of the greater good. That is why this committee must draw on its heritage of setting aside partisanship and the concerns of those with single interests, and maintain a common front to favor the rights of the investor, whose confidence will determine the health of our markets, our economy, and ultimately, our nation.

Monday, March 30, 2009

Selling Your Soul for $186,000 a year

The SEC complaint against Bernie Madoff's auditor, alleges that David Friehling enabled Bernard Madoff's Ponzi scheme by falsely stating, in annual audit reports, that F&H audited Madoff's financial statements. In fact, the complaint alleges, the defendants did not conduct anything remotely resembling an audit.

Friehling & Horowitz is enrolled in the program but hasn't submitted to a review since 1993, says AICPA spokesman Bill Roberts. That's because the firm has been informing the AICPA -- every year, in writing -- for 15 years that it doesn't perform audits.

Meanwhile, Friehling & Horowitz has reportedly done just that for Madoff. For example, the firm's name and signature appears on the "statement of financial condition" for Madoff Securities dated Oct. 31, 2006.

New York state is one of only six states that does not require accounting firms to be peer-reviewed. Recently, the New York State senate passed legislation that requires such a process.

F&H also allegedly made false representations that BMIS financial statements were presented in conformity with GAAP. Finally, Friehling allegedly falsely stated that he had reviewed internal controls at BMIS, including controls over the custody of assets, and found no material inadequacies.

If properly stated, the Madoff financial statements, along with related disclosures regarding reserve requirements, allegedly would have shown that the firm owed tens of billions of dollars in additional liabilities to its customers and was therefore insolvent. The complaint alleges that Friehling and F&H obtained ill-gotten gains through compensation of $186,000 per year from Madoff. They are also accused of withdrawing $5.5 million from Madoff funds held in the name of Friehling and his family members (with a balance of $14 million as of November 2008).

The Old Fake Auditor Trick

Following is the story of a hedge fund that allegedly defrauded investors and eluded regulation over several years by having a non-existent auditor.

In the Westgate case, the SEC charged that James M. Nicholson and his company, Westgate Capital Management, an investment management firm based in Pearl River, N.Y., defrauded investors of millions of dollars by significantly overstating investment returns and misrepresenting the value of assets under management in 11 unregistered hedge funds.

The SEC's complaint alleges that Nicholson and Westgate solicited new investors with sales materials that claimed a nearly impossible record of investment success, including one Westgate fund that claimed positive returns in 98 of 99 consecutive months.

Nicholson also allegedly created a fictitious accounting firm and provided some of his investors with bogus audited financial statements. By late 2008, the funds had sustained such losses that Nicholson and Westgate could no longer honor redemption requests.

They allegedly hid the losses from investors with misrepresentations, false sales brochures and other deceptive devices. Nicholson closed one fund that was heavily invested in bankrupt Lehman Brothers and folded its assets into another Westgate fund.

Nicholson allegedly issued bad checks to some investors seeking to cash out, and ultimately suspended all investor redemptions due to what he called investors' "irrational behavior." Nicholson was already barred from the brokerage industry in 2001 for failing to reply or supplying false information in response to inquiries.

The SEC is prosecuting the case.

Friday, March 27, 2009

G--20 to Mess with Accounting Standards?

On April 1, the richest 20 nations in the world--the G20 nations will meet in London to deliberate on the current state of world financial affairs in an attempt to find solutions to the global financial crisis. Given the political attention to mark to market rules in the U.S. and the EU, can political demands to relax the fair value accounting rules to allow banks more lending leeway be far off?

Over the past few months, accounting for financial instruments has been controversial with opposing views circulating. Bankers and their lobbyists continue to push lawmakers to force accounting standard setters to relax the rules as to whether financial instruments in inactive or distressed markets should be recorded on balance sheets at fair value. Current rules force mark-to-market accounting in illiquid/distressed markets, even for securities that are being held to maturity. The rules also provide guidance on how to use inputs other than trading prices — including internal models in situations where no other information is available.

Bankers hate fair value and are receiving more support from U.S. and international lawmakers, who say financial instruments that are held to maturity should be allowed to be valued without reference to current market prices.

The U.S. Congress last week pressured the FASB to fast track a proposal that would provide added guidance on fair value requirements to generally give the banks what they want. The comment period for the IASB/FASB proposal ends on April 1, after being out for an unusually short 15-day period. The comment period on the IASB's proposal is 30 days.

In addition to the fair value rules, banks also want action on reserve rules. Banks are limited in what they can lend based on their asset and equity positions. Lawmakers may want to change these rules to loosen up lending practices. Banks and lawmakers blame the current credit crisis on mark to market and bank reserve rules. International rules on the current regulatory capital ratios for banks were set up in the Basel II agreement.

Different ideas exist on this:
  • IASB chairman David Tweedie has suggested using the insurance company model of catastrophic reserves, i.e. banks would establish a non-distributable reserve on the balance sheet, i.e. not on the income statement. The balance sheet asset would be clearly marked as being non-distributable so investors understood its purpose. If catastrophe hit — such as a credit crisis — the company would be allowed to tap the reserve to keep the event from decimating company earnings.
  • Other experts have suggested using what is known as dynamic provisioning, a reserve technique used by banks in Spain. In this case, reserves are increased during good times so they can be drawn down when losses pile up. Dynamic provisioning, also referred to as the "cookie jar" method, smoothes earnings when cash is released from the reserve and fed through the profit and loss statement. However, some companies have used earnings smoothing to manage and inflate earnings, as the release of reserves can be masked on financial statements.
  • A third method, involving two net income lines, has also been discussed. The concept here is to create a second line representing regulatory net income to show a company's profit minus its capital reserve. Along with separating the cash reserve from the earnings calculation, a company could use this line to calculate performance-based executive compensation. In that way, executives would not be getting rich off of inflated profit numbers.
With information from Maria Leone at CFO.com

Thursday, March 26, 2009

Arthur Levitt: FASB Caved in to Banks and Political Pressure

Arthur Levitt, former chair of the SEC doesn't like the FASB/IASB changes to mark to merket rules. Some of his comments:

The FASB's proposal goes against what we know investors prefer: Stronger rules for the reporting of changes in the values of investments in income statements. Under the proposed rule, no matter how toxic the investment, whether it's a penny stock or the bonds of a government ward such as AIG, companies can choose to largely ignore the fundamental reasons behind the investments' decline. All that companies have to do is say they don't intend to sell those investments until their value rebounds.

Such a subjective judgment is bound to decrease investor confidence in reported income.
In a strange twist of fate, the FASB's proposals may create even greater opportunities for short sellers who are adept at digging into numbers that do not tell the whole story.

The real scandal here is not the decision by the FASB, rather it is how the independence of regulators and standard-setters is being threatened. This isn't just about the income statements of banks. It's about further eroding investor confidence, precisely at a moment when investors are practically screaming for more protection.

In seeking to protect its independence, the FASB has surrendered some of it in the bargain.

Independence from public pressure has a value, and when you give some of it away, you've lost something that takes years to rebuild.
The rule change agreed to by the FASB on Tuesday followed only one public meeting on this topic, and the board is giving investors just two weeks to comment, with a final vote the next day. This is a rush job.

The FASB should rethink its approach to these rules.
Above all, the Securities and Exchange Commission should take a firm stand on the side of investors and vigorously resist all political efforts to reduce the independence of financial rule-making agencies and boards.

Investors once believed that U.S. markets were sufficiently protected from political pressure and manipulation by a system of interlocking independent agencies and rule-making bodies -- some government-run, some not. That system is being dismantled, piece by piece, by political jawboning and rushed rule rewrites. Now, investors find themselves with fewer protections and weakened.
Full article here.

Wednesday, March 25, 2009

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.

Friday, March 20, 2009

IASB and FASB Show their Cards on Leases

The IASB FASB have begun the public discussion process on lease accounting. They published a joint discussion paper setting put preliminary views for comment, today, march 20.

Leases: Preliminary Views represents preliminary views on the subject in response to concerns raised over many years by investors and other financial statement users over lease treatment in financial statements under IFRS and US GAAP.

Leasing volumes are beginning to approach a trillion dollar U.S. dollars a year. It’s likely that a majority of those lease contracts do not appear on company balance sheets. Capital leases (also called finance leases) are recorded on balance sheets. GAAP rules set out bright lines that allow lessees and lessors to arrange lease contract terms to keep leases off-balance sheet as operating leases. Operating leases only recognize payments as expenses over the lease term.

Critics of the current regime say that:

  • All leases give rise to assets and liabilities that should be recognized in financial statements. Users such as debt rating agencies and analysts adjust the reported amounts on balance sheets to roughly approximate the amount of debt that a company would have if operating leases were classified as capital leases.
  • Capital leases and operating leases can result in nearly identical transactions being accounted for very differently, reducing comparability between companies.
  • Bright lines let lessees and lessors manipulate lease terms to obtain an accounting result, rather than having the substance of the transaction drive the accounting treatment.

The discussion paper advocates a new approach to lease accounting. Lease accounting should be based on the principle that all leases give rise to liabilities for future rental payments and assets that should be recognized in an entity’s balance sheet. This approach is aimed at ensuring that leases are accounted for consistently across sectors and industries.

This is not a change that can be planned for in detail at this time, since the method of transition and effective dates are not known. Those issues will be discussed after comments are received on this discussion paper, and re-exposed.

The discussion paper Leases: Preliminary Views is open for comment until July 17, 2009 and can be found here: FASB site or IASB site.

Thursday, March 19, 2009

Got Goodwill? Part 20: More on Market Cap

Following is a good article form the Globe and Mail on how market cap and goodwill are related. The profiled company files under Canadian GAAP, which is the same as U.S. GAAP in the area of goodwill impairment calculations.

By late 2008, David Adams could tell with one glance at his books that the market had handed him a problem.

The chief financial officer at Groupe Aeroplan Inc. was carrying almost $3-billion in goodwill on the flight-reward company's balance sheet, most of it residue from its 2005 spinoff from ACE Aviation Holdings Inc. But the entire market capitalization of Aeroplan's stock, which had been close to $5-billion in early January, had tumbled to $1.3-billion by late November. According to the market, the entire company was worth less than half of the value of its goodwill alone.

Accounting rules and regulatory directives were crystal clear: The discrepancy between the market value and the goodwill was a flashing red warning signal that the goodwill was probably no longer worth what Aeroplan's books said it was. The company was compelled to run an impairment test. The result: a $1.16-billion writedown against earnings, which the company reported last month.

"It was actually pretty simple," Mr. Adams said. "The securities regulators are driving the bus on this."

Aeroplan is hardly alone: Plunging asset values, slumping earnings prospects, rising borrowing costs and a key 2002 accounting change have left an unprecedented amount of increasingly hard-to-justify goodwill on corporate balance sheets, prompting Canadian and U.S. regulators to remind companies to take a hard look at their goodwill. The result has been a wave of big-money writedowns that might still be in its early stages.

A recent report from Desjardins Securities showed that companies on the S&P/TSX composite index had a combined $168-billion of goodwill on their balance sheets at the end of the third quarter. Since then, TSX companies have announced at least $13-billion in goodwill writedowns, including charges of more than $1-billion each at Aeroplan, Nortel Networks Corp., CanWest Global Communications Corp., Great-West Lifeco Inc. and Gerdau Ameristeel Corp.

Financial executives argue that the writedowns are non-cash charges that don't reflect on a company's operations. But analysts warn that the implications may be more severe.

By definition, a goodwill writedown reflects a permanent impairment in an asset's future cash flow potential, which could imply a risk to dividends. Analysts warn that the writedown of assets may put at risk debt covenants and hurt a company's ability to raise funds, and that it also amounts to an admission by management that it overpaid to acquire assets.

"I would argue that if you're holding the stock [of a company with high exposure to goodwill], you should be concerned about it," said Peter Gibson, vice-chairman and strategist at Desjardins.

While goodwill is a fuzzy concept, in strictly balance sheet terms it represents the gap between the fair value of an asset and the price its owner paid to acquire it. When a company acquires assets at a price above their fair value, the excess is recorded as goodwill - the implication being that the asset's prospects for future growth in cash generation justify the premium paid, and thus have value in themselves.

Goodwill writedowns typically accelerate during bear markets, as companies adjust their assessment of the cash-generating potential of assets purchased during better times to reflect the new, much less rose-coloured reality. But this time around, goodwill charges are headed for unprecedented heights, because regulators changed the rules governing the accounting for goodwill since the last bear market.

Before 2002, companies were required to amortize goodwill on their books annually, so it would eventually shrink to nothing over time. In 2002, U.S. and Canadian accounting regulators decided to allow companies to carry goodwill perpetually on their balance sheets, but required them to run an annual test to determine if there were any underlying change in valuations that had undermined those goodwill estimates, known as a goodwill impairment.

If warning indicators crop up in between annual impairment tests - such as a sharp drop in market value, or a serious deterioration in business conditions - regulators have directed companies to test immediately to see if a goodwill writedown is required.

During the downturn of 2001, before the rule change, goodwill writedowns in the U.S. totalled $51-billion (U.S.). That number has already been easily eclipsed in this recession: Two companies alone - Sprint Nextel Corp. and Courier Corp. - combined for $54-billion in goodwill writedowns.

"I'm not sure there is any historical precedent, " said Karen Parsons, an accountant and business adviser at consulting firm Grant Thornton LLP in Toronto. "This is really the first test."

Compounding the rule change is the fact that during the 2002-07 bull market, companies routinely paid big premiums for acquisitions. Now, many of the growth assumptions that justified those premiums have been turned on their heads, as market values collapsed and economic prospects withered.

This has left many companies carrying goodwill on their books that hasn't been depreciating and, over the space of a few months, has rapidly become impossible to justify.

"If you made an acquisition in the past two or three years and you expected that business to keep growing, or if you paid with your own shares and they have gone down, that could indicate an impairment of goodwill," Ms. Parsons said.

Anthony Scilipoti, an analyst at Veritas Investment Research Corp., thinks resource-based companies look especially exposed to goodwill writedowns because they bought assets in the past few years based on high assumptions for future commodity prices.

Still, he said the current depressed stock prices might already have priced in the risk of goodwill writedowns.

"Very often, it is a lagging indicator," Mr. Scilipoti said. "The stock price has already gotten hit because the underlying business fundamentals have turned sour. Then you question [whether] the goodwill is impaired."

Given the already discounted values for stocks in the markets, some experts feel that companies may be better off absorbing goodwill writedowns now, cleaning up their balance sheets and better positioning themselves for the next upturn - especially since the 2002 removal of the amortization rule for goodwill may have made writedowns ultimately unavoidable.

"At some point in time, most organizations are going to be faced with a goodwill impairment," Aeroplan's Mr. Adams said. "You may as well just get it out of the way."

Canadian and U.S. securities regulators recently reminded companies that they must consider their sinking stock prices as an indicator of a potential impairment of goodwill - a directive that may be accelerating the number and size of goodwill writedowns. Much like the mark-to-market question surrounding troubled mortgage-backed securities in the banking sector, this regulatory position has sparked a debate: Is it fair?

"That's the million-dollar question," said accounting expert Karen Parsons of Grant Thornton LLP. "One viewpoint is that [the market value] is the fair value today, there's an impairment, and if you don't take it, you're not reporting appropriate information to the market.

"On the other end of the spectrum, there are people who would say this is just a very unusual circumstance, it's not an indicator of the market on the long term, and we shouldn't be putting as much emphasis on it," Ms. Parsons said.

Wayne Brownlee, chief financial officer at Potash Corp. of Saskatchewan, said one big concern for companies is that goodwill tests triggered by slumping markets may be feeding a vicious circle.

"It's a continual spiralling down or self-fulfilling prophesy on valuation," he said. "The more you write down, the more the earnings come down, and you have to go back and reassess [goodwill] every quarter. It just keeps pulling [the stock price] down and down."

Some experts, however, argue that the market's pricing of many of these stocks already reflects investors' belief that a goodwill impairment exists - that the business case for the assets has deteriorated sufficiently to have blasted a hole in assumptions about future growth.

"The investor has already decided that an impairment exists. The market is making a determination of value," said Richard Crosson, national head of the business valuation group at Ernst & Young LLP.

"You would need more persuasive reasons [to avoid taking a goodwill writedown] than simply the market is irrational."
DAVID PARKINSON from Globe and Mail March 17, 2009

Wednesday, March 18, 2009

Cutting Back on IFRS Resources - How Much is Too Much?

Good article from the blog at Controllers' Leadership Roundtable:

In response to the economic crisis and continued regulatory uncertainty surrounding IFRS, 71% of companies are slowing their implementation efforts, specifically holding off allocating staff to the project, or postponing their accounting differences diagnostics. However, companies need to ensure that these cuts do not compromise their long-term plans, and must use 2009 for low-cost, targeted assessment and preparation activities.

Waiting Game:
In the last few months, companies have been slowing-but not suspending-their IFRS implementation efforts. This is manifested in two key areas – companies have avoided ramping up their overall project teams, either by cutting back on their budgets, or by holding off allocating staff. At the same time firms are postponing accounting and IT diagnostics, or conducting them internally instead of using more costly consultants as initially planned.

Other Things on the Plate:

There are two main reasons for this slowdown:
Regulatory Uncertainty: Companies are holding back because of the uncertainty surrounding the IFRS Roadmap; including conflicting comments by senior policymakers about whether the SEC will continue ‘full speed ahead’ towards adoption, and strong dissatisfaction with having to wait until 2011 for the ‘go/no-go’ decision. This should be temporary, and will probably go away when the administration’s intentions become clearer, but as of now, companies are scared of committing to an expensive, company-wide set of changes, only to revert back because of policy shifts.

The Economic Crisis:

Companies have much more immediate spending needs than IFRS – currency exchange issues, higher pension costs, and other ‘distractions’ all crowd out increasingly scarce dollars, and are making it difficult for companies to justify spending for an IFRS transition that may not happen until 2014.

Don’t Cut Back Too Far:
While cutting back on IFRS may be an attractive option, companies need to be wary of stopping their IFRS efforts altogether. IFRS is a long term process, and even with the current uncertainty, companies must lay the groundwork in 2009 for the ongoing project in targeted, low-cost ways, including:

Conducting preliminary IFRS accounting research:

As IFRS standards are still being written, conducting highly detailed accounting diagnostics may be counterproductive at this stage. However, companies should dedicate an individual to track and evaluate IASB standards as part of their job, determine which ones are in flux, and which are stable, and use publicly-available and Roundtable resources to understand the key differences. This allows you to prioritize your future workplans.

Evaluate your organization for IFRS competency: Even if you don’t plan to form your project team yet, use 2009 to evaluate your company for people with good project management skills (including ‘big project’ experience in SOX or an ERP implementation), as well as those who have practical IFRS experience, perhaps through a foreign subsidiary. Determine whether you will be able to move these people onto your team, and determine any competency gaps that might need to be filled by outside consultants.

Start reaching out to key stakeholders:

IFRS will have a broad impact on corporate functions, and you need to start making stakeholders aware of IFRS. Start letting IT know you may need to change your General Ledger and other systems (and make sure you are in their long-term work plans), and inform legal and treasury about any debt covenants and contracts that mention US GAAP terms, and may need to be changed.

The key is not to commit to expensive changes
– the external environment may not give you that flexibility, and many of the detailed changes are unknowable at this point anyway-but to get an understanding of the specific challenges you face, so that you will be in a good position to start detailed planning when its appropriate.

IASB to Change Fair Value Rules in Lockstep with FASB?

FASB changes to fair value “mark to market” accounting rules could be adopted quickly into IFRS. The IASB agreed on Tuesday to put out documents for comment IASB was getting ready to use the FASB’s exposure document for public comment as its own fair-value rule.

Rumours are that the IASB would have issued a statement on that Tuesday, however dissent among IASB members about the FASB proposal means IASB is debating for another say today (Wednesday).

It has been reported that a majority of IASB members will vote in favor of using the FASB proposal as a basis for IFRS convergece to that standard, with a comment period of 30 days.

Insider comments on the IASB’s move included:
  • FASB is allowing companies to "ignore" the traded price of a financial instrument in favor of using internal models to value the instrument. "It's going to be the higher of price or model, that will be the measurement." "What are we going to do when the banks organize a 5000-bank comment letter that says, 'Right-on baby, our earnings will go up, and we'll have no more losses'?"
  • "So you had to change the standard because the auditors ignored it?" "What makes you think the new FASB guidance is going to help?"
  • "I would ask whether the IASB should even consider whether the FASB proposal is worthy of mention ... Should we even consider doing anything or should we ignore it?"
  • "It's not a discussion paper, it's not an exposure draft ... what is it?" "Because we don't know what it is, that's why I wouldn't do it. If I was going to do anything, it would be to write a paper about why we're not doing it."
  • "As distasteful as it is, we've got to recognize that there is a crisis on and we can't totally ignore what another standard setter is doing ... it would sound as if we were ignoring the rest of the world."
  • IASB chairman David Tweedie hopes that that the IASB will converge global and U.S. standards by releasing the FASB exposure document as an IASB document.
  • Lynn Turner, former Securities and Exchange Commission chief accountant, said: “They are taking accounting standard-setting back four decades.” “The reality is that with this proposal, FASB is really suspending fair value accounting. The bottom line is that these type of things never gets reversed.”

Tuesday, March 17, 2009

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.

Monday, March 16, 2009

Mergers and Acquisitions--the Real Thing

Sorry, my blog posts have been sporadic recently. Got busy with some real, live M&A work. See here:

Is there a viable alternative to fair-value accounting?

MANY culprits have been singled out to take the blame for the financial and economic crisis. Fair-value reporting too has been blamed for the depth of the crisis, where troubled companies claim that mark-to-market valuations are forcing them to declare declines in asset values that aren’t real, thereby worsening sentiment in jittery world markets.

Indeed, opponents of fair-value reporting argue that the information provided by fair-value financial statements can be unreliable and hence, financial decisions can be put at risk. But is there a viable alternative to fair value in this highly complex business world?

Although fair-value accounting may have gotten bad press as a result of the crisis, key producers and users of financial reports - such as chief financial officers and accountants - recognise the benefits of fair value.

In a recent survey done by CFO Research Services and ACCA, 128 CFOs stated that adopting global financial standards reporting - including mark-to-market valuations - will be good for their companies.

There are several reasons for their mindset. In this dynamic global environment where valuations can change in the blink of an eye, historical-cost financial statements may no longer be relevant because they are not able to give accurate information on current values.

Traditional accounting rules have not kept pace with sweeping reforms in regulations, customer sophistication, knowledge-based products and the evolving valuation methods of enterprises.

Value creation has also changed, and this has made reforms very necessary to the way we report, interpret and compare with a common set of acceptable standards to meet customers’ demands and protect public interest.

This is where fair value accounting - with its emphasis on mark-to-market valuations - is highly relevant. Historical-cost accounting methods may not work quite so well in measuring current values and in projecting future values.

It needs to be kept in mind that common double-entry accounting worked in systems based on transactions and are most relevant to economies based on buying and selling transactions.

Most sophisticated economies today have evolved beyond that to embrace dynamic value creation and there needs to be a means to reflect and measure this value.

For instance, intangibles including brand, patents, trademarks, intellectual property, and thought leadership towards corporate performance, has become a tremendous asset for the majority of companies, and a key element in valuations.

Most of the information metrics and reporting systems now appearing on the investment radar screen are designed to measure and report financial health, which are a challenge to their immediate users. Again, this is where the fair-value accounting framework comes in handy.

Many companies today also operate globally across many regimes and jurisdictions, thereby increasing the need for better quality disclosures and consistency in understanding and interpretation of complex financial and risk matters in order to better serve their investors and shareholders.

Delivering such quality and consistency is a key tenet of the international financial reporting standards, or IFRS, in which fair-value accounting is fundamental.

One of the biggest benefits of fair value accounting may also be that investors will have the opportunity to better manage the risk of investing in highly leveraged companies.

In other words, it enables investors to use their judgement to describe how to recognise real value.

Therefore, it can be argued that fair-value accounting best fits the bill in the demand for a robust new measurement and reporting framework that can serve the needs of business.

However, since fair-value accounting is a fairly new creature, there will be issues of interpretation and usage as it evolves.

Although the new financial reporting framework is here to stay, it will probably be tweaked to make it more relevant, user-friendly and palatable to all stakeholders in the financial value chain, as well as to critics like French President Nicholas Sarkozy who called for an overhaul of fair-value reporting as part of the solution to the current financial mess.

The International Accounting Standard Board - architect of the shift to fair-value accounting via the international financial reporting standards - has acknowledged that the global financial crisis underlined the importance and urgency of making financial reporting more transparent, comparable and clearer.

At the recent G20 summit, delegates agreed that immediate actions towards a more robust reporting and value measurement will be necessary as part of the global solutions towards addressing current financial woes.

Regardless, reforms must come with greater clarity, comparability and responsibility if the bitter lessons learnt from the current financial and economic crisis are to shape the world into a better place for everybody.

By TAY KAY LUAN at The Star Online

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.