S&P: Mark to Market Rule Changes Don’t Help Banks

Standard & Poor's says that changes made by the FASB to mark-to-market rules on valuing securities in illiquid markets and on other-than-temporary-impairment don’t change anything for banks.

S&P said that its ratings of banks won’t change, in spite of the rule changes. U.S. banks lobbied heavily in favour of the new rules.

Related comments by S&P:

• "In our view, the revised fair-value measurement standard provides more flexibility in how banks and other financial institutions will value financial assets,"
• "when market observations are substantially lacking or are meaningfully influenced by temporary supply-and-demand imbalances or market disruptions." This "should be accompanied by relevant financial statement disclosures."
• the key indicator to watch in the upcoming round of quarterly filings from large complex banks will be expansions in the valuation of level 3, or illiquid assets
• They are in favor of the increased transparency of credit losses the “other than temporary impairment losses” rules bring, but that they could result in “reliability issues related to a company’s ability to bifurcate losses into credit and noncredit components because the credit impairment amounts may be difficult to decipher in isolation.”
• Fair value measurement changes will result in increased analysis in evaluating significant adjustments companies make to observable market prices and related assumptions and judgements they apply.
• “This shift [to assets being valued using level 3] ... is a move toward greater use of internally derived measures," Determination of whether a market is active or not will be based on "the highly subjective judgement of each company."

Got Goodwill? Part 21

A few more large goodwill impairments:

HONG KONG -- Ping An Insurance (Group) Co. of China Ltd. an impairment charge of 22.79 billion yuan (US$3.33 billion) on the company's stake in Fortis NV.

First Data Corp. reported goodwill impairment charge of $3.2 billion which resulted from the decline in economic conditions which drove a change in First Data's management projections and an increase in discount rates reflected in First Data's fair value estimates.

MGM MIRAGE reported goodwill and indefinite-lived intangible asset impairment charges of $1.2 billion as a result of global economic conditions and market trends--and that these trends have continued into the first quarter of 2009.

Rite Aid goodwill impairment, store impairment and deferred tax asset write-down that totaled $2.2 billion. The goodwill impairment charge is related to the July 2007 Brooks Eckerd acquisition.

Oshkosh Corporation anticipates recording non-cash impairment charges of $1.2 - $1.5 billion for the write-down of goodwill and other indefinite-lived intangible assets in the second quarter of driven by the short-term economic environment.

MTM in Plain English

The FASB issued a “plain English” summary of its recently announced changes to mark-to-market rules. Perhaps they should consider issuing the standards in plain language as well.

The "plain language" version of the changes.

The FASB considered three proposals yesterday. Two of the proposals were related to fair value (mark-to-market) accounting, and one was associated with accounting for impaired securities, such as mortgage-backed securities.

The first proposal (on FAS 157) relates to how to figure out fair values when there is no active market or where the price inputs being used really represent distressed sales. After considering all of the feedback we received on our original proposal issued two weeks ago, the FASB yesterday reaffirmed that the objective of measuring fair value has always been and continues to be the same since FAS 157 was published. The objective is to reflect how much an asset would be sold for in an orderly transaction (as opposed to a distressed or forced transaction) at the date of the financial statements. Specifically, yesterday's vote said that companies should look at factors and use judgment to ascertain if a formerly active market has become inactive.

Once a company has made that determination, more work will be required to estimate the fair value. In trying to estimate fair value in an inactive market, the company must see if the observed prices or broker quotes obtained represent "distressed transactions". Other techniques such as a management estimate of the expected cash flows might also be appropriate in that circumstance. However, even if a company analysis is used, it must meet the objective of estimating the orderly selling price of the asset under current market conditions. Some financial institutions have made public statements that they do not expect this proposal to significantly impact their financial statements.

The second proposal relates to fair value disclosures for any financial instruments that are not currently reflected on the balance sheet of companies at fair value. The current rule is that fair values for these assets and liabilities are only disclosed once a year. The board voted yesterday that these disclosures should be required on a quarterly basis, providing qualitative and quantitative information about fair value estimates for all those financial instruments not measured on the balance sheet at fair value. For commercial banks, one financial asset impacted by this is loans, which will now have disclosures about their fair value every quarter.

The third proposal deals with other-than-temporary impairment (OTTI). The proposal would not change when a company recognizes impairment. It could change where in the financial statements the impairment is reported. Under the current rules, unless the severity and duration of a drop in fair value is too great, if a company can assert that it intends and is able to hold a security until the fair value recovers, it need not record an impairment charge on the income statement. The new proposal the board approved indicates that no impairment charge is required if there is both no current intention to sell and, it is more likely than not, that it will be required to sell prior to the fair value recovering.*

However, if management expects at the financial statement date that all of the cash flows won't be 100% collected, an impairment must be recorded in the statement of income.

In certain situations, the proposal changes the presentation of the impairment charge, splitting it up into two pieces. First, the amount of the impairment related to just the credit losses will be reflected on the income statement and will reduce net income. Second, the amount of the impairment related to all other factors will be shown in other comprehensive income in the equity section of the balance sheet. There will be a "gross" presentation of this on the income statement, one which will clearly display the total reduction in fair value below cost, the amount offsetting it that is being charged to other comprehensive income, and the net amount that is being recorded through net income.

Many balance sheet metrics used to analyze banks, such as tangible common equity, should be relatively unaffected by this proposal, though earnings, other comprehensive income and retained earnings would be impacted. The board did add significant new disclosures as part of this proposal as well.

Generally, these new proposals will be effective for the second quarter, though companies may elect to adopt them for the first quarter. However, we indicated that if a company wants to adopt the impairment proposal in the first quarter, it must also adopt the FAS 157 fair value in inactive markets proposal.

These proposals should be considered in the context of the larger ongoing joint project with the International Accounting Standards Board (IASB) to reconsider accounting for financial instruments. A proposal on this project is expected to be issued later this year.

*This sentence may be true for a HTM security but it is not true for an AFS security. For an AFS security an impairment charge is required anytime the security’s fair value is below cost since the measurement attribute for AFS securities is fair value – it just maybe that the charge would go into OCI--instead of earnings if it is determined to be not other than temporary.

Survey Says...64% Have Not Budgeted for IFRS

Deloitte published the results of a survey on the SEC's proposed IFRS roadmap, which was last November. The comment period for the roadmap ends on April 20, 2009 .

The point of the survey was to gather data and information about how companies perceive the SEC's proposed IFRS roadmap. and how companies are approaching IFRS, given current economic and regulatory uncertainty.

The survey was conducted in March 2009 on over 150 finance professionals.

Survey highlights:

• 75% supported or strongly supported a movement toward a single set of high quality accounting standards, such as IFRS.


• 62% agreed or strongly agreed that the SEC should establish a date (the so-called "date certain") for requiring U.S. companies to use IFRS.


• 56% of respondents surveyed indicated t hat the SEC should extend the option for early use of IFRS to a broader group of U.S. companies than outlined in t he current SEC roadmap. (Proposed to be limited to those among the top 10 in their industry globally as measured by market capitalization and operate in an industry where IFRS is the predominant accounting standard used among the top 10 largest listed companies worldwide in their industry.)


• 61% responded that the SEC' proposed requirement that would entail having companies maintain U.S. GAAP books on an ongoing basis until 2011, would decrease the likelihood of companies electing the option of early conversion.


• 56% of financial executives described the proposed SEC timeline to be "about right" or could be accelerated further.


• 64% of respondents stated that no budget has yet been allocated for IFRS conversion, in contrast to 25% who have budgeted for assessment and readiness, or all aspects of conversion.


• 54% of responden ts indicated some or sufficient in-house knowledge of IFRS, while 40% acknowledged no IFRS in-house knowledge or experience.

G-20 Wants Global GAAP

The Group of 20 last week committed to global accounting standards. They asked standard setters to “work urgently with supervisors and regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards.”

The group athey also called for a Financial Stability Board to have authority to review and advise financial regulators and standard-setting bodies.

Their wish list includes:

• Progress towards a single set of high-quality global accounting standards;
• Reduction in complexity of accounting standards for financial instruments;
• Clarity and consistency in the application of valuation standards internationally;
• Independent standard-setters;
• Improved accounting standards for provisioning, off-balance-sheet exposures and valuation uncertainty;
• Improves involvement of stakeholders, including regulators and emerging markets, through the IASB’s constitutional review.

New York Times: ‘Integrity’ and Standard Setting

Floyd Norris is an astute writer at the New York Times—you know something is up when the New York Times comments on accounting issues.

Commenting on the most recent changes to mark-to market accounting rules by the FASB, Norris states in his blog:

“the change came after a subcommittee of the House Financial Services Committee made clear that FASB could be destroyed if it did not knuckle under to the banking lobby.

“Arthur Levitt and Bill Donaldson, two former chairmen of the Securities and Exchange Commission, bemoaned the politicization of the board, but the current chairman of the commission, Mary Schapiro, does not appear to have resisted the political pressure. That is understandable, but not necessarily admirable.”

Barney Frank, the chairman of the U.S. Congress Financial Services Committee stated after the changes were fast-tracked through the FASB rule-changing process that : “The integrity of the standard-setting process is preserved, while avoiding the pro-cyclical effects of improper valuation practices.”

Norris questions “Just how was the “integrity of the standard-setting process” preserved by using political pressure to force the board to do something it did not want to do? And how does Mr. Frank know that markets are now producing “inaccurate asset valuations,” but that the banks that created and bought these assets know what they are really worth?

“If the disclosures the FASB will now require really provide useful information, this could be a pyrrhic victory for the banks, much as the win on stock option accounting might have been.”

“Then, as now, those putting pressure on the banks wanted to keep reported profits from being changed by something they deemed unreasonable. But the FASB, in backing down, forced disclosure of what the impact would have been if options were expensed. The information that accumulated helped make it possible for the board to eventually impose the rule it had wanted to pass in the first place.”

“Could it be that these disclosures will work in the same way, by making it clear to those who read the footnotes just how much profits are being pumped up by the banks assuming that they know the real values of assets, even though nobody will pay that price for them right now?”

“In the long run, such disclosures might make it possible for us to track just how right (or wrong) the banks were in their confidence that they knew better than the market.”

“Or maybe my innate optimism is showing, and the new disclosures will not provide much useful information at all.”

FASB vs. IASB?

The IFRS Roadmap calling for replacement of U.S. GAAP with IFRS by 2014 is coming under increased scrutiny. The change represents a huge shift in accounting rule changes for U.S. public companies.

The last six months have been controversial for both U.S. GAAP and IFRS. Political pressures have been brought against both the U.S. standards and IFRS as a result of controversy over fair value/mark to market accounting.

The specter of political issues haunting accounting essentially could pit the SEC and the FASB against with the International Accounting Standards Board (IASB). In announcing the roadmap a few months back, the SEC called for improvements to funding and governance of the IASB. In more recent statements, the SEC has criticized IFRS as inadequate.

Recently MIT and Wharton professors argued in a paper that there are reasons to slow down the change to IFRS.

The authors theorize that unique aspects of the U.S. economy and capital markets will not be well served by IFRS “the [IFRS] standard setting process involves a compromise among a large and very diverse set of constituents across the world. Different countries have different goals with respect to financial reporting regulation. While current IFRS are arguably focused on the needs of “outside investor” economies such as the U.K., Australia or the U.S., the majority of the economies around the world still relies heavily on close relationships among a large set of stakeholders and is less focused on outside capital markets. A potential risk for the U.S. and countries with similar “outside investor” models is that the IASB could be influenced to modify IFRS to meet the demands of “inside stakeholder” economies. As a result, future IFRS may be less suited for “outside investor” economies such as the U.S.”

“We expect incentives and institutional factors to remain a driving force of reporting practices in the years to come. Hence, adopting IFRS on a worldwide scale will hardly eliminate all national, industry and firm-level forces and incentives that influence firms’ financial reporting practices. Local capital markets, enforcement institutions and economic forces are simply too strong and diverse, making a uniform implementation of IFRS around the globe highly unlikely. Moreover, globally adopting IFRS likely shifts regulatory competition from the creation of accounting standards to the interpretation, implementation and enforcement of existing IFRS in local markets. These forces could lead to regional versions of IFRS or different de-facto standards. For instance, financial crises, new business practices or innovations in the capital markets can require changes or new interpretations of extant IFRS, which in turn might lead certain countries to opt out or adopt their own version of IFRS. The carve-out of specific sections in IAS 39 (Financial Instruments) during the endorsement process of IFRS by the European Commission in 2004 and 2005 is just one example of 72 such a nationalized version of IFRS, which sets an important precedent. The recent financial crisis presented the IASB with the threat of another EU carve-out.”

The paper is: "Global Accounting Convergence and the Potential Adoption of IFRS by the United States: An Analysis of Economic and Policy Factors."

Macy's Impairs $5 Billion

Macy's Inc,, the U.S. based department store chain has recorded a goodwill impairment charge of $5.4 billion in the fourth quarter. The impairment charge follows a sharp decline in the company's market capitalization.

Macy's market cap today is about $4 billion, down from about $20 billion at its peak in 2007.

Macy’s had previosuly warned of the impairment charge and said the estimate is subject to further adjustment when it completes its calculations in the first quarter of 2009.

The non-cash write-down should not affect Macy’s financing covenants and accordingly will not cause defaults in bank credit agreements or bond indentures.

Macy’s reported operating income of $1 billion but the impairment charge brings their fiscal 2008 loss to $4.4 billion.

The goodwill arose on Macys' 2005 acquisition of May Co., the economic downturn and the decline in market capitalization.

FASB Approves Fast Tracked Fair Value Changes

The FASB voted to adopt its most recently proposed changes to fair-value rules. The changes to mark-to-market accounting rules will now allow companies to use “significant judgment” when pricing certain investments in distressed or inactive markets. Analysts say the changes may reduce banks’ write-downs and goose Q1 earnings.

Congress had threatened FASB Chairman Robert Herz at a March 12 Senate hearing to change the fair-value rules or Congress would unilaterally. FASB came out with changes four days later, and fast-tracked them on a two-week comment period. Investors and accountants opposed the changes.

Arthur Levitt is chair of the Investors Working Group and commented “The group is deeply concerned about the apparent FASB succumbing to political pressures, which prevent U.S. investors from understanding the true obligations of U.S. financial institutions.”

A few reference points in the debate on fair value:
Arthur Levitt’s remarks to Congress
FASB Technical Accounting Advisory Group views on MTM
The long-running campaign by banks against fair value
Summary of the rule changes
Politics and Accounting
CFO Views on MTM
The Politics of Fair Value
A Warren Buffet Advisor’s View on MTM
Former SEC Chair Comments on Independence of Accounting Standard Setters

WSJ Says Banks Making Bogus Claims about Mark-to-Market

At times Wall Street Journal articles almost seem to be written by bank lobbyists. Below is an opinion piece that refutes the banks' claims that MTM is wrecking the banking system and the economy.

Accounting Rules Should Avoid Impairment

Plenty of banks have succumbed to the credit crunch. Now, accounting rules look set to join the list of casualties.

Accounting rule makers will vote Thursday on proposals to soften "mark-to-market" accounting, the controversial rules requiring companies to peg their investments' value to the market's ups and downs. Many banks blame the rules for worsening their current problems, by locking in losses that they say are merely temporary.

The banks' claims are largely bogus -- after all, no accounting rule forced them to create and invest in the toxic securities that helped cause this crisis. But the Financial Accounting Standards Board is being pressured to water down the rule.

And one of the proposals that the board will vote on Thursday, to relax the standards under which companies must take impairment charges on their "available-for-sale" investments, would be particularly worrying for investors.

Companies record declines in their value of these securities as "unrealized" losses that get assessed on the balance sheet but don't affect earnings or regulatory-capital levels.

If the losses are later determined to be "other than temporary," however, companies must take impairment charges that lower net income and regulatory capital.

FASB's proposal makes it much less likely that stressed banks would take those charges in a timely fashion. Under the plan, all banks would have to do is say they don't intend to sell an "available-for-sale" investment that has incurred mark-to-market losses and probably won't be forced to sell before it recovers. Then, only "credit losses," the amount a company expects to lose if it holds an investment to maturity, would have to be recognized in earnings. The other declines in market value would only go onto the balance sheet, as now.

The loophole is big enough to fit a bloated bank balance sheet through: The risk is that banks wouldn't admit to a major credit loss on such securities unless the losses really were so obvious they simply couldn't be ignored. Banks could instead try to explain away low market values because of external factors such as liquidity risk, and many losses would never get recognized on the income statement.

That could be very important for some banks where toxic securities, with serious mark-to-market losses, comprise a big part of the capital structure. The unrealized losses on "available-for-sale" securities in effect for at least a year are equivalent to 6.6% of risk-weighted capital at U.S. Bancorp and 3.2% at Wells Fargo. That is another reason why investors should focus on tangible common equity as a capital measure instead, which does include such unrealized losses.

A rule change would be good for the banks -- not good for investors who need accurate valuations of companies' assets, reported clearly, on which to base their investment decisions. In fact, making things easier on the banks may only make already-cynical investors even more suspicious of the numbers that the banks are reporting.

This is happening now because of pressure on FASB Chairman Robert Herz from politicians who, at a recent hearing, threatened to eviscerate fair-value accounting if the changes didn't happen. So it isn't just the fair-value rules that are at stake here -- it is FASB's independence in setting all accounting rules. The risk is that plans to water down mark-to-market rules are only the start.

By Michael Rapoport at the Wall Street Journal.

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.

Conclusion

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.

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.

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

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.

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.

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.

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."

THE GREAT DEBATE
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

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.”