Showing posts with label fair value. Show all posts
Showing posts with label fair value. Show all posts
Thursday, May 31, 2012
Friendly Accounting at Facebook
This post is courtesy of the Accounting Onion
U. S. Senator Carl Levin recently spoke on the Senate floor, referencing the discrepancy between tax and accounting treatment of stock options in the (then upcoming) Facebook IPO:
"According to its filings, when Facebook goes public, Mr. [Mark] Zuckerberg plans to exercise options to purchase 120 million shares of stock for 6 cents a share. Mr. Zuckerberg's shares, obviously, are going to be worth a great deal more than 6 cents, a total of about $7 million; they will apparently be worth more than 600 times as much, something in the neighborhood of $5 billion.
Here's where the tax loophole comes in. Under current law, Facebook can – perfectly legally – tell investors, the public, and regulators that the stock options he received cost the company a mere 6 cents a share – that's the expense shown on the company's books. [This is wrong – see later.] But the company can also – perfectly legally – later file a tax return claiming that those same options cost the company something close to what the shares actually sell for later on – perhaps $40 a share. And the company can take a tax deduction for that far large [sic] amount. So the books show a highly profitable company – profitable, in part, because of the relatively small expense the company shows on its books for the stock options it grants to its employees. But when it comes time to pay taxes, to pay Uncle Sam, the loophole in the tax code allows the company to take a tax deduction for a far larger expense than they show on their books. …
Now, the end result is that a profitable U.S. corporation – a success story – could end up paying no taxes at all for years, even decades."
To Levin, the Facebook IPO is a dramatic illustration of an inequitable "loophole" in the tax law. As Levin and Sherrod would have it, Facebook's tax deduction for using stock options to compensate executives – as opposed to any other form of compensation – would be essentially zero (that's probably a little dramatic on my part, but the point is the same); yet, Zuckerberg's tax liability when he exercises the options could be somewhere in the area of $3 billion.
The strong implication of Levin's narrative is that the extra amount of expenses would have wiped out every dollar of Facebook's reported net income that it had ever 'earned.' On top of that, there could be other outstanding options held by Zuckerberg and other employees extending way down the organization, which are going to have the same effect on future reported net income.
Which brings me to my second question: For all practical purposes, could Zuckerberg be taking Facebook public at this point in time with no history of profitability, perhaps negative shareholders' equity, and perhaps no hopes for earnings for some for years to come?
My inclination is to say "no," but I can only speculate. So, I will answer that question with another question: Since the FASB's rules understate the economic cost of options granted to employees, did the FASB provide a perverse incentive to Facebook to grant more options (or at terms overly favorable) to employees than it should have?
If one accepts the maxim that "what gets mismeasured gets mismanaged," then the answer to that question should be "YES." The stock option problem lies not with the tax rules that eventually recognize the full cost of the options to shareholders, but with the financial reporting rules that allowed Facebook to grant options without recording their full cost.
Surely, the senators can see that different accounting rules would have wrought different compensation policies from Facebook. Senator Levin would not have had a story to tell and Mark Zuckerberg would be a few billion dollars poorer.
Footnote: It is my distinct pleasure to provide Senator Levin (and his staff) with yet another accounting lesson. The amount of expense to be reported by Facebook is not, as the senator claims, the exercise price of the options (i.e., 6 cents per share). Assuming that the options were issued without any intrinsic value, then their "grant-date present value" (i.e., the amount upon which periodic option expense is measured) could end up being more or less than 6 cents per share. Although this technical correction to Senator Levin's story it doesn't fundamentally change the message, it once again reveals a lack of understanding that makes one question if Senator Levin has an adequate grasp on the issues.
Tuesday, September 6, 2011
Impairment Bucket List
No, it’s not a list of cool impairments that an accountant might calculate in his lifetime, if he or she had the time and luck.
Accounting standard-setters are working on a new method of categorizing impaired financial instruments.
The recent credit crisis has advanced a need for revision of the current model as large financial institutions did not agree with existing standards. Large banks, for example, claim that the existing standards result in a “pro-cyclical” result. That means that when times were good, they accounting rules made things look better, faster. And when times were bad, things looked bas faster. Or went to hell faster, as we saw in 2009/03. The rules also impact other sectors.
Credit Crisis Effects
In 2008, banks were following a system of incurred loss reporting, meaning assets were marked down, or impaired, only once their value had demonstrably fallen. Critics said this caused catastrophic shortcomings in financial early warning systems, meaning banks were unable to build up reserves for expected losses and were woefully unprepared when asset values suddenly went into freefall.
The IASB has developed a more forward-looking set of rules for calculating impairment.
“Three-Bucket Solution”
One approach, and the major one being advocated now, is called the three-bucket approach.
One pre-IFRS problem was earnings management, when banks would set aside provisions with little justification, only to release them in lean years to plump up earnings. Critics said this made it hard for investors to get a handle on banks' true financial positions; from these concerns was born incurred loss reporting.
After the credit crisis, the accounting problem was how to permit the judgment essential for expected loss provisioning without paving the way for a potential return to earnings management.
The three-bucket approach aims to break down assets according to impairments, keeping a tighter rein on provisioning and giving analysts a clearer picture of financial health.
Into bucket one goes 'healthy' assets, those for which banks expect a reasonable return and need only make minimal provisions. Bucket two is reserved for assets with some level of impairment, but which are not completely useless, while bucket three is for assets that are undeniably 'bad'.
Throughout its life, the asset can move between buckets according to macro- and micro-economic triggers, hopefully allowing banks to make exactly the right provision at exactly the right time.
An example might be a bundle of mortgages. The bank grants the mortgages, and works out on the basis of historical data that it is likely to take an 80% return on them. It therefore makes provision for the 20% loss and the mortgage bundle sits in bucket one until a trigger makes re-evaluation necessary.
This trigger could be a macro-economic event such as falling oil prices, a contracting economy or rising unemployment. From this, the bank might deduce that a greater proportion of mortgage holders will struggle to pay and shift the asset bundle into bucket two, requiring higher provisions to be made.
For the mortgages to jump to bucket three, they must be demonstrably impaired, for example when the inhabitants of a town hit by unemployment begin defaulting on their mortgages. This is essentially an incurred loss model and would result in very high or 100% provisioning for the de-valued assets.
Unfinished business
Like all theoretical models, there is much uncertainty to be hammered out. What constitutes a bucket-moving trigger? When an asset is impaired, who decides whether the impairment is expected – therefore already provided for – or unexpected, meaning more cash should be set aside? How will auditors examine such a complicated model and will it really prevent earnings management if banks are determined to do it?
A number of question exist, and will need to be ironed out prior to implementation.
Accounting standard-setters are working on a new method of categorizing impaired financial instruments.
The recent credit crisis has advanced a need for revision of the current model as large financial institutions did not agree with existing standards. Large banks, for example, claim that the existing standards result in a “pro-cyclical” result. That means that when times were good, they accounting rules made things look better, faster. And when times were bad, things looked bas faster. Or went to hell faster, as we saw in 2009/03. The rules also impact other sectors.
Credit Crisis Effects
In 2008, banks were following a system of incurred loss reporting, meaning assets were marked down, or impaired, only once their value had demonstrably fallen. Critics said this caused catastrophic shortcomings in financial early warning systems, meaning banks were unable to build up reserves for expected losses and were woefully unprepared when asset values suddenly went into freefall.
The IASB has developed a more forward-looking set of rules for calculating impairment.
“Three-Bucket Solution”
One approach, and the major one being advocated now, is called the three-bucket approach.
One pre-IFRS problem was earnings management, when banks would set aside provisions with little justification, only to release them in lean years to plump up earnings. Critics said this made it hard for investors to get a handle on banks' true financial positions; from these concerns was born incurred loss reporting.
After the credit crisis, the accounting problem was how to permit the judgment essential for expected loss provisioning without paving the way for a potential return to earnings management.
The three-bucket approach aims to break down assets according to impairments, keeping a tighter rein on provisioning and giving analysts a clearer picture of financial health.
Into bucket one goes 'healthy' assets, those for which banks expect a reasonable return and need only make minimal provisions. Bucket two is reserved for assets with some level of impairment, but which are not completely useless, while bucket three is for assets that are undeniably 'bad'.
Throughout its life, the asset can move between buckets according to macro- and micro-economic triggers, hopefully allowing banks to make exactly the right provision at exactly the right time.
An example might be a bundle of mortgages. The bank grants the mortgages, and works out on the basis of historical data that it is likely to take an 80% return on them. It therefore makes provision for the 20% loss and the mortgage bundle sits in bucket one until a trigger makes re-evaluation necessary.
This trigger could be a macro-economic event such as falling oil prices, a contracting economy or rising unemployment. From this, the bank might deduce that a greater proportion of mortgage holders will struggle to pay and shift the asset bundle into bucket two, requiring higher provisions to be made.
For the mortgages to jump to bucket three, they must be demonstrably impaired, for example when the inhabitants of a town hit by unemployment begin defaulting on their mortgages. This is essentially an incurred loss model and would result in very high or 100% provisioning for the de-valued assets.
Unfinished business
Like all theoretical models, there is much uncertainty to be hammered out. What constitutes a bucket-moving trigger? When an asset is impaired, who decides whether the impairment is expected – therefore already provided for – or unexpected, meaning more cash should be set aside? How will auditors examine such a complicated model and will it really prevent earnings management if banks are determined to do it?
A number of question exist, and will need to be ironed out prior to implementation.
Thursday, February 3, 2011
Joint Proposals Push Toward IFRS/GAAP Convergence in Issues Affecting Banks
FASB and the IASB announced moves toward convergence of IFRS and GAAP through joint proposals on offsetting transactions and impairment of financial assets.
The two main changes are 1) an exposure draft released last week on a common approach to offsetting financial assets and financial liabilities. This would end a major difference between IFRS and U.S. GAAP. 2) A supplementary document with a new impairment model for financial assets like loans managed in an open portfolio. The proposal would replace the incurred loss model with a more forward-looking expected loss model--a response to complaints in the financial crisis.
The two main changes are 1) an exposure draft released last week on a common approach to offsetting financial assets and financial liabilities. This would end a major difference between IFRS and U.S. GAAP. 2) A supplementary document with a new impairment model for financial assets like loans managed in an open portfolio. The proposal would replace the incurred loss model with a more forward-looking expected loss model--a response to complaints in the financial crisis.
The issue with offsetting is that companies can, in some instances, report IFRS balance sheet figures that are 100 percent greater than their U.S. GAAP numbers. This is confusing to the global capital markets and the proposals would eliminate the difference.
U.S. GAAP would only net in more limited circumstances, with note disclosure of other netting arrangements in footnotes.
Offsetting/netting is required when company presents in net amounts on their balance sheet. As it stands now, financial assets and financial liabilities may show up on a balance sheet as one net amount, or as two gross amounts, depending on whether the balance sheet is in IFRS or U.S. GAAP.
The above netting arrangements cause the largest difference between balance sheets using IFRS and U.S. GAAP. Derivative assets and related liabilities are the most common area where this occurs. Balance sheets of financial institutions generally have the largest derivative positions.
The new proposed rules apply only when the right of setoff is enforceable at all times, including in default and bankruptcy, and the ability to exercise this right is unconditional—i.e. offsetting only occurs after a future event. A company must intend to settle net, i.e. with a single payment, or simultaneously. If all of these requirements are met, offsetting is mandatory. This would also change industry conventions.
The Exposure Draft is Offsetting Financial Assets and Financial Liabilities [FASB Proposed Accounting Standards Update, Balance Sheet (Topic 210): Offsetting]. Comments are due April 28.
On Impairment, changes introduce an expected loss model that is more forward-looking in accounting for credit losses, and is said to better reflect the economics of lending decisions. IFRS and U.S. GAAP currently account for credit losses using an incurred loss model, which requires evidence of a loss (known as a trigger event) before loans can be written down.
“The FASB and IASB are seeking comment on the changes, i.e. whether they agree conceptually and whether the changes can be practically applied.
Some advocate that a more forward-looking approach to loan losses would have made loan provisions show up earlier than before, and may have held off or mitigated the credit crisis by giving earlier warnings about the health of financial institutions.
Comments on the document Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, are due April 1.
If you need a nap, the IASB is hosting a webcast on the impairment of financial assets proposal on Friday, Feb. 4, with sessions timed for Europe and the U.S. Also “FASB in Focus” has overviews on the new rules netting on FASB’s website and another FASB in Focus on the impairment model.
Wednesday, January 26, 2011
FASB Reversal a Major Step Toward International Convergence
The FASB has made a major compromise in the area of impairment of financial instruments. Full details will be released later, but this is a major concession to U.S. and European banks. It is also a major step toward convergence of U.S. accounting rules with IFRS and the end to what what previously called a "religious war" over fair value accounting. As well, political influence over accounting may be resolved by the compromise.
This new FASB approach is similar to the International Accounting Standards Board’s model in IFRS 9. FASB has agreed that at least some assets should qualify for cost accounting, whereas banks were forced to use a fair value model for all loans under the new rules. Existing rules forced fair value on portions of banks’ loan portfolios.
The FASB’s original proposal was opposed by the banking industry as being pro-cyclical (making problems worse as business cycles worsened). Banks say that proposed the fair value approach is a danger to the survival of marginal financial institutions that could have their capital called by bank regulators because the rules have and would continue to force banks to take large and inappropriate write-downs on temporary market declines. They also lobbied that the rules would hurt lending and unfairly reduce banks' book value. They argued that banks would not make loans if the value of the loan could be written down immediately due to temporary market fluctuations.
Supporters of the FASB fair-value proposals say it would have improved transparency and unmasked potential weaknesses at banks. Proponents of fair value accounting, including the CFA Institute, argue it is what is needed to make the financial statements of banks reflect their true financial positions and operations more clearly to investors.
FASB said that financial statement users, including preparers, auditors and others would prefer to have loans held for collection recorded on the balance sheet at amortized cost, but with a more robust impairment test.
The FASB will go back to users for input toward an impairment model for loans. The original proposal required a fully fair value-based approach that the banks have lobbied against for years. The new approach would recognize a portion of the estimated loan losses over time unless greater losses are expected in the foreseeable future, in which case that larger floor amount would be recognized currently. Some loans, including loans traded actively by banks instead of held to collect payments will be valued at market prices.
The changes are partly the result of a fierce lobbying campaign by the American Bankers’ Association and others and seen as a major victory for the banking industry. However it was not solely the banks in opposition to the proposals. The FASB reported an overwhelmingly negative reaction to its proposal from companies and investors, who wrote more than more than 2,800 comment letters.
This new FASB approach is similar to the International Accounting Standards Board’s model in IFRS 9. FASB has agreed that at least some assets should qualify for cost accounting, whereas banks were forced to use a fair value model for all loans under the new rules. Existing rules forced fair value on portions of banks’ loan portfolios.
The FASB’s original proposal was opposed by the banking industry as being pro-cyclical (making problems worse as business cycles worsened). Banks say that proposed the fair value approach is a danger to the survival of marginal financial institutions that could have their capital called by bank regulators because the rules have and would continue to force banks to take large and inappropriate write-downs on temporary market declines. They also lobbied that the rules would hurt lending and unfairly reduce banks' book value. They argued that banks would not make loans if the value of the loan could be written down immediately due to temporary market fluctuations.
Supporters of the FASB fair-value proposals say it would have improved transparency and unmasked potential weaknesses at banks. Proponents of fair value accounting, including the CFA Institute, argue it is what is needed to make the financial statements of banks reflect their true financial positions and operations more clearly to investors.
FASB said that financial statement users, including preparers, auditors and others would prefer to have loans held for collection recorded on the balance sheet at amortized cost, but with a more robust impairment test.
The FASB will go back to users for input toward an impairment model for loans. The original proposal required a fully fair value-based approach that the banks have lobbied against for years. The new approach would recognize a portion of the estimated loan losses over time unless greater losses are expected in the foreseeable future, in which case that larger floor amount would be recognized currently. Some loans, including loans traded actively by banks instead of held to collect payments will be valued at market prices.
The changes are partly the result of a fierce lobbying campaign by the American Bankers’ Association and others and seen as a major victory for the banking industry. However it was not solely the banks in opposition to the proposals. The FASB reported an overwhelmingly negative reaction to its proposal from companies and investors, who wrote more than more than 2,800 comment letters.
Monday, November 22, 2010
Fair Value Fight between FASB, IASB heats Up with Volcker Comments
The FASB vs IASB fight has heated up substantially following comments by Paul Volcker, an advisor to Barack Obama and former chairman of the US. Federal Reserve Board, and former Chairman of the Trustees of the IFRS Foundation. The FASB wants to expand the use of fair-value accounting to all financial assets, including loans and deposits. This concept is opposed byUS bankers and also somewhat by the IASB, which prefers a milder version of fair value accounting. The battle that is shaping up between opposing forces could determine how much capital banks are required to maintain, and accordingly would determine to some extent how much leverage a bank could utilize.
The FASB proposal could result in the largest U.S. banks writing down the value of their loan portfolios.
Volcker said that treatment of financial instruments has not been resolved because of political pressure. Volcker also said “When you have global corporations operating around the world, and analysts looking at them from around the world, you want one accounting standard.”
The two accounting bodies have worked diligently toward convergence of the two different sets of accounting rules for the past five years. Disagreements are most significant around fair value rules for financial instruments, including derivatives, and rules governing what companies have to consolidate on their balance sheets. Many issues are close to being resolved.
The FASB likes a version of fair value accounting that forces loans and bank deposits to be marked to market values as is already done for banks trading books. Theis would not necessarily affect earnings, since some fair-value adjustments can be recorded in other comprehensive income which goes directly to equity.
The IASB prefers an approach that allows financial assets to stay on the books at original cost if the assets are held to maturity, i.e. for the long term. The IASB says it has no plans to re- open discussion of fair-value accounting, however the FASB and the IASB may eventually move to a middle ground.
Volcker prefers the IASB approach on valuing financial instruments. “You can’t have everything at fair value,” Volcker, said--“I’m not in favor of fair valuing bank loans because we don’t know their fair value anyway. It’s not consistent with the basic business model of commercial banks.”
In a similar episode, a few months earlier, IASB bowed to European Union demands to relax its fair-value rules, letting banks move some assets to a different part of the balance sheet so they wouldn’t have to be marked to market values.
Goldman Sachs Group Inc., the most profitable U.S. securities firm, has said that banks hide losses on loans used to generate investment-banking fees. In a Sept. 1 letter to FASB, Goldman Sachs described how banks lend at below-market rates to win equity and debt-underwriting deals, a practice known as “lend to play.” Goldman Sachs executives have argued that the firm’s practice of marking assets to market value helped it prepare for the credit contraction earlier than rivals.
The FASB proposal could result in the largest U.S. banks writing down the value of their loan portfolios.
Volcker said that treatment of financial instruments has not been resolved because of political pressure. Volcker also said “When you have global corporations operating around the world, and analysts looking at them from around the world, you want one accounting standard.”
The two accounting bodies have worked diligently toward convergence of the two different sets of accounting rules for the past five years. Disagreements are most significant around fair value rules for financial instruments, including derivatives, and rules governing what companies have to consolidate on their balance sheets. Many issues are close to being resolved.
The FASB likes a version of fair value accounting that forces loans and bank deposits to be marked to market values as is already done for banks trading books. Theis would not necessarily affect earnings, since some fair-value adjustments can be recorded in other comprehensive income which goes directly to equity.
The IASB prefers an approach that allows financial assets to stay on the books at original cost if the assets are held to maturity, i.e. for the long term. The IASB says it has no plans to re- open discussion of fair-value accounting, however the FASB and the IASB may eventually move to a middle ground.
Volcker prefers the IASB approach on valuing financial instruments. “You can’t have everything at fair value,” Volcker, said--“I’m not in favor of fair valuing bank loans because we don’t know their fair value anyway. It’s not consistent with the basic business model of commercial banks.”
In a similar episode, a few months earlier, IASB bowed to European Union demands to relax its fair-value rules, letting banks move some assets to a different part of the balance sheet so they wouldn’t have to be marked to market values.
Goldman Sachs Group Inc., the most profitable U.S. securities firm, has said that banks hide losses on loans used to generate investment-banking fees. In a Sept. 1 letter to FASB, Goldman Sachs described how banks lend at below-market rates to win equity and debt-underwriting deals, a practice known as “lend to play.” Goldman Sachs executives have argued that the firm’s practice of marking assets to market value helped it prepare for the credit contraction earlier than rivals.
Tuesday, October 12, 2010
Looking for Work? Try FASB or IASB
If you are an accounant with a converged accounting skillset, perhaps there are a couple of jobs youu might be interected in. Both Robert Herz, and Sir David Tweedie, respectively the chairman of the U.A. Financial Accounting Standards Board (FASB) and the head of the International Accounting Standards Board (IASB) are due to retire shortly. Despite the departures of Sir David and Mr Herz, big accounting firms and their clients still expect convergence of standards to top the agenda of their successors.
Both men have had to deal with controversial issues in financial reporting. In particular, fair value accounting for financial assets: and liabilities is a particularly cumbersome issue. In fact, the two men and their accounting bodies have butted heads over this issue, with both business people and politicialns sticking their oars in to the dispute. Recently, the FASB has taken a more principles-based approach, calling for most measurements to be at fair value. IASB has taken a two-category approach, saying that loans and loan-like equivalents held to maturity may be marked at amortised cost, whereas frequently traded instruments should be marked to market. Comments to date are leaning more toward the IASB approach, with “Big Four” accounting firms and many companies on the IASB’s side. Conjecture is that Herz’s replacement may be a pragmatic consensus-builder rather that the principles-based stalwart that herz was.
At IASB, meanwhile, the skills of a politician or diplomat may be required as the EU politicians have in some cases refused to agree to the IASB's proposed standards.
Both men have had to deal with controversial issues in financial reporting. In particular, fair value accounting for financial assets: and liabilities is a particularly cumbersome issue. In fact, the two men and their accounting bodies have butted heads over this issue, with both business people and politicialns sticking their oars in to the dispute. Recently, the FASB has taken a more principles-based approach, calling for most measurements to be at fair value. IASB has taken a two-category approach, saying that loans and loan-like equivalents held to maturity may be marked at amortised cost, whereas frequently traded instruments should be marked to market. Comments to date are leaning more toward the IASB approach, with “Big Four” accounting firms and many companies on the IASB’s side. Conjecture is that Herz’s replacement may be a pragmatic consensus-builder rather that the principles-based stalwart that herz was.
At IASB, meanwhile, the skills of a politician or diplomat may be required as the EU politicians have in some cases refused to agree to the IASB's proposed standards.
Tuesday, August 3, 2010
FASB in Midst of "Religious War" on Fair Value
This is a posting on a blog called "Finance Director" about a n article by Mario Christodoulou, Accountancy Age, 22 Jul 2010.
Attempts to bring in fair value standard "almost like a religious war" board member claims.
A member of the US accounting standard setter has likened attempts to bring in fair value to a “religious war” in a speech with regulators this week.
Lawrence Smith, board member with the Financial Accounting Standards Board (FASB), made the comment in a panel discussion with US audit regulator, the Public Company Accounting Oversight Board, in the midst of a far ranging consultation on the accounting principle.
FASB is pushing ahead with plans to bring in a full fair value measurement model which would force banks to value their financial assets at market prices. The proposals are being fought by banks who argue the rules would add volatility to balance sheets.
Smith said he is not a "fair value zealot", but was swayed to the model when he saw the effect on deposits.
"That’s what threw me over the edge," he said.
“Some people have advised us that we shouldn’t say this, but I’ll say it – fair value, to some of us, is almost like a religious war out there and we are trying to deal with that as best we can.”
FASB is attempting to harmonise its accounting rules with international standards, despite clear differences in their approach to fair value. Whereas FASB’s proposal measures assets measured at fair value, the international model allows some loans to be valued at amortised cost.
The contentious proposals was passed by a single vote, with the five-member FASB board split 3-2.
Smith’s comment will likely widen the gap between FASB’s proposal and its international counterpart, the International Accounting Standards Board (IASB). Failure to reach agreement on the standard will undermine US attempts to adopt international rules.
The US Securities and Exchange Commission is currently investigating the impact of international accounting rules on US markets. A key part of their final decision will depend on the level of convergence between US and international accounting rules, with fair value being among the most important project on the table.
Attempts to bring in fair value standard "almost like a religious war" board member claims.
A member of the US accounting standard setter has likened attempts to bring in fair value to a “religious war” in a speech with regulators this week.
Lawrence Smith, board member with the Financial Accounting Standards Board (FASB), made the comment in a panel discussion with US audit regulator, the Public Company Accounting Oversight Board, in the midst of a far ranging consultation on the accounting principle.
FASB is pushing ahead with plans to bring in a full fair value measurement model which would force banks to value their financial assets at market prices. The proposals are being fought by banks who argue the rules would add volatility to balance sheets.
Smith said he is not a "fair value zealot", but was swayed to the model when he saw the effect on deposits.
"That’s what threw me over the edge," he said.
“Some people have advised us that we shouldn’t say this, but I’ll say it – fair value, to some of us, is almost like a religious war out there and we are trying to deal with that as best we can.”
FASB is attempting to harmonise its accounting rules with international standards, despite clear differences in their approach to fair value. Whereas FASB’s proposal measures assets measured at fair value, the international model allows some loans to be valued at amortised cost.
The contentious proposals was passed by a single vote, with the five-member FASB board split 3-2.
Smith’s comment will likely widen the gap between FASB’s proposal and its international counterpart, the International Accounting Standards Board (IASB). Failure to reach agreement on the standard will undermine US attempts to adopt international rules.
The US Securities and Exchange Commission is currently investigating the impact of international accounting rules on US markets. A key part of their final decision will depend on the level of convergence between US and international accounting rules, with fair value being among the most important project on the table.
Wednesday, May 12, 2010
"Own Credit" Liability Rules Explained
What is the own credit issue?
The accounting effect of changes in the credit risk of a financial liability is referred to “own credit”.
Changes in a financial liability’s credit risk affect the fair value of that financial liability. This means that when an entity’s creditworthiness deteriorates, the fair value of its issued debt will decrease (and vice versa). For financial liabilities measured using the fair value option, this causes a gain (or loss) to be recognized in the P&L.
Many investors find this result counter-intuitive and confusing.
This was confirmed in responses to the IASB’s June 2009 discussion paper Credit Risk in Liability Measurement and in the user questionnaire on own credit that the IASB issued as part of its outreach activities.
The IASB undertook outreach on the issue of own credit in preparation for the publication of this ED, including discussions with preparers, audit firms, regulators and investors.
What did investors tell the IASB?--Extensive input was obtained from investors, including a questionnaire to which there were more than 90 responses. Whilst there was a range of responses, in general investors confirmed that:
Income statement (P&L)
Liabilities under fair value option
100 total change in fair value
100 Profit for the year
===================
Proposed Two-Step Approach
Income statement (P&L)
Liabilities under fair value option
100 Step 1 – Total change in fair value
(10) Step 2 – Change in fair value from own credit
90 Profit for the year
===================
The accounting effect of changes in the credit risk of a financial liability is referred to “own credit”.
Changes in a financial liability’s credit risk affect the fair value of that financial liability. This means that when an entity’s creditworthiness deteriorates, the fair value of its issued debt will decrease (and vice versa). For financial liabilities measured using the fair value option, this causes a gain (or loss) to be recognized in the P&L.
Many investors find this result counter-intuitive and confusing.
This was confirmed in responses to the IASB’s June 2009 discussion paper Credit Risk in Liability Measurement and in the user questionnaire on own credit that the IASB issued as part of its outreach activities.
The IASB undertook outreach on the issue of own credit in preparation for the publication of this ED, including discussions with preparers, audit firms, regulators and investors.
What did investors tell the IASB?--Extensive input was obtained from investors, including a questionnaire to which there were more than 90 responses. Whilst there was a range of responses, in general investors confirmed that:
- P&L volatility caused by own credit does not provide useful information (except for derivatives and liabilities held for trading);
- they did not want us to develop a new measurement method; but • information on the effects of own credit can still be useful.
In response to the input received, the ED proposes a limited change that addresses the issue of own credit for financial liabilities that an entity chooses to measure at fair value by introducing a two-step approach.
The two-step approach proposed in the ED would address the P&L volatility arising from own credit as follows:
• the fair value change of liabilities under the FVO would be recognized in P&L;
• the portion of the fair value change due to own credit would be reversed out of P&L and recognized in other comprehensive income.
Income statement (P&L)
Liabilities under fair value option
100 total change in fair value
100 Profit for the year
===================
Proposed Two-Step Approach
Income statement (P&L)
Liabilities under fair value option
100 Step 1 – Total change in fair value
(10) Step 2 – Change in fair value from own credit
90 Profit for the year
===================
Statement of comprehensive income
Liabilities under fair value option
10 Step 2 – Change in fair value from own credit
===================
No other changes are proposed for financial liabilities.
The current requirements for the measurement of financial liabilities would not be changed in any other way.
Importantly, the current requirements to split structured debt into a ‘vanilla’ instrument measured at amortized cost and a derivative component measured at fair value (bifurcation) would remain. As a result, those who prefer to bifurcate financial liabilities when relevant could continue to do so.
P&L volatility will no longer result from changes in own credit while information on own credit will still be available for investors.
IASB Restricts Gains form "Own Credit" Changes
Previous posts in this blog have noted that current accounting rules on financial instruments have a counter-intuitive result when a company’s credit rating is lowered. In theory, any liability should be recorded on a company’s books at the amount that is reasonably expected to be paid. If the liability is to be paid over the long-term, it should be discounted. The amount od a discounted liability on a company’s balance sheet would vary as the discount rate change. The discount rate reflects the risls associated with the liability, and as the risks increase, so does the discount rate. A higher discount rate means a lower liability. The company then reduces the liability (debit to liability) and to balance the books, requires a credit entry, which results in a gain to a company’s income statement. And that I show the counterintuitive result occurs—a drop in a company’s credit rating means a gain in earnings.
The liability treatment follows asset treatment—for example if a company thought that a debt was uncollectible, it would write the debt down to what it thought it would recover. So that the principle of fair value is maintained across the balance sheet, the same theory applies to liabilities.
The International Accounting Standards Board (IASB) has proposed changing the way banks measure their liabilities so they can no longer book the gain noted above and confuse investors after a ratings downgrade.
The IASB acknowledged that there are theoretical arguments for treating financial assets and liabilities in the same way, it is hard to defend the accounting as providing useful information when a company suffering deterioration in credit quality is able to book a corresponding gain.
The "counter intuitive" rule angered policymakers during the financial crisis when profits were being booked by banks despite ratings downgrades"
The proposal is part of an overall revamp of the IASB's fair value or marking to market rule which will be finalized by the end of this year but it is unclear when it comes into force.
HSBC Europe's biggest bank, recently reported that It had both a $5 billion hit from bad debts on U.S. home loans and asset writedowns while at the same time recording a fair value gain of $2.7 billion on its own debt during the period due to a widening in credit spreads.
Earlier in May, UBS recorded a gain of 2.1 billion Swiss francs ($2 billion) due to the widening of its own credit spread.
The debate about whether banks should allow for fair value gains on liabilities is not new, but has assumed fresh importance after a hugely volatile first quarter in credit markets, which saw bank debt trading at a discount in some cases to non-financial bonds.
Some analysts argue that if banks are taking mark-to-market losses on their assets and on hedging instruments, they should also be allowed to account for gains on their liabilities even if the underlying credit quality has not changed.
One of the practical problems with the theoretical approach noted above , however, is that a bank is unlikely to repay the debt early. A bank would usually wait until the debt matures and then buy it back at par.
The liability treatment follows asset treatment—for example if a company thought that a debt was uncollectible, it would write the debt down to what it thought it would recover. So that the principle of fair value is maintained across the balance sheet, the same theory applies to liabilities.
The International Accounting Standards Board (IASB) has proposed changing the way banks measure their liabilities so they can no longer book the gain noted above and confuse investors after a ratings downgrade.
The IASB acknowledged that there are theoretical arguments for treating financial assets and liabilities in the same way, it is hard to defend the accounting as providing useful information when a company suffering deterioration in credit quality is able to book a corresponding gain.
The "counter intuitive" rule angered policymakers during the financial crisis when profits were being booked by banks despite ratings downgrades"
The proposal is part of an overall revamp of the IASB's fair value or marking to market rule which will be finalized by the end of this year but it is unclear when it comes into force.
HSBC Europe's biggest bank, recently reported that It had both a $5 billion hit from bad debts on U.S. home loans and asset writedowns while at the same time recording a fair value gain of $2.7 billion on its own debt during the period due to a widening in credit spreads.
Earlier in May, UBS recorded a gain of 2.1 billion Swiss francs ($2 billion) due to the widening of its own credit spread.
The debate about whether banks should allow for fair value gains on liabilities is not new, but has assumed fresh importance after a hugely volatile first quarter in credit markets, which saw bank debt trading at a discount in some cases to non-financial bonds.
Some analysts argue that if banks are taking mark-to-market losses on their assets and on hedging instruments, they should also be allowed to account for gains on their liabilities even if the underlying credit quality has not changed.
One of the practical problems with the theoretical approach noted above , however, is that a bank is unlikely to repay the debt early. A bank would usually wait until the debt matures and then buy it back at par.
Monday, April 5, 2010
New Thoughts on Goodwill Impairment Testing
New thoughts on goodwill impairment testing by Marie Leone of CFO.com
Over two-thirds (68%) of U.S. public companies in the United States wrote down goodwill by taking impairment charges in 2008. Total charges were $260 billion according to a report issued by financial advisory firm Duff & Phelps and the Financial Executives Research Foundation. The report examined 2008 financial statements of nearly 6,000 publicly held companies.
As 2009 results are being filed it appears that goodwill write-downs have declined., says Greg Franceschi, who heads up the global financial reporting practice for Duff & Phelps. Since the worst of the financial crisis ended, company market values have increased and accordingly there are fewer goodwill write-offs.
However a new accounting wrinkle has surfaced related to goodwill impairments. At issue is whether companies should determine the fair value of a reporting unit — and thereby the value of the related goodwill — based on either the unit's equity value or its enterprise value. (In general, enterprise value is the sum of the fair value of debt and equity.)
The question was sparked by a December speech given by Evan Sussholz, an accounting fellow in the Office of the Chief Accountant at the Securities and Exchange Commission. In his speech, Sussholz suggested that in certain situations, using an enterprise-value measurement may provide a more economically accurate picture of the reporting unit. His suggestion left preparers and auditors clamoring for a clarification, as companies have historically applied the equity-value approach to impairment testing, says PricewaterhouseCoopers partner Larry Dodyk.
In response, the Financial Accounting Standards Board and the American Institute of Certified Public Accountants have launched efforts to figure out whether additional guidance on the subject is needed. FASB's emerging issues task force is slated to start discussing potential guidance during the second half of the year, while the AICPA is currently working on completing a practice aid, which is a sort of unofficial manual that discusses best practices and concepts that auditors and preparers may want to apply.
Under U.S. GAAP, companies must perform a goodwill impairment test at least once a year to determine if the current value of an acquired reporting unit is worth more or less than its original price. The test is a two-step process in which the company must first compare the fair value of a reporting unit with its original price — the amount the company carries on its books. If the book value exceeds the fair value, then the asset is impaired and a second step is required to measure the amount of the impairment. If the book value is lower than the unit's fair value, then the asset passes the test and nothing more is required.
The confusion over whether to use equity value or enterprise value stems from the seemingly straightforward first step of the test, because the accounting rule is unclear. Sussholz said that originally, the SEC didn't believe the selection of one approach over the other would affect the test outcome. However, since taking a closer look at the practical implications, SEC staffers have acknowledged one unanticipated situation that is a potential problem: when the book value of a reporting unit measured at the equity level is negative.
Intuitively, it might seem that a negative book value would mean a reporting unit is on the verge of bankruptcy, but that may not be the case. Dodyk explains that a single reporting-unit company, for example, may have negative shareholders' equity as a result of unrecognized assets (such as intangibles) that have significant value but don't figure into the equity equation. Heavy borrowing for a leveraged buyout could also send shareholders' equity into negative territory.
Consider what happens in an equity-value impairment test when a reporting unit's book value is negative. By definition, the fair value of common equity cannot be less than zero, because the equity is essentially a call on the company's operations. That means the fair value of a reporting unit measured at the equity level would always be greater than a negative book value, and therefore always pass step one of the impairment test. That would be the case even if significant goodwill exists and the underlying operations of the reporting unit "may be deteriorating," asserted Sussholz.
On the other hand, says Franceschi, testing for impairment at the enterprise level would include the reporting unit's debt burden, providing what Sussholz claimed was a more accurate picture of the company's financial health. To be sure, his speech opened up the possibility that another testing approach may be permitted or required.
Franceschi doesn't believe the additional guidance will cause a significant increase or decrease in goodwill write-offs. But it may require companies to rethink valuation models and approaches, especially if the guidance recommends that companies use more judgment when determining a reporting unit's fair value. "For valuation issues, you can never have something that says, 'This is the way to do it, and the only way to do it,'" he says. "There may be multiple approaches one needs to consider."
Another concern with tinkering with Topic 350 is that it may spark other changes. "Once you open the rules to the goodwill impairment test, you never know where it is going to go," says Dodyk.
Over two-thirds (68%) of U.S. public companies in the United States wrote down goodwill by taking impairment charges in 2008. Total charges were $260 billion according to a report issued by financial advisory firm Duff & Phelps and the Financial Executives Research Foundation. The report examined 2008 financial statements of nearly 6,000 publicly held companies.
As 2009 results are being filed it appears that goodwill write-downs have declined., says Greg Franceschi, who heads up the global financial reporting practice for Duff & Phelps. Since the worst of the financial crisis ended, company market values have increased and accordingly there are fewer goodwill write-offs.
However a new accounting wrinkle has surfaced related to goodwill impairments. At issue is whether companies should determine the fair value of a reporting unit — and thereby the value of the related goodwill — based on either the unit's equity value or its enterprise value. (In general, enterprise value is the sum of the fair value of debt and equity.)
The question was sparked by a December speech given by Evan Sussholz, an accounting fellow in the Office of the Chief Accountant at the Securities and Exchange Commission. In his speech, Sussholz suggested that in certain situations, using an enterprise-value measurement may provide a more economically accurate picture of the reporting unit. His suggestion left preparers and auditors clamoring for a clarification, as companies have historically applied the equity-value approach to impairment testing, says PricewaterhouseCoopers partner Larry Dodyk.
In response, the Financial Accounting Standards Board and the American Institute of Certified Public Accountants have launched efforts to figure out whether additional guidance on the subject is needed. FASB's emerging issues task force is slated to start discussing potential guidance during the second half of the year, while the AICPA is currently working on completing a practice aid, which is a sort of unofficial manual that discusses best practices and concepts that auditors and preparers may want to apply.
Under U.S. GAAP, companies must perform a goodwill impairment test at least once a year to determine if the current value of an acquired reporting unit is worth more or less than its original price. The test is a two-step process in which the company must first compare the fair value of a reporting unit with its original price — the amount the company carries on its books. If the book value exceeds the fair value, then the asset is impaired and a second step is required to measure the amount of the impairment. If the book value is lower than the unit's fair value, then the asset passes the test and nothing more is required.
The confusion over whether to use equity value or enterprise value stems from the seemingly straightforward first step of the test, because the accounting rule is unclear. Sussholz said that originally, the SEC didn't believe the selection of one approach over the other would affect the test outcome. However, since taking a closer look at the practical implications, SEC staffers have acknowledged one unanticipated situation that is a potential problem: when the book value of a reporting unit measured at the equity level is negative.
Intuitively, it might seem that a negative book value would mean a reporting unit is on the verge of bankruptcy, but that may not be the case. Dodyk explains that a single reporting-unit company, for example, may have negative shareholders' equity as a result of unrecognized assets (such as intangibles) that have significant value but don't figure into the equity equation. Heavy borrowing for a leveraged buyout could also send shareholders' equity into negative territory.
Consider what happens in an equity-value impairment test when a reporting unit's book value is negative. By definition, the fair value of common equity cannot be less than zero, because the equity is essentially a call on the company's operations. That means the fair value of a reporting unit measured at the equity level would always be greater than a negative book value, and therefore always pass step one of the impairment test. That would be the case even if significant goodwill exists and the underlying operations of the reporting unit "may be deteriorating," asserted Sussholz.
On the other hand, says Franceschi, testing for impairment at the enterprise level would include the reporting unit's debt burden, providing what Sussholz claimed was a more accurate picture of the company's financial health. To be sure, his speech opened up the possibility that another testing approach may be permitted or required.
Franceschi doesn't believe the additional guidance will cause a significant increase or decrease in goodwill write-offs. But it may require companies to rethink valuation models and approaches, especially if the guidance recommends that companies use more judgment when determining a reporting unit's fair value. "For valuation issues, you can never have something that says, 'This is the way to do it, and the only way to do it,'" he says. "There may be multiple approaches one needs to consider."
Another concern with tinkering with Topic 350 is that it may spark other changes. "Once you open the rules to the goodwill impairment test, you never know where it is going to go," says Dodyk.
Monday, February 22, 2010
FASB, IASB Fair Value Progress
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) tentatively decided this week on revisions to fair value accounting standards, particularly concerning nonfinancial assets.
Highest and best use of nonfinancial assets
The Boards tentatively decided:
Highest and best use of nonfinancial assets
The Boards tentatively decided:
- That a fair value measurement of a nonfinancial asset considers its highest and best use by market participants
- To describe the meaning of physically possible, legally permissible, and financially feasible.
Incremental value
The Boards tentatively decided:
- Not to require entities to separate the fair value of an asset group into two components when an entity uses an asset in a way that differs from its highest and best use
- To require entities to disclose information about when they use an asset in a way that differs from its highest and best use (and that asset is recognized at fair value based on its highest and best use).
Valuation premise for nonfinancial assets
The Boards tentatively decided:
- That the objective of a fair value measurement of an individual asset is to determine the price for a sale of that asset alone, not for a sale of that asset as part of a group of assets or business. However, when the highest and best use of an asset is to be used as part of a group of assets, the fair value measurement of that asset presumes that the sale is to a market participant that has, or can obtain, the “complementary assets” and “complementary liabilities.” Complementary liabilities include working capital but do not include financing liabilities.
- To describe the objective of the valuation premise without using the terms in-use and in-exchange because those terms are often misunderstood.
Measuring the fair value of financial instruments
The Boards tentatively decided:
- That the concepts of highest and best use and of valuation premise are relevant only for nonfinancial assets and are not relevant for financial assets or for liabilities
- To describe valuation adjustments that entities might need to make when using a valuation technique because market participants would make those adjustments when pricing a financial asset or financial liability under the market conditions at the measurement date. These valuation adjustments were described in the IASB’s Expert Advisory Panel report, Measuring and Disclosing the Fair Value of Financial Instruments in Markets That Are No Longer Active.
The Boards will discuss at a future meeting whether the fair value of financial instruments within a portfolio should consider offsetting risk positions, including credit risk and market risk.
Premiums and discounts in a fair value measurement
The Boards tentatively decided:
- To clarify what a blockage factor is and to describe how it is different from other types of adjustments, such as a lack of marketability discount, for an individual instrument
- To prohibit the application of a blockage factor at any level of the fair value hierarchy
- To specify that a fair value measurement in Levels 2 and 3 of the fair value hierarchy considers other premiums and discounts that market participants would consider in pricing an asset or liability at the unit of account specified in the relevant standard (except for a blockage factor).
Friday, January 22, 2010
FASB, IASB Agree on Something!
The Financial Accounting Standards Board and the International Accounting Standards Board finally agreed on something after a number of public differences of opinion over the last year. They have agreed to define fair value as an exit price, as a result of a recent joint meeting.
Both the FASB and the IASB have been controversial recently as they have come under pressure to revise fair value and “mark to market” standards to give financial institutions more flexibility in valuing assets that became difficult to trade during the crisis.
The two boards have decided to meet on a monthly basis, to resolve outstanding issues in areas such as fair value, revenue recognition, leases and consolidation.
The agreed-upon definition provides that when markets become less active, the two boards tentatively decided that an entity should consider observable transaction prices unless there is evidence that the transaction is not orderly. If an entity does not have enough information to determine whether the transaction is orderly, it should perform further analysis to measure the fair value.
The boards also decided (tentatively):
- that a transaction price might not represent the fair value of an asset or liability at initial recognition if, for example, the transaction is between related parties, the transaction takes place under duress or the seller is forced to accept the price in the transaction, the unit of account represented by the transaction is different from the unit of account for the asset or liability measured at fair value, or the market in which the transaction takes place is different from the market in which the entity would sell the asset or transfer the liability.
- to confirm that a fair value measurement is market based and reflects the assumptions that market participants would use in pricing the asset or liability. Market participants should be assumed to have a reasonable understanding about the asset or liability and the transaction based on all the available information, including information that might be obtained through due diligence efforts that are usual and customary. A price in a related-party transaction may be used as an input to a fair value measurement if the transaction was entered into at market terms.
Wednesday, December 9, 2009
FASB Chairman: Fair Value Not Cause of Crisis; Separate Banking Regulation from Accounting
Journal of Accountancy is monitoring the AICPA SEC PCAOB conference this week.
They report here on a speech by FASB Chairman Robert Herz on Tuesday that addressed head on criticism of the role of accounting standards in the financial crisis and called for GAAP to be “decoupled” from bank regulation.
Herz, speaking at an AICPA conference, contended that many of FASB’s critics simply do not understand its mission. “There seems to be some confusion in the media and elsewhere about the relationship between the accounting standards we set and regulation of financial institutions,” said Herz. He explained that FASB does not determine the capital levels banks are required to maintain, but under laws enacted in the wake of the savings and loan crisis, bank regulators determine regulatory capital caccstarting with GAAP numbers. But bank regulators can adjust the GAAP figures, and they also have other tools to address capital adequacy, liquidity issues, and concentrations of risk at regulated institutions, Herz said.
He said that while FASB has a deep interest in the strength and stability of the financial system and the economy, its public policy mission and focus is designed to be different from that of banking regulators. “Our focus as accounting standard setters is on the communication of relevant, reliable, transparent, timely, and unbiased financial information on corporate performance and financial condition to investors and the capital markets,” he said. “The transparency provided by external financial reports contributes to financial stability by reducing the level of uncertainty in the system—and a lack of transparency can hide the extent of risks facing financial institutions from both investors and regulators.”
The mandate of the Federal Reserve and other banking regulators, according to Herz, differs in that it relates to ensuring the soundness of banks and the overall stability of the financial system. He says most of the time FASB and banking regulators can find common ground, but in some situations they’re actually in conflict. “In dire situations, bank regulators may be appropriately concerned that public release of data on severe losses and asset impairments could spark a run on a bank,” said Herz. “But investors would likely want to know the extent of the problems on a timely basis.”
The answer to this problem, according to Herz, is to “decouple” bank regulation from U.S. GAAP reporting requirements. “Doing so could enhance the ability of both the FASB and the regulators to fulfill our critical mandates,” he said.
And Herz, citing a 1991 GAO report following the S&L crisis, seemed to indicate that he believes that although GAAP and specifically much-criticized fair-value accounting did not cause the financial crisis, a GAAP unencumbered by pressure from banking interests would have done a better job of alerting investors and other stakeholders of an impending crisis. “The [1991] GAO report found that regulatory call reports significantly overstated the values of loans and debt securities (and hence the financial condition and capital) of failed banks,” he said.
He pointed out that the stress tests banking regulators recently conducted of the 19 major U.S. bank holding companies also found that the bulk of the $600 billion of potential additional losses revealed under the more adverse scenario related to loans and other receivables carried on a historical cost basis such as that used in the 1980s and not to items carried on a mark-to-market or fair value basis. In other words, fair value accounting, which is currently applied to only some financial assets, has done a better job of indicating the true financial condition of those assets than the cost basis.
Addressing another criticism of fair-value accounting, Herz admitted that reporting fair values can have procyclical effects on behavior. But he contends that “timely recognition of problems at financial institutions can have countercyclical effects through lessening the impact of financial downturns by providing an early warning of developing problems.”
This year both FASB and the IASB, under pressure from political influences, have struggled to agree on changes to accounting for financial instruments, which involves the fair value applications that have been most widely criticized. Herz provided assurances that FASB and the IASB would continue to work together on these issues, while acknowledging that the two boards have recently had differences in approach and timing. “Next year, once we have received comments and other input on our proposal, we will redeliberate at public board meetings all the key issues identified including discussing them with the IASB and making changes as appropriate,” he said. “Only after having completed this very extensive and thorough public due process will we issue a final standard carefully considering effective dates and transition.”
Original Journal of Accountancy article by Matthew G. Lamoreaux
They report here on a speech by FASB Chairman Robert Herz on Tuesday that addressed head on criticism of the role of accounting standards in the financial crisis and called for GAAP to be “decoupled” from bank regulation.
Herz, speaking at an AICPA conference, contended that many of FASB’s critics simply do not understand its mission. “There seems to be some confusion in the media and elsewhere about the relationship between the accounting standards we set and regulation of financial institutions,” said Herz. He explained that FASB does not determine the capital levels banks are required to maintain, but under laws enacted in the wake of the savings and loan crisis, bank regulators determine regulatory capital caccstarting with GAAP numbers. But bank regulators can adjust the GAAP figures, and they also have other tools to address capital adequacy, liquidity issues, and concentrations of risk at regulated institutions, Herz said.
He said that while FASB has a deep interest in the strength and stability of the financial system and the economy, its public policy mission and focus is designed to be different from that of banking regulators. “Our focus as accounting standard setters is on the communication of relevant, reliable, transparent, timely, and unbiased financial information on corporate performance and financial condition to investors and the capital markets,” he said. “The transparency provided by external financial reports contributes to financial stability by reducing the level of uncertainty in the system—and a lack of transparency can hide the extent of risks facing financial institutions from both investors and regulators.”
The mandate of the Federal Reserve and other banking regulators, according to Herz, differs in that it relates to ensuring the soundness of banks and the overall stability of the financial system. He says most of the time FASB and banking regulators can find common ground, but in some situations they’re actually in conflict. “In dire situations, bank regulators may be appropriately concerned that public release of data on severe losses and asset impairments could spark a run on a bank,” said Herz. “But investors would likely want to know the extent of the problems on a timely basis.”
The answer to this problem, according to Herz, is to “decouple” bank regulation from U.S. GAAP reporting requirements. “Doing so could enhance the ability of both the FASB and the regulators to fulfill our critical mandates,” he said.
And Herz, citing a 1991 GAO report following the S&L crisis, seemed to indicate that he believes that although GAAP and specifically much-criticized fair-value accounting did not cause the financial crisis, a GAAP unencumbered by pressure from banking interests would have done a better job of alerting investors and other stakeholders of an impending crisis. “The [1991] GAO report found that regulatory call reports significantly overstated the values of loans and debt securities (and hence the financial condition and capital) of failed banks,” he said.
He pointed out that the stress tests banking regulators recently conducted of the 19 major U.S. bank holding companies also found that the bulk of the $600 billion of potential additional losses revealed under the more adverse scenario related to loans and other receivables carried on a historical cost basis such as that used in the 1980s and not to items carried on a mark-to-market or fair value basis. In other words, fair value accounting, which is currently applied to only some financial assets, has done a better job of indicating the true financial condition of those assets than the cost basis.
Addressing another criticism of fair-value accounting, Herz admitted that reporting fair values can have procyclical effects on behavior. But he contends that “timely recognition of problems at financial institutions can have countercyclical effects through lessening the impact of financial downturns by providing an early warning of developing problems.”
This year both FASB and the IASB, under pressure from political influences, have struggled to agree on changes to accounting for financial instruments, which involves the fair value applications that have been most widely criticized. Herz provided assurances that FASB and the IASB would continue to work together on these issues, while acknowledging that the two boards have recently had differences in approach and timing. “Next year, once we have received comments and other input on our proposal, we will redeliberate at public board meetings all the key issues identified including discussing them with the IASB and making changes as appropriate,” he said. “Only after having completed this very extensive and thorough public due process will we issue a final standard carefully considering effective dates and transition.”
Original Journal of Accountancy article by Matthew G. Lamoreaux
Friday, November 13, 2009
IASB Issues New Standard on Financial Instruments
The International Accounting Standards Board (IASB) issued today a new International Financial Reporting Standard (IFRS) on the classification and measurement of financial assets.
Publication of the IFRS represents the completion of the first part of a three-part project to replace IAS 39 Financial Instruments: Recognition and Measurement with a new standard—IFRS 9 Financial Instruments.
The second part, the impairment methodology for financial assets has been exposed for public comment, and proposals on the third part, on hedge accounting, continue to be developed.
The new standard enhances the ability of investors and other users of financial information to understand the accounting of financial assets and reduces complexity – an objective endorsed by the Group of 20 leaders (G20) and other stakeholders internationally.
IFRS 9 uses a single approach to determine whether a financial asset is measured at amortised cost or fair value, replacing the many different rules in IAS 39. The approach in IFRS 9 is based on how an entity manages its financial instruments (its business model) and the contractual cash flow characteristics of the financial assets.
The new standard also requires a single impairment method to be used, replacing the many different impairment methods in IAS 39. Thus IFRS 9 improves comparability and makes financial statements easier to understand for investors and other users.
The effective date for mandatory adoption of IFRS 9 Financial Instruments is 1 January 2013. Consistent with requests by the G20 leaders and others, early adoption is permitted for 2009 year-end financial statements.
To read the standard, interested parties wilI need to purchase it hard copy from the IASB or subscribe to eIFRSs at www.iasb.org.
Publication of the IFRS represents the completion of the first part of a three-part project to replace IAS 39 Financial Instruments: Recognition and Measurement with a new standard—IFRS 9 Financial Instruments.
The second part, the impairment methodology for financial assets has been exposed for public comment, and proposals on the third part, on hedge accounting, continue to be developed.
The new standard enhances the ability of investors and other users of financial information to understand the accounting of financial assets and reduces complexity – an objective endorsed by the Group of 20 leaders (G20) and other stakeholders internationally.
IFRS 9 uses a single approach to determine whether a financial asset is measured at amortised cost or fair value, replacing the many different rules in IAS 39. The approach in IFRS 9 is based on how an entity manages its financial instruments (its business model) and the contractual cash flow characteristics of the financial assets.
The new standard also requires a single impairment method to be used, replacing the many different impairment methods in IAS 39. Thus IFRS 9 improves comparability and makes financial statements easier to understand for investors and other users.
The effective date for mandatory adoption of IFRS 9 Financial Instruments is 1 January 2013. Consistent with requests by the G20 leaders and others, early adoption is permitted for 2009 year-end financial statements.
To read the standard, interested parties wilI need to purchase it hard copy from the IASB or subscribe to eIFRSs at www.iasb.org.
Tuesday, November 10, 2009
Accounting Rules Mess Up Lending Market
New accounting rules on securitizations have messed up the market for bonds backed by credit-card debt.
No new credit card securities have been issued since the beginning of October. Such securities are created when card loans are packaged into bonds and sold to investors.
The new rules (FAS 166 and 167) require banks issuing the securities to account for them as if they were on their balance sheets. Previous treatment allowed off-balance sheet treatment for the securities.
On-balance sheet treatment gives federal regulators the right to claim those assets should the institution file for bankruptcy, effectively diminishing bondholders' claim to the assets.
On-balance sheet treatment also may increase banks’ capital requirements.
The Federal Deposit Insurance Corp. plans to discuss the issue at a board meeting Thursday and may make a ruling that clears up the confusion. The rule takes effect on the date companies begin their 2010 fiscal years.
From the start of the year until October, issuers had sold an average of about $3.5 billion worth of credit-card deals each month.
Under the old accounting standard, card issuers -- such as Citigroup, Bank of America, American Express, Capital One, J.P. Morgan Chase, and Discover packaged up pools of credit-card loans and sold them to investors.
Citigroup' said on Friday that the result should be an addition of about $154 billion to its assets, based on Sept. 30 figures.
If the Federal Deposit Insurance Corp does not change the rules regarding how it treats debt from these securities when a bank collapses, rating agencies may downgrade the securitized debt. The debt may not be rated triple-A securities.
The new debt could potentially be rated no higher than Citigroup's own ratings. That would likely lift the bank's borrowing costs when funding new credit card loans or other debt.
Until the accounting rule was changed, these securities didn't have to be included on the banks' balance sheets, so they weren't subject to the same accounting standards and disclosures required for on-balance-sheet items.
Critics of the old treatment argued this rule allowed companies to hide risky assets in these off-balance-sheet items. The new rule will force card issuers to bring off-the-book credit-card loans onto their balance sheets and set aside additional reserves to account for potential losses in these securities.
No new credit-card-backed bonds have emerged in the market since Bank of America issued a $300 million deal on Oct. 2.
Year-to-date issuance of securities made up of credit-card loans has fallen 41% to $32.3 billion from $55.2 billion a year ago, according to a Deutsche Bank note published Nov. 5.
The FDIC could issue guidelines Thursday on the accounting-rule change, which will include the grandfathering of existing credit-card securities so as to minimize the disruption caused to the issuance of such deals.
No new credit card securities have been issued since the beginning of October. Such securities are created when card loans are packaged into bonds and sold to investors.
The new rules (FAS 166 and 167) require banks issuing the securities to account for them as if they were on their balance sheets. Previous treatment allowed off-balance sheet treatment for the securities.
On-balance sheet treatment gives federal regulators the right to claim those assets should the institution file for bankruptcy, effectively diminishing bondholders' claim to the assets.
On-balance sheet treatment also may increase banks’ capital requirements.
The Federal Deposit Insurance Corp. plans to discuss the issue at a board meeting Thursday and may make a ruling that clears up the confusion. The rule takes effect on the date companies begin their 2010 fiscal years.
From the start of the year until October, issuers had sold an average of about $3.5 billion worth of credit-card deals each month.
Under the old accounting standard, card issuers -- such as Citigroup, Bank of America, American Express, Capital One, J.P. Morgan Chase, and Discover packaged up pools of credit-card loans and sold them to investors.
Citigroup' said on Friday that the result should be an addition of about $154 billion to its assets, based on Sept. 30 figures.
If the Federal Deposit Insurance Corp does not change the rules regarding how it treats debt from these securities when a bank collapses, rating agencies may downgrade the securitized debt. The debt may not be rated triple-A securities.
The new debt could potentially be rated no higher than Citigroup's own ratings. That would likely lift the bank's borrowing costs when funding new credit card loans or other debt.
Until the accounting rule was changed, these securities didn't have to be included on the banks' balance sheets, so they weren't subject to the same accounting standards and disclosures required for on-balance-sheet items.
Critics of the old treatment argued this rule allowed companies to hide risky assets in these off-balance-sheet items. The new rule will force card issuers to bring off-the-book credit-card loans onto their balance sheets and set aside additional reserves to account for potential losses in these securities.
No new credit-card-backed bonds have emerged in the market since Bank of America issued a $300 million deal on Oct. 2.
Year-to-date issuance of securities made up of credit-card loans has fallen 41% to $32.3 billion from $55.2 billion a year ago, according to a Deutsche Bank note published Nov. 5.
The FDIC could issue guidelines Thursday on the accounting-rule change, which will include the grandfathering of existing credit-card securities so as to minimize the disruption caused to the issuance of such deals.
Wednesday, October 21, 2009
New IFRS Fair Value Standard will be released In November
International Accounting Standards Board chairman, Sir David Tweedie, said thath the IASB will release a new fair value accounting rule by November.
In an address to a meeting of European Finance Ministers, which have in the past been critical of the IASB’s response to the financial crisis, Tweedie has sought to ease concerns by announcing that he is on track to deliver a new fair value standard by the end of this year.
“I gave a commitment to deliver on this timetable. We will publish the new standard in November,” he said.
Fair value accounting came under fire from banks and governments in the European Union and the U.S. after the financial crisis.
Tweedie said he will not require loan books to be held at fair value which has now become a potential sticking point between the IASB and the FASB.
FASB's proposal will see all assets measured at fair value. The IASB's mixed measurement model would see banks' loan books valued on an amortized cost basis.
The two standard setters are trying to converge US and international accounting rules, in the hope that the US will eventually adopt the new rules. But the fair value standard has now emerged as a significant obstacle, highlighted by Tweedie who said he simply did have the time to co-ordinate efforts with FASB in the revision of fair value, in the wake of the financial crisis.
“As I said in June, given the urgency of the fundamental issues surrounding IAS 39, none of us can afford the potential protracted back-and-forth resulting from piecemeal changes in international and US standards that would undermine the comprehensive and desperately needed reform that is under way,” he said.
“In our discussions with the FASB aiming to reach a common global approach, we will emphasise our position in favour of a mixed measurement model over one that requires full fair value measurement on the balance sheet… I remain optimistic that we can overcome our current differences.”
In an address to a meeting of European Finance Ministers, which have in the past been critical of the IASB’s response to the financial crisis, Tweedie has sought to ease concerns by announcing that he is on track to deliver a new fair value standard by the end of this year.
“I gave a commitment to deliver on this timetable. We will publish the new standard in November,” he said.
Fair value accounting came under fire from banks and governments in the European Union and the U.S. after the financial crisis.
Tweedie said he will not require loan books to be held at fair value which has now become a potential sticking point between the IASB and the FASB.
FASB's proposal will see all assets measured at fair value. The IASB's mixed measurement model would see banks' loan books valued on an amortized cost basis.
The two standard setters are trying to converge US and international accounting rules, in the hope that the US will eventually adopt the new rules. But the fair value standard has now emerged as a significant obstacle, highlighted by Tweedie who said he simply did have the time to co-ordinate efforts with FASB in the revision of fair value, in the wake of the financial crisis.
“As I said in June, given the urgency of the fundamental issues surrounding IAS 39, none of us can afford the potential protracted back-and-forth resulting from piecemeal changes in international and US standards that would undermine the comprehensive and desperately needed reform that is under way,” he said.
“In our discussions with the FASB aiming to reach a common global approach, we will emphasise our position in favour of a mixed measurement model over one that requires full fair value measurement on the balance sheet… I remain optimistic that we can overcome our current differences.”
Friday, July 17, 2009
FASB Issues Financial Instruments Proposals
The Financial Accounting Standards Board (FASB) this week announced it will issue an exposure draft proposing that more financial instruments (including loans held by banks and held-to-maturity securities) be recognized at fair value on the balance sheet.
The proposals don't line up perfectly with what the IASB proposed earlier in the week, so this is the newest "fasb vs iasb" scenario, and next year should be interesting as to how the two proposals converge. As per an earlier post, IASB proposals focus on whether a financial instrument has "basic loan features" or is managed on a contractual yield basis. Basic loan features meant that the instrument bears market interest and repays original principal only. To put it bluntly FASB likes fair value better than IASB. The FASB proposals will result in more financial instruments at fair value than the IASB proposals.
Changes in fair value would be recognized either in net income for trading instruments or in other comprehensive income (OCI) for non-trading instruments.
Key aspects of the proposal:
- Fair value changes on derivatives, equity securities, and hybrid instruments containing embedded derivatives requiring bifurcation under FAS 133 (i.e., those not clearly and closely related to the host contract) will be recognized in net income.
- For all financial instruments, interest and dividends will continue to be recognized in net income.
- Credit impairments and realized gains and losses arising from sales or settlement of financial instruments will be recognized in net income.
- The classification of financial instruments will be determined at initial recognition with no subsequent reclassification allowed.
- One statement of financial performance will be required, with subtotals presented for net income and OCI. However, only earnings per share for net income will be required.
While an exposure draft is planned to be released for public comment in the fourth quarter of 2009, it is possible that it will be issued sooner. At future meetings, the FASB plans to discuss related matters to be included in the exposure draft, including measurement of demand deposits, a credit impairment model based on expected losses, whether to allow nonpublic entities to measure certain financial instruments at amortized cost, and the proposed effective date and transition provisions for a final standard.
This proposal represents a significant change to the existing fair value accounting model and substantial debate is expected, including how the FASB's proposal will align with the International Accounting Standards Board's (IASB) recent exposure draft on financial instrument classification and measurement.
(content from PWC)
Thursday, July 16, 2009
Simpler Accounting for Financial Instruments
Accounting for financial instruments will be simplified from previous methods according to the recent IAS 39 Exposure Draft.
A reduction in the number of different categories from 4 to 2 and the elimination of the messy ex guidance around embedded derivatives and some of the impairment requirements, significantly streamlines this area.
The classification is an attempt to replicate the business model in FI acconting. This means that where a loan portfolio is held to generate income from interest and principal cash flows, it will be measured on that basis and not on one that looks at fair value at a point in time.
The exposure draft draws on input from the March 2008 Discussion Paper Reducing Complexity in Reporting Financial Instruments and discussions of the Financial Crisis Advisory Group.
There are still some major issues to deal with. Amortised cost measurement will be available only for instruments with ’basic loan features’ which are managed on a ‘contractual yield basis’. The latter of these is hard to define for financial instruments that sit in the middle ground between those to be held for their entire term to generate income and those to be traded for profit in the short term; that is going to be a particular concern for those who invest surplus funds temporarily. The IASB itself has not yet concluded on this point and that it’s likely that additional guidance will be required.
There’s also the question of whether equivalent changes will be made to US GAAP. The FASB is currently reviewing the requirements of its own financial instruments standards, but is at a less advanced stage of its project than the IASB. Indications are that the FASB is in a different place to the IASB and their proposals may well require more instruments to be measured at fair value.
The IASB has indicated that if the FASB does reach different conclusions, then these will be exposed for comment to the IFRS constituency.
Old model:
Held for trading
Available for sale
Amortized cost
Held to maturity
New Model:
A reduction in the number of different categories from 4 to 2 and the elimination of the messy ex guidance around embedded derivatives and some of the impairment requirements, significantly streamlines this area.
The classification is an attempt to replicate the business model in FI acconting. This means that where a loan portfolio is held to generate income from interest and principal cash flows, it will be measured on that basis and not on one that looks at fair value at a point in time.
The exposure draft draws on input from the March 2008 Discussion Paper Reducing Complexity in Reporting Financial Instruments and discussions of the Financial Crisis Advisory Group.
There are still some major issues to deal with. Amortised cost measurement will be available only for instruments with ’basic loan features’ which are managed on a ‘contractual yield basis’. The latter of these is hard to define for financial instruments that sit in the middle ground between those to be held for their entire term to generate income and those to be traded for profit in the short term; that is going to be a particular concern for those who invest surplus funds temporarily. The IASB itself has not yet concluded on this point and that it’s likely that additional guidance will be required.
There’s also the question of whether equivalent changes will be made to US GAAP. The FASB is currently reviewing the requirements of its own financial instruments standards, but is at a less advanced stage of its project than the IASB. Indications are that the FASB is in a different place to the IASB and their proposals may well require more instruments to be measured at fair value.
The IASB has indicated that if the FASB does reach different conclusions, then these will be exposed for comment to the IFRS constituency.
Old model:
Held for trading
Available for sale
Amortized cost
Held to maturity
New Model:
Tuesday, July 14, 2009
SEC Comment Letters: Goodwill Impairment
In a webcast last week, the Controllers’ Leadership Roundtable discussed SEC Comment letter activity surrounding goodwill impairment charges. Below is their summary of recent activity in this area.
SEC is hitting on three main areas.
SEC is hitting on three main areas.
- Clear Identification of Impairment Recoverability Risks: If they are not doing so already, companies are going to need to ensure that they quantitatively disclose information about potential risks to revenue, operating results, and asset recoverability, so that investors have the ‘raw material’ required to judge the likelihood of future impairments. This includes explicitly addressing the economy, and the range of assumptions they used in evaluating its potential impact (and what changes in those assumptions would do to potential impairments).
- Requiring Detailed Sensitivity Analysis: Along with identifying the range of assumptions used in their calculations, companies need to also disclose the sensitivity analyses used, so that investors and users can get a better sense of how impairment might change if certain conditions (e.g. 1% decline in revenue, 50 basis point increase in the interest rate) came to pass. This provides a check both on the validity of the impairment charges, and on the validity of management’s thought processes.
- Managerial Judgment Process: In general, the SEC is also requiring companies to detail their impairment ‘thought process,’ including what inputs they used, and how they came to those input values. One comment letter called on firms to:
In the interest of providing readers with a better insight into management’s judgments in accounting for goodwill and intangible assets, please consider disclosing the following: - The reporting unit level at which you test goodwill for impairment and your basis for that determination;
- Sufficient information to enable a reader to understand how you apply the discounted cash flow valuation model in estimating the fair value of your reporting units and why management selected this method as being the most meaningful in preparing your goodwill impairment analyses;
- How you determine the appropriate discount rates and attrition rates to apply in your intangible asset impairment and analysis;
- A qualitative and quantitative description of the material assumptions used and a sensitivity analysis of those assumptions based upon reasonably likely changes; and
- If applicable, how the assumptions and methodologies used for valuing goodwill and intangible assets in the current year have changed since the prior year, highlighting the impact of any changes.
Friday, July 10, 2009
FASB Beats Up the Banks
After a full year of contemplation and consultation, the FASB eliminated qualified special purpose entities (QSPEs).
QSPEs allow banks and other financial institutions and companies to hold asset-based securities off-balance sheet. This move will not likely have a significant impact on earnings in the banking sector, but it will affect capital levels at institutions that sold mortgage and other loans into such securities.
The previously off-balance sheet assets will now show up on the balance sheet at the start of 2010 for most institutions.
While there may be minimal differences in banks' earnings, the impacts on balance sheets will be more significant, possibly requiring banks to increase reserves.
Banks were initially upset by the timing of the initial proposal, which was put off after objections from the American bankers’ Association. The FASB says ABA lobbying will not change the current implementation date.
The ABA continues to lobby for changes to FASB's mark-to-market accounting rules and other than temporary impairment rules. The banks feel that mark-to-market accounting is not the best measurement for many transactions, advocating that the current approach works for assets expected to be sold, but not for assets that are expected to be held, among other issues. 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".)
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.
Recently the FASB issued changes to accounting rules that would allow looser mark to market accounting. The changes 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 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.
QSPEs allow banks and other financial institutions and companies to hold asset-based securities off-balance sheet. This move will not likely have a significant impact on earnings in the banking sector, but it will affect capital levels at institutions that sold mortgage and other loans into such securities.
The previously off-balance sheet assets will now show up on the balance sheet at the start of 2010 for most institutions.
While there may be minimal differences in banks' earnings, the impacts on balance sheets will be more significant, possibly requiring banks to increase reserves.
Banks were initially upset by the timing of the initial proposal, which was put off after objections from the American bankers’ Association. The FASB says ABA lobbying will not change the current implementation date.
The ABA continues to lobby for changes to FASB's mark-to-market accounting rules and other than temporary impairment rules. The banks feel that mark-to-market accounting is not the best measurement for many transactions, advocating that the current approach works for assets expected to be sold, but not for assets that are expected to be held, among other issues. 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".)
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.
Recently the FASB issued changes to accounting rules that would allow looser mark to market accounting. The changes 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 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.
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