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.

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.

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.

"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:

• 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.

Current Requirement
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.

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.
  

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

Politics and Accounting: EU Delays Adoption of Fair Value Accounting Rule Changes

Politicians in the European Union have held up a radical overhaul of accounting rules for banks and insurers which came into force yesterday across most of the non-U.S. accounting world.

Politics comes to the fore in this as the rules have been postponed at a time when the commission itself is a lame duck because the commissioner’s job will come open with the new Commission beginning next year. Diplomats in Brussels say France is interested in the internal market commissioner's job in the next Commission.

The move highlights a major split among European financial institutions over the fair value new rules.

Analysts say some French, German and Italian banks with large investment banking activities would be hit disproportionately by the changes, forcing them to book losses on large holdings of derivatives.

The decision by the European Commission to delay the changes within Europe has angered other banks in the region who fear they will be put at a disadvantage compared to international peers.

The International Accounting Standards Board recently published major changes to the rules on fair value accounting, where assets are marked to market prices. Supporters of the new rules say this makes reporting more transparent. Critics believe fair value rules made the financial crisis worse by forcing banks to take losses on assets when markets fell.

The IASB fast-tracked the changes in response to calls by the G20 to make the changes by the end of the year. The European Commission said it would not adopt the changes until it had carried out an in-depth analysis, and would consider adoption in the new year.

The decision means that European banks and insurers will not use the new rules for their 2009 accounts while companies in more than 80 countries outside the EU will be required to do so.

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.”

American Bankers' Association Criticizes FASB, IASB over mark to Market Changes

The American bankers Association (“ABA”) has written to Robert Herz, Chairman of the FASB and Sir David Tweedie Chairman of IASB, about their concerns around the process being taken on the FASB and IASB projects relating to financial instruments.

The ABA has lobbied against mark to market accounting for years and their response is no surprise.

The ABA says that the changes that the FASB and IASB are considering represent the most significant accounting changes the ABA has ever experienced. The ABA encourages the FASB and IASB to make such changes only "with utmost caution and the appropriate level of due process to correspond with the magnitude of the changes."

The ABA agrees that a certain amount of change is urgently needed, but that the FASB and IASB direction may cause significant disruption, with both preparers and users of financial statements.

They state that rule-makers must be very careful in this effort to ensure that any changes:
1) represent solid and meaningful change that is valuable and understandable to financial statement users;
2) focus on the business models used by entities that prepare the financial statements, and
3) can be implemented and maintained at a reasonable cost.

Other points made:

• The rapid paces at which both organizations are working, as well as the paths being taken, are causing some to question whether there is due process in evaluating these important issues.
• Some bankers also question whether such efforts are driven by a search for simplicity, transparency, and accuracy or by an appetite to expand fair value accounting, no matter the implications.
• A major concern is that the current directions in which the FASB and IASB are moving appear to be similarly requiring more mark to market accounting (MTM) within the financial statements, more capital for many existing banking activities, and more operational challenges to comply with these rules for banks of all sizes.
• The cost of accounting compliance puts continued participation in certain market activities at risk for some smaller institutions.
• Concern over the current divergence between the FASB and IASB proposed models and time frames for completion. The IASB plans to finalize its accounting standard in 2009, and the FASB's completion date will be subsequent to that date. In such case, the FASB will have only one of two choices: (1) to follow the IASB model – which will not provide U.S. companies with appropriate due process for providing input, or (2) a lack of international convergence – which should be avoided.

ABA says that the IASB appears to be solving the accounting puzzle on a piecemeal basis, which may result in pre-determining the outcome for subsequent parts of the puzzle that may not fit.

ABA feels that it is extremely important that new standards be developed jointly by the FASB and IASB, with proper due process and open consultation with a wide range of constituents that ensures a holistic review.

ABA's points for consideration when making substantial changes to the accounting model:

• Serious consideration must be give to field testing proposals prior to implementation, and sufficient transition time must be provided.
• Regulatory accounting rules should be consistent with GAAP.
• Accounting changes must meet a “costs vs. benefits” test.
  

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:

Contrary Views on Liability Measurement

GAAP introduced in FAS 157 and elsewhere supports a view that an entity’s own credit risk is a determinant in measuring fair value of a a liability.

Some financial statement preparers don’t like the idea that a reduction in an entity’s credit rating would create a gain. How does this work? If a company’s credit rating dropped, the likelihood that it would repay its liabilities decreases, resulting in an entry such as:

Dr Liability
Cr Gain

If later the company’s credit rating was raised, then a loss would result:

Dr Loss
Cr Liability

If an entity’s credit rating increased above the rating when the liability was set up, the liability would be carried at an amount in excess of the amount that was required to be repaid, resulting in a gain if early repayment occurred.

In June, the FASB sought comments proposed FSP Measuring Liabilities under FASB Statement
No. 157 (FSP 157-f).

The Government Relations Committee (GRC) of the Association of financial Professionals sent a comment letter to FASB to voice its concerns with the guidance.

The GRC generally supports the FASB in its efforts to issue timely guidance on fair value measurement. However the GRC takes the position that the FASB’s current model for measuring liabilities is significantly flawed for the following reasons:

1. The inability to actually realize the fair value at the reporting date should be considered.


2. The fair value calculation of a liability should not exceed the contractual value of the debt a company actually owes.


3. Gains arising from a company’s own credit impairments should not be allowed.


4. Any restrictions on a debt should be taken into consideration in subsequent measurement.

Check out the AFP's site: http://www.afponline.org/

Politics and Accounting

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

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

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

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

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

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

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

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

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

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

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

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

Watering Down Fair Value Accounting is "Crazy"

Moves by Wall Street lobbyists slammed

Excellent article from the Financial Post

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Economist to Banks: Back Off Accounting Rules

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

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

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

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


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

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

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

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

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

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

CFAs Don't Like IASB Changes to Fair value Accounting Rules

The CFA Institute, the governing body that administers the Chartered Financial Analyst designation, does not like IASB proposed changes to market-to-market accounting rules.


They argue that the IASB needs a comprehensive review of the financial instrument accounting rules and not follow a piecemeal agenda to reform accounting standards.

A CFA managing director warns that the amendments to IAS 39 reclassification rules, and the political pressures that have led to the revision of FASB rules on fair value and impairments, are likely to result in "unintended consequences."

"It is essential the IASB avoids engaging in an exercise to dilute standards to align with U.S. GAAP," he says. "This crisis presents a window of opportunity for the IASB to improve the current financial instrument accounting in the interests of all its stakeholders. This can be judged a success if it improves the overall transparency of information available to investors, and if the IASB is able to operate independently to pursue this objective. The short-term focus should be on providing capital relief by amending capital adequacy rules and not by simply changing measurement rules."

The CFA Institute claims that investor interests must come first, and this can only be achieved through improved and transparent financial reporting. They say the new rules could obscure true economic performance and accordingly reduce investor confidence and reduce the ability of constrain the ability of banks to raise private capital, as a result increase risk in world financial systems.

CEO of Goldman Sachs: Fix System; Keep Mark-to-Market Accounting

Lloyd C. Blankfein, CEO of Goldman Sachs Group, recently endorsed mark-to-market accounting and transparent financial reporting.

In a speech in Washington, Blankfein took a shot at critics of fair value accounting and those who claim that mark to market accounting caused or made worse the current financial crisis.

Blankfein stated: “If more institutions had correctly valued their positions and commitments at the onset, they would have been in a much better position to reduce their exposure,”

“To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk. How can one justify that the same instruments or risks are priced differently because they reside in different parts of the balance sheet within the same institution?”

The full text of his speech is a good read and is reproduced below.

Good morning. I appreciate the opportunity to speak with you today. For more than two decades, the Council of Institutional Investors has committed itself to the values of accountability, transparency, and responsible ownership. I'm pleased to be able to speak to those principles in front of a group that has played such a powerful role in advancing them over the years.

To begin with an obvious point, much of the past year has been deeply humbling for my industry. We held ourselves up as the experts, and the loss of public confidence from failing to live up to the expectations that we created will take years to rebuild. Worse, decisions on compensation and other actions taken and not taken, particularly at banks that rapidly lost a lot of shareholder value, look self-serving and greedy in hindsight.

Financial institutions have an obligation to the broader financial system. We depend on a healthy, well functioning system, but we collectively neglected to raise enough questions about whether some of the trends and practices that became commonplace really served the public's long-term interests.

Meaningful change and effective reform are vital and should naturally emanate from the lessons learned. I will discuss a few of the more important lessons from this crisis. I'd also like to highlight some of the regulatory guideposts that may help us to improve the broader systemic management of risk, increase the level of institutional accountability, and enhance investor confidence.

Without trying to shed one bit of our industry's accountability, we would also further our collective interests by recognizing other contributing causes to the severity of the cycle we are living through.

As a matter of policy, we allowed housing prices to be subsidized, including through implied government support of Fannie Mae and Freddie Mac. We watched as high consumption and low savings rates as well as entitlement spending were increasingly encouraged and financed through the twin deficits.

Factors from both Main Street and Wall Street contributed to today's circumstances. Neither part of our economy acted completely independent of the other. So, any examination of how we got to this point must begin with an understanding of some of the global economic and financial dynamics of the last two decades.

Certainly, what started in a localized part of the U.S. mortgage market spread to virtually every corner of the global financial markets. But the genesis of the problem wasn't in sub-prime. Instead, the roots of the damage to our financial system are broad and deep. They coalesced over many years to create a sustained period of cheap credit and excess liquidity. The resulting underpricing of risk led to massive leverage across wide swaths of the economy -- from households to the corporate sector to the public sector.

I see at least three broad underlying factors:

First, there has been enormous growth in the amount of foreign capital, much of it held in large pools, and a very significant shift in the balance of payments of many emerging markets;

Second, and linked to this, nearly ten years of low long-term interest rates; and

Third, the official policy of subsidizing homeownership in the United States.

Let's take each in turn, beginning with the growth in foreign capital.

Between 1992-2007, the U.S. current account deficit increased by more than 1,300 percent. During the same period, China's current account surplus increased by over 5,700 percent, as did the surplus for the oil exporting nations.

After previous financial crises, emerging economies began to self-insure against a repeat of those events by building up their foreign currency reserves. Their primary objective was to reduce their dependence on dollar-denominated domestic debt.

Of course, the other, perhaps more significant factor in the growth in current account surpluses had been the record run-up in oil prices since 2000. Increases in global savings run almost parallel with the increase in petrodollar flows.

The growth in foreign capital had a profound effect on the global economy. Foreign holdings of U.S. government and corporate debt skyrocketed. China's monthly average purchases of U.S. long-term securities went from less than $2 billion in 2001 to over $15 billion in 2007.

The flood of foreign capital into safe and liquid assets, particularly U.S. Treasurys, helped push relatively low long-term interest rates down even further. And they stayed low, even after the Federal Reserve began raising short-term rates in 2004.

This was accompanied by a significant reduction in inflation. Between the period 1985 and 1995 versus the next 12 years, inflation in advanced economies fell by more than one-half.

Enormous excess liquidity, strong global economic growth, and low real-interest rates created a desire to find new investment opportunities. Many of the best were thought to be in the housing market. The reasons are threefold.

First, governments, particularly the U.S., explicitly supported homeownership through a variety of government programs and initiatives. Second, mortgage assets were considered relatively impervious to sharp downturns. And lastly, the creation of more flexible and varied mortgage products attracted even more capital in search of higher returns.

These factors, to varying degrees, contributed to a housing bubble -- not just in the U.S. but in many other countries as well. While real home prices increased nearly 50 percent in the U.S. between 1998 and 2006, they increased more than 130 percent in Ireland, 120 percent in the U.K. and Spain and over 100 percent in France.

Not surprisingly, in the U.S., mortgage origination as a percentage of total mortgage debt outstanding rose from an average of 6.3 percent between 1985 and 2000 to 10 percent between 2001 and 2006. Subprime debt, in particular, grew from just over 2 percent in 2002 to 14 percent in 2008. In a sustained environment of cheap capital, lending standards for residential mortgages simply deteriorated.

As I have thought about our industry's understanding of the previous years' risks, it is important to reflect on some of the lessons.

At the top of my list are the rationalizations that were made to justify that the downward pricing of risk was different. While we recognized that credit standards were historically lax, we rationalized the reasons with arguments such as: The emerging markets were more powerful, the risk mitigants were better, there was more than enough liquidity in the system.

We rationalized because our self-interest in preserving and growing our market share, as competitors, sometimes blinds us -- especially when exuberance is at its peak.

A systemic lack of skepticism was equally true with respect to credit ratings. Too many financial institutions and investors simply outsourced their risk management. Rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them. This was true at the inception and over the period of the investment, during which time they did not heed other indicators of financial deterioration.

This overdependence on credit ratings coincided with the dilution of the coveted triple A rating. In January 2008, there were 12 AAA-rated companies in the world. At the same time, there were 64,000 structured finance instruments, like CDO tranches, rated AAA. It is easy to blame the rating agencies for their credit judgments. But the blame is not theirs alone. Every financial institution that participated in the process has to accept part of the responsibility.

More generally, risk management will come to define the events of 2007 and 2008. First, models, particularly those predicated on historical data, were too often allowed to substitute for judgment.

In the last several months, we have heard the phrase, "multiple standard deviation events" more than a few times. If events which were calculated to occur once in twenty years in fact occurred much more regularly, it doesn't take a mathematician to figure out that risk management assumptions did not reflect the distribution of actual outcomes. Our industry must do more to enhance and improve scenario analysis and stress testing.

Second, size matters. For example, whether you owned $5 billion or $50 billion of (supposedly) no-risk super-senior debt in a CDO, the likelihood of losses would appear to be the same. But the consequences of a miscalculation were obviously much bigger if you had a $50 billion exposure.

Third, a lot of risk models incorrectly assumed that positions could be fully hedged. After LTCM and the crisis in emerging markets in 1998, new products like basket indices and credit default swaps were created to help offset a number of risks. However, we didn't, as an industry, consider carefully enough the possibility that liquidity would dry up, making it difficult to apply effective hedges.

Fourth, risk models failed to capture the risk inherent in off-balance sheet activities, such as Structured Investment Vehicles. It seems clear now that managers of companies with large off-balance sheet exposure didn't appreciate the full magnitude of the economic risks they were exposed to; equally worrying, their counterparties were unaware of the full extent of these vehicles and, therefore, could not accurately assess the risk of doing business. Post Enron, that is quite amazing.

Fifth, complexity got the better of us. The industry let the growth in new instruments outstrip the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.

Lastly, financial institutions didn't account for asset values accurately enough. I've heard some argue that fair value accounting -- which assigns current values to financial assets and liabilities -- is one of the major reasons for exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.

For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in positions that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions. We mark-to-market, not because we are required to, but because we wouldn't know how to assess or manage risk if market prices were not reflected on our books.

While this is not an exhaustive list of what went wrong, our focus is on learning from these lessons and others that will undoubtedly emerge as we work our way through this period.

The administration, legislators, and regulators have begun to consider the important regulatory actions to be taken and our firm pledges to be a constructive participant in that process. In that vein, I believe it is useful, in light of the lessons we take away from this crisis, to consider important principles for our industry, for policy makers and for regulators.

For the industry, we can't let our ability to innovate exceed our capacity to manage. Given the size and interconnected character of markets, the growth in volumes, the global nature of trades and their crossasset characteristics, managing operational risk will only become more important.

Risk and control functions need to be completely independent from the business units. And clarity as to whom risk and control managers report is crucial to maintaining that independence. Equally important, risk managers need to have at least equal stature with their counterparts in revenue producing divisions.

If there is a question about a mark or a disagreement about a risk limit, the risk manager's view should prevail.

Understandably, compensation continues to generate a lot of controversy and anger. We recognize that having TARP money creates an important context for compensation. That is why, in part, our executive management team elected not to receive a bonus in 2008, even though the firm produced a substantial profit. Beyond TARP, public scrutiny, a renewal of common sense and, perhaps, regulation will naturally affect compensation practices going forward.

More generally, we should apply basic standards to how we compensate people in our industry. Compensation should reflect an individual's ability to identify and create value, including his or her contribution to the client franchise, enhancing the firm's reputation and contributing to the better functioning and efficiency of markets.

Equally important, compensation should take into account strict adherence to a firm's management and controls, especially with respect to a person's judgment and exercising that judgment in terms of risk in all of its forms. That evaluation must be made on a multi-year basis to get a fuller picture of the effect of an individual's decisions.

And, individual performance must not be viewed in isolation. Individual compensation should not be set without taking into strong consideration the performance of the business unit and the overall firm. Employees should share in the upside when overall performance is strong and they should all share in the downside when overall performance is weak.

No one should get compensated with reference to only his or her own P&L. Compensation should encourage real teamwork and discourage selfish behavior, including excessive risk taking, which hurts the longer-term interests of the firm and its shareholders.

We also believe it is important to set forth specific guidelines on how we compensate in our industry.

Compensation should include an annual salary plus deferred compensation, which is appropriately discretionary because it is based on performance over the entire year.
The percentage of compensation awarded in equity should increase significantly as an employee's total compensation increases.

For senior people, most of the compensation should be in deferred equity. Only the firm's junior people should receive the majority of their compensation in cash.

As I mentioned earlier, an individual's performance should be evaluated over time so as to avoid excessive risk taking and allow for a "clawback" effect. To ensure this, all equity awards should be subject to future delivery and/or deferred exercise over at least a three-year period.

And, senior executive officers should be required to retain the bulk of the equity they receive until they retire. In addition, equity delivery schedules should continue to apply after the individual has left the firm.

At Goldman Sachs we believe attracting and retaining the best people is vital to our effectiveness and that incentives are an important element in that process. But we also recognize that, misapplied, they can also encourage excess. As an industry, we need to do a better job of understanding when incentives begin to work against the social good rather than for it and take action to redress the balance.

For policymakers and regulators, it should be clear that self-regulation has its limits. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.

While all of us in the industry have a common responsibility to ensure the system's operational integrity, it is not realistic to expect that one firm alone can fix a system-wide problem like unsigned trade confirmations or the establishment of a central clearing facility.

Capital, credit and underwriting standards should be subject to more "dynamic regulation." Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates upward to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated.

To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk. How can one justify that the same instruments or risks are priced differently because they reside in different parts of the balance sheet within the same institution?

As recognized at the recent G20 summit, the level of global supervisory coordination and communication should reflect the global interconnectedness of markets. Regulators should implement more robust information sharing and harmonized disclosure, coupled with a more systemic, effective reporting regime for institutions and major market participants. Without these, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.

In this vein, all pools of capital that depend on the smooth functioning of the financial system, and are large enough to be a burden on it in a crisis, should be subject to some degree of regulation. Yes, that includes large hedge funds and private equity funds.

After the financial shocks and unsettling developments of recent months, I understand the desire for wholesale reform of our regulatory regime. And, in many cases, it is warranted. But we also should resist a response that is solely designed to protect us against the 100-year storm.

As long as human emotions influence decisions, this won't be the last financial crisis the world has to contend with. But, most of the last century has been defined by markets that fund innovation, reward entrepreneurial risk taking and act as an important catalyst for economic growth.

History has proven that a vibrant, dynamic financial system is at the heart of a vibrant, dynamic economy. The U.S. brand of that system has produced growth nearly one-third higher than the rest of the industrialized world over the last two decades.

The events of the last year have put into stark relief the tension between innovation and stability. But, if we abandon, as opposed to regulate, market mechanisms created decades ago, like securitization and credit default swaps, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.

Certain developments of recent decades, like changes in the structure of financial institutions post Glass-Steagall, have brought the risk of less frequent but more intense upheavals. The diverse income streams of mega financial conglomerates reduce the effects of the 10-year storm, but their size and ubiquity exacerbate the consequences of the 20- or 30-year storm.

Over the last several months, there have also been a number of broader policy lessons. Many had previously accepted the bifurcation of Wall Street and Main Street as well as the decoupling of the United States from the international economy. Both have proven false. In 2007, there were pitched debates over whether policy was being geared towards Wall Street at the expense of Main Street. Today, Wall Street remains destabilized, impeding the broader economy.

In terms of international implications, we have also seen actions that, for all intents and purposes, are protectionist and self-defeating. For instance, recent legislation constrains the ability of financial institutions to hire employees through the H-1B visa program. This program helps bring the most highly trained and technical people into our labor market.

The U.S. has always been a magnet for many of the most talented, hungry and qualified people in the world. Especially at this time in our economy, do we really want to tell individuals who will help companies to grow and innovate -- ultimately creating more jobs -- that they should go work elsewhere?

Equally significant and using Goldman Sachs as an example, we have approximately 200 employees who are in the U.S. because of the H-1B program. But, we have 2,000 employees who are working overseas and pay U.S. taxes. Do we want to invite other countries to take punitive measures against us?

This may be a relatively minor issue in the midst of the significant challenges we face, but I think it speaks to a potentially dangerous trend of withdrawing at a time we should do the opposite. While I don't dismiss political considerations, short-term salves like the "Buy America" provision or mandating a certain level of domestic lending will only end up harming the process underlying economic growth.

All along, we have known that market events and economic trends are interwoven on a global basis. But the events of the last year have shown that the connections are more direct and immediate than perhaps we previously appreciated.

In times of economic distress, the relationships between creditor and debtor countries take on even more complex dynamics ... especially as we are the largest debtor. We have learned that when a major financial institution fails in a debtor country, a creditor country is likely to pull back from its financing relationship in one way or another and, maybe, in every way.

For the United States at this time, the relationship is not just a matter of here and abroad; it is also a relationship between a debtor and its creditors. Certain of our economic decisions that have implications for our international partners could reverberate back to us very quickly and with great consequences in the current environment.

I want to conclude today with the following thought: We are fighting for nothing less than the immediate health and security of every person. We can never forget the products of economic growth -- more accessible health care, better education, less crime, tolerance of diversity, social mobility and a commitment to democracy.

In so many respects, change is the order of the day. We have much to do to repair our financial system and reinvigorate our regulatory structure. At the same time, our financial system, rooted in the belief of putting risk capital to work on behalf of ideas and innovation, has helped produce a long-term record of economic growth and stability that is unparalleled in history.

We have to safeguard the value of risk capital, which is at the heart of market capitalism, while enhancing investor confidence through meaningful transparency, effective oversight and strong governance. But, there should be no doubt: Markets simply cannot thrive without confidence.

Though honest disagreements will occur, the best companies don't shy away or selfishly frustrate efforts to compel better industry practices. These companies recognize that they are the first to benefit from better standards, especially if their business requires extensive dealings with partners or counterparties. But, we have to recognize a higher responsibility: to speak up, to draw attention to potentially destabilizing trends and to act like an owner responsible for the integrity of the system.

I, for one, know we have not done the best job in the recent past but working with you, as many of the world's most important investors, Goldman Sachs pledges to recommit itself to this fundamental obligation.

Thank you very much.

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

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

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

Related comments by S&P:

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

MTM in Plain English

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

The "plain language" version of the changes.

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

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

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

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

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

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

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

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

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

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

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

New York Times: ‘Integrity’ and Standard Setting

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

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

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

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

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

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

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

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

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

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

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

FASB Approves Fast Tracked Fair Value Changes

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

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

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

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