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Two threats to sound accounting by banks and thrifts.

The recent changes to fair value accounting and to the criteria for other-than-temporary loss recognition in current earnings--as well as the lender mortgage loan loss "cram-downs" that had been proposed--pose real risks to sound financial reporting by banks and thrifts. These changes raise the specter of a repetition of the unfortunate experiment with supervisory goodwill in the period immediately before the massive (by historical, not current, standards) thrift and banking crises of the late 1980s and early 1990s. While the changes to accounting rules for determining fair value and to the recognition prescribed for other-than-temporary losses on debt instruments have already been enacted, there are still important lessons to be recalled and, perhaps, used to avert further harm. The risk of a lender mortgage loan loss mandate has been avoided (at least for the time being) but remains a concern as Congress and the Obama administration craft further responses to the current economic crisis.


Changes to Fair Value Accounting

As a result of an unprecedented rush to appease the critics of fair value accounting in Congress and elsewhere--who had succeeded in spreading the impression that the current recession and crippling dearth of bank lending activity was the direct result of exaggerated asset write-downs caused by the recently promulgated fair value accounting standard (SFAS 157, Fair Value Measurements)--the FASB has now enacted revised guidance on the measurement of fair value and, in a related move, on the reporting of certain other-than-temporary losses on debt instruments held as assets. Under threat of congressional action, announced during FASB Chairman Robert H. Herz's testimony on March 12, 2009, the board responded with several exposure drafts in a matter of mere weeks, and--after an abbreviated exposure period and some further changes--on April 9,2009, released three FASB Staff Positions (FSP) that may have a significant impact on financial reporting, most importantly by banks and thrifts.

The requirements that many classes of assets--including debt and equity investments held for sale or available-for-sale--be reported at fair value using the mark-to-market approach, have long been well understood and reasonably well applied in practice. SFAS 157, released in 2006 and mostly effective in 2008, provided a hierarchy of fair value measurement techniques but did not extend the requirements for fair value accounting beyond what already existed under U.S. GAAP. Nevertheless, the confluence of two phenomena--preparers and auditors still gaining familiarity with certain complexities in SFAS 157 and the bursting of an asset pricing bubble in 2007-2008--created an unfortunate perception that the former caused, or at least exacerbated, the effects of the latter. Although this is almost certainly not true, perception is often reality, and it became politically appealing to fan the flames of outrage over the presumptive impact that arcane accounting rules seemed to be having on the public welfare.

Herz gamely defended fair value accounting before Congress, and the new rules, described below, preserve most of the basic requirements for recognition and measurement, but there are profound changes that will--under certain conditions and for certain financial assets with certain declines in value--alter loss recognition, particularly for assets held by financial institutions. As is often the case, responsibility will fall upon the auditors to ensure that these requirements are properly applied and that this does not serve as an invitation to financial reporting abuse.

FSP FAS 157-4. Three related FSPs have been issued. The first, FSP FAS 157-4, "Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly," provides guidance for assessing fair values when conditions might suggest that orderly markets do not exist, making ostensible fair value information suspect. While reiterating its commitment to fair value accounting, including the intention of measuring fair value at an objective exit value (the price that would be received to sell the asset in an orderly transaction, not in a forced liquidation or distressed sale), the FASB concluded that there was a practical need for further guidance to provide a basis for avoiding undue reliance on the "last transaction price" during unsettled market situations. In taking this step, the FASB was also reacting to the recommendations of an SEC study mandated by the Emergency Economic Stabilization Act of 2008 that called for interpretive guidance on the application of SFAS 157's Level 2 and Level 3 estimation procedures.

FSP FAS 157-4 offers insights into determining when "the volume and level of activity" for asset transactions have "significantly decreased" such that quoted prices "may not be determinative of fair value because of increased instances of transactions that are not orderly." A number of factors, which are illustrative but not exhaustive, are suggested that, if present, could imply disorderly markets and hence unreliable price data. These include a paucity of recent transactions, volatile prices, and widened bid-ask spreads, among others. Qualitative evaluations by financial statement preparers will be needed because a formulaic approach is not offered, and therein lies the major risk: that preparers will aggressively seek to minimize the recognition of declines in value by citing selected stressed market conditions as a reason to modify values.

According to the new FSP, if a significant decrease in market activity has occurred, such that transactional data or price quotations might not be reflective of fair value, then further analyses must be performed in order to ascertain whether significant adjustments to transactional data or price quotes should be made. If warranted, the preparer may then elect to change the previously employed valuation technique, make reference to a range of other techniques, and ultimately select an appropriately weighted average value indicator that the preparer deems most representative of fair value under current market conditions.

To its credit, the FASB has reiterated the SFAS 157 directive that value assessments cannot be divorced from current conditions--however extreme those conditions are and whatever the expectations for an eventual market recovery may be. This last prescription is intended to avoid having preparers effectively assume away market conditions on the grounds that they are mere aberrations. It will likely fall to auditors to enforce this constraint, however, given the now-common view that fair value measurements have exaggerated the market declines or even contributed to a downward spiral, particularly with respect to mortgage derivatives.

Besides the laudable reminder that fair value assessments must be in the context of current market conditions, FSP FAS 157-4 also reiterates that the intent to hold the asset indefinitely or to maturity cannot be allowed to affect fair value estimates (but see the second new FSP below). Fair value is a market-based measurement, FSP FAS 157-4 reminds accountants, not an entity-specific measurement. If it is determined that the market for the asset in question is not currently orderly, then the reporting entity is instructed to place less weight on current transactional data or price quotes and more weight on other indicators of fair value (e.g., present value of projected cash flows), a process that will inevitably be rather subjective. Examining and attesting to these judgments will likely pose major challenges for auditors, particularly because optional measures and alternative weighting decisions will often have a material impact.

Finally, the FSP expands required disclosures so that financial statement users can assess, to a degree, the impact of the various decisions made by management regarding use of alternative techniques in response to putatively disorderly market data. It also mandates a more detailed breakdown by asset categories, in both annual and interim financial statements.

FSP FAS 115-2 and FAS 124-2. The second pronouncement, FSP FAS 115-2 and FAS 124-2, "Recognition and Presentation of Other-Than-Temporary Impairments," makes a fundamental change to the application of the other-than-temporary loss reporting practices that have been in place since the advent of SFAS 115 for debt securities held as assets only. This change is directly in response to critics' demands that steep accounting write-downs of mortgage and other loans, as well as derivative securities backed by such loans, be curtailed so that bank and thrift capital can be conserved and, hopefully, that the institutions' lending activities will resume a more normal pace.

Under longstanding rules, impairments of held-to-maturity and available-for-sale investments deemed to be other than temporary have required immediate recognition on the income statement, in contrast to those impairments deemed only temporary. For investments categorized as available for sale, temporary declines are reported only in other comprehensive income (a contra-equity account not included in earnings); for held-to-maturity (debt) instruments, temporary declines have generally not been reported at all, although they are disclosed in the footnotes. Thus, a determination that declines in the value of either available-for-sale or held-to-maturity investments were actually other than temporary in nature often had a very significant impact on an entity's reported results of operations.

In accordance with longstanding U.S. GAAP, recognition of other-than-temporary losses in earnings could be averted if management had both the intent and the ability to hold the investments for a sufficient time for a price recovery to occur. Under the new rule, other-than-temporary designation of losses will only be required when management is unable to assert that 1) it does not have the current intent to sell the security, and 2) it is more likely than not that it will not have to sell the security before recovery of its cost basis. Note the subtle change: Whereas formerly a positive assertion of intent to hold was required, now only an assertion of a present lack of intent to sell, coupled with a modest expectation (more likely than not equals a greater than 50% probability) of not being forced to sell, will be required to avoid recognizing a loss in the current period.

FSP FAS 115-2 and FAS 124-2, which will only apply to debt securities, imposes a new reporting model on the other-than-temporary declines in value that are identified. In many instances, the effect will be to diminish the magnitude of losses taken to current earnings. It requires that such declines be parsed into two newly defined components. The first of these is the decline associated with a change in credit quality, which would be deemed truly other than temporary and thus reportable in current earnings. The second, attributable to all causes other than a decline in credit quality, would not be reflected in current earnings but rather in other comprehensive income. (The total other-than-temporary loss would be displayed in the income statement, with the "other" portion then subtracted out and reported in equity.)

This new, secondary element of what was formerly a unitary measure of other-than-temporary declines in fair value presumably includes the effects of irrational market moves, such as those that have arguably occurred during the recent credit crisis. In adopting this new approach, which is likely to be quite popular among reporting entities, the FASB is anticipating that those "other" declines will have less longevity than those that can be tied to credit quality changes. While the existing U.S. GAAP guidance (e.g., SFAS 114 and SOP 03-3) will provide assistance in measuring the impact of credit quality changes, the net result will be that some losses formerly included in earnings will no longer impact that highly sensitive measure of entity performance.

FSP FAS 107-1 and APB 28-1. The last of the three fair value pronouncements, FSP FAS 107-1 and APB 28-1, "Interim Disclosures about Fair Value of Financial Instruments," expands the disclosure requirements for interim financial statements. This is partly necessitated by the further complexity created by the promulgation of the other two FSPs. Applying only to publicly held companies, the FSP extends disclosure requirements to summary interim financial information, mandating tabular or other presentations to compare carrying amounts to fair value amounts, and disclosure of the methods and significant assumptions employed to develop fair value estimates, as well as any changes in methodology or assumptions.

All three of these FSPs are effective for the second quarter of 2009. Companies can opt to adopt in the first quarter but only if all three FSPs are early adopted.

It is hoped that these FSPs will defuse other efforts to more severely limit the application of fair value accounting. For preparers and auditors, the challenges will be to resist the implied invitation to exaggerate "other" (i.e., non-credit quality) changes in value when other-than-temporary declines are observed, as well as to obtain sufficient audit evidence to support management's financial statement assertions. In a litigious climate, any subsequent determinations that other-than-temporary declines should have, but were not, charged against earlier periods' earnings, will be obvious targets.

Mortgage Loan Loss 'Cram-Downs'

One of the many proposals made to deal with the current economic crisis is to provide relief to homeowners who are "upside down" in their mortgage loans, owing balances greater than the depressed value of the property. The Helping Families Save Their Homes Act of 2009, in its initial form, would have given bankruptcy judges the power to "cram down" reductions in home loan balances, thus forcing lenders to absorb the loss of value in the homeowner's property. Although the final version of the law (as enacted May 20, 2009) did not contain this cram-down provision, should the federal government consider such an approach in the future (if, for example, foreclosures continue to grow, as they have through the first half of 2009), it would be prudent to consider the significant red flags.

As recently as 1993, a unanimous Supreme Court, in Nobelman v. American Savings Bank (508 U.S. 324), held that provisions of Chapter 13 of the Bankruptcy Code [specifically 11 USC section 1322(b)(2)] prohibited bankruptcy judges from modifying mortgages on principal residences. In that case, one of the more liberal Supreme Court members, Justice Stevens, specifically noted that the prohibition on modifying mortgages on principal residences was "explained by the legislative history indicating that favorable treatment of residential mortgagees was intended to encourage the flow of capital into the home lending market" (Nobelman, 508 U.S. at 332). Thus, as recently as the Clinton administration, it was considered beyond dispute that prohibiting the modification of rights of lenders and obligations of borrowers serves the collective greater good, ensuring access to mortgages on principal residences at reasonable rates.

To the contrary, mortgage cram-downs would contravene Justice Stevens' specific admonition, a unanimous Supreme Court ruling, and the legislative history upon which it was based, thus creating the ability for some debtors to demand that the principal amount of their mortgages be rewritten or crammed down. This would presumably ameliorate the current financial plight of some debtors, but it appears that little thought is being given to future consequences, whether intended or not. Besides the question of "moral hazard," the major risk is that this will begin a chain of events that may ultimately lead to accounting requirements that will serve to exacerbate, rather than resolve, the problem.

If further legislation were to enable the cramming down of mortgage loan losses on lenders, they would have to acknowledge the uncollectability of a portion of the bankruptcy-eligible loans, and thus recognize losses for financial reporting purposes. Given the other serious problems (e.g., losses on investment securities) currently affecting banks, even a modicum of such write-offs could certainly trigger capital impairment sufficient to threaten them with regulatory sanctions, or even seizure.

Whatever the intended social equity underlying this idea, it would obviously precipitate bank losses and the depletion of bank capital, thus impeding recovery in bank lending activities. But a further, unremarked-upon time bomb is likely hidden in the plan, which could have even graver consequences for banks and taxpayers. Fortunately, the savings and loan and banking crises of the late 1980s and early 1990s offer an object lesson on how to avoid this threat.

Recall that, by the 1980s, a combination of political and economic factors--including rampant inflation, low regulatory interest rate ceilings on thrift and bank deposits, and the escalating pace of disintermediation of funds from deposit gathering and mortgage lending institutions--had imposed on most lenders an unsustainable negative interest spread situation. This caused enormous losses and the drying up of lending, including for home and commercial mortgage loans. Growing numbers of thrifts and banks became insolvent on a mark-to-market (i.e., real economic) basis, and were subject to various sanctions, including seizure, all of which had the potential to bankrupt the FSLIC (thrift) and FDIC (bank) insurance funds.

In the face of this threat, certain accounting and regulatory manipulations were deployed to allow many of these institutions to continue, for a time, to appear solvent on their balance sheets. Such legerdemain did not, however, alter the fundamentals or likelihood of recoveries. The scheme of immediate interest was used to encourage the relatively stronger institutions to acquire those more urgently facing demise by postponing loss recognition. Inasmuch as it would have been irrational for another institution to assume the assets and obligations of one having negative (market value) equity, thus imperiling the acquirer's own balance sheet, the willing buyer was granted the right to pretend that the negative net assets assumed represented supervisory goodwill. This was defined as an asset subject to long-term amortization (usually at least 15 years) and treated as a good asset for regulatory capital computation purposes.

This accounting fiction was at first opposed by the accounting profession, but was ultimately legitimatized by Congress and grudgingly accepted in SFAS 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions. By the late 1980s, after many assisted mergers involving recognition of supervisory goodwill had taken place, it became clear that the thrift and bank industry problems could no longer be disguised through fanciful financial reporting. Congress at last took action, first by enacting FIRREA (1989) and then FDICIA (1991). This left many of the acquiring banks and thrifts insolvent on a balance sheet basis and subject to immediate seizure, as the formerly allowed supervisory goodwill was completely eliminated.

Hundreds of institutions suffered. Litigation ensued, and ultimately, in the 1995 Winstar decision, the Supreme Court held that the regulatory flip-flop constituted a breach of contract by the government. Scores of failed institutions and their former investors sought damages in the Court of Federal Claims, eventually recovering billions of dollars. The use of accounting chicanery, intended to grant temporary reprieve to institutions that had been mortally wounded by earlier government policy missteps, only added to the harm.

What is the lesson for the current crisis? It is that, if government social and economic policies demand actions such as mortgage loan cram-downs, there should be full and fair--and immediate--accounting recognition of their effects. If bankruptcy laws were to be amended as such, if large numbers of homeowners seek such relief, and if that assistance comes at the expense (partially or entirely) of lending institutions, the financial reporting effects should not be disguised or deferred. To do otherwise would, as with supervisory goodwill in the 1980s, only incur more damages in the longer term, while threatening the credibility of all financial reporting.


While a mortgage cram-down law may (or may not) seem warranted for societal reasons, accounting rules, whether set by the FASB or the banking regulatory authorities, should not abet the harm to lenders by fostering creative yet doomed financial reporting fictions intended to disguise or delay loss recognition. If Congress wants to place some or all of the burdens of bailing out unfortunate or imprudent borrowers onto lenders, then financial reports should clearly reveal the losses suffered, so that, inter alia, investors can evaluate the political risks of ownership of such institutions.

As for fair value accounting, any further efforts to moderate this decades-long evolution of financial reporting to measure and report the economic positions and results of operations should be strenuously resisted. Accounting standards setters should avoid being used as tools of policy makers. For auditors, the clearest lesson is that they must recognize their responsibility to master the intricacies of SFAS 157 and the recently issued FSPs, and strictly apply the evidence gathering and evaluation requirements under the auditing standards.

Barry Jay Epstein, PhD, CPA, is a partner in Russell Novak & Company, LLP, Chicago, Ill, His practice is concentrated on technical consultations on U.S. GAAP, IFRS, and expert testimony on civil and white-collar criminal litigation.
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Title Annotation:accounting
Author:Epstein, Barry Jay
Publication:The CPA Journal
Geographic Code:1USA
Date:Sep 1, 2009
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