AS6 Finally Arrives; Sub-prime Rules; More

Auditors have a new standard in place that requires them to say more precisely whether an adjustment of a previously issued financial statement results from a mistake or a change in accounting policy.

The Public Company Accounting Oversight Board met last week to approve Auditing Standard No. 6, Evaluating Consistency of Financial Statements, along with a handful of amendments to existing interim standards that align audit rules with accounting rules. Specifically, the PCAOB wanted to make auditing standards consistent with the requirements of Financial Accounting Standard No. 154, Accounting Changes and Error Corrections, and the expected completion of a hierarchy for U.S. Generally Accepted Accounting Principles.

Olson

AS6 updates the auditor’s responsibilities when a company’s financial reports reflect either an error correction or a change in accounting principle in accordance with FAS 154, PCAOB Chairman Mark Olson said at the meeting. “AS6 will improve the auditor’s report by differentiating between a change in accounting principle or a material misstatement in the auditor’s explanatory paragraph,” he said. “While improving auditor reporting, these changes are not meant to change the auditor’s existing fundamental responsibilities.”

Separately, the PCAOB’s amendments to existing standards move the hierarchy of U.S. GAAP outside the auditing literature in anticipation of the Financial Accounting Standards Board’s plan to establish the GAAP hierarchy in accounting literature. The Securities and Exchange Commission must approve the PCAOB’s standards before they become final.

Michael Yates, head of national auditing at audit firm Crowe Chizek, says AS6 will drive consistency in financial reporting. “It’s not going to change substantially the auditor’s approach in an audit,” he says. “It is going to change the way they may report on inconsistencies with past practices that were adopted by management.”

Yates

Yates says the distinction between errors and changes in accounting policy may be straightforward enough, but AS6 also calls for a focus on changes in classification. “That may be one that catches auditors a little off guard sometimes,” he says. “In the past, auditors didn’t think about classification changes as being corrections of errors or accounting principles. This standard helps clarify that those are inconsistencies.”

The movement of GAAP from auditing standards to accounting standards is a fairly commonsense change, Yates says, but it will help define roles more precisely. “This makes it clear that auditing standards are the auditor’s responsibility and accounting standards are management’s responsibility,” he says. “The water used to be muddied when accounting standards were in the auditing standard.”

FASB Rejects Request for Sub-prime Workaround

As financial institutions continue to work out troubled mortgages, they will not get another pass on the accounting requirements for showing the related losses.

FASB last week unanimously rejected a request from the Mortgage Bankers Association to consider providing an exemption from the requirements of FAS 114, Accounting by Creditors for Impairment of a Loan. The MBA asked FASB to consider allowing financial institutions to reflect losses related to troubled loan workouts using FAS 5, Accounting for Contingencies, instead of using FAS 114.

FAS 114 provides the accounting for loans that have been modified in some fashion as part of a troubled debt restructuring. Bankers face an unprecedented number of such workouts as troubled loans, particularly sub-prime and adjustable-rate mortgages, have started to default in record numbers.

The MBA says members do not have the systems capability to remeasure the sudden large number of loans that require workouts under FAS 114, which generally requires a fair-value approach for measuring loan losses. FAS 5, on the other hand, gives more flexibility for how to measure the expected loss, including use of historical data.

FASB members generally were unsympathetic to the MBA’s request. “To me, it is very clear that when a lender grants a concession—whether it’s in terms of a reduction of the contractual payment or a significant adjustment of the timing of them—that a loss recognition threshold has been triggered,” FASB member Leslie Seidman said. “We’re not telling you how to apply 114. There is permissible grouping in 114, and if that provides simplification or addresses some of the operational issues, fine.”

FASB member Tom Linsmeier said the mortgage banking sector has already received a significant accounting break from the SEC, which exempted the banks from the requirements of FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. That exemption will allow banks to work out mortgages held off the balance sheet in securitized assets without reflecting the workouts or the related losses on the face of the balance sheet.

Linsmeier

“The economics of the circumstances suggest there’s a loss being incurred in light of these loans, and it’s important for investors to be able to understand the magnitude of those losses,” said Linsmeier. “I do not support adding a relief agenda item for Statement 114. In some respects this industry has already received some exemptions from accounting in statement 140. I don’t have sympathy for another exemption in this circumstance.”

The MBA provided only a brief statement following FASB’s denial that it was “disappointed by the decision.”

FASB Offers Guidance on Measuring Liabilities

FASB has published a proposed staff position to help with implementation of FAS 157, Fair Value Measurement, focused on how to measure liabilities under new rules.

The guidance was promised in lieu of a full one-year delay for the effective date of FAS 157, as was requested by some high-profile preparer groups late last year. The five-page proposed staff position clarifies that preparers should rely on market prices where they are available, but gives some comfort in relying on judgments when there may be little or no observable market activity to serve as a benchmark, says Al King, a member of the Financial Reporting Committee for the Institute of Management Accountants.

Olu Sonola, director of credit policy for Fitch Ratings, says the guidance will address inconsistencies that could arise in applying FAS 157 to valuing liabilities. “This clarifies that if the debt is traded in the market, your fair value should be the market price,” he says. “I’m surprised that some companies will want to use hypothetical, mark-to-model valuation when there’s a market price.”

The guidance is “almost commonsense,” King says. “FAS 157 says to develop values based on market participants. Most people who look at it say there aren’t a lot of market participants. Without this guidance, we would still have to fall back on some kind of internal analysis. This formalizes what we would have been doing anyhow.”

FASB is open to comments on the proposed staff position through Feb. 18.