The Financial Accounting Standards Board has issued proposals that would repair the misuse of a certain exception in derivative accounting rules and make the risk profile of insurance companies more transparent to investors.
In derivative accounting rules, FASB has issued proposed implementation guidance related to Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities. FASB is taking on what it views as misapplication of a specific exception described in the statement.
A primary purpose of FAS 133 is to explain what a derivative is; to that end, the statement includes a list of specific instruments that would not be considered derivatives for the purpose of hedge accounting rules. One such exception says a contract would not be a derivative if it is indexed to its own stock and classified in stockholders’ equity in the company’s financial statements.
Porter
Thomas Porter, a senior consultant at NERA Economic Consulting and a former FASB staffer, says the Board now wants to tweak that position with its proposed implementation guidance. Its new idea: If a contract is indexed in the company’s own stock but settled in a currency other than its functional or homeland currency, it should be regarded as a derivative because the ultimate settlement is dependent on currency movements.
“Previously companies were applying this scope exception too broadly,” Porter says. The practical effect was an understating of liabilities or assets.
For insurance companies, FASB has issued a proposed statement of accounting standards that says all insurance companies must use the same specific method for accounting for financial guarantee insurance contracts, so that investors can more easily see and compare the risk insurance companies have assumed.
FASB wants insurance companies to use the same yardstick for measuring their risk and recognizing a claim liability resulting from financial guarantee insurance contracts.
“Prior to this there had been different approaches for how insurance companies accounted for these contracts, which meant you couldn’t always compare one against another,” Porter says. “Previously companies were allowed to determine whether to record a liability without having to tell anyone how it was determined. Some companies chose not to record anything at all until they had to make a payment. This will reduce diversity in practice and make financial statements more comparable.”
Bahnson
Paul Bahnson, accounting professor at Boise State University, says the guidance establishes a schedule around which the insurance company must measure risk based on the magnitude of the underlying liability and the time horizon for extinguishing it.
“I can’t say that I think much of the accounting,” Bahnson admits. “At its core, it’s not market-based. Any time accounting is based on setting up an orderly schedule at the outset of a contract and then using it going forward without judgment, it ignores what is happening in the markets affecting risk.”
Three FASB board members offer an alternative view within the body of the proposed implementation guidance, saying they disagree with the staff’s recommended approach because they believe it’s not the only way to interpret the rule and only adds to the lengthy and complex body of rules already surrounding derivatives.
FASB is open to comments on the implementation guidance through May 24. For the proposed statement regarding insurance contracts, FASB is open to remarks through June 18; related resources and coverage can be found in the box above, right.
Survey Calls For More Disclosure About Auditor Changes
The majority of CFOs believe that the Securities and Exchange Commission should require companies to explain all instances where companies and auditors decide to part ways, according to a recent survey by Grant Thornton.
In a national survey of 134 CFOs and senior comptrollers, 67 percent said the SEC should revise its Form 8-K rules to require the disclosure of reasons for all company dismissals of auditors, for all auditor resignations, and for all instances where an auditor decides not to seek reappointment to an engagement.
In 2006, the firm polled investors and found the majority thought it was important for companies to be required to give detailed information when they change audit firms. Only 8 percent said such disclosure would be unimportant.
Fusco
Cono Fusco, managing partner of strategic relationships at Grant Thornton, says current 8-K rules only call for reasons behind an auditor change when there’s a disagreement or reportable event involved, but there are legitimate business reasons for changing auditors that are not required to be explained to investors.
“That leaves to the imagination of the investor what might have happened that’s not being disclosed,” he says. “In the absence of transparency and sunshine, whatever goes on behind the curtain is always a little bit of a concern.”
Fusco says companies might not voluntarily describe auditor changes where there is no disclosure requirement because they fear offending the outgoing audit firm, which still has a role to play in the audit process through a transition period.
“It could be that the company wanted better service, but the predecessor firm might not feel good about being identified as giving lesser service,” Fusco says. “The company has to live with the predecessor audit firm for a few years, and they can exert leverage over the company even after they’ve been dismissed. That issue hamstrings companies from saying too much because they have some concern about how they will be treated.”
Last spring, Grant Thornton called on the SEC to amend policies regulating form 8-K required disclosures and communications related to audit firm changes. Fusco says the current rules have existed since a time when the SEC was concerned companies would “shop” audit firms for favorable opinions, but that concern no longer fits the current rules and reporting environment.
The Grant Thornton study and related resources can be found in the box above, right.
Small Companies Post More, Bigger SAB 108 Fixes
Slightly more than 5 percent of the Standard & Poor’s 500 had to adjust 2006 earnings to comply with the SEC’s new order to correct lingering errors in financial statements, according to an analysis by R.G. Associates.
By contrast, nearly 6 percent of companies in the Russell 2000 with market capitalizations below $400 million made comparable adjustments, and their corrections were roughly twice the dollar figure as those made by the larger companies.
R.G. Associates, an accounting research firm, examined a sampling of 393 S&P 500 companies and 373 Russell 2000 companies to conduct its analysis. In the S&P group, 17 companies—or roughly 5.2 percent—made corrections that resulted in an adjustment to beginning retained earnings, while five others made adjustments through earnings or restatements. In the Russell group, 24 companies (5.9 percent) made corrections, all by adjusting opening retained earnings.
Companies made the corrections in compliance with SEC Staff Accounting Bulletin No. 108, which was issued in 2006 to require companies to use a more comprehensive approach to correcting financial statement errors to prevent them from accumulating over long periods of time uncorrected.
Ciesielski
Jack Ciesielski, president of R.G. Associates, says he was surprised there weren’t more errors to correct. “I expected more, but I wasn’t surprised at the nature of the corrections,” he tells Compliance Week. “I thought it was a bit telling about the big companies that their adjustments were both favorable and unfavorable and that the small companies' errors were all unfavorable—and relatively bigger. I also expected a much higher incidence rate among smaller companies.”
Ciesielski notes that the SAB 108 disclosures he analyzed made no mention of internal control weaknesses in conjunction with the errors needing correction, but for a likely reason. “Internal controls are not supposed to detect all errors, just material ones,” he explains. “So if errors had been noted and they were considered immaterial—acceptable behavior of the era in which they occurred—you wouldn’t necessarily have had a reportable control issue.”
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