As debate continues over the role of fair-value measurement in the ongoing financial crisis, the Financial Accounting Standards Board is turning its attention to off-balance-sheet treatment of complex financial instruments, another accounting problem that played a supporting role in the meltdown.
The Board plans to revisit its proposal to revise Financial Accounting Standard No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and Financial Interpretation No. 46R, Consolidation of Variable Interest Entities. The proposals generally eliminate the concept of a qualifying special purpose entity—the choice breeding ground for securitized assets built on mortgages now failing at record rates. The plans also compel new disclosures that would give investors a better view of off-balance-sheet activity.
FASB gathered a roomful of advocates on all sides of the financial reporting process last week for a daylong confab on the wisdom of its proposals. The Board plans to revisit the issue at its regular weekly meeting Nov. 12 to determine where and how its original plans will be swayed by the feedback.
Few dispute the notion that the QSPE, originally intended to serve as a brain-dead entity to which securitized assets could be transferred and thus be regarded as “sold” for accounting purposes, has been stretched. That abuse became apparent when regulators provided guidance allowing banks to work out troubled loans held in off-balance-sheet structures without sacrificing off-balance-sheet accounting; that permission was the smoke signal indicating financial institutions were more involved in the assets than the accounting literature would intend to qualify for off-balance-sheet treatment.
Julie Roth, a director at Credit Suisse, implored FASB to consider how dramatically the elimination of the QSPE will transform the balance sheet, with untold billions suddenly appearing on the face of financial statements. “More transactions will come onto the balance sheet, but the economic risks have not changed,” she said. “We want to assure the impact of that has been considered.” Roth wondered if regulatory bodies, rating agencies, analysts, and investors would take that into account when reading balance sheets after FASB’s planned proposal would take effect. “The economic picture will look very different than it does today.”
In its letter to FASB commenting on the proposed amendments, Credit Suisse said FASB needs to scrutinize how assets will be treated when neither party—the institution that originates the instrument nor the investor who buys into it—is fully isolated from the instrument.
COMMENTS ON AMENDMENTS
Below are several comments on FASB's plans to revise FAS 140 and FIN 46R, as posted on FASB's Website.
We support the Board’s effort to amend certain key provisions of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (Statement 140), primarily the proposed elimination of the qualifying special-purpose entity (SPE) concept from Statement 140 and the exception from applying FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities (interpretation 46(R)), to qualifying SPEs. However, we are concerned with the practicability of certain proposed amendments, in particular those related to the new paragraph 9(b) of the Exposure Draft.
Under the Exposure Draft, if the transferee is constrained from pledging or exchanging the transferred financial asset and such constraint is not designed primarily to provide a benefit to the transferee, the transferor is considered to maintain effective control over the transferred financial asset. We believe the requirement for the transferor to assess whether the constraint is designed primarily to provide a benefit to the transferee is overly subjective and not operational as currently presented in the Exposure Draft. Clearly outlining the accounting framework to be applied when analyzing this criterion will be important since this amendment represents a significant revision to the
existing guidance.
—Russell Golden,
Dir. Of Technical Application,
Ernst & Young
We fully support the Board’s efforts to amend FASB Statement No. 140, Accounting for Transfers of Financial Assets and Extinguishment of Liabilities to revise and clarity the derecognition requirements for transfers of financial assets and the initial measurement of beneficial interests that are received as proceeds by a transferor in connection with transfers of financial assets. We believe that there are number of significant practice problems that have emerged from the application of the qualifying special purpose entity concepts articulated in Statement 140 that need to be addressed, and we applaud the Board for attempting to address these issues with the proposed Statement. However, we do have several concerns with the proposed amendments in the Exposure Draft, in particular the following:
The lack of convergence with International Financial Reporting Standards (“IFRS”);
The inconsistencies in the definitions of control between the proposed Statement and the proposed Statement of Financial Accounting Standards, Amendments to FASB
Interpretation No. 46(R) (“Proposed Amendments to Interpretation 46(R)”);
The elimination of the special provisions in Statement 140 and FASB Statement No. 65, Accounting for Certain Mortgage Banking Activities (“Statement 65”) for guaranteed
mortgage securitizations (“GMS”);
The definition of participating interests and the related amendments to the guidance for transfers of participating interests; and
Some of the proposed and existing disclosure requirements.
—Denny Fox,
VP, Accounting Policy,
Freddie Mac
The FASB and IASB have each undertaken separate derecognition and
consolidation projects in response to the global credit crisis. FASB’s project
started first and the SEC understandably is pressing for rapid completion. As a
result, both Boards are expected to issue separate standards, and then eventually
converge, potentially requiring constituents to change their accounting twice—an
inefficient use of time and resources. Ideally, both Boards should combine their
separate projects, take the best of both, and issue a single set of identical standards
as quickly as possible. We urge the FASB to reconsider the timing of its projects
and engage the SEC in a similar dialogue. FASB’s expected FSP, Disclosures
about Transfers of Financial Assets and Interests in Variable Interest Entities,
provides an appropriate bridge until then.
The QSPE model is broken, and we agree it should be eliminated.
We support determining the primary beneficiary (parent) of a variable interest
entity (VIE) on the basis of control so as to obtain benefits, a view we have long
held and advocated. The Board’s definition of control—power when it matters—
is very broad and will materially increase the balance sheets and reported leverage
ratios of enterprises that service securitization and structured finance vehicles and
have economic exposure to them. We are not convinced this is an appropriate
outcome in the many situations where assets are held in a bankruptcy-remote
entity, there is no practical ability to control, the liabilities have no explicit or
implicit substantive recourse to the general credit of the parent enterprise, and the
enterprise does not have exposure to a majority of the entity’s substantive risks
and rewards.
—Matthew Schroeder,
Managing Director,
Goldman Sachs
Source
Comments on FASB’s Website.
“Consolidation [where originators will bring those assets back onto their own balance sheets] of these entities may lead to balance sheets that include assets that entities do not have legal title to, and therefore would not represent the consolidating entity’s true exposure,” Credit Suisse wrote. “Consolidation of these vehicles will impair financial ratios, financial covenant performance, and regulatory capital requirements.”
Lamonte
Mark LaMonte, vice president at Moody’s, and Steve Merriett, a financial analyst at the Federal Reserve, assured FASB they were fully prepared to align their view of economics and risks based on the proposal. LaMonte told FASB he believes the analyst community can alter its usual metrics and methods perhaps even faster than the preparer community might be ready to implement the standard.
Merriett told FASB that banking regulators would relish in having “as much [time] as possible” to be ready to follow the new standard, but he was optimistic. “In this case, the banking regulators are moving faster than normal,” he said. “We already have teams in place evaluating structures … We’re deciding whether we think the current capital approach works in those cases or whether we need to adjust it.” Merriett said the Federal Reserve is coordinating its approach with other regulatory agencies and even international counterparts to be prepared for the change.
Define ‘Control’
Identifying control over the assets is the tricky issue. Securitization has grown so complex that the traditional lines between buyer and seller have blurred, giving FASB a knot of issues to unravel as it writes rules to govern who benefits from securitized assets and, therefore, who has control.
Bob Uhl, national director of Deloitte & Touche’s accounting standards and communications group, said the most contentious issues in FASB’s proposal center on how to define who should consolidate existing entities onto the balance sheet. Analysts generally are pushing for rules that would require a financial institution with any continuing involvement with a given entity to bring it on to the balance sheet, or at least require enough footnote disclosure so that analysts can bring it onto the balance sheet in their own adjustments.
FASB’s proposal, however, is more in line with allowing banks to derecognize such entities (that is, move them off the balance sheet) if they’ve substantially surrendered control, even if they still get some cash flow associated with the assets, Uhl said.
The enormity of the task, coupled with the U.S. migration toward International Financial Reporting Standards, is prompting financial institutions to suggest FASB should postpone the entire amendment process for U.S. Generally Accepted Accounting Principles and focus its efforts on developing a standard that is fully converged with IFRS.
An unidentified speaker at FASB’s roundtable said financial institutions are objecting more about the process of change than about the conceptual direction of change. “By eliminating the [QSPEs] in a very quick manner with a rushed standard, we’re going to have a lot of implementation issues,” he said. Given that FASB is revising GAAP with the current proposal, yet is also working with the International Accounting Standards Board on a longer-range look at consolidation and derecognition, “is it necessary to go through all these implementation issues when we’re going to have to change them again in 2010?”
Herz
FASB Chairman Robert Herz said the changes and related disclosures are important enough to investors that they should be pursued now, with an eye on the future direction of change as well. “We’re trying to make sure that whatever answer we come out with here would be consistent with the model that would be developed on broader consolidation and derecognition fronts,” he said.
LaMonte said he’s suspicious about the prospects for improvement if it’s expected to come from a convergence project. “I have little faith in FASB and IASB to get a project done by 2010,” he said. “There is a need for an immediate fix. If it’s directionally consistent with where we want to go, that’s meaningful.”
Jim Kroecker, deputy chief accountant at the Securities and Exchange Commission, weighed in with his view that he’d hate to see the rules put off as well. With the time it takes to develop standards, especially in conjunction with the international body, plus the demands for additional time that are often factored into standard setting, “it’s going to be five, six years, some long period of time,” before changes would take effect, he said. He wondered aloud whether users of financial statements are willing to wait that long.
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