Impairment Guidance Coming Soon

Corporate America should prepare for new accounting rules on how to report devalued assets, since the financial crisis has pushed current rules on reporting impairments to the brink of collapse.

Robert Herz, chairman of the Financial Accounting Standards Board, told a national conference of the American Institute of Certified Public Accountants last week that FASB is racing to develop guidance that would take effect for the filing of 2008 annual reports. He did not, however, elaborate on what specific views or guidance FASB plans to offer.

The move comes after a series of roundtables in New York, London and Tokyo, where FASB and the International Accounting Standards Board heard preparers and auditors repeatedly tussle over when and how to reflect impairments in troubled securities, partly because guidance is scattered among several pieces of accounting literature.

Herz

Herz said the staff is studying how it can draw direction from Financial Accounting Standard No. 114, Accounting by Creditors for Impairment of a Loan, and FAS 115, Accounting for Certain Investments in Debt and Equity Securities, to see if FASB can provide a more cohesive approach. “There are questions about what we can do expeditiously, maybe even in time for 2008 reporting, and that would have to be very expeditious,” he told the AICPA crowd.

Russell Golden, technical director for FASB, reiterated that the staff is trying to get impairment guidance developed in time for 2008 annual reports. He said the staff also hopes the Board can take up a project to look at the extent to which FAS 133, Accounting for Derivative Instruments and Hedging Activities, could be improved in light of recent events, especially as it applies to embedded features in financial instruments that should be treated as embedded derivatives.

Guidance Go-Around

The news is a pronounced detour from September, when financial institutions pleaded for relief from requirements to mark the values of languishing financial instruments at current market prices. As part of the $700 billion Wall Street bailout, Congress promised banks it would at least consider how much fair-value accounting rules may be contributing to market woes, and told the Securities and Exchange Commission to look into the matter.

Now the SEC says it doesn’t expect its study (due back to Congress by Jan. 2) to fault fair-value accounting rules for the current mess, nor does it expect to seek radical changes to current requirements. Jim Kroeker, the SEC deputy chief accountant assigned to lead the study, said preliminary findings suggest there is room for improvement in the current accounting and reporting framework, but the focus has shifted to the model for impairment.

“Most agree that the current framework for impairment can be challenging to apply, and the utility of information to investors can be improved.”

— Jim Kroeker,

Deputy Chief Accountant,

SEC

“For example, there appears to be general agreement that investors could be better served by a more streamlined model for addressing impairments of assets that are not held for trading purposes,” he said. “Most agree that the current framework for impairment can be challenging to apply, and the utility of information to investors can be improved.”

Kroeker also indicated there has been enough flap over how to measure fair value in frozen markets that preparers and auditors could use some help to better establish the measures.

FASB has resisted providing application guidance in its quest for a more principles-based approach to rulemaking. Herz, however, said the Board is looking at disclosure or presentation ideas, apparently stemming from earlier suggestions that FASB establish a way for companies to distinguish where earnings are hurt by credit problems, rather than liquidity problems.

That approach would serve as a bridge in the ongoing argument over whether fair value should be used to measure long-term instruments that still produce cash flows but fetch lousy current prices. “I have my doubts about the ability to separate credit from liquidity, but it would be good to see that information and see how people react to that array of information,” Herz said.

Pozen

Robert Pozen, chairman of the SEC Advisory Committee on Improvements to Financial Reporting—which earlier this year offered two dozen recommendations to simplify corporate reporting—told the AICPA audience he likes the idea of a new presentation that would give investors a better view of earnings from core operations compared with unrealized gains or losses. He sees it as a way to address the “mixed-attribute” problem in financial reporting, both for investors and preparers, where some items in financial statements are measured at fair value and others are not.

IMPAIRMENT OF SECURITIES

The following excerpt is from FASB’s Financial Accounting Standard 115, “Accounting for Certain Investments in Debt and

Equity Securities.”

112. The Board concluded that it is important to recognize in earnings all declines in fair value below the

amortized cost basis that are considered to be other-

than-temporary; a loss inherent in an investment security should be recognized in earnings even if it has

not been sold. This is consistent with the other-than-

temporary-impairment notion that was included in

Statement 12.

113. The Board recognizes that the impairment provisions of this Statement differ from those in FASB

Statement No. 114, Accounting by Creditors for Im-

pairment of a Loan, which indicates that a loan is impaired when it is probable that the creditor (investor)

will be unable to collect all amounts due according to

the contractual terms of the loan agreement. This

Statement requires that the measure of impairment be

based on the fair value of the security, whereas Statement 114 permits measurement of an unsecuritized

loan’s impairment based on either fair value (of the

loan or the collateral) or the present value of the expected cash flows discounted at the loan’s effective

interest rate. The Board recognizes that a principal

difference between securities and unsecuritized loans

is the relatively greater and easier availability of reliable market prices for securities, which makes it

more practical and less costly to require use of a fair

value approach. In addition, some Board members

believe that securities are distinct from receivables

that are not securities and that securities warrant a

different measure of impairment—one that reflects

both current estimates of the expected cash flows

from the security and current economic events and

conditions.

114. During the course of this project, some have

urged the Board to develop guidance that would resolve recent practice problems about the application

of other-than-temporary impairment. Although the

Board believes that other-than-temporary impairment exists if it is probable that the investor will be

unable to collect all amounts due according to the

contractual terms of the security, the Board believes

that providing comprehensive guidance on other-

than-temporary impairment involves issues beyond

the scope of this Statement.

Financial Instruments Used to Hedge Investments

at Fair Value 115. This Statement does not address the accounting for other financial instruments used to hedge investments in securities.

Source

Financial Accounting Standard No. 115 .

“For investors, they would start to be educated about the difference between cash or accrued earnings and unrealized profit or loss,” Pozen said. “It also allows management to explain the volatility of earnings that really is separate from the core business.”

Pozen is not as keen on FASB’s plans to bring all securitizations onto the balance sheet. He described it as “over-reaction” that will kill lending. “You would loan it once and that would be it,” he told Compliance Week. “You would lose the ability to sell loans to the greater market.”

Exit the QSPE

FASB is revising FAS 140, Accounting for Transfers and Servicing of Financial Assets, and Financial Interpretation No. 46R, Consolidation of Variable Interest Entities, to eliminate the notion of a qualifying special purpose entity—the off-balance-sheet vehicles where securitizations are often hidden. Golden, the FASB technical director, said the new rules may be ready in late March or early April of 2009.

Instead of requiring financial institutions to bring all those structures onto balance sheets, Pozen said, entities should be required to state through disclosures where they still have risk, and they should be required to retain capital to back those obligations.

FASB and the SEC can compel disclosures; banking regulators would need to address capital requirements. But Pozen believes such a model is achievable, even in the short term, to get credit flowing again.

“Originators had no skin in the game, but we can change that,” Pozen said. “Sponsors had obligations that weren’t really revealed very well, but now all that is coming out. We need clear disclosures.”

While FASB works on the revisions to the standard, it is requiring some new disclosures in the meantime. The board finalized a staff position calling for new disclosures regarding where entities may have continuing involvements or obligations related to assets held in off-balance-sheet entities.

Kroeker also seemed to acknowledge the SEC needs to show more respect for well-reasoned judgments, even if the answer is different from the one regulators would prefer. “In line with one of the recommendations of CIFR, we have again heard about the importance of fostering an environment where reasonable judgments are both developed and respected,” he said.