New SEC Accounting Rule Softens Blow for Banking Sector

The Securities and Exchange Commission has tossed another bone to the banking sector, giving its blessing to an accounting maneuver that will soften the blow to third-quarter reports.

Herz

SEC Chief Accountant Conrad Hewitt told the Financial Accounting Standards Board to get to work providing permanent guidance on how to assess the fair value of perpetual preferred securities under existing accounting conventions, where the SEC says the principles are strained by current market conditions. In the meantime, Hewitt said his office “would not object” to banks and other entities immediately using a workaround procedure outlined in a letter to FASB Chairman Robert Herz.

According to Hewitt, preparers are stumped on how to assess declines in fair value for perpetual preferred securities under the “other-than temporary impairment” model of Financial Accounting Statement No. 115: Accounting for Certain Investments in Debt and Equity Securities. Impairment occurs when the current fair value of the security is lower than the amortized cost basis, putting it under water. If the impairment is deemed “other than temporary” according to accounting rules, the value is written down and becomes a hit to earnings.

The American Bankers Association did not immediately comment on Hewitt’s new guidance, but an alert to members describes the guidance as “something ABA has requested of both agencies several times.” ABA’s most recent letter to the SEC is focused primarily on its demand that SEC overturn FASB’s recent crisis guidance on applying fair-value measurements in illiquid markets, but it includes a note imploring SEC and FASB to address impairment.

Applying FAS 115 to perpetual preferred securities in the current market isn’t straightforward, Hewitt said, because PPSs are structured like equity, or ownership interests, but have a number of characteristics that make them look a lot like debt.

Hewitt

Hewitt says FAS 115 doesn’t say how the debt-like traits impact the assessment of whether the instruments should be written down temporarily or permanently. In the absence of clarity, Hewitt says he won’t mind if preparers assess the writedown as if the instruments were debt rather than equity securities. There are conditions, of course. There can’t be any evidence of deterioration in credit, and there must be plenty of disclosure, Hewitt’s letter says.

“What people want is some comfort in the price and the value. You don’t get that by hiding changes in value.”

— Jeff Mahoney,

General Counsel,

Council of Institutional Investors

By assessing the impairment under the credit model instead of the equity model, the focus shifts, says Rick Ueltschy of Crowe Horwath. “In the credit model, the focus can be either price recovery or recovery through the company’s ability to pay off or refinance,” he says. “As a result, there will be less focus on price recovery and a greater focus on recovery of principal through means which are reflected in credit quality, such as ability to redeem or refinance.”

The bottom line, he says, is to determine the trigger point for taking an other-than-temporary impairment charge, which has a direct impact on earnings.

Jeff Mahoney, general counsel for the Council of Institutional Investors, says banks generally want the impairment treatment to avoid writedowns, which they acknowledge are still to come under current accounting approaches. “ABA wants to get more held to maturity and convince the auditors that they’re not other-than-temporarily impaired so they don’t have to take any more writedowns,” he says.

Mahoney says banks ultimately won’t do themselves any favors by trying to reclassify securities as held to maturity to avoid the impairment and writedown problem. “What people want is some comfort in the price and the value,” he says. “You don’t get that by hiding changes in value.”

FSP FAS 157-D

Summary of decisions reached in proposed FSP FAS 157-d, Determining the Fair Value of a Financial Asset in a Market That Is Not Active

The Board discussed the comments received on proposed FSP FAS 157-d, “Determining the Fair

Value of a Financial Asset in a Market That Is Not Active,” which would clarify the application of

FASB Statement No. 157, Fair Value Measurements. The Board affirmed its decision to limit

the scope of the FSP to financial assets. The Board also affirmed that the final FSP will be

effective upon issuance. Prior periods for financial statements that have not been issued would

comply with the guidance in the final FSP.

Based on the comments received, the Board also decided to make the following clarifications to

the FSP:

A. Clarify that when distinguishing between an active market and an inactive market,

practitioners should (1) look to the market for a particular asset or class of assets

being measured rather than the overall market and (2) consider the factors that

characterize an inactive market, such as a decline in the volume and level of activity,

prices that are not current, and prices that vary substantially

B. Include a discussion about disorderly markets and the distinction between distressed

markets and distressed transactions

C. Emphasize that significant judgment is needed when determining if a particular

transaction is an indicator of fair value

D. Clarify that the use of contractual cash flows using the discount rate adjustment

valuation technique in the example would not change the application of EITF Issue

No. 99-20, "Recognition of Interest Income and Impairment on Purchased Beneficial

Interests That Continue to Be Held by a Transferor in Securitized Financial Assets,"

when determining whether a particular instrument is subject to other-than-temporary

impairment.

The Board directed the staff to proceed with a draft of a final FSP for vote by written ballot.

Source

FASB: Summary of Decisions Reached (Oct. 10, 2008).

The impairment issue has taken a back seat in recent weeks to the more urgent question of how to measure fair value when market prices have tanked and market activity has evaporated. FASB issued final guidance offering its views on how to apply Financial Accounting Statement No. 157 Fair Value Measurements in illiquid markets, which investor advocates cheered as consistent with FAS 157. The ABA, on the other hand, said the guidance ignored the problems, and the politically heavy-handed group demanded SEC intervention.

FASB’s guidance followed what many viewed as a more banker-friendly piece from both the SEC and FASB that reminded preparers and auditors of the need for judgment, not bright lines, in applying FAS 157 in the current environment.

Roper

Barbara Roper, director of investor protection for the Consumer Federation of America, says the SEC and FASB obviously are under enormous political pressure to bow to the demands of troubled financial institutions. Their actions to help such institutions, however motivated, are not fooling investors, she says.

“When you look at the gaps between the book value that banks are reporting and the market values, which are significant for a number of institutions, the lesson seems to be investors don’t believe the information they’re getting from banks now,” she says. “They think the banks are overstating their financial health, and it’s not just unsophisticated investors who think that. The evidence suggests the banks think it too. They won’t even lend to each other. They won’t trust who’s going to be around in a couple of weeks based on the information they’re getting.”

Ueltschy

Ueltschy says FASB’s final staff position should ease tension between preparers and auditors over the significance of broker quotes to the valuation process. ABA complained auditors were insisting on using broker figures even when they were age based on little or no recent activity in the market. “The FSP allows auditors and preparers of financial statements to properly execute internal modeling on par with the information companies and auditors are receiving from broker quotes,” he says.

The FSP also gives auditors a little more backbone to demand market data when companies want to give more weight to factors such as cash flows or discount rates, he says. “The FSP does a good job of explaining that those inputs need to reflect not just the company’s own thinking, but also assessments that are available in the marketplace,” Ueltschy says. “The discount rate needs to include a factor for lack of liquidity. That’s been an item some preparers have wanted to disagree with.”

Mahoney worries that the political pressure for bank-centric accounting guidance will cause the U.S. economy to follow Japan’s banking crisis in the 1990s. “In Japan, it took longer than it should have to get out of that crisis,” he says. “They held back on reporting losses.”