Peeling away financial reporting issues one layer at a time

FAS 140: Let’s Call the Whole Thing Off

I concluded my previous post by stating that financial reporting could be a lot less complex if the exclusive focus were on providing information of value to investors. There are many examples of the costs of failing to adhere to this basic principle, but certainly none more timely than FAS 140, that bric-a-brac of off-balance sheet accounting gimmickry.

A Grim History Lesson

The bells and whistles of SFAS 140 are best seen in the context of the FASB's financial instruments project, which was started way back in 1986, and spewed out sub-prime accounting standards over the ensuing decade and a half. This chronological listing gives you some flavor as to how hypersensitive the FASB has been to offending the sensibilities of big banking and big industry:

  • FAS 105 and 107 tippy-toed around fair value or impairment questions with watery disclosure requirements.
  • After the savings and loan collapse, the FASB reluctantly stuck its tootsies in waters made frigid by banking interests with FAS 114 and 118. The standards require some modicum of consistency with regard to assessing and measuring loan impairment, but implementation is an unprincipled mess to permit unwarranted delays in the recognition of bad loans and to avoid taking the deeper plunge toward market-based valuation.
  • FAS 115 on marketable equity securities created the ludicrous notions of 'held-to-maturity' and those weasel words, 'other-than-temporary decline in market value.' But, at least some financial assets were required to be measured at their market values.
  • FAS 122 (superseded by FAS 140) on mortgage servicing rights allowed for liberal impairment evaluations and earnings manipulation.
  • In FAS 123 on stock-based compensation, the entire FASB should have threatened resignation in response to Congress's bluff to shut them down; instead they permitted a disclosure-only alternative to fair value of stock options that perpetuated a corrupt system of executive compensation.
  • FAS 125 was the predecessor to FAS 140 for the accounting for transfers of financial assets. Bankers didn't like it, because off-balance sheet financing wasn't easy enough.
  • FAS 133 requires certain derivative financial instruments to be measured at fair value. However, its byzantine hedge accounting rules permitting management to smooth earnings is costly and of absolutely no benefit to investors. If there is life on another planet, it surely won't be so primitive as to have an accounting rule like FAS 133.
  • FAS 140 was created out of FAS 125 by tinkering with, among other things, the control criteria and the rules to determine whether an entity is a QSPE – you know, that cute little bug we're trying to squish, but can't.

The Basic Idea and Problem with FAS 140

Given the checkered history of financial instrument accounting, it is somewhat ironic that the core provision of FAS 140 is deceptively straightforward and even sensible: a transferor may only derecognize a financial asset, or a component of a financial asset, if it has surrendered 'control' over it. Thus, upon de-recognition, a gain or loss is recognized for the difference between the carrying amount of the transferred asset and the proceeds received in exchange.

As simple as that sounds, implementation has been complicated for two related reasons. First, a loss-of-control derecognition threshold still allows an entity to have all kinds of continuing interests in a financial asset subsequent to being "transferred." Second, allowing derecognition, while at the same time allowing the transferor to have certain forms of a continuing interest in transferred financial assets, opens a Pandora's box of detailed additional criteria for a broad range of specially-defined off-balance sheet financing gimmicks. Naming them is a bit like reciting the FBI's ten most-wanted list: securitizations (via SPEs and QSPEs), variable interest entities, repurchase agreements, securities lending, transfers of receivables with retained interests, etc. Investors have grown to despise each one of these, as the accounting too often obfuscates important risks that have come back to bite far too many.

My point is that from an investor's standpoint, none of these special accounting rules for achieving off-balance sheet financing are necessary or appropriate. If an investor could write the most basic and only rule of FAS 140, this is a version that would be far simpler and superior to what we have now: a transferor derecognizes a financial asset, or a component of a financial asset, if it no longer has any continuing interest in it. Therefore, all proceeds are accounted for as liabilities until all continuing interests in the transferred financial assets are terminated. (I would also add by way of clarification that any options exchanged as part of a transfer that meet the definition of a derivative in FAS 133 are, in the regime I propose, accounted for under that Statement. So, for example, if a portfolio of loans is transferred without recourse, but the transferee receives a qualifying option to put the loans back at a later date, the transferor would derecognize the loans receivable – and recognize the put option at fair value.)

Not Utopia, But Close Enough

The FASB's decades-long, quixotic quest to find just the right definition of 'control' that will make everybody happy is never going to end well, and it is clearly time to look for a workable solution somewhere else. Having stated what should be obvious to the FASB, but apparently is not, I will, with utmost alacrity, be the first to admit that my proposal is not perfect. This is because I am proposing asymmetric recognition and de-recognition criteria. Specifically, entities should recognize assets when they obtain control of them; and they must stay on the books until the entity no longer has any continuing interest in them.

Such a policy must inevitably lead to asymmetric accounting by transferors and transferees, but that is where we have been for a very long time in the accounting for non-financial assets. For example, consider revenue recognition on the sale of goods; if the buyer has a right of return, the SEC is adamant that a sale, and hence transfer of inventory, has not occurred until the buyer's right of return has expired, except in the special case where estimates of return rates can be made from a history of numerous similar transactions. In other words, if there is more than a trivial probability that the inventory is coming back to you, and you don't have reliable historic base rate information to estimate what that probability is, you have a continuing interest in the inventory.

And, let me also add that any time we can eliminate an off-balance sheet financing gimmick, disclosures get a lot simplier. Under my proposal to eliminate all the off-balance sheet trickery in FAS 140, the revised disclosures could go something like this:

Separately identify, either on the balance sheet or in the notes to the financial statements, those assets that are controlled by the entity, and those that have been transferred. For transferred assets, explain the nature of the continuing interests, and identify any related liabilities.

FAS 140 currently has about 2000 words (ignoring additional implementation guidance)worth of disclosure requirements, with more soon to come. In short, it is much simpler to provide disclosures pertaining to on-balance sheet amounts than it is for off-balance sheet amounts.

Parting Words of Wisdom

Both the FASB and IASB concluded back in 2006, before this latest current financial crisis, that FAS 140 was "irretrievably broken." Now, far too late (as usual), FAS 140 will be modified to eliminate QSPEs, and FIN 46(R) will also be modified to reign in some of the severest known abuses of securitization accounting. But as I hope I have demonstrated in this post, much more can, and should, be done. Otherwise, it's just a matter of time before some enterprising Ira Fastow-type financial executive or banker will serve us up yet another latest and greatest off-balance sheet vehicle that blows up in our faces.


  1. Reply Anonymous August 11, 2008

    Interesting idea. It doesn’t cover the SIV mess – where contractually the banks did not have an interest in the assets but because they didn’t want to upset the people who had, they bought them back anyway – and it would make the US banking system capitally inadequate (because so much stuff would come back on balance sheet that the bank’s capital ratios would fall dramatically) so it will never happen, but it is interesting. One problem is that those put options are rather complicated things and hard to value: think of a credit card deal where the originator has to substitute cc receivables if performance is not good enough. At the beginning that option is hard to value and not much of a liability as the pool is performing, but as time goes on its value might go up very fast, giving a nasty surprise for investors.

  2. Reply Independent Accountant August 11, 2008

    Bravo! I’ve been saying this for years. By the way, SFAS 133 is absurd too.

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