Peeling away financial reporting issues one layer at a time

FSP EITF 99-20-1: Dissenting Board Members Hit the Nail on the Head

Do you think that stable funding could allow the IASB to divorce itself from the influence of the EU? If so, consider the example the FASB is setting under similar circumstances, and think again.

The U.S. standard setter was granted its own legal separation papers from special interests six years ago by S-OX; yet it continues to play the henpecked spouse. Take, for example, that seven-years-and-running financial statement presentation project, which I wrote about in my last three posts (here, here, here). That project is moving slower than a one-legged turtle because the FASB chooses to debate and procrastinate, rather than give investors what issuers don't want them to have.

But, a brand spanking new example, which I am about to relate, illustrates a corollary: if Wall Street needs the FASB to make a quick fix, they're Johnny-on-the-spot to service the big boys.

EITF 99-20, which the new FSP amends, concerns itself with the once-arcane question of accounting for the impairment of 'retained interests in securitized financial assets' – you know, remnants of contracts or portfolios considered "junk" at the time the better parts were securitized for the consumption of sane investors. The problem became a front-burner issue to the holders of those junk retained interests as they proceeded to devolve into "toxic."  So, already, you may be getting my drift: the capital of financial institutions were about to get hammered, yet again, by fourth-quarter write downs unless they could get a rule change through the FASB – fast. Basically, what happened was that the financial institutions got their wish via an amendment to an impairment methodology that shouldn't have existed in the first place — and investor interests were further trampled upon in the process.

The Rest of the Story

Before I describe the new FSP, we should review the salient provisions of its progenitors: SFAS 115, sired out of holy wedlock by the prince of accounting gibberish; which in turn begat EITF 99-20.

SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, requires that investments with a readily determinable market value be measured at fair value. Mandating fair value for some assets was a landmark achievement, but beyond that, SFAS 115 is a charade: an exercise in hiding legitimate unrealized losses from view, solely to appease those who can't handle the truth. Unrealized holding gains and losses on marketable securities classified as "available for sale" (weasel word) are reported in other comprehensive income unless and until they are deemed by management to have become "other than temporary"  (a worse weasel word). Of particular relevance to the issues I am discussing here is this: an other than temporary impairment of a debt security within the scope of SFAS 115 would be recognized only if the holder (i.e., management) determines it is "probable" (the worst weasel word) that it will be unable to collect all amounts due according to the contractual terms.

EITF 99-20 arose from two differences between debt securities covered by SFAS 115 and the retained junk of which I ere did speak. First, junk retained interests do not have a readily determinable market value. Second, it is indeed "probable," by any way one chooses to interpret that weasel word, that the investor will be unable to collect all amounts due according to the contractual terms of retained junk remnants.

If I (or any reasonable investor) had my druthers, there would be no such thing as an available-for-sale financial asset. Retained interests in securitizations, junk or otherwise, would be measured at fair value through the income statement. But, that's not how the EITF works its magic.  Its job is to blithely analogize to some extant rule, no matter how ill-conceived it may be, and presto change-o, out pops a new rule for auditors to lean on, even if that rule is the accounting equivalent of sausage made from leftovers.

So, similar to SFAS 115, EITF 99-20 provides that an impairment of junk retained interests is considered "other than temporary" (with a resulting charge to earnings) only if there has been an adverse change in estimated cash flows. But, at least the EITF took care to specify that estimates of cash flows must be equivalent to those that a market participant would use in determining the current fair value of the investment. In fact, you could say that the EITF foreshadowed the approach to fair value that the FASB would take in SFAS 157.

Notwithstanding whether EITF 99-20 was a well- or ill-intentioned adaption of SFAS 115, the EITF's intentions were clear; and unlike the new FSP that undid those two little words, "market participant," the original choice of them made EITF 99-20 better than having to rely on inherent management bias.  The fact that the implications of using market-based assumptions grew to monster proportions as junk retained interests turned to toxic in droves only serves to highlight the need to de-link financial reporting from the overly sanguine projections of management. 

But that's not the way the Wall Street crowd wants the FASB to see things.  Nobody has been buying toxic loan remnants at anywhere near their original valuations, so the financial institutions would prefer to say that there is no market for them, and hence no "market participants." Therefore, instead of writing down their toxic assets, EITF 99-20 needed to be 'fixed.'

Here is the gist of the way EITF 99-20 was:

"If, based on a holder's best estimate of cash flows that a market participant would use in determining the current fair value of the investment, there has been an adverse change in estimated cash flows… [then an OTTI has occurred, and the investment should be written down to its fair value, and a loss recognized in earnings]."

And here is the 'fix' FSP EITF 99-20-1 made:

"If based on current information and events it is probable that there has been an adverse change in estimated cash flows… [then an OTTI has occurred, the investment should be written down to its fair value, and a loss recognized in earnings]."

If you look at them closely, one could argue that there is no difference in princple between those two mandates.  But obviously, in practice there must be a pretty significant difference.  Though I suppose that the three FASB members who voted for the FSP would vigorously disagree, the effect of the 'fix' is to permit management to ignore the input of the indifferent and dispassionate for management's estimates, whose compensation may be directly effected by the reported earnings for the year ended December 31, 2008.  Obviously, there will be a lot of investments that market participants consider toxic and management, in its infinitely biased wisdom, will persuade the auditors that they hire and fire are just fine.

If there is a silver lining to this debacle, it can be found in the eloquent and forceful dissent of two board members.  Here is just the beginning of what they wrote (names hidden, for the sake of more fun to come!):

"[X] and [Y] dissent from issuance of this FSP because they believe this short-term project does not provide sufficient improvements to financial reporting to support its issuance on an expedited basis with limited due process. [X] and [Y] believe that accounting standards should be focused on serving the needs of investors, who did not request this urgent change. They note that the majority of investors who responded strongly opposed the FSP. Investors are exhibiting a current lack of confidence in financial statement information prepared in conformity with current GAAP, as demonstrated by the high percentage of bank stocks that have market valuations below their tangible book values. As a result, these investors favor valuing all financial instruments at fair value through net income and believe this FSP represents a step away from that goal by failing to require that all changes in the reported fair values of Issue 99-20 assets be recognized in income." [bold italics supplied] 

These are damning words to which I would add that the FASB has deliberately ignored key findings of the SEC in its recent report to Congress. On December 30th, the SEC issued its 211-page Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-to-Market Accounting. As mandated by the Act, the report addresses, among other things, the adequacy of the processes used by the FASB in developing accounting standards. Among its conclusions, the SEC found that while the existing FASB process works well, additional formal measures to address the operation of existing accounting standards in practice should be established in order to be responsive to the information needs of investors in a timely fashion. Most important, the report states that accounting standards should continue to be established to meet the needs of investors. General-purpose financial statements may be utilized by others, such as prudential regulators of financial institutions; however, GAAP should not be revised to meet the needs of other parties if doing so would compromise the needs of investors.

So, less than a month after the SEC issued its unequivocal views, in FSP EITF 99-20-1 the FASB flaunts those views by short-circuiting due process and diminishing the quality of information provided to investors.

About Those Brave Dissenters

And, who were those masked men (or woman)? If I give you a list of the current FASB members along with a brief description of their backgrounds, I'm betting you can guess correctly, even without knowing anything else about them:

  • Robert Herz — former senior partner of PwC and part-time member of the IASB.
  • Thomas Linsmeier — former academic whose research has explored the role of accounting information in securities markets and consultant to the SEC on market risk disclosures.
  • Leslie Seidman — former consultant to corporations and accounting firms, and former VP of J.P. Morgan.
  • Marc Siegel — a recognized expert in forensic accounting and financial statement analysis.
  • Lawrence Smith — former senior partner of KPMG and chair of the EITF.

The lone rangers are Tom Linsmeier and Marc Siegel, of course — the only two who did not spend the bulk of their careers serving corporate clients. And incidentally, they are the two most recent additions to the FASB.

The likes of Linsmeier and Siegel give me some hope for the future of standard setting following the second major financial reporting crisis of the decade. If we could somehow get just one more on the board like them, the SEC's recommendations to the FASB could become a reality.

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