Peeling away financial reporting issues one layer at a time

FAS 141(R): Turning Toxic Loans into Star Performers*

From a story published this Wednesday headlined "Banks Stand to Reap Billions from Purchased Bad Loans," came an account of a jaw-dropping transaction. It was spawned by FAS 141(R), the latest and greatest standard on accounting for business combinations:

"When JPMorgan bought WaMu out of receivership last September, it used the purchase accounting rule [FAS 141(R)] to record impaired loans at fair value, marking down 118.2 billion of assets by 25 percent.

Now, JPMorgan says its first-quarter gains from the WaMu loans resulted in $1.26 billion in interest income and left the bank within an accretable-yield balance that could result in additional income of $29.1 billion."

Business combination accounting has forever been fertile ground for earnings and balance sheet management for one simple reason: the opportunity to tweak the amounts reported for the assets acquired and liabilities assumed, with the ultimate objective of brightening post-acquisition earnings reports. But, as tiresome as that old game might be, the kind of maneuver that JPMorgan's management has engineered is a novel twist on an old loophole that had once been closed pretty tightly by the SEC.

The Closed Loophole that Would Be Re-Opened by the FASB

Once the "pooling of interests" method of business combination accounting of APB 16 was abolished with the advent of FAS 141 (not to be confused with FAS 141(R)), the most basic surviving principle of business combination accounting became thus: the acquisition of a business should always be reflected on the financial statements of the acquiror by assigning a new carrying amount to each of the acquired company's assets and liabilities. This new carrying amount would be updated, based on current assumptions and estimates regarding the future role of the acquired assets and liabilities in the combined entity. The implementation of this principle had long been known as the "purchase accounting" method for business combinations.

With certain important exceptions, SFAS 141 mandated that new carrying amounts for assets acquired in a business combinations would be based on their fair values. The exception that is germane to the JPMorgan story pertains to loans (i.e., trade receivables, interest-bearing loans and marketable debt securities classified as held-to-maturity). The measurement bases for these items were carried forward from APB 16's version of the purchase accounting method: a gross amount reduced by an appropriate allowance for uncollectible accounts. This exception to loan measurement was important, because it also meant that a 1986 SEC staff position would still be applicable to purchase accounting.

At that time, the SEC saw fit to put a stop to unwarranted increases in the allowance for loan losses as part of the business combination transaction. Increases to loan loss allowances would mathematically transfer future loan losses to goodwill, where they would be deferred indefinitely, with the effect of reporting inflated earnings in future periods as the loans were eventually settled for more than their understated carrying amounts. Staff Accounting Bulletin 61 (Topic 2-A(5)) states that the SEC would not permit any adjustments of the acquiree's estimate of loan loss reserves, unless the acquiror's plans for ultimate recovery of the loans were demonstrably different from the plans that had served as the basis for the acquiree's estimates of the loss reserves.

FASB Amnesia?

FAS 141(R) did away with the "purchase method" and established the "acquisition method" of accounting for business combinations. It apparently did so out of a belief that measurements of assets and liabilities that are based on the most current information available are usually, if not always, preferable to valuations based on less-current information. The JPMorgan case glaringly points to a significant flaw in that belief: inconsistent application of fair value could be more harmful than consistent application of a less desirable attribute. As to the case at hand:

  • WaMu, as is quite common, accounted for its loans based on a held-to-maturity model. That is, except for recognizing declines in creditworthiness, the loan carrying amount is based on the original contractual terms; interest is accrued by multiplying the net carrying amount by the yield to maturity as of the date the loan was originated/acquired.

  • Even though the market value of these loans had declined significantly as they turned toxic, WaMu apparently was not required to record losses to bring the loans down to their fair values.

  • JPMorgan, when acquiring WaMu, was required by FAS 141(R) to mark the loans to market. Subsequent accounting by JPMorgan will continue the WaMu the held-to-maturity model.

It would be a pretty safe bet that JPMorgan was very 'conservative' in their estimates of fair value for the loans; that's because the lower the fair value, the higher the yield to maturity, and the higher the amount of reported future earnings. Of course, there are some limits to JPMorgan's estimate of fair value: auditor pushback, SEC review, increased risk of goodwill impairment charges, and capital adequacy regulations. But, at least in this case, it is possible to become rich without being greedy.

Where is the SEC!?

Maybe there has been more coverage of this issue, but I haven't seen it; kudos to its author, Julie Crawshaw of Newsmax. If we are concerned that bank executives are being overcompensated, especially on the taxpayers' dime, here is a prime example of where insufficient oversight has spawned a new source of moral hazard.

For starters, the SEC should put a stop to this obvious and blatant abuse, immediately. They should issue another SAB, carving out the offending provision of FAS 141(R) and restoring the long-established and functioning status quo. Every company that benefitted from the ill-conceived accounting rule should be forced to retroactively restate their earnings – especially any financial institution on the government dole.

Perhaps the lack of permanent leadership in the Commission's Office of the Chief Accountant is contributing to a lack of attention to this obvious problem, but it is in no way an excuse. Also, this is a problem created by the FASB. Let's be charitable and call it an unintended consequence, but whatever the cause, the FASB should move to fix it forthwith. I'm suggesting that the SEC should act first, solely because they have the demonstrated capability of being able to move the fastest. That's because a SAB doesn't have to be exposed for comment before it can be issued.

But, lacking any actions by either the FASB or SEC to put the cat back in the bag, auditors (perhaps via the PCAOB), and boards should be put on notice of a new potential scheme to inflate executive compensation in the absence of actual value creation for stakeholders. If a single dime of executive compensation comes out of accreted excess earnings from these business combination games, I hope that private securities lawyers will round up the proxies and the lawsuits, settling for nothing less than "a pound of flesh."

A larger lesson is important to briefly discuss in order to understand how this kind of loophole can occur: in accounting for financial assets, the only workable system is comprehensive mark-to-market, all of the time. The current situation is a consequence (intended or otherwise) of the piecemeal approach pursued by the FASB (and IASB) towards fair value accounting.


*Note:  I made a technical correction to this post, that you can view here.


  1. Reply Kyle June 1, 2009

    I am a bit confused here. What is your suggestion as to how to fix the issue? JPM seems like they would’ve been damned in either instance on this. Either they write the loans down, and take flack for booking increased earnings, or they don’t write them down enough, and take flack for carrying crap on their books at an inflated value.

  2. Reply Raza June 1, 2009

    Hi Tom – excellant post as usual. I guess it is a ‘live with it,” kind of situation here. I could not agree with you more on the “piecemeal approach to the FV Accounting.” Seems like standard setters “knows” what they are doing 🙂

  3. Reply Kevin Brown June 1, 2009

    Dear Tom:
    I am trying not to snicker and I am not blaming you for picking up the obvious and yes the banks are gaming their financial statements what a surprise…Financial engineering is not dead yet

  4. Reply Michael June 1, 2009

    Tom, I think I’m with you on your conclusion (i.e. mark all financial assets to fair value (replacement cost?)) but the area of GAAP causing the inconsistent measurement is not FAS 141R. FAS 141R was first effective for transactions that closed on or after 1/1/09 for calendar year companies. JPMorgan was subject to FAS 141 (no R) for this transaction and disclosed as such. However, you may be aware that even under FAS 141, certain loans were required to be accounted for at fair value, notwithstanding the SAB…those loans that were purchased at a significant discount are subject to the guidance in SOP 03-3, which requires a fair value measurement for such loans. Given the purely awful composition of WaMu’s portfolio, it is not surprising that half their loans fell into that guidance. I think most of the focus should be on the criminal allowance put up by WaMu pre-transaction…$2 billion on $240 billion in loans at 3/31/08, $8 billion on $240 at 6/30/08. Yikes.
    In actuality the banks HATE FAS 141R because it depresses asset values and, therefore, regulatory capital. FAS 141R was in part to blame for many acquisitions not getting done (I’ve had a good seat for a few) despite the attractive values of banks because the remeasurement of the loans would drain all the regulatory capital out of the acquired banks and jeopardize the capital position of the acquiring bank.
    Lastly, let’s assume that all financial instruments were remeasued each period at fair value. While there will be timing differences with loans that are measured at fair value at acquisition, net income over the life of the same loans will be the same…if JPMorgan had to continue to remark the loans, they’d still recognize that accretion into earnings if the loans ultimately perform. I understand your generally well founded skepticism, but I think this is one of the less offensive areas of FAS 141R.

  5. Reply msoliman July 9, 2009

    Wow. more coverage you say. I thought I was the only soul who figured the mal- function out.The banks HATE FAS 141R. Turn the Banks over to the receivers and lets get SARBOX after the accountants. You say, most of the focus should be on the criminal allowance put up by WaMu pre-transaction…$2 billion on $240 billion in loans at 3/31/08, $8 billion on $240 at 6/30/08. Yikes.
    Yikes and Yikes (Is that a Lenders Law Firm LOL).
    God Job,
    Ind. Examiner

  6. Reply Michael Gemel August 20, 2009

    If a bank is acquiring another bank and the acquired bank has documented the values of assets by writing down loans and securities based upon due dilligence, would it be possible that additional write downs would be necessary under 141R merely due to the location of the bank, i.e. say in Florida?
    M. Gemel

  7. Reply tony December 1, 2011

    it is a tough question as to if you want to treat balance sheet right or income statement right.
    I remember back in 1990 when we have fas91 restrospective amortizaiton we had the simliliar quesiton..

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