In a recent post on business combinations accounting that is related to SAB 112, I criticized the FASB for creating yet another loophole in business combinations accounting that make M&A transactions more attractive than they really should be. To recap, I described how JP Morgan wrote down toxic loans acquired from WaMu so that, going forward, JP Morgan had a built-in stream of future earnings at very high interest rates.
First, a Mea Culpa
I was feeling pretty satisfied with myself until reader Michael interrupted my reverie with several interesting and valid comments. With great reluctance, I began to re-think parts of my screed.
First of all, he found a couple of inaccuracies in my telling, which should be corrected:
"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 141(R). FAS 141(R) 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 [Topic 2A-(5)]…those loans that were purchased at a significant discount are subject to the guidance in SOP 03-3, which requires a fair value measurement [at the acquisition date] 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." [italics and bolding supplied]
That's a really interesting last sentence, especially coming from an auditor, and I'm betting that even the PCAOB will not want to go near that one. As important as that may be, it's a digression from the mea culpa I now proffer to all who read that post: I overlooked the fact that SOP 03-3 would be applicable, because I mistakenly thought the acquisition of WaMu was accounted for under FAS 141(R).
Michael's comment and my mea culpa notwithstanding, the fact remains that henceforth, FAS 141(R) has taken over for SOP 03-3 in the earnings management toolbox when it comes to making sure that a business combination transaction will be accretive to future earnings. (Note: that doesn't mean that SOP 03-3 has become obsolete. Loan acquisitions that are not part of a business combination are also within its scope.)
Michael also responded to my suggestion that the offending provision of FAS 141(R) should be suspended until loans are fair valued. He pointed out that should that day ever come, the invitation for earnings management of which I spoke doesn't completely go away:
" … [L]et's assume that all financial instruments were remeasured 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.
Michael is right (again). I could live with an outcome whereby unbiased fair value measurements will provide a stream of accounting earnings to an acquiree. But, I am indeed more than a little skeptical that two versions of fair value will emerge from FAS 141(R)—if they haven't already from other games that executives will play with earnings. The WaMu's will still have strong incentives to overstate market value, and even Michael implies that auditors are not likely to stand in their way. The JP Morgans of the world have incentives to understate the same fair values.
Enter SAB 112
That's where SAB 112 comes into the discussion. Among other ministerial changes, it deleted Topic 2A-(5) of the SAB codification, which I described in the earlier post and became unnecessary after FAS 141(R) instituted the fair value requirement for acquired loans. The crux of this post is this: if the SEC thought that manipulation of loan loss reserves during a business combination merited an anti-abuse rule, then more than ministerial adaptations were called for. How can the SEC be so naïve as to think that fair value will fix the problem of loan value manipulation? Instead of merely deleting Topic 2A-(5), they should have re-written it to put the brakes on what will surely become a new recipe for chicken salad. It would have been really simple for the SEC to make the following rule:
Irrespective of pre- and post-acquisition bases of measurement, the new carrying amount of every asset recognized may be no less at the date of acquisition than the carrying amount recognized by the acquiree; similarly, the fair value of liabilities assumed may be no greater than amounts recognized by acquirees.
I know that my suggestion may sound unprinicpled and draconian to some (and I would be prepared to allow for some exceptions), but the reality is that no set of business combination accounting rules will be perfectly 'efficient.' For any accounting rule, it is inevitable that some value-creating transactions will be discouraged, and some value-destroying transactions will occur because the accounting result is too sweet to resist. The key for regulators is to strike an appropriate balance based on broadly acceptable objectives for financial reporting.
In regard to business combinations, there have been no such objectives ever before. It is clear that the rules have been completely out of whack since the inception of GAAP in the 1930s. As for the last few decades, the evidence is crystal clear that our economy has been administered a nearly lethal dose of value-destroying business combinations to juice executive compensation while killing share prices and wreaking havoc among rank and file employees. That's why I believe it is time to trying something more radical: an acquiror should not be able to create a stream of reported earnings by writedowns to assets or increases to liabilities. Therefore, post acquisition writedowns of assets and write-ups of liabilities would be charged against the post-combination earnings of the acquiror.
Let's see if the 'new SEC' is up to the task. We'll know they're doing it right if the EU and IASB have conniptions over it.