In my previous post, I argued that the FASB should require accounting for investments in loans at inflation-adjusted replacement cost. I have not been flooded with reactions from readers, but I did ignite a lively discussion on the AECM listserv, composed mainly of academics, and which included a pretty comprehensive analysis from Emeritus Professor Bob Jensen of Trinity University. It's hard to say how most of the 700-odd members felt, but I did receive some hard jabs. That indicates to me that there are some legitimate and broad concerns – as opposed to merely selfish preferences of big money special interests.
In this post, I have taken their comments (mostly those of Bob Jensen, but there were others who contributed their own, thoughtful two cents) to synthesize ten comments that I can respond to in an organized fashion. Well, there are actually two posts, because the whole enchilada is just too much too swallow in one gulp without putting everyone to sleep. I'll cover five issues today, and five tomorrow. There will shortly follow another post in which I will present a T-account derivation of the financial statements I provided, accompanied by calculational notes.
Why have I decided to make such a big deal out of this? I predict this topic will be debated as vigorously by capital market participants in the coming year as healthcare is being debated by the general public. Also, just as with the healthcare debate, there will be spillover to other issues: such as convergence with IFRS and adoption; measurement of all liabilities; measurement of real assets; and most important, the objectives of financial reporting. Thus, reasonable professionals, academics and students will probably have to do a lot of thinking to distill all the rhetoric and to feel comfortable with their positions on the issues.
As to my own views, it is no secret that am in favor of comprehensive inflation-adjusted replacement cost accounting. Here’s my fantasy: put me in a room for a year and pay me my consulting rates. When the year is up, I will emerge with a set of comprehensive accounting standards based on constant-dollar replacement costs that will cover everything that GAAP now covers—in about 100 pages. The basis for conclusions might take 50 more, and worked out application examples might require another 100. Not everybody will like them, but everybody will come to understand them. After that, I’ll re-write Article 2 of Regulation S-X to specify the roles of auditors and other experts in SEC-filed financial statements.
But getting back to reality and the scope of this post, I am going to limit the scope to debt instruments and liabilities. I am also going to ignore the effects that changes in financial reporting per se have on regulatory capital, instead assuming that regulators will develop metrics of capital adequacy that are independent of changes in accounting rules and policies. Indeed, there are indications that this may finally be happening.
The First Five Arguments Against MTM for Loans — and Why I Think They are Wrong
- Some argue that HTM fair value adjustments reflect opportunity gains and losses when evaluating management. But these opportunity gains and losses may be so inaccurate that they remain in the realm of total fiction. [The commenter, Bob Jensen, considers "fiction" in this context to be "something that is either intentionally or accidentally reported as fact when in reality it is entirely made up out of thin air and does not relate to anything in reality."]
We should not allow fiction that we are 99.999999% certain is fiction. Keep in mind that all the fair value ups and downs of earnings totally wash out over the lifetime of an HTM security. Interim value changes are pure fiction, especially under IFRS where the penalties are too severe to turn fiction into cash.
Sometimes in accounting, we have to choose among the lesser of two evils. As I have written about in a previous post, until FAS 106 was promulgated in 1990, it would be fair to state that a more insidious "fiction" had been fed to investors: that retiree health care cost liabilities were zero, when it was far more likely that the amount was closer to a trillion dollars – plus or minus a few hundred million. Indeed, the chicken salad accounting (so-called "pay-as-you-go") prior to FAS 106, which inappropriately delayed recognition of those costs until they were actually paid in cash, is in large part responsible for the demise of GM, just to name one of many casualties. Thus, even when economic values are measured with huge error, unbiased estimates of changes in value are far better than presentations that pretend that such changes are zero. Despite its flaws, I'm quite confident that most would aver that FAS 106 was a much-needed improvement to financial reporting. So, if one is against reporting "fiction" as a matter of principle, how can one justify "fiction" in measuring retiree health care costs, but not for loans?
One might argue that narrative disclosures of changes in market conditions and other factors are preferable to imprecise measurement, but history has proven conclusively that in both the notes to the financial statements and MD&A, little more is provided than boilerplate. As Pat Walters (Fordham) indicated on the AECM listserv, it would be preferable to measure economic values on the financial statements, and disclose contractual amounts in the notes.
I also wonder whether those who support HTM because of measurement limitations, also support HTM for investments in bonds with readily determinable market values? In fact, the two FASB members who objected to HTM accounting when it was promulgated as an allowed alternative were Bob Swieringa and Clarence Sampson. Swieringa is an academic (whom I'm proud to say was one of my teachers), and Sampson is a former SEC chief accountant who worked at the SEC for 28 years. The other five came from the Big Six and/or industry, and would have been seen by Lawrence Revsine through his "selective measurement hypothesis" as having been "captured" by the regulatees.
Speaking of Clarence Sampson, in an interview sponsored by the SEC Historical Society, he provided a gem of a story that could foreshadow the kind of 'feedback' (to put it mildly) the FASB will get to its forthcoming exposure draft. Sampson was asked about the SEC's decades-long battle to improve the accounting for financial instruments by banks:
"[Accounting by banks] … was by today's standards horrendous back in the '60s … bad debts were not shown as an expense; they determined income before they took out the bad debt …[W]hen the Commission considered this question, the Chairman of the Federal Reserve came over and protested, dragging his feet all the way …" [italics supplied]
I am supposing that the banking industry's arguments against bad debt expense reporting was something like, "We should not allow fiction that we are 99.999999% certain is fiction." If that kind of reasoning didn't wash then, it shouldn't now, which incidentally leads us to dealing with the second issue.
2. Suppose a firm borrows $100 million by selling 10-year bonds at 5% with the holding that debt to maturity. Letting earnings fluctuate for 40 quarters for fictional gains and losses of value changes on those bonds is more misleading than helpful investors in my viewpoint. It may be especially fiction if there are cost-profit-volume considerations. Just because a few investors in those bonds are willing to sell at current market (thereby making a market) does not mean that all investors are willing to sell at current market rates. There are issues of blockage costs of trying to buy all the bonds back versus buying only $1 million of those bonds back.
It is indeed true that the earnings fluctuations will wash out IF there is no inflation, AND IF the loan is paid in full. The problem, though, is that inflation is ALWAYS with us; my example conclusively demonstrates that, when properly measured, the holding gains and losses on debt don't wash out, even when the bond is repaid in full. The reason for this is that inflation, even when it is low, can have a significant effect on economic earnings. Thus, it's a pretty safe bet that, if inflation were properly taken into account, managers' preferences for long-term debt as opposed to equity financing would shift towards equity. And as another consequence of the proper accounting, it would become more common for regulated financial institutions to hedge their exposures to unexpected inflation. Currently, accounting standards discourage that, even though it may be in everyone's interests to do so.
But, since the FASB is not proposing to measure the changes to loan valuations at their inflation adjusted amounts, I support their proposal to relegate the fluctuations in fair value to other comprehensive income (OCI), and to exclude them from the EPS calculation. That's because I'm fairly indifferent as to income statement presentation, especially with the prospect that XBRL will allow investors to tailor income statement presentation to their needs.
As to the problems attendant with the valuation of one's own debt, I believe in symmetrical measurement of financial transactions, i.e., transactions that only transfer wealth as opposed to create it (see this post). This means that a debtor should report its obligation at the lender's replacement cost of its investment (except that the debtor would not include the transaction costs that the investor would incur to replace the investment). Among the advantages of relative simplicity and clarity of principle, blockage factors would come into play only if there were investors holding relatively large blocks.
3. But even if we can accurately measure the value of the $100 million in debt, value to financial reporting is not served by booking repeated gains and losses that automatically wash out over the year life of the bonds. This is especially the case in IFRS where severe penalties are incurred for firms that the IASB imposes on companies that renege on their held-to-maturity pledges. How can you adjust fair market value of HTM securities for the penalty clauses of the IASB for reneging on HTM pledges?
Refer to my answer to 2, above, regarding the washing out of gains and losses when measured in nominal dollars, i.e., when adding apples and oranges.
As to the IFRS "penalties," that comment refers to a provision in IAS 39 (para. 46b) in which a company must essentially cease use of HTM accounting for the current and subsequent two years if they liquidate a bond investment before maturity. Actually, U.S. GAAP is not significantly different; the two-year penalty provision has been a long-established policy of the SEC staff since virtually the effectiveness of SFAS 115. The IASC, probably controversially, inserted it in IAS 39 as part of their hasty scheme to appease the SEC and be able to state that it completed the momentous, five-year "core standards" project one year early (1999). What a joke.
As to whether there is a "severe penalty" for breaking the HTM "pledge," absent any regulatory effects that are neither the fault or responsibility of accounting standards setters, I fail to see how changing the location in the accounts of one's debits and credits penalizes shareholders in any real sense. Call me old fashioned, but cosmetic accounting changes don't affect future cash flows unless they are factored into management's decision making processes. For example, a change in accounting could affect that portion of management's compensation which is earnings-based, and management could react accordingly; but if the BOD thinks that would be a bad thing, they could certainly make the necessary adjustments.
4. We might be able to estimate a reliable change in value of a HTM-designated asset or liability, but reneging on the HTM pledge will impact a raft of other past and future contracts that are almost impossible to factor into the damage caused by reneging on a single HTM pledge.
If we require current-cost accounting in any form, then HTM goes away; and absent HTM, I can't conceive of any reason why management would pledge to hold a security to maturity without adequate compensation for giving up their options. So, let's say that management does make that pledge and debt securities must be valued at replacement cost. Valuing the security by the replacement cost of the security as an asset to investors should handle this problem.
5. Debtors could book debt at current call back values, but these call back values often have penalty clauses that make them poor surrogates of current value, especially when penalties are severe.
I don't see this to be a significant factor if, as I stated earlier, the measurement of debt is its replacement cost to the holder.
That's all for now. My next post will deal with issues related to derivatives, hedge accounting, what agency theory has to say about the controversy, and complex executory contracts. I'll give you the issues I'll be responding to, and you can start thinking about your own responses now!
6. There are also hedge accounting considerations. Paragraph 79 of IAS 39 does not allow interest rate risk hedge accounting for HTM securities. Paragraph 21(d) of FAS 133 similarly precludes hedge accounting treatment for interest rate risk and FX risk, although credit default hedges are permitted. Available-for-sale securities can get hedge accounting relief. Mark-to-market proponents could argue that elimination of HTM designations and valuation of all financial securities at fair value eliminates some of the complexity of having hedge accounting available for AFS securities and unavailable for HTM securities. However, in my viewpoint having hedge accounting for securities that the company pledges will truly be held to maturity causes more problems by having both hedge accounting and fair value adjustments on these securities set in stone for the duration of their life.
7. The argument for valuing the right side of a balance sheet on the basis of CLAIMS is grounded in agency theory. Trying to parcel out, in real time, the shift in relative economic fortunes is a pickle of a problem.
8. We cannot report economic earnings to a point where fair value adjustments have errors of magnitude that destroy credibility in the reporting of earnings or assets or liabilities or equity. This is one of the reasons we do not report economic earnings from long-term purchase contracts such as the Dow Jones contract to buy newsprint (paper) from St Regis paper for 50 years. Sure we can build a model to estimate the 2009 $1.3 billion change in net present value over 43 more years of purchasing paper, but no sensible investor would have any faith whatsoever in that $1.3 billion number because of all the contingencies affecting both Dow Jones and St Regis over the next 43 years, including the possibility that newspapers will cease publishing hard copy in the next decade.
9. Continuing the previous example, courts of law most likely would not pay any attention to the net present value of paper from trees that have not yet been planted. One of the reasons we do not book long term purchase contracts is that, when broken, the damage settlements are often a miniscule fraction of net present value estimates of full-term contracts.
10. Mark-to-market accounting makes sense only to a point where the reported numbers have some relevance in estimating future returns and risks. However, when carried to extremes of sheer fantasy and valuation models with enormous missing variables, then we are no longer providing a service to investors. The problem with measuring assets and liabilities at replacement cost (or fair value) is that it is not the goal. If we report earnings with a total loss of credibility, the profession of accounting will become a laughing stock alongside the profession of astrology. Even economists (gasp) will laugh at us. Clients will no longer want to pay our fees — that’s ultimate loss.
(Click here for Part 2)