Peeling away financial reporting issues one layer at a time

The FAF Trustees Hold the Fate of Fair Value and IFRS Adoption in Their Hands

This is one thing of which I am certain:

If finalized, the fair value provisions of the FASB's financial instruments exposure draft (file no 1810-100) would be the most significant change to financial reporting since the founding of the FASB in 1973 – or perhaps even since the passage of the securities laws in 1933 and 1934. 

The volume of comment letters already posted to the FASB's website only tell some of the story – there are already 250 of them and the comment period still has a month to run. But, it's hard to find the good ones, as a lot of them go something like this one:

"Dear Director, as a Director and Shareholder of a small community bank, I wanted to voice my opposition to the "Mark-to-Market" accounting proposal. We as a small bank were affected greatly by the FASB 166 change. It has wrecked [sic] havoc with not just our capital levels, but it has also distorted numerous performance ratios. The last thing we need now is another change to current accounting practices.


[Name omitted]

Sent from my iPhone"

One reason I am writing this post is because there is also some really good stuff buried under the chaff. Ed Trott, former Board member wrote two letters. Trott's first letter strongly supports reporting financial instruments at their fair value, and here's a taste of it:

"I hope that the FASB (and ultimately the IASB) will act with true independence to develop accounting guidance for financial instruments for the benefit of the capital markets. Unfortunately I believe IFRS 9 was developed based on not threatening the IASB's franchise with the European Union rather than the opportunity to develop a high quality standard that could be used globally….

I served as an FASB Board member for 8 years [and before that, 7 years on the EITF and a few more on AcSEC.] In the final 7 years of my service the weighting of my auditor experience [appropriately] became secondary to the weight given to providing useful information to the users of financial statements. …

… My concern about being second-guessed with respect to using fair value measurements for [financial instruments] was overwhelmed by information that could be captured and communicated using a fair value measurement. With continued observation of financial reporting and enforcement, I believe fair value estimates, done objectively, are less likely to be second-guessed than many other parts of financial reporting.

Although I believe all financial instruments should be reported at value using a fair value measurement and that using a "business strategy" to determine where to display the changes is suboptimal, my comments will accept this approach."  [emphasis supplied]

Trott's second letter thoroughly debunked the "alternative view" expressed with the ED, which for convenience I'll refer to as an historic cost approach:

"The writers raise concern about 'subjective' data being included in financial statements…. I believe the subjectivity introduced in the proposal on recognition and measurement of credit impairments (which the writers seem to agree with) will dwarf the fair value measurement subjectivity. I believe [fair value measurement] is is much less subjective, and many more observable inputs are available, to determine a debt instruments [sic] overall fair value than the impact of only one factor….

Although I am not sure world leaders speak for financial statement users, I would love to see a high quality accounting standard for Financial Instruments that was used globally. However a less than high quality standard, even if converged with the IASB standard, should not be the goals of the FASB. I don't believe a convergence effort starting with two non-high quality approaches can end up with a high quality standard. " [emphasis supplied]

That's really good stuff.

David Mosso also wrote a comment letter, and it was completely consistent with his book, which I recently reviewed, but this excerpt at least will give you a flavor for the strength of his convictions:

"I am dead certain that no matter how many new regulations are written to prevent future financial crises, crises will recur periodically until the GAAP system … are given a revolutionary overhaul to adopt comprehensive mark to market accounting with emphasis on diagnosing companies' financial health."

I have to contrast that with the steady drone of the IFRS adoption machine in the U.S., which too much like those inexorable vuvuzelas at the World Cup irritatingly drone: "inevitable." Mosso is saying that if we fail to adopt IFRS in the U.S., our economy will go to hell in a hand basket. Someone please tell me why, after all we have gone through, that we should really care about IFRS adoption? 

Sorry Guys, But The Fix Is In … Maybe

As I stated above, one purpose of this post is to do my part to ensure that Mosso and Trott don't get buried by the whipped up hysteria of the banking lobby. The other reason is to point out the real threat that their voices will be rendered moot by political interests trumping user interests on the board of trustees of the Financial Accounting Foundation.

The Financial Accounting Foundation (the group that oversees the FASB and the GASB) announced last week that it would be expanding the FASB from five members to the original seven. It was only about a year and a half ago that the FAF shrunk the board from 7 to 5 members. Commenters on the proposal to shrink the Board were almost uniformly against doing so, but the FAF ignored the feedback and did what they said they were going to do in the first place, and in the name of faciliting IFRS adoption in the U.S.

Last week, the FAF announced it has taken another tack: without requesting comments from the masses, it would put the FASB back to seven members forthwith. Yet the stated reason was the same: to facilitate IFRS adoption. Go figure.

Actually, if the FAF wants to completely ignore the protestations of users, and practically everybody else except the largest audit firms and corporations on the topic of IFRS adoption, then re-inflating the Board to seven members makes sense.

The math is as simple as it gets. With one of the three members voting to issue the financial instruments ED, having announced his retirement (Bob Herz), four Board members continue to serve. Two of them favor fair value and two, like the IASB, support some new historic cost-based concoction. By expanding the Board to seven, the FAF can cherry pick enough new historic cost-favoring Board members, so as to overwhelmingly defeat the ED. Convergence and ultimate adoption of IFRS would be, as the horn blowers drone, "inevitable." And, at this juncture, I would have to agree.

Next, let's look at the FAF voting math, which is a little more complicated, albeit just as crucial. There are 14 voting trustees. I'm going to put the three from the audit firms plus the securities lawyer, investment banker and Microsoft executive firmly in the 'historic cost' camp. That's six already, and I am going to assume that only eight are needed to approve a new FASB member.

The three investors and the two academics ought to be 'fair value' folks, but I feel more than a little bit on shaky ground here. Neither academic appears to have big accounting chops—although they both have very strong credentials in finance.

I am also concerned about the three investors, because it is difficult to predict whether they will vote with their conscience or their wallets. It is not always clear that investment managers care for transparent financial reporting, as it could threaten opportunities to create a competitive advantage with proprietary analysis and modeling techniques that can cut through the haze emanating from low quality accounting standards.

The three trustees from government/not-for-profit are huge question marks. I readily grant that it is right and proper for NFPs to have their say on many of the issues addressed by the FAF; but, this ain't one of them. How ludicrous would it be for the NFP bloc to determine such a significant issue — one noe less that much, if any, impact on their constituencies.

So, that's the math that makes me fearful that the fix is in. I am just as fearful that a 'historic cost' bloc of trustees will control the appointment of two like-minded FASB members. And, since that will be enough to control the FASB via simple majority (which I am against), the third appointee will be nothing more than a $500,000 per year lamp post.

Whatever the ultimate scenario, if there is only one though that you will take from this posting, I hope it is this: 

The fate of the most significant financial reporting initiative in the history of the FASB will not be decided by the Board. It will be decided by the 14 trustees of the FAF.

The timing of the FAF's decision to increase number the size of the FASB, and their control over the new appointments, has rendered it thus; and for or all I know, that's the reason why Bob Herz, the current chairman, chose to retire early. If I were in his shoes, that exactly what I would have done.  Moreover, unless the FAF does the right thing, resign in protest is what Tom Linsmeier and Marc Siegel (the two remaining fair value guys on the Board) should do.

On the other hand, I have not a single shred of direct evidence as to how any individual FAF trustee will vote. Perhaps, they will appreciate why three bright stars of the accounting firmament, David Mosso, Ed Trott and (soon) Walter Schuetze have spoken out and appoint new Board members accordingly. But, the stated purpose of the Board expansion, and the arithmetic of Board voting strongly suggest otherwise–which leaves us with little to do, except to wait for the banks to fail us yet again.


  1. Reply David Merkel September 2, 2010

    Saw this today, thought you would like to see it:
    Why the SEC Won’t Flip the IFRS Switch

  2. Reply Felix del Gato September 7, 2010

    Herz was the primary mover behind the reduction in the number of Board members, which move also included providing the chair with more discretion in setting the agenda. I have not seen if that power is be taken back, but I would suggest that the reduction in agenda setting authority may have something to do with RHH’s early departure. Your comment regarding FAF making the final call of FV may be correct, but may also run afoul of FAF’s charter, which says the Foundation cannot set standards. So, I guess they could try indirectly, but that would be a most unusual move.

  3. Reply J Hale October 13, 2010

    Fair Value and M2M for a bank’s assets doesn’t make sense to me. For example, it if a banker negotiates a jumbo mortgage with a borrower, then it would seem that the transaction itself establishes the fair market value of the loan (willing buyer & willing seller, between the bank and the borrower), rather than the exit price (fair value). Under the M2M system, the only loans a bank could afford to make would be when there is an active secondary with little if any discount, such as loans that conform to Fannie and Freddie’s standards. Banks cannot afford to make loans that have to be immediately marked down to exit price.
    M2M for liabilities seems to be counter-intuitive. For example, if the institution’s credit rating declines, the market value of the liabilities declines and the difference is phantom income. So a bank’s credit rating drops from “A” to “BBB” and their debt is less desirable. The reduced M2M fair value is non-cash income. Or another example, if TARP contributes to a bank, then one would think that the credit rating would improve. Unfortunately any credit rating improvement creates phantom M2M losses from the increased market value of the bank’s liabilities. Such losses flow through the income statement and decrease equity. (If a company’s credit rating improves, it would theoretically cost more to buy back its’ own liabilities. Fair Value accounting flushes this through the income statement as a loss.) TARP gives a bank money and this action indirectly increases the phantom losses. How’s that for counter-intuitive?

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