Peeling away financial reporting issues one layer at a time

ASU 2011-2: The Accounting for Troubled Debt Restructurings Still Leaks Oil

I hand-waxed my 1990 Honda Accord last weekend in celebration of its 21st birthday. Since it still runs like a top, I can take some satisfaction in having 'improved' my car. On the other hand, and it should go without saying, I would have been wasting my time if the engine were leaking oil.

The accounting standards for a "troubled debt restructuring," (TDR) just happened to get its second major wax job recently — in the form of ASU 2011-02, Receivables (Topic 310): A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring. And, unlike my Honda, TDR accounting was a lemon from Day One.

As everybody knows, the Honda brand is associated with very high standards for initial quality. Honda's mission is self-evident from its products: to make a profit from selling cars to misers like me; who are more interested in safety and long-term reliability than high styling, high performance and gadgets that will break and require my attention. But, I don't know how anyone could deduce the FASB's mission from its output, nor its target market. Here's how Leslie Seidman unhelpfully explained it in her recent Senate testimony (and for which I named her my "first goat" of those hearings):

"The FASB's mission is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information." [emphasis supplied]

There may be no better example than TDR accounting for illustrating just how vacuous that mission statement is. Basically, a lousy car will always be a lousy car, no matter how much "improvement" you get from a wax job.

SFAS 15: The Birth of a Lemon in 1977

According to Stephen A. Zeff's must-read 2005 article, "The Evolution of U.S. GAAP: The Political Forces Behind Professional Standards", TDR accounting, as "established" by the FASB was a lemon:

"In 1973, the City of New York was said to be bankrupt, and, with great difficulty, the banks that held the city's debt instruments restructured the debt by modifying its terms. The principal payments were postponed, and the interest rate on the debt was lowered. The banks proposed not to reduce the balance on their books of the loan receivable from the city and therefore not to recognize any immediate accounting loss. FASB began to study the question, and the possibility of recognizing a loss in the event of such restructurings was put to a public hearing. At the hearing, Citicorp Chairman Walter B. Wriston said that if the banks had known that they might be required to recognize an immediate accounting loss from restructuring the city's debt, 'the restructuring just might not have happened.' Furthermore, the prospect of a required recognition of a loss in such cases led Wriston to doubt that such restructurings would be possible in the future. His bombshell testimony put considerable pressure on FASB. In the end, the board [by a 5 – 2 vote in 1977, four years later] said in SFAS 15 that if, after a restructuring, the total cash flows to be received under the new terms were no lower than the balance in the receivable account, no writedown or loss recognition would be required. The standard was heavily criticized because it ignored the economic reality of the transaction altogether." [emphasis supplied, and thanks to Bob Jensen for bringing this portion of Steve's article to my attention.]

The economic reality, of course, was that New York City's new debt contract was worth much less to the bank than the original debt contract when it was issued; yet, not a single dollar of loss would be recognized. FAS 15 was a case of carrying the questionable logic of historic cost accounting much further than intended, while at the same time exposing its soft underbelly: the flawed logic was that accounting profits could be measured as if time, and to a certain extent risk, did not exist; the soft underbelly was the 'principle' that an arms-length exchange should trigger a new basis of accounting for an asset. Does an arms-length exchange take place when debt is re-negotiated? Of course it does, but TDR accounting depends on the pretension that, if played within the rules, no exchange is deemed to have occurred.

The upshot of SFAS 15 is that if it were a car, the engine would have seized soon after being driven off the dealer's lot.  According to Steve Zeff:

"Application of SFAS 15 also prolonged and deepened the financial crisis faced by banks and savings and loan institutions in the 1980s. Many banks and thrift institutions effectively became insolvent because of many bad loans, especially at a time of high interest rates. Federal regulators allowed them not to record writedowns or recognize losses after they had restructured loans to accommodate the debtors. Hence, many of these financial institutions could issue balance sheets projecting an apparent solvency, when many should have been closed. SFAS 15 was used by regulators to justify this policy. As a result, the standard was said by many to be the worst ever issued by FASB. [emphasis supplied]

One might be able to forgive the FASB if only it had learned two important lessons. First, it is not sufficient to merely "establish" any old accounting standard; it should be the equivalent of my Honda Accord — i.e., built to last and be proud of.  

Second, it is not sufficient to merely state that accounting standards should be 'neutral', but they really do have to be neutral.  Financial statements can only be neutral if they reflect economic reality. TDR accounting was, and still is today, a misguided and biased attempt to obtain a political result by deliberately distorting the process by which loans should be measured and reported. What Walter Wriston was essentially saying is that the 'right' accounting for TDRs is the accounting that results in the proper quantity of loan concessions from banks. But, the question is 'right' for whom — bank executives, or bank shareholders?

The problem is that the 'right' accounting for shareholders is anathema to the Walter Wristons of the banking establishment. If creditors were required to measure loans at fair value as of each balance sheet date and as of each modification of the loan terms, then long-term modifications would only occur if the affect were to increase the fair value of the loan, relative to its fair value just prior to the agreed-upon modification by both parties.  Under SFAS 15, all we might know is that a loan modification did not upset the bank executive's earnings-based bonus arrangement.

Lemon Wax 

The S&L crisis exposed the fact that financial institutions were exploiting loopholes like TDR and vague standards for measuring loan loss allowances (FAS 5) to inflate their balance sheets. So, along came the first wash and wax job in the form of FAS 114. I won't go into the details here, but FAS 114 said that if it became 'probable' that a debtor looked wasn't going to pay what it owed, then the creditor would have to give the carrying amount of the loan a haircut. Not all the way down to fair value, but a haircut nonetheless.

Was FAS 114 an 'improvement'? Strictly speaking, yes. But, it was only just enough to perpetuate the ruse that TDR accounting made any sense at all. The loan-loss allowances recorded from the application of  FAS 114 were but a drop in the ocean compared to the actual losses incurred as a result of the financial crisis of 2008.

Which, finally brings us to the latest wax job, ASU 2011-02. FAS 114 proved to be an utter failure when applied to all loans, but let's for now just focus on the TDR accounting provisions. The ASU has not changed the measurement provisions of TDR accounting one iota, but has purported to firm up that soft underbelly I referred to earlier—maintaining the false dichotomy that some loan modifications are TDRs, and others are exchanges requiring a new basis of accounting.

Yes indeedy, all ASU 2011-02 does is to make it a little more difficult for a creditor to qualify for TDR accounting. But is ASU 2011-02 an 'improvement'? Strictly speaking, yes. But, let me ask the question another way. If the Federal Aviation Administration wrote safety standards like the FASB writes accounting standards, would you fly, or would you drive?

I'd be driving in my Honda.

* * * * * * * * *

The primary reason I dubbed Leslie Seidman "first goat" of the recent Senate hearings on accounting is because we have had more than enough of merely 'improved' accounting standards. The FASB's mission statement is a joke. Either Seidman fails to see that, or she knows how to keep a straight face when reading her prepared remarks. Whatever the case, someone (it's supposed to be the SEC) needs to tell the FASB to stop behaving like petty bureaucrats and acknowledge that after four financial meltdowns in 40 years, it is past high time for fundamental changes to accounting standards.

I have said it before, and I'll say it again: I believe that Bob Herz recognized the problem and articulated a solution. That's why he was fired, and that's why we have Leslie Seidman.


  1. Reply Independent Accountant June 27, 2011

    I’m so old I remember when SFAS 15 came out. I read it and concluded the FASB did not understand discounted cash flow analysis and that SFAS 15 was an economic joke.

  2. Reply steve July 20, 2011

    Hi Tom,
    Don’t know how you do it… just reviewed and I’ve purchased 9 new cars in 11 years (1 was totaled, so had to replace) for my wife and I.
    Bought a new camaro two weeks ago… I now wax cars, havent in 20 yrs…
    I’m good for the economy i suppose.

  3. Reply Jamal August 12, 2011

    TDR accounting was, and still is today, a misguided and biased attempt to obtain a political result by deliberately distorting the process by which loans should be measured and reported.
    I think you are getting it right.

  4. Reply Benjamin Skinner January 19, 2012

    Yet another problem stemming for debt.

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