Peeling away financial reporting issues one layer at a time

Getting the Accounting for Derivatives Right — to Get Rid of Financial Regulations and Regulators

This may be a little hard to explain, but my thoughts went to lease accounting after reading Jonathan Weil's Bloomberg piece about the JPMorgan derivatives debacle. And, it happened again after I read Floyd Norris's piece in NYT about the misleading accounting produced by MF Global. Anyway, here goes nothing.

First, My Lease Accounting Ruminations

A few weeks ago, as I was trying to think of ways to add a dose of economic logic to the FASB/IASB's leasing project, which increasingly reminds me of a game of hopscotch for all of its contortions and jumping around, it came to me that a plain-vanilla lease is fundamentally nothing more than a series of forward contracts. For either a lease (or a series of forward contracts), there is a series of future cash payments; and these more or less coincide with the right to use an asset for a period of time (or deliveries of the underlying commodity). If there is any economic distinction to be made between leases and forward contracts, it is that forward contracts are often subject to net cash settlement provisions, whereas a lease generally permits only 'gross' settlement through cash in exchange for a right to use an asset for a period of time. Although U.S. GAAP hinges on the distinction between gross and net settlement, for analytical purposes I don't see that the manner of settlement should matter.*

I also have a theory as to why the accounting for leases is so controversial:

  • On one side of the debate, there are the 'accounting purists' (and piggybacking special interests) who argue that leases or any other so-called 'executory contract' would not give rise to a liability until performance under the contract takes place. Stated another way, the right to use an asset in the future is not an asset today; therefore, no obligation exists to pay for the right of use until some future point in time.
  • On the other side of the debate, are the 'accounting pragmatists' who would respond that the principle of non-recognition of 'executory contracts' poses problems in practice. Imagine this hypothetical: FedEx leases 100% of its planes and vehicles, and accounts for those contracts as operating leases. There is no arguing that its balance sheet, and any measures of risk and operating performance that relied on it for inputs, would be useless at best, if not downright misleading.

The pragmatist view is why the only workable solution for lease accounting is to require capitalization – as both the FASB and IASB have essentially recently concluded. And, some might also judge that the issue of fair value measurement takes on much less practical importance when leases are capitalized on the balance sheet by any ballpark measurement.

But, before going on to the financial institutions of concern to Messrs Weil and Norris, I want to take the argument for capitalization beyond the pragmatist approach against abuses of operating lease accounting to present for your consideration the notion that the principle of non-recognition of executory contracts has become outmoded. The far better principle to embrace would that all contractual rights and obligations must be recognized as assets and liabilities – without offsetting – unless an exception is provided. (I would indeed make exceptions, which I discussed here.)

The general principle borne out of the leasing lesson brings me to derivatives and financial institutions. Let's start with another, yet similar hypothetical: Imagine if JPMorgan had on its balance sheet just $10 million in loans receivable and $9 million in liabilities – that's it. Next, imagine that it enters into an interest rate swap (or a credit default swap if you'd prefer) with a notional principle amount of $10 billion. Like the FedEx hypothetical, there is no arguing that JPMorgan's balance sheet as of the date of entering into the derivative (and probably beyond) would also be useless and misleading. And again, the effects of recognition under any reasonable measurement method pale in comparison to the sunlight added by putting both the contractual asset and liability on the balance sheet.

The accounting policy lesson I want to convey is that a lease is both an executory contract and a forward contract – just like an interest rate swap, a credit default swap, or any other 'financial' derivative you can think of. If the FASB wants to capitalize leases, than why won't it capitalize financial derivatives in the same manner? I don't know if it's because board members would disagree with my logic, or whether they lack the gumption to argue for what's right and necessary. But, whatever their reason might be, the consequences of inaction are the same – which finally brings me to the pieces by Jon Weil and Floyd Norris.

What Floyd and Jon Got Me to Thinking

Regulators Snooze While JPMorgan Lights the Fuse Jon Weil observes that JPMorgan incurred $2 billion (and counting) of 'hedging' losses in a derivatives screw-up that took place right under the noses of more than 100 federal regulators sitting right next to the traders in the bank's Manhattan headquarters. Weil also said that Federal regulators were in situ and implicitly blessing Lehman's missteps, which according to him might explain why the SEC has been reluctant to take up enforcement actions against individual executives for violating securities laws. "We have come to expect … ineptitude from the … agencies charged with keeping large banks safe. They failed to prevent the last banking crisis; their policies even helped cause it."

My own reaction to Jon Weil's story is to focus less closely on the armies of regulators on the ground as it were, and more on the makers of the regulations. These makers of the regulations should have at some point come to see that nothing – not JP Morgan's or Lehman's CEO, not any other human being, or a so-called "value at risk" simulation – is capable of understanding, much less anticipating, all of the threats to profitability and solvency posed by these overly complex institutions and their contractual arrangements.

My point is that if the banks were forced to present a balance sheet that separately recognized the assets and liabilities arising from their participations in these derivatives contracts (just like lease capitalization), a different and far more accurate picture of the banks' future prospects would have been apparent to everyone. Simply put, better (and virtually costless) accounting regulations would have rendered superfluous a great man financial regulations and regulators; and far better outcomes would have been obtained.

Accounting Backfired at MF Global Floyd Norris tells the story how flawed repo accounting rules – basically, the same failure to recognize a liability arising out of a derivative contract – distorted the financial statements of MF Global. But, rather than express outrage, like Jon, Floyd timidly states, "It would be wrong to say bad accounting caused MF Global to fail. But it did both encourage and obscure risk-taking that ended in collapse and scandal."

It would have been more salient of Floyd to ask whether better accounting for MF Global's repos (which I described in greater detail in previous posts here and here), would have prevented its management from taking those risks in the first place. For me, the answer is obvious, along with the implication that the FASB has been complicit in the banking disasters – mainly through their procrastination and sputtering about convergence with IFRS. The undeniable effect has been to acquiesce to the big banks demands that they continue to follow their favorite recipes for accounting chicken salad. Even if the FASB can deny that they couldn't have anticipated how its repo accounting rules would be abused, it should have known from past experience that abuses of one kind or another were inevitable.

* * * * * * * *

Jon Weil says that the first thing we need to do is break up the too-big-to-fail banks. He's right, but an accounting requirement to gross up derivatives would add needed discipline and transparency to financial institutions of all shapes and sizes.

The reasons for grossing up leases and derivatives are exactly the same; only the politics is different.


* By the way, the view of a lease as a series of forward contracts also has important implications for the measurement of periodic expense associated with lease contracts. I've worked out some of my thoughts on that and hope to post them in the near future.


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