Peeling away financial reporting issues one layer at a time

It’s Crunch Time for Loan Accounting – and Convergence

Once one chooses to ignore market values and to account for loans on the basis of "amortized cost" – as the IASB has "tentatively" concluded and the FASB may now be starting to question once again – the inevitable and ineffable question then becomes how and when to recognize losses on bad loans. Let's examine the alternatives.

The current rules constitute what is known as the 'incurred loss model.' Its only defender in the U.S. is the American Bankers Association, and that should be sufficient to put it to bed. But, if you would like to have the gory details, click here.

The proposed rules are based on the 'expected loss model.' Europeans have taken up its cause, but with apologies to the French and Yogi Berra, it is nothing more than déjà vu all over again. It means that bankers and other financial statement issuers will be required to predict future losses over the lives of loans even in the absence of evidence that a loss has incurred.

As Denny Beresford, former FASB chair once explained in an email to the AECM listserv, one of the important reasons the FASB issued SFAS No. 5, Contingencies, way back in 1975 was to eliminate the practice of accruing "catastrophe losses" in advance of the catastrophe itself. Loans and casualty losses are not the same, but the principle is; and setting aside that principle for loans would not improve the quality of accounting reports from banks any more than that 'cookie jar reserve' accounting was contributing to high quality financial statements from insurance companies before the practice was abolished.

Thus, it warmed the cockles of my heart to read that the FASB and IASB were falling out over the expected loss model. Here is how NYT columnist Floyd Norris called it:

"This week — days after the United States Securities and Exchange Commission made clear it was not going to move toward adoption of international standards anytime soon — the two boards found themselves in angry disagreement over one of the most contentious issues to emerge from the financial crisis: how banks should account for loans that may be going bad [i.e., the expected loss model].

… Leslie Seidman, the chairwoman of the American board, told a joint meeting of the two boards that bank regulators and others had voiced concern about the rules and that she wanted more time to work out guidance and details.

'This is deeply embarrassing,' responded Hans Hoogervorst, the chairman of the international board, which was meeting in London and was linked by videoconference to the American board's meeting in Norwalk, Conn. He said he feared 'this whole thing is going to unravel' after three years of extensive effort." [bold italics supplied]

I hate to be such a spoilsport, but I really hope it does unravel. Very simply, the expected loss model is an even worse solution to the loan accounting problem than the incurred loss model.

Auditing Loan Loss Reserves is a Bigger Problem than Measuring Them

But, the reason I am writing this post is to point out an even bigger problem than the loan accounting rules themselves. The problem I am referring to is that neither mode for measuring loan loss reserves is auditable. Moreover, the problem extends beyond the well-publicized findings of PCAOB inspectors: that many audit firms are incapable of consistently following their own audit programs (see poster children McGladrey, Crowe Horwath and Deloitte).

The mother of all loan loss accounting problems is that, even when auditors do check all of the boxes in their audit programs, they cannot be relied on to make consistent audit judgments.

For example, among the embarrassments to come out of the Greek bond accounting debacle, was the revelation that PwC audited three major financial institutions in Europe that held identical Greek bonds and purported to account for them the same way. Somehow, PwC found a way to conclude that a 51% haircut was reasonable for one client, but a 21% haircut on the exact same bonds was reasonable for another client. Please.

The root of the auditability problem is that management has extremely broad discretion in measuring the amount of impairment, and that auditors are reluctant to challenge those judgments – especially if the client is a too-big-to-argue-with bank. Making matters even more dismal, there is no accounting requirement to refer to current market prices, or even a specific methodology for estimating future defaults. The reality is that so long as an auditor does not object, management can pick pretty much any number it wants. So it does.


But, Market Value Alone is Not the Answer

By now, and especially if you are a regular reader of this blog, you are probably thinking that I am going to state that estimated market values can be the only reasonable approach to measuring loans on the balance sheet. Actually … not quite.

In theory at least, estimates of a loan's (or a pool of loans') market should be more "auditable" and "reliable" than loan loss reserves measurements, because an auditor could compare estimated market values to actual market values of traded assets that have similar characteristics. But, my confidence in that theory's applicability to practice was tempered by an observation from Hossein Nouri, when I floated this idea on the AECM listserv.  Hossein wrote, "[T]here are practical limitations to it [i.e., my theory]. For example, for mortgage loans, the banks have hundreds of thousands of loans, if not millions, in different states at different locations. Even within the same city, from one location to another location prices change drastically. In addition, each property has its own criteria, which makes it different from the other properties in the same neighborhood. In sum, there is no easily market value for these properties to come at the fair market value." [italics supplied]

I agree with Hossein that estimates of value are difficult, but it is hard for me to see that they should be more difficult or less accurate than estimates of loan loss reserves. I see the fundamental problem to go beyond the degree of subjectivity in making estimates, to whom is making them.

So, in addition to supporting market value measurement for loans, I go a step further to recommend that loans should be measured by an independent expert – i.e., not management. We need to get beyond the simplistic idea that financial statements should be prepared by management; that's like a student grading herself.

It is time to abandon any notion that management can provide unbiased estimates of value and/or future cash flows, and that auditors are equipped to produce independent and knowledgeable assessments of management's self-interested estimates. The auditor's role in loan accounting should be limited to:

  • Verification of the components of financial statements that can be verified (such as contractual amounts and existence).
  • Verification of the qualifications of third-party experts charged with estimating market values; and that those experts have performed the procedures they said they were performed.

* * * * *

Loan accounting may well prove to be the demise of IASB and FASB convergence. But whatever the outcome of this project, convergence should take a back seat at the SEC to achieving greater harmonization between accounting and auditing.

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