At its August 22nd meeting, the FASB came to some significant tentative conclusions regarding the recognition and measurement of loans:
"The Board decided that the model [of loan loss measurement] should utilize a measurement objective of "expected credit losses" and there should not be an initial recognition threshold that must be met before an entity recognizes a credit impairment. Expected credit losses are defined as the estimate of contractual cash flows not expected to be collected…"
Withholding judgment for a teensy moment, let's begin with a simple example. Let's call it Exhibit A in the case against the FASB:
- On December 31, 2007, Bankco (calendar fiscal year-end) originates a bunch of 20-year, fixed-rate mortgages for a total principal amount of $10 million.
- Under the "Current Expected Credit Loss Model" (CECL) proposed by the FASB, Bankco must not only be able to estimate the total amount of contractual cash payments expected to be uncollected, but also the timing of the non-collections. That's because the estimated non-collections are to be discounted at the "effective interest rate" to "reflect the time value of money."
The application of the CECL model yields the following journal entry: Dr. Loan loss expense, $50,000; Cr. Allowance for loan losses, $50,000.
OK, here comes the judge. This court finds the FASB guilty on the following counts: (1) misappropriation of the term "measurement objective"; (2) time value of money malpractice; (3) manslaughter of basic accounting principles; (4) reckless endangerment of auditors; and (5) obstruction of accounting justice.*
Misappropriation of "measurement objective" — To establish motive to commit a crime, we begin by first noting that the FASB has not stated a measurement objective for the right of use asset to be recognized by lessees under its proposed lease accounting model; nor has it stated a measurement objective for performance obligations recognized under its proposed revenue recognition standard. We find the inconsistency suspiciously manipulative.
With respect to the charge of misappropriation in the instance of loan accounting, the term "measurement objective" is commonly understood to apply to measuring assets and liabilities in their entireties, and not merely the contra accounts that capture a component of the asset or liability. For example, the measurement objective for trade accounts receivable under U.S. GAAP is to produce the expected undiscounted cash flows to be received from customers. Accordingly, the allowance for doubtful accounts, adjusts the undiscounted contractual amounts such that the net balance meets this measurement objective.
But, by focusing only on estimations of amounts that are not expected to be collected, the CECL does not actually accomplish a legitimate measurement objective. The resulting net balance from this process ($9,950,000 in Exhibit A) cannot possibly be described in any systematic manner other than by the arithmetic that yielded the result. Thus, it cannot be said that loans are being measured with any particular objective in mind.
Time value of money malpractice — The aforementioned misappropriation of the term "measurement objective" is compounded (no pun intended) by time value of money malpractice. The FASB states as follows:
"…because the amortized cost basis of a financial asset represents the principal and interest cash flows discounted at the original effective interest rate, measurement approaches that estimate expected credit losses based on historical charge-off rates are an acceptable method of estimating expected credit losses in a manner that reflects the time value of money."
We honestly don't profess to understand the FASB's logic. What is clear, however, is that the FASB is discounting "for the time value of money" something that isn't money: i.e., contractual cash flows not collected are neither cash inflows or cash outflows.
The FASB could have required a reporting entity to determine the carrying amount of loans by discounting the expected cash flows to be collected using a rate of interest that reflects both the time value of money and the 'risk' that the actual amounts collected will be different than the actual amounts collected. But, to discount only the portion of the contract that won't be collected is a crime against finance. If it were left unpunished, then we shudder to think how condoning this kind of violation will be explained to future innocent accounting students who seek knowledge of principles and abhor being drowned by arbitrary rules to spit back on the CPA exam.
Manslaughter of basic accounting principles – Not only has the board not explained what the initial measurement of the loan could possible represent, they have not provided any defense for the crime of recognizing a Day 1 expense ($50,000 in Exhibit A), even before there has been any opportunity to generate earnings from the borrower.
In finding the FASB guilty on this count, we recognize that a loss on Day 1 could be justified for a trade receivable that arose from a product sale on which an operating profit is earned; however, that is not the facts of this case. It is impossible to make the argument that cash transferred on Day 1 to a borrower, in what is purely a financial arrangement, could exceed the value on Day 1 of the borrower's promise to make future contractual payments.
Reckless endangerment of auditors – Isn't it already enough that auditors put themselves at risk simply by attesting to the "reasonableness" of management's estimates of the allowance for doubtful accounts on short-term trade receivables? The CECL method is orders of magnitude more complex than that. It would require management to estimate expected losses for multiple periods extending out for decades.
Even under the best of circumstances (which the PCAOB has demonstrated through its inspections is far too often not the case), providing a reliable audit of the present value of expected loan losses under the CECL method will be an impossible task – for which auditors will no doubt be called to account should (or when) another financial crisis occur.
* * * * * *
As regards to the charge of obstruction of accounting standards, this court finds that inadequate accounting standards for loans and related financial instruments contributed to the Financial Crisis of 2008. Consequently, the FASB knew, or should have known, that loan accounting is the most urgent item on its agenda; and that it should have been prioritized above all else, including convergence. It is unconscionable for the FASB not to have a final standard that is clearly and straightforwardly crafted to protect investors from further overstatement of loan portfolios, or even just an exposure draft.
We note as a potential mitigating factor that the FASB has taken the step of disassociating itself with the IASB's "three-bucket" artifice; however, this is far from sufficient to justify an acquittal on any of the counts. The motives for the FASB's actions were clear: to ensure that bankers should be spared from having to measure their loan portfolios with current market-based information over which they have no influence.
Shame on the FASB for continuing to put investors at risk in order to serve bankers. And, most important to this judge, for insulting our intelligence.
*An additional count of failure to adequately define "expected" will be adjudicated at a later date.