Peeling away financial reporting issues one layer at a time

Loan Accounting: It’s High Time for the SEC to Step Up to the Plate

“Full convergence with the United States – leading to the creation of one single set of global accounting standards – is no longer an achievable project…   But IFRS moves on – we have a large part of the world to take care of.”

The above declaration by IASB chair Hans Hoogervorst comes on the heels of the finalization of IFRS 9. Among the things the IASB “takes care of” in that financial instruments standard is to resurrect — for the benefit of European banking establishment — the hoary German tradition of general loan reserves for unidentifiable uncertainties.   Owing to the central role that accounting played in the 2008 Financial Crisis, loan accounting had been the most consequential project the boards undertook together; and owing to the intractable position of the too-big-to-defy of Europe, it was the project that posed an existential threat to the IASB.

Mr. Hoogervorst’s statement is an acknowledgement that the FASB will not be issuing a loan impairment standard that is fully-converged with IFRS 9.  Kudos to the FASB for not completely caving to the IASB, but the chopped liver that the FASB is fixing to serve up is way too close to the IASB’s recipe for comfort.  In respect to this topic alone, to state that the 12-year convergence effort had been simply a waste of valuable time does not go far enough.  Had it not been for the protracted attempts to find common ground with foreign standard setters, for whom investor protection is evidently not a top priority, the variant on the so-called “expected loss” approach the FASB now promotes would have been a non-starter on this side of the pond.

All of the above is by way of background to a letter that Walter Schuetze, former FASB member and SEC Chief Accountant, has sent to the SEC and FASB.  Here is the body of that letter, verbatim:

I see in The Wall Street Journal of July 25 that both the Financial Accounting Standards Board and the International Accounting Standards Board plan to require banks to measure and book the effect of future loan losses on an arbitrary basis. The FASB wants to require that all future loan losses be booked at the time a loan is originated. The IASB wants to require that next year’s loan losses be booked at the time a loan is originated.

Neither proposal will produce financial statement amounts that can be audited by reference to a fact or facts, i.e., “competent evidential matter.” Neither proposal will produce financial statement amounts that will be relevant to investors and creditors. Both proposals retain management’s ability to manage a bank’s reported earnings and shareholders’ equity.

Banks should be required to disclose the fair value of their loan portfolios. Fair value is an amount that investors and creditors can and will use—it is a relevant amount.

I recognize that fair value also cannot be verified by reference to a fact because it involves the unknowable future. But, if banks were required to obtain and publish the opinion of an independent valuation expert agreeing with the disclosed fair value amount of the loan portfolio, then investors and creditors would be well served; the relevance of the disclosed fair value amount would be enhanced—greatly enhanced—in the eyes of investors and creditors.

I recommend that the SEC and the FASB require disclosure by banks of the fair value (as presently defined by the FASB) of their loan portfolios. The SEC also should require that banks engage independent valuation experts to provide their opinions on the disclosed fair value of the loan portfolios and that those opinions be published/disclosed by the banks. [emphasis added]

As it turns out, Walter also shared his letter with Lynn Turner, who replied as follows:

Walter, I not only agree that banks should be required to disclose the fair value of their loans based on an independent valuation, but they also account for those loans in the balance sheet using those values. I find the FASB and IASB proposals to be a waste of time – they will mislead investors. [emphasis added]

And, this was Walter’s email response to Lynn:

I do not disagree. But, my proposal will, for now, be easier to sell. And, investors will be happy with my proposal. Even if the data are not on the face of the basic financial statements, once the investors find the data, even if the data are on page XXX, they will luxuriate in the data. [emphasis added]

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Convergence has been defeated, but the U.S. standard-setting apparatus is in terrible shape.  I hope that SEC Chair Mary Jo White will use this feedback — from the two former Chief Accountants of the last 25 years whom investors should trust the most — to at least take a hard look at how loan accounting is playing out.  I would also like her to think about how the SEC’s role in key projects like this one can be more visible and prominent.

It is high time for the SEC to be more involved in accounting standard setting — perhaps similar to the way the SEC is required to approve, as required by S-OX, the actions of the PCAOB.

Fundamental changes are long overdue.

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