On the one hand, I am happy to report that we are approaching the end of the darkest era in the history of U.S. accounting standards, during which the Accounting Establishment did their best to convince the rest of us that convergence with IFRS was inevitable. With the FASB vote to finalize its proposed Accounting Standards Update on loan loss reserves, the final chapter of that specious venture has been written, coming right on the heels of revenue recognition and leasing in quick succession.
But on the other hand, the final fruits of their labors are not pleasant to behold. The boards “deliberated” (more like ruminated) for years on end over each one — IMHO not to seek the truth, but to create elaborate justifications that are perhaps clever, yet it must be said, sometimes downright deceitful. The revenue recognition standard is the worst of the three, but the most disappointing by far, is this loan accounting standard. It was, and remains, the topic most urgently in need of improvement starting with the savings and loan debacle of the 1990s and further intensified by questionable loan valuations leading up to the Financial Crisis of 2008. Yet, pretty much all that we are about to receive is effectively a statement that not much will have changed, except that two plus two must henceforth be less than four.*
To see what I mean, let’s apply the new loan standard to a simple example:
- On December 31, 2020, Bankco (calendar fiscal year-end) takes a 10%, 20-year note from the third world country of Greaseland in exchange for $10 million. The note requires equal quarterly payments of principal plus interest over 20 years.
- Under the forthcoming “Current Expected Credit Loss Model” (CECL) Bankco must not only be able to estimate the total amount of contractual cash payments expected to be uncollected, but also the timing of those non-collections.
- Accordingly, the application of the CECL model yields the following journal entry: Dr. Loan loss expense, $500,000; Cr. Allowance for loan losses, $500,000. The 12/31/20 balance sheet will report $10 million in loans at $9,500,000, and the income statement for the year will have an expense of $500,000.
If you have been following my blog even for a little while, you would know that I am an ardent proponent of reporting the current values of assets and liabilities — most especially for financial instruments. But, even if you disagree, I want to at least convince you that the best evidence we have for the value of the loan to Greaseland is $10,000,000 on December 31, 2020; otherwise, Bankco would not have loaned the Greaselanders that amount of money. Yet, under the revision to GAAP that is forthcoming, the evidence will be cast aside and the loan will be reported at only $9,500,000.
It is straightforward to illustrate that the measurement of the loan is a deceit, but as I will explain below, the means by which the FASB justifies this deceit is itself a deceit.
“Measurement Objective”— The term “measurement objective” is commonly understood to apply to measuring assets and liabilities in their entireties, and not merely the contra accounts that captures an accrual of something or another. 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.
For trade accounts receivable, this could be a reasonable and legitimately-reasoned accounting treatment, because the sales prices of the goods/services to customers presumably anticipate some defaults. But, in the case of an interest-bearing loan, the yield to maturity at loan origination is set by the lender to compensate for expected defaults. If Greaseland’s creditworthiness for a 10% loan was only worth $9,500,000, then Bankco would not have loaned it $10,000,000!
Stated another way, the initial amount reported under the FASB’s new rules cannot possibly be described in any manner other than by regurgitating the arithmetic that yielded the result. Thus, it would be a deceit to claim that this loan is being measured with any particular objective in mind. But “never mind,” says the FASB. Now, without any attempt at justification — because there is none — “measurement objective” only refers to some silly contra account.
Convergence was supposed to improve accounting, wasn’t it? But the new loan loss accounting standard will be regressive. In the early days of the FASB it created a restrictive loss contingencies approach (SFAS No. 5) to put an emphatic stop to the practice of arbitrary accruals. Now, preparers are supposed to wait until an event actually occurs to indicate that a loss may have been incurred.
I think that’s pretty good accounting, and the irony is to see the FASB of today backing away from this hard-won principle, and in order to do so to flout basic economic logic and reasonable accounting conventions. How can the value of a loan at its inception be anything different than the net proceeds to the borrower?
I know that I am being somewhat repetitive, but this was part of the the logical basis for the current GAAP for loans, the so-called “incurred loss” model. Under the coming CECL model not only can the carrying amount be different than economic reality from the get go, but it must be different. At least the FASB still holds to the axiom that debits must equal credits. But only owing to that, the difference between the current value of the loan and the CECL reserve must be recorded as a reduction to income on the day the loan was originated — before any indication that a loss could arise that wasn’t already taken into account by the agreed upon terms of the loan.
But, the real question is not which loss model is better. It is why the FASB, despite every common sense indicator, has adopted a policy of ‘anything but market value.’ Cynical me believes that the FASB real agenda was to pass a standard that might pass for ‘progress,’ and as a bonus would actually look ‘conservative.’ It is merely a pretense to hide the fact that they couldn’t muster the political will to defy the all-powerful banking lobby. For the banks, large and small, it will still be business as usual: in good years, they will accrue “conservative” loss reserves, and in tough years, they will have their cookie jar reserves to draw down.
(And as an aside, it should be noted that the IASB’s standard is even more banker-friendly. The IASB’s CECL variant initially anticipates losses for one year only, which has got to be an amazing earnings management tool!)
Auditability** — Could an auditor prevent the accounting manipulations that the new standard practically invites? The CECL model would require estimates by Bankco’s management of the timing of underpayments that could extend out for decades. As always, the auditor’s job will be to attest that the estimates are “reasonable.”
Please. Tell me, how is an auditor going to be able to do that? In the best of circumstances, an auditor might find at least some basis for its opinion by comparing management’s current estimates to historic loan loss rates. But, what if current conditions in Greaseland are no longer stable; i.e., they are not similar to past conditions? That was supposed to be the whole point of a new standard: to take into account the fact that the recent past is not necessarily predictive of the future.
* * * * * *
The bottom line is that the FASB twisted themselves into logical pretzels just so that bankers are spared from having to directly refer to market values — over which they have no influence — when valuing their loan portfolios. And they also took their time, knowing as well as anyone that loan accounting was the most urgent item on its agenda for the last 8 years, if not the last 30 years. It should have been prioritized above all else, including convergence. Yet, all the FASB has finally produced is a standard that says 2 + 2 < 4.
And it is unauditable to boot. If you believe that another financial crisis is just a question of time, there will be a generation of auditors that will once again have to answer for turning a blind eye to market indicators of deteriorating economic conditions. The auditors of the present generation, by supporting the chicken salad that the FASB has just served up to their clients, must be betting, or plain ole praying, that it won’t be them.
*Just in case you haven’t heard the old accounting joke about two plus two, here it is:
A businessman was interviewing candidates for the position of manager of a large division. He quickly devised a test for choosing the most suitable candidate. He simply asked each applicant this question, “What is two plus two?”
The first applicant said “Four”.
The second applicant pulled up a spreadsheet on his laptop and came up with an answer “somewhere between 3.999 and 4.001.”
Finally, the businessman interviewed an accountant. When he asked him what two plus two was, the accountant got up from his chair, went over to the door, closed it, came back and sat down. Leaning across the desk, he said in a low voice, “How much do you want it to be?”
**I am a member of the PCAOB’s Standing Advisory Group. The opinions expressed in this post are my own.