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Accounting Pressure in Obama Regulatory Reform?

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By: Tammy Whitehouse | July 13, 2009

The Obama Administration’s plans to reform financial regulation pin part of their hopes on changes to accounting rules. Some of those changes, however, harken back to Enron-era tactics for earnings management and may undercut much of the push for transparency seen this decade.

At the heart of the issue is the difference between U.S. Generally Accepted Accounting Principles and rules issued by banking regulators; the former apply to all public companies and help investors understand financial statements, while the latter apply to financial institutions and help regulators keep the banks financially sound. The reform plans unveiled by the White House last month seem to bend GAAP more to banking regulators’ needs, even if those changes might undercut investors’ understanding of financial statements.

President Obama specifically calls on the Financial Accounting Standards Board and the Securities and Exchange Commission to “review accounting standards to determine how financial firms should be required to employ more forward-looking loan loss provisioning practices that incorporate a broader range of available credit information.”

In other words, the Administration wants to change accounting rules so banks can set aside a portion of earnings in good years to pay for loans that may go bad in other years. Trent Gazzaway, managing partner for Grant Thornton, describes the idea as earnings management so banks can achieve capital-reserve requirements set by banking regulators. “From an economic perspective, having reserves is good,” he says, “but for financial reporting purposes it clouds the picture for investors.”

Obama’s plan also says fair-value accounting rules “should be reviewed with the goal of identifying changes that could provide users of financial reports with both fair-value information and greater transparency regarding the cash flows that management expects to receive by holding investments.” Any change to fair-value accounting is bound to spark controversy: Investors say it gives them a better understanding of assets’ current values, but banks say it ignores their intent to hold under-valued assets until they recover.

Espen Robak, president of Pluris Valuation Advisers, worries that those reform ideas will accommodate regulators’ desire to assure the stability of the banking system—even if that might obscure financial information for investors.

The banking sector has come to dominate the attention of standard setters, “because of their need not to recognize losses when otherwise losses might have been taken,” Robak says. “If we reduce the consistency and the clarity of financial statements, investors are going to have a lot less faith in the quality of financial reporting, and that’s going to affect the cost of capital for firms.”

FASB Chairman Robert Herz has spoken frequently of the need for more distance between GAAP and banking regulations. In a June 26 speech at the National Press Club, he specifically called for a “greater decoupling” between the two and said: “It is not appropriate to subordinate or subvert external reporting to investors to the needs of the regulators or vice-versa.”

Congress’ appetite to enact the Obama reforms is unclear, but the House Financial Services Committee has already demonstrated its willingness to advocate for the banking industry. Earlier this year the committee all but forced FASB to publish new, bank-friendly guidance on applying fair-value accounting rules. The guidance steers valuations away from depressed market prices and allow banks to report losses on the balance sheet rather than the income statement.

FASB and the International Accounting Standards Board have not openly discussed the idea of giving banks even more flexibility in measuring cash-flow projections and establishing fair value of assets. David Larsen, a managing director at Duff & Phelps, says some people have interpreted FASB’s recent guidance as achieving that objective since it allows banks to take only the credit component of loan losses to earnings, while reporting the non-cash decline in value on the balance sheet. The credit component has been interpreted by many to be the change in expected cash flows, he says.

Gazzaway says the fair-value measurement of financial assets is essentially an exercise in measuring cash flow, where the corporation and the marketplace each offer their own views of what that value is. In a perfect world, he explains, the market’s estimate would equal the company’s projection of future cash flows.

The problem, he says, is how that future cash-flow is actually predicted: Corporations today have a much rosier view of what those assets should generate in cash flow than buyers do, and that has led to the frozen markets we’ve seen on Wall Street since last fall. To give corporations more latitude in establishing cash-flow projections and fair value “is putting all the decisions in the hands of management that has a bias toward reporting higher earnings,” Gazzaway says.

Earnings Management or Not?

All that leaves the future of fair-value accounting uncertain. Accounting provisions for loan losses, however, are another matter entirely—and discussions on that front already are underway in much more concrete terms.

FASB recently introduced a new accounting standard that would enhance disclosures around credit-related loss provisions, but the measure does not introduce any new accounting concepts, says Andy Gibbs, senior vice president at Mercer Capital. “It would take analysis that banks already do and put it into the financial statement footnotes,” he explains. “The disclosures would be based on data that banks already prepare, but just don’t share in that much detail in financial statements.”

Thinking beyond disclosure, the Financial Crisis Advisory Group that has helped FASB and IASB find their way through recent economic turmoil has broached the merits of “dynamic” loan provisioning, where a company sets aside a portion of earnings when the economy is humming to provide a cushion against a future downturn.

DISSECTING OBAMA PLAN

The following excerpt is from Robert Herz’s speech on the Obama reforms:

Despite the differences in mission and focus, my experience is that by working together and sharing perspectives, we can often find common ground and develop common reporting solutions that meet the needs of the regulators while preserving the integrity of reporting to investors. But in some cases, a single accounting or reporting treatment may not properly achieve the objectives of both the regulators and reporting to investors and the capital markets.

In such cases, transparency on the different treatments is important. Moreover, it is not appropriate to subordinate or subvert external reporting to investors to the needs of the regulators or vice versa. Both are essential public policy goals in ensuring the proper functioning of the financial system and the economy. Therefore, preserving and clearly delineating the separate public policy missions of securities regulators and accounting standard setters in terms of investor protection and transparency and that of financial institution regulators in terms of safety and soundness and financial stability are, in my view, important in any regulatory reform.

The goal should be to promote a close working bond, while ensuring that transparency and sound reporting to investors and the capital markets are not subordinated to the objectives of financial institution regulators and that the regulators are not inappropriately handcuffed by requirements that they conform their treatments to GAAP. Accordingly, I would be supportive of a greater decoupling between the determination of bank regulatory capital and our standards.

My next principle is that any reforms of our financial and regulatory system must be perceived by the public as substantive, as balanced, and as producing fair and equitable outcomes. They must promote public confidence in the proper functioning of and fair dealing in our capital markets and in the overall health and stability of our financial and economic system. They must also be perceived as balanced. On the one hand, they must not stifle innovation and appropriate risk taking. But, on the other hand, I also believe that the reforms need to convince the American public that we have taken the steps necessary to move beyond the one-way capitalism, the “heads I win, tails everybody else loses” mind-sets and practices that have, quite rightly in my view, sparked widespread outrage. So while the taxpayer- funded bailouts of major financial institutions and other major corporations were necessary to avert deeper harm to the economy and our society and to begin to get us out of the ditch, the “too big to fail” phenomenon is clearly fraught with danger and is perceived by many as downright unfair. Accordingly, reforms of our system must have an eye to avoiding, or at least, reducing the incidence of this in the future.

Under GAAP, Larsen says, that practice is prohibited. Companies currently must obey Financial Accounting Standard No. 114, Accounting by Creditors for Impairment of a Loan, which defines an “incurred loss model” that allows provisions as losses occur or when it becomes clear they will occur. For example, Larsen says, a factory shutdown would be a trigger to allow provision for a loan loss. (FAS 114 has now been subsumed into FASB’s new Accounting Standards Codification, so the standard actually now exists under ASC 310, Receivables.)

Mark Sunshine, president of First Capital, a financial services company focused on asset-based lending, says the FAS 114 model is illogical for financial institutions. According to current requirements imposed on banks, he says, they are setting aside provisions for loan losses that have already happened, but aren’t allowed to set aside equity for losses that are going to happen. “That makes no sense,” he says.

Larsen counters that while there may be economic merit to establishing a loan loss provision before the loss is known to occur, from a GAAP perspective, “that's effectively over-reserving and understating earnings … Anytime you pump up reserves, you’re reducing earnings.”

Indeed, Gazzaway likens the idea to a baseball team that saves up runs it scores against poor teams, to use when it plays stronger ones. “When you get to the end of the year, it’s hard to see who is the best team,” he says. “Financial statements are not here to guess or prognosticate about the future value of a company. That’s what we pay investment bankers and financial analysts to do. Financial statements are about the here and now.”
Grant Thornton urged the Treasury Department to consider applying the dynamic-provisioning concept to regulatory capital requirements instead of GAAP rules. “It doesn’t make sense for companies to maintain the same level of reserve in all sorts of economic circumstances,” Gazzaway says. Instead, regulators could establish triggers that would automatically require more money be placed in reserve during good years and released during bad years, he says.

Gazzaway says that approach would also address bankers’ concerns about fair value when applied to depressed market prices. “They're trying to reach into the future, borrow expectations about what might happen, and pull it into the financial statements,” he says. A dynamic provision around regulatory capital requirements would address that problem because “it would separate the fair value of those assets from the way regulators view them.”