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The FAS 159 Mulligan

A loophole in a new fair value accounting standard had investment advisors pushing clients to hide losses from investors. But most companies remained principled.
Marie Leone, CFO.com | US
May 8, 2007

By the time May rolled around, and the deadline for early adoption of an accounting standard known as FAS 159 passed, American companies had, for the most part, stuck to principles-based accounting. But it was touch-and-go there for a while.

FAS 159, The Fair Value Option for Financial Assets and Financial Liabilities, was issued in February, and will become effective for most companies on November 15. The rule gives companies the option to account for certain financial assets and liabilities — including stocks, bonds, loans, warranty obligations, and interest rate hedges — using the fair value method of accounting, rather than more traditional methodologies, such as historical cost.

For corporations that wanted to try out the fair-value approach at an accelerated pace, the Financial Accounting Standards Board gave companies with a calendar-year end an April 30 deadline. Unexpectedly, the impending deadline acted like a large glowing flame to moths — which in this case were investment advisors. Over the past six weeks, corporate investment advisors flooded companies with promotional material touting a loophole sometimes referred to as the "FAS 159 Mulligan" — an accounting do-over of sorts. The aim was to get companies to sign on to their loophole strategy before the early adoption deadline ran out.

FAS 159 works like this: A company selects an eligible financial asset or liability that will be marked to market and recorded at fair value. When the asset or liability is remeasured, the change — whether it is a loss or gain — is entered directly into the equity section of the financial statements as retained earnings, rather than run through the income statement. This one-time, direct posting to retained earnings is part of the rule's transition provision, and reflects the prospective nature of fair value (fair value is calculated at current prices), rather than the retrospective nature of a historical cost allocation. Because the gain or loss is not reflected in the income statement, there is no charge to earnings.

However, if a company has less-than-honorable intentions, it could use FAS 159 the way many investment advisors have suggested: First identify all the losers in a company's investment portfolio — for example, held-to-maturity stocks that are underwater or available-for-sale loans that have interest rates much higher than current market rates. Next, apply FAS 159, and elect to fair value the underwater stocks or expensive loans. Then, calculate the remeasured loss, bypass the income statement, and record the loss in retained earnings. Finally, have the company sell-off the stock or refinance the loan, and immediately turn around and purchase a replacement instrument that is valued at historical cost, dropping the fair value treatment altogether.

The move uses the transition provision of FAS 159 to shield earnings from the loss, while the company retreats from fair value accounting. Jay Hanson, national director of accounting for audit firm McGladrey & Pullen said his clients were inundated with offers from investment advisors who claimed that they could help "rebalance portfolios," by using the FAS 159 loophole. The advisors were using "one sentence" from the transition provision to create a bright-line exception to hide losses from shareholders, surmised Hanson. But in the end, "few companies abused [the provision]."

Some companies that originally announced early adoption decided against it, including the CIT Group and Colonial Bankshares. "The situation eventually righted itself," commented Scott Taub, former deputy chief accountant of the Securities and Exchange Commission and currently managing director of consultancy Financial Reporting Advisors. Nevertheless, he told CFO.com that a stampede of loophole-touting advisors was pushing companies to use the bright-line loophole to achieve an accounting boost.

And while FASB and SEC didn't ban the loophole outright, both commented that if the scheme lacked economic substance, and was being done just to hide losses from investors, then the treatment would surely violate the spirit of FAS 159, if not the letter of the standard. Furthermore, recent guidance issued by the Center for Audit Quality (CAQ), an arm of the American Institute of Certified Public Accountants, also seems to have prompted companies to rethink their initial intent to adopt the standard early.

FAS 159 becomes a problem if it is used to hide losses or generate short-term financial reporting gains, commented Neri Bukspan, chief accountant at Standard & Poor's and a member of FASB's User Advisory Council. "This is a concern to investors and creditors," he insists. "If prudently used, [FAS 159] is beneficial," because it increases transparency, mitigates volatility, and gives investors a more realistic picture of the company. "But in the wrong hands, it's a great concern," notes Bukspan.

FASB issued FAS 159 to improve financial reporting, for instance, to help address mixed measurements in accounting, says Lisa Filomia-Aktas, a partner and practice leader with Ernst & Young. For instance, she points out that companies can have accounting "mismatches" on profit and loss statement, when one side of a transaction is recorded using fair value — because of a FASB requirement — while the other side is valued at historical costs. For example, FAS 133 requires that instruments like interest rate hedges be measured at fair value, while the related liability may be valued using the historical cost method. To fix the lopsided entry — if hedge accounting is not already being used —FASB, via FAS 159, allows companies to choose fair value on an instrument-by-instrument basis.


What may have kept some companies from following the bright line was another accounting rule, FAS 157, Fair Value Measurements. Early adopters of FAS 159 were also required to adopt FAS 157, which establishes a framework for measuring fair value and expands disclosure requirements — two tasks that Hanson says will keep many companies busy until the November 2007 deadline.

Other companies cited the guidance issued by the CAQ as the reason for shying away from early adoption. For example, the CIT Group announced on April 18 that it planned select the fair value option for fixed high-coupon debt securities, which were hedged in accordance with FAS 133. The new accounting treatment would have resulted in an $85.3 million direct after tax reduction of retained earnings, according to the company's SEC filings. Further, the company said that a portion of the debt was refinanced with lower cost, floating-rate debt.

But after reevaluating the CAQ guidance, CIT reversed its decision on April 30, and determined that applying the fair value accounting option to replacement liabilities could introduce continuing volatility into its earnings, so it nixed the early adoption plan. According to its filings, "CIT recognized that a substantial portion of the liabilities initially elected for fair value accounting under [FAS] 159 were subsequently paid off and that it did not apply fair value accounting to any replacement liabilities."

Indeed, most experts think that investment advisors will rush to reacquaint companies with the FAS 159 Mulligan at the end of the year. But by that time, it's likely that corporate finance executives will just see the loophole for what it is, a bright line bogey.




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