A FAS 159 Bogey for Cadence

Early adoption of a new fair-value rule turned into a restatement for Cadence Financial — and the company is pointing a finger at FASB, the SEC, an...
Stephen TaubJuly 20, 2007

The chief executive of Cadence Financial Corp. is frustrated at the lack of consensus on fair-value accounting between standard setters and the Securities and Exchange Commission. Commenting on a Cadence restatement, CEO and chairman Lewis F. Mallory asserted “it was very disappointing” that the Financial Accounting Standards Board would issue a new standard and “subsequently have other related regulatory bodies begin questioning the early adoption because of their interpretation of the ‘spirit and intent’ of this statement.”

At issue is FAS 159, The Fair Value Option of Financial Assets and Liabilities, which was issued in February. Subsequent guidance from the SEC and the American Institute of Certified Public Accountants (AICPA) regarding the rule’s early adoption provision has pushed Cadence to rework the way it applies fair value to such items as fixed-rate collateralized mortgage obligations (CMOs) and adjustable-rate mortgage-backed securities (MBSs). As a result, the company will restate earnings for the first quarter of 2007, which will drop first-quarter net income to $103,000, or a penny per share, from a previously reported $3.7 million, or $0.31 per share.

The decision to adjust its accounting came after Cadence received an alert from the AICPA’s Center for Audit Quality, as well as guidance from the SEC, that warned of a FAS 159 early-adoption loophole. Essentially, the so-called FAS 159 Mulligan allows companies to use the rule to hide losses from investors. Indeed, in the early-adoption phase, FAS 159 could be used without a legitimate business purpose, which would surely violate the spirit of the rule, concluded the center.

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Such as scheme would work 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.

Cadence, in its regulatory filing, points out that it did have a legitimate business purpose for using FAS 159, but the “uncertainty” surrounding the guidance forced the restatement. Cadence explains that it used FAS 159 to book a transaction that helped the company exchange lower-yielding investments for higher-yielding securities.

Specifically, Cadence reclassified about $168 million in CMOs and adjustable-rate MBSs from “available for sale” to “held for trading.” As a result, it recorded a $726,000 mark-to-market gain in the first quarter of 2007. Under early adoption, Cadence also reclassified $3.1 million as an “unrealized loss on investment securities” from “other accumulated comprehensive income (loss)” to retained earnings as of January 1, 2007. “This had no effect on total capital since both accounts are included in the capital section of the balance sheet,” the company wrote.

The reclassified trading securities were sold early in the second quarter and the proceeds were reinvested in higher-yield government agency securities. Cadence said it did not elect the fair-value option for the higher-yield replacement securities; however, CEO Mallory stressed that FAS 159 was adopted “based on sound business reasons.”

In addition, the early-adoption election gave Cadence the opportunity to “decrease the duration of its security portfolio, reduce the negative convexity inherent in mortgage-backed securities and CMOs, improve cash-flow predictability, and increase our average yield on investment securities,” added the CEO. “Although, in our opinion, we complied with the technical requirements of [FAS 159], recent information from the AICPA and comments from the SEC staff created uncertainty regarding our application.”

Mallory also emphasized that as of Friday, when he released his press statement, “no agency has issued any official guidance on this issue.” He added that the company’s decision to “rescind” the application of FAS 159 regarding this transaction will have no effect on Cadence’s cash flow, strong financial condition, or book value.

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