Capital Markets

Digging Common Ground on Bank Accounting

IASB and FASB have pledged to work together on several big projects, though loan loss reserves will raise thorny issues.
Marie LeoneMarch 26, 2009

For what could be the first time in history, a meeting of accounting standard-setters this week may have some relevance to the critical G20 meeting set for next week.

At a joint session held in London this week, the International Accounting Standards Board and the Financial Accounting Standards Board promised to work at an accelerated pace to develop common standards for the treatment of both off-balance-sheet items and financial instruments. The two boards also will tackle the controversial subject of loan loss accounting as part of their financial instruments project.

While the boards set their sights on these longer-term projects, they also pledged to finish work on short-term efforts at revising existing standards, including tying up loose ends related to FAS 140, the U.S. rule on transferring financial assets. To be sure, on March 4 FASB decided to amend FAS 140, and among other changes, ousted the concept of a qualified special purpose entity — or QSPE — from U.S. accounting literature. The FASB staff is now preparing a final rule for release.

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FASB shut down QSPEs in response to abusive practices linked to the way some companies used the vehicles to hide losses. Interestingly, QSPEs were created to combat the very off-balance-sheet shenanigans that the rule was suppose to quell.

Indeed, the so-called Qs were originally intended to exempt financial securitization from the more stringent rules for special purpose entities that were put in place in response to the Enron fraud. As a result, Qs were “meant to be passive pass-through type entities — essentially a lock-box: The money from the collateral comes in, gets collected and distributed to the security holders,” explained FASB chairman Robert Herz in December. But the concept of a passive entity was “stretched and stretched and stretched” to the point where QSPEs became “ticking time bombs,” asserted Herz.

The rewrite of FAS 140 also will address the transfer of financial assets, mostly related to whether a company can book a transfer as a true sale and thereby shed all associated risk. Much of that determination hinges on what kind of control the company holds over the transferred assets, and FASB and IASB jointly will review the definition of control in the coming months as part of their longer-term consolidation and derecognition projects.

Also up for discussion between the two boards is enhancing disclosures that pertain to consolidated and non-consolidated subsidiaries.

Over the past few months, accounting for financial assets has remained a hotly-contested topic, as bankers and lawmakers continue to fight accounting standard setters and investors on the issue of whether financial instruments in inactive markets should be booked at fair value. Accounting rules require mark-to-market accounting in illiquid markets, even for securities that are being held to maturity. The rules also provide guidance on how to use inputs other than trading prices — including internal models — in extreme situations.

Contesting those rules are bankers, supported by many U.S. and international lawmakers, who say financial instruments that are held to maturity should be valued and booked based on internal models when markets for the securities are illiquid.

Under pressure from the U.S. Congress, FASB has rushed out a proposal that would provide added guidance on fair value requirements, and may give the banks what they want with respect to nixing fair value accounting. The short 15-day public comment period for FASB’s proposal ends on April 1, and the board is expected to take on a final action soon after.

Meanwhile, IASB has floated its own fair value proposal to its constituents. The IASB proposal is based on FASB’s draft and asks for public comment on whether the international standards should conform to the American guidance. Public comment on the IASB proposal, which is being vetted for 30 days, is due in mid-April.

Layered on top of the fair value debate is the question of how banks and other financial institutions should account for loan loss reserves, a topic that the two boards will work in tandem to address. Banks are required by regulators to hold a certain amount of cash in reserve as a cushion for loans that go into default. The reserve amount is a percentage of a bank’s capital based on its risk-weighted assets. By setting aside the regulatory capital, banks have less cash with which to make loans, which stifles their business. As a result, the credit markets tighten, and in extreme cases shut down, causing a credit crisis like the one the world economy is experiencing now.

Changing regulatory capital requirements, and allowing banks to reserve less, is one way to deal with the huge losses tied to the subprime mortgage meltdown. Changing accounting rules to solve the bank’s loan loss woes is another option, and one that would not require the decade of rule debating and writing that preceded Basel II, the international agreement that established the current regulatory capital ratios for banks.

Different ideas have been discussed regarding how accounting rules should be revised to accommodate the loan loss conundrum. IASB chairman David Tweedie has suggested using the insurance company model of catastrophic reserves. That is, companies would establish a non-distributable reserve, separate from the profit and loss statement, but one that appears on the balance sheet. The balance sheet asset would be clearly marked as being non-distributable so investors understood its purpose. If catastrophe hit — such as a credit crisis — the company would be allowed to tap the reserve to keep the event from decimating company earnings.

Other experts have suggested using what is known as dynamic provisioning, a reserve technique used by banks in Spain. In this case, reserves are increased during good times so they can be drawn down when losses pile up. Dynamic provisioning, also referred to as the “cookie jar” method, smoothes earnings when cash is released from the reserve and fed through the profit and loss statement. However, some companies have used earnings smoothing to manage and inflate earnings, as the release of reserves can be masked on financial statements.

A third method, involving two net income lines, has also been discussed. The concept here is to create a second line representing regulatory net income to show a company’s profit minus its capital reserve. Along with separating the cash reserve from the earnings calculation, a company could use this line to calculate performance-based executive compensation. In that way, executives would not be getting rich off of inflated profit numbers.

On April 1, the G20 nations — the richest in the world — will meet in London to discuss the global financial crisis, and loan loss provisioning, as well as fair value accounting, will likely be on the agenda.