Thursday, March 26, 2009

Levitt, Beresford on Congress, FASB and Fair Value; Breeden Calls for Merger of SEC, CFTC and PCAOB

It’s an exciting time when a former SEC Chairman and a former FASB chairman weigh in on issues involving Congress, FASB and fair value. Former FASB Chairman Denny Beresford, an FEI member and one of the founding inductees in FEI’s Hall of Fame (and a reader of this blog), brought to my attention the OpEd in today’s Washington Post by former SEC Chairman Arthur Levitt, Jr. on Congress, FASB and fair value.

Levitt's OpEd, entitled, Weakening A Market Watchdog: An Accounting Rule Change's Real Costs, talks about the pressure that was brought to bear on FASB to amend or provide further guidance on its rules on fair value measurement (aka mark-to-market accounting), particularly with respect to applying FAS 157, Fair Value Measurement, in inactive markets, and with respect to the accounting rules impacting other-than-temporary-impairment (OTTI). He notes that FASB Chairman Robert Herz was told at the March 12 Congressional hearing on mark-to-market accounting: "Don't make us tell you what to do, just do it," (Rep. Randy Neugebauer (R-Tex.)) and "If you don't act, we will," (Rep. Gary Ackerman (D-NY)).

"This is like being forced to give your boss several mulligans in a round of golf," says Levitt in the WashPost OpEd, adding, "And so last week, the FASB voted to propose allowing banks to obscure -- some might say bury -- the full extent of impairments on many of the bad loans and investments they made and securitized over the past few years."

NOTE: The proposals Levitt refers to are FASB's Proposed FSP FAS 157-e, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed, and Proposed FSP FAS 115-a, FAS 124-a and EITF 99-20-b, Presentation of Other-Than-Temporary Impairments. The proposals were released by FASB on March 17 for a 15 day comment period, ending April 1. FASB confirmed in its Action Alert issued today that it will hold a board meeting on Thursday April 2 (in addition to its regularly scheduled board meeting on Wed. April 1) to "redeliberate" the proposals, "in light of the comments it has received." Presumably, in line with the commitment made by Herz and SEC Acting Chief Accountant Jim Kroeker to Congress at the March 12 hearing, FASB will not only 'redeliberate' but will vote to issue final rules, with or without some changes from the proposals for issues raised in comment letters; letters filed so far (in advance of the April 1 deadline) can be found here (fair value) and here (OTTI).

Levitt continues in his OpEd: "The FASB's proposal goes against what we know investors prefer: Stronger rules for the reporting of changes in the values of investments in income statements. Under the proposed rule, no matter how toxic the investment, whether it's a penny stock or the bonds of a government ward such as AIG, companies can choose to largely ignore the fundamental reasons behind the investments' decline. All that companies have to do is say they don't intend to sell those investments until their value rebounds. "

Before going on, it is interesting to focus on Levitt's statement that 'FASB's proposal goes against what we know investors prefer.' 'Investor' views are sometimes said to be elusive, and some look to groups like FASB's Investors Technical Advisory Committee (ITAC), heavily constituted by analysts, to represent 'investor' views (see, e.g. the ITAC comment letter to FASB on fair value in May 2008, and the ITAC letter to the SEC Nov. 2008). ITAC has generally taken views closest to what Levitt describes. There are other groups viewed as representing the investor view, or as proxies for investors, including groups I refer to as 'the four C's' - the Center for Audit Quality (CAQ), Council of Institutional Investors (CII), Consumer Federation of America (CFA), and the CFA Institute - which have taken to filing joint comment letters to the SEC, Treasury and the Fed and to Congress on issues concerning fair value. However, some or all of the four C's have supported, to varying degrees, issuance of further guidance on fair value in inactive markets and OTTI - see, e.g. testimony of CAQ's Executive Director Cynthia Fornelli at the March 12 Congressional hearing, in which she said:

"On Feb. 18, 2009, in response to recommendations in the SEC’s study on mark‐to‐market accounting as well as input received from FASB’s own Valuation Resource Group, FASB added multiple important projects to its agenda. Those agenda projects are intended to improve (1) the application guidance used to determine fair values and (2) disclosures of fair value estimates. (The FASB’s Valuation Resource Group is a group of valuation and accounting professionals who provide FASB staff and Board with information on implementation issues surrounding fair value measurements used for financial statement reporting purposes.)" She added, "One major criticism of fair value accounting is that it can be difficult to apply in illiquid markets. FASB’s projects on application guidance will address this concern by helping to: determine when a market for an asset or a liability is active or inactive; determine when a transaction is distressed; and apply fair value to interests in alternative investments, such as hedge funds and private equity funds. The project on improving disclosures about fair value measurements will consider requiring additional disclosures on such matters as sensitivities of measurements to key inputs and transfers of items between the fair value measurement levels. "

Additionally, other users of financial statements - who some may view as an equal proxy for investor views as some of the above organizations, including experts Vinny Catalano and Randy Schostag - have supported the call for further guidance on fair value in inactive markets.

Back to Levitt's OpEd, he adds: "[T]he real scandal here is not the decision by the FASB -- with which I strongly disagree but which others might be able to defend. Rather, it is how the independence of regulators and standard-setters is being threatened. This isn't just about the income statements of banks. It's about further eroding investor confidence, precisely at a moment when investors are practically screaming for more protection. "

Levitt continues: "Chairman Herz acquiesced, it appears, in order to keep Congress from invading FASB turf. Yet in seeking to protect its independence, the board has surrendered some of it in the bargain," and warns, "Every regulatory agency should take note: Independence from public pressure has a value, and when you give some of it away, you've lost something that takes years to rebuild. Just ask the Federal Reserve, which lost its reputation for independence from political pressure in the early 1970s and didn't regain it for a decade."

To further support his point, Levitt argues there was inadequate due process provided on the recent proposals. He states, "In the past, the FASB has made significant changes to its rules only after significant due process, including comment periods that often lasted for three months and a full discussion reflecting those public comments... The rule change agreed to by the FASB on Tuesday followed only one public meeting on this topic, and the board is giving investors just two weeks to comment, with a final vote the next day. This is a rush job. "

However, in considering Levitt's reference to there having been 'only one public meeting' on the issues of fair value and OTTI, as noted in CAQ Exec. Dir. Fornelli's testimony to Congress cited above, and in FASB's Feb. 18 press release, the call for further guidance on fair value in inactive markets had come from FASB's Valuation Resource Group, which met most recently in a public meeting on Feb. 5, and calls for further guidance on fair value and OTTI had come from the SEC's Dec. 30 Congressionally mandated study on mark-to-market accounting.

Additionally, FASB held roundtables on fair value and other issues arising in the credit crisis last fall, the SEC held roundtables on this subject last fall, and the FASB-IASB Financial Crisis Advisory Group has debated this subject at its meetings this year. So, all told, there have been numerous public meetings (at least in the form of roundtables) which led to FASB taking on the projects to issue guidance on fair value and OTTI. And, FASB had a hefty comment file (including this letter from FEI's Committee on Corporate Reporting) from the last time it proposed guidance on fair value in inactive markets- in the form of Proposed FSP FAS 157-d, released for public comment on Oct. 3, 2008 with a comment deadline of Oct. 9, approved by FASB in final form on Oct. 10 as FSP FAS 157-3. So, in many respects, the current proposals represent an evolution in thinking (or at least, an evolution in wording, now that 5 months of practical experience in applying the words in FSP FAS 157-3 are behind us), rather than, say, a new project starting from scratch.

The significant factor - in my personal view- of Congress' recent involvement was to persuade FASB to move up its timetable for issuing the fair value guidance which it had already agreed to issue, (at least in terms of fair value in inactive markets, if not OTTI), by drawing a line in the sand so to speak of 3 weeks from the March 12 hearing date, which perhaps not coincidentally aligns with the start of the G-20 meeting.

Levitt, Roper, Breeden, Others Testify To Senate
Levitt's views are highly regarded, and he opined on broader subjects in his testimony earlier today at the Senate Banking Commitee hearing on investor protection and market regulation.

Others testifying on his panel were former SEC Chairman Richard Breeden and former SEC Commissioner Paul Atkins. The first panel, as we noted in our blog post earlier today, included SEC Chairman Mary L. Schapiro. And the third panel included various representatives from the private sector, including Jim Chanos, founder of Kynikos Associates, (who, as noted in his wikipedia bio "rose to fame in the 1980s as a "short" - a short seller who had a knack of spotting stocks that he thought to be overvalued") - and famously was one of the first to identify weaknesses at Enron - author of an OpEd in the WSJ earlier this week entitled We Need Honest Accounting. Another panelist at the Senate hearing was Barbara Roper of the Consumer Federation of America (CFA, one of the 4 C's noted above).

Roper testified that the SEC should drop its push to move U.S. companies from U.S. GAAP to International Financial Reporting Standards, and instead focus again on encouraging convergence of the two sets of standards (i.e. FASB and IASB standards).

Sounding a similar alarm regarding threats to FASB's independence as Levitt did in his OpEd, Roper told the Senators: "In arguing against adoption of the IFRS roadmap, CFA has in the past cited IASB’s lack of adequate due process and susceptibility to industry and political
influence. Unfortunately, FASB’s recent proposal to bow to industry pressure and weaken fair value accounting standards – and to do so after a mere two-week comment period and with no meaningful time for consideration of comments before a vote is taken – suggests that FASB’s vaunted independence and due process are more theoretical than real. We recognize and appreciate that leaders of this Committee have long shown a respect for the independence of the accounting standard-setting process. Moreover, we appreciate the steps that this Committee took, as part of the Sarbanes-Oxley Act, to try to enhance FASB’s independence."

She thus recommended: "[I]n light of recent events, CFA believes more needs to be done to shore up those reforms. Specifically, we urge you to strengthen the standards laid out in SOX for recognition of a standard-setting body by requiring that a majority of both the board itself and its board of trustees be investor representatives with the requisite accounting expertise."

Additionally, Roper called upon the Senators to "Ignore calls to weaken materiality standards and lessen issuer and auditor accountability for financial misstatements," referring to recommendations that had been made by the SEC Advisory Committee on Improvements to Financial Reporting or CIFiR.

I am sure others will summarize testimony of the many other panelists at today's Senate hearing. Before I leave this subject I'd like to highlight one quote from former SEC Chairman Richard Breeden's testimony: "It isn’t enough for regulators to write rules and give speeches. More time needs to be spent conducting examinations, analyzing results, discovering problems and, where necessary putting effective limits in place to prevent excessively risky activities. Directors and regulators need backbone, and a willingness to shut down a party that gets out of control. Regulators can’t catch all the frauds any more than police can catch all the drug dealers. Nonetheless, when failures happen it shouldn’t be acceptable to just ask for more resources without making the necessary corrections first. Regulators need accountability for performance failures just as much as any of us." He added, "While we need to demand better effectiveness from regulators, we must not shift the burden of running regulated businesses in a sound and healthy manner from management and the boards of directors that are supposed to oversee their performance."

I have a feeling Breeden's recommendations - which number a dozen - are going to receive a great deal of attention, from his call to merge the SEC, CFTC and PCAOB (rec. #1) to his call for increased proxy access (rec. #2), and his call to "Reverse or suspend the SEC decision to abandon U.S. accounting standards and to adopt so-called "International Financial Reporting Standards" for publicly traded firms headquartered in the U.S." (rec #3).

Beresford on Congress, FASB and Fair Value
As noted at the top of this post, former FASB Chairman Denny Beresford had pointed out to me Levitt's OpEd in the Washington Post regarding FASB, Congress and fair value.

I asked Denny if he'd like to share his reaction to Levitt's column with me and our blog readers. Here is what he said: "On the 157e proposal, I believe that one or more of the Board members thought they were already calling for what is in the new proposal when they issued the initial 'guidance' last fall. But they worded the guidance at that time too generally and companies were disinclined to apply the judgment that the FASB and SEC thought they should for fear of being second guessed by the auditors and the SEC. And the auditors were afraid of being second guessed by the PCAOB."

"The proposals may not be perfect," he continued, "but I think they are a major improvement in determining how fair value should be estimated when active market prices aren't readily available. Those who argue for the most conservative prices that can be found in the relatively few 'fire sales' of some of these complex securities seem to feel that the standard should call for 'market value,' however that would be defined, rather than "fair value," which is what SFAS 157 calls for."

Beresford closed, "There will undoubtedly be some unintended consequences of new rules that are rushed out like this. But many of us believe that current economic circumstances necessitate this kind of action." He added, "I do hope that the FASB doesn't require the new accounting to be applied in the first quarter but makes it mandatory for the second quarter and allows companies to do so in the first quarter if they can get it done in time."

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