Tuesday, July 28, 2009

FASB-IASB Financial Crisis Advisory Group Issues Report

Earlier today, the FASB-IASB Financial Crisis Advisory Group issued its final report (FCAG report). As summarized in this press release, the report contains 23 recommendations in 4 categories: (1) effective financial reporting, (2) limitations of financial reporting, (3) convergence of accounting standards, and (4) standard-setters’ independence and accountability.

I would distill FCAG’s 23 recommendations into slightly different categories, as follows. (Numbers in parenthesis refer to related recommendations in FCAG’s report, I have restated some of them slightly here but reference can be made to the report; references to 'the boards' refers to the FASB and IASB boards.)

Highest Priority: Financial Instruments Project, Including Potential Changes To Loan Loss Model

  • The financial instruments project (a joint project of FASB and the IASB) should be given the ‘highest priority’ and the boards should proceed on this project with a sense of urgency, but with wide consultation. (1.1)
  • The boards should explore alternatives to the incurred loss model for loan loss provisioning that use more forward-looking information such as an expected loss model and a fair value model; this should be done as part of the boards’ financial instruments project. (1.3)
  • “If the Boards pursue an expected loss model, care must be taken to avoid fostering 'earnings management,' which would decrease transparency.”(1.4)
  • In conducting the financial instruments project, the Boards should not compromise their due process procedures. (4.1)
  • It is of critical importance that neither business nor political pressures divert the accounting standard setters from the financial instruments project, which is so important to the global financial system. (part of rec. 4.1)

No Delay In Implementing FASB's New Standards On Off-Balance Sheet

  • FASB’s new off-balance sheet standards [FAS 166, amending FAS 140, and FAS 167, amending FIN 46R [under the board's pre-codification nomenclature] should be implemented without revision or delay. (1.9)

Inherent limitations of financial reporting

  • In their joint conceptual framework project, the Boards should clearly acknowledge the limitations of financial reporting. (2.1)
  • Users of financial reporting should recognize its limitations and should never suspend their own judgment and due diligence. (2.2)

External limitations on financial reporting: clearing mechanisms, infrastructure

  • FCAG urge[s] the appropriate authorities to ensure that all over-the-counter markets, especially those for structured products and derivatives, have robust infrastructure that fosters the transparency of market prices. (2.3)
  • Business entities, especially financial institutions, should employ effective price verification processes and otherwise improve their valuation of assets and liabilities. For price verification to be most reliable, these functions should, wherever possible, be completely independent of sales, trading and other commercial functions. (2.4)

Single set of global accounting standards

  • FCAG urges national governments, financial market participants, and the global business community to support actively the development of a single set of high-quality accounting standards. (3.2)
  • To sustain momentum, FCAG encourages all national governments that have not already done so to set a timetable that is both practicable and firm for adopting or converging with IFRS. (3.3)

Caution re: business, political pressure vis-a-vis standard-setters' dual need for independence, accountability

  • It is of critical importance that neither business nor political pressures divert the accounting standard setters from the financial instruments project, which is so important to the global financial system. (part of rec. 4.1)
  • While, as part of the system of public accountability, policymakers can and should voice their concerns and provide input to standard setters, we urge them to refrain from seeking to prescribe specific standard-setting outcomes. (4.3)
  • Such restraint is important in maintaining public confidence in the independence of the standard setting process, and, thus, in financial reporting and the financial system as a whole. (4.3, continued)

IASB Funding and Monitoring Board Should Be Expanded

  • To protect its independence from undue influence, the IASB must have a permanent funding structure under which sufficient funds are provided to it on an equitable and mandatory basis. (4.4)
  • To bolster the authority of the Monitoring Board, its composition should be broadened geographically to include securities regulators from a wider range of nations (4.5)

My two cents
Allow me to remind you of the disclaimer which appears on the right side of this blog before I share some personal observations on the FCAG report and related commentary.

Whose expectation gap is this?
I think there can be a positive benefit in FCAG's reminder that there are inherent limitations on financial reporting, because if people (including, but not limited to, auditors and the plaintiff's bar) were not (subconsciously, if not consciously) in search of the 'one correct number' for, e.g., the fair value of a non-traded or thinly traded instrument, or the amount of expected loan losses, then I think there'd be less pressure and more room for professional judgment (or for those who prefer the term: reasonable judgment), recognizing accounting is more of an art than a science.

However, I wonder if some of the emphasis on inherent limitations - and more significantly, the emphasis on external limitations on the reliability of financial reporting (such as weakness in clearing mechanisms and market infrastructure, which FCAG encourages the 'appropriate authorities' (presumably government, regulators) and 'business entities' to address - may place too much of the onus or 'blame' on those external parties for fair value information that is not reliable or not relevant, rather than allowing for the idea that perhaps some of the fundamental underpinnings of the fair value model established in FAS 157 should be given further consideration, such as the emphasis on the 'market participants' (aka 'exit value') model, and the prioritization ('level 1' of the 3 level hierarchy) on observable market values, and other wording in the original standard which ring fenced the area in which FASB's further guidance (the FSPs issued on April 2nd) could operate.

Deciphering terminology
Whenever you see someone use the word 'simplify' in connection with accounting standards, (e.g., rec. 1.1's reference to the current project to 'simplify'- and improve - financial instruments accounting) look deeper into what 'simplify' means.

In this case, and for the past couple of years, references to the financial instruments project's objective of improving and 'simplifying' accounting for financial instruments generally means reducing the number of measurement models and categories of measurement from the current 'mixed attribute' model (i.e. some assets are held at historical cost, some at fair value, some at lower of cost or market, with the measurement model sometimes based on the nature of the asset, sometimes based on the intent of the holder of the asset to hold the asset to maturity, for the foreseeable future, or to trade it, etc.).

Although there is clearly an element of 'simplification' to narrowing the various choices under the mixed attribute model, the general rallying cry, as noted in our post earlier this week about FASB's decision at its July 15 board meeting, is to carry all financial instruments at fair value (with limited exceptions). There are some who question how simple fair value really is (i.e. other than for highly liquid, tradable instruments).

Is 'consultation' synonymous with 'due process'?

With the above as background on the financial instruments project, consider another part of rec. 1.1: that the boards should move forward on the financial instruments project "as a matter of urgency but with wide consultation."

Is "consultation," even "wide consultation," the same thing as 'due process?' It could be that I am not as familiar with the meaning of the term 'consultation' which is more prevalent in, e.g. the EU, so perhaps the two terms are equivalent. However, I think of it this way: If I invite 100 people over and ask them if they'd rather watch a movie or mow the lawn, and 90% say they'd prefer watching a movie, but I make them all mow the lawn, have I conducted 'due process' by engaging in 'wide consultation?" I've commented on this issue previously here.

Continuing with rec. 4.3, FCAG distinguishes between the appropriateness of policymakers "voic[ing] their concerns and provid[ing] input" to the standard-setters, vs. "seeking to prescribe specific standard-setting outcomes."

First, some would say there's a large gray area (other's would say a 'fine line'), between voicing a 'concern' vs. seeking a 'specific outcome,' and some may argue there's nothing wrong with seeking a 'specific outcome' such as: provide additional guidance on X, and provide it within a time period of Y.

Additionally, similar to the comment further above, although FCAG acknowledges the standard-setters have public accountability, does accountability consist of policymakers providing 'input' - or does it involve what the standard-setters then do with that - and other constituents' - input?

Next: "Restraint" is the operative word with respect to FCAG's view of how policymakers should participate in the standard-setting process as described above. Specifically, rec. 4.3 states: "Such restraint is important in maintaining public confidence in the independence of the standard setting process, and, thus, in financial reporting and the financial system as a whole."

I would argue that confidence in the standard-setting process is based as much on due process conducted by the standard-setter, the extent to which standards have balanced the sometimes seemingly opposing forces of relevance and reliablity, cost and benefit.

Other considerations that feed into confidence in the standard-setting proces have to do with the extent to which accounting standards may be viewed as unnecessarily complex, or unnecessarily contributing to pro-cyclicality, whether accounting standards result in information that they purport to represent (e.g. 'fair value,' 'market value,'); and the degree of competence, independence and integrity of the indiviudal members of the standard-setting boards and their staff (which in my view is very high). I believe these factors are equally important to confidence in the standard-setting process, besides whether policymakers have exercised 'restraint' in connection with their dealings with standard-setters.

Trott on banks: is there a double standard?

One last observation I have relates to commentary included in a related article by Floyd Norris in the New York Times today, Politicians Accused of Meddling in Bank Rules. (Separately, Jennifer Hughes reported on the FCAG report in today's Financial Times, in, Accounting Rules Exonerated.)

NYT's Norris notes: "Earlier this year both boards, under pressure from banks and politicians, made rapid changes to allow banks more leeway in valuing assets and thus reduce the losses they would otherwise have to report."

Norris quotes former FASB board member Ed Trott as stating: “the banks impos[e] different standards on their customers than they wis[h] to have imposed on them ... In my experience, banks want current fair value information about assets that serve as collateral for loans. They do not want information about what assets cost two or three years ago.”

As to the sentiment expressed by Trott above, to the extent that banks desire 'fair value' information for collateral, I wonder if the banks define 'fair value' for this purpose more broadly than the fair value methodology as set forth under FAS 157, or under related IASB standards? (For example, if discounted cash flow is considered an acceptable model for valuing collateral for certain types of loans where the collateral is not marketable securities, or for loans where there is not a secondary market for the particular asset held as collateral. Additionally, it seeems to me the market value or fair value of the collateral, which may be volatile, would not necessarily drive a balance sheet valuation adjustment with respect to the loan itself on the books of the lender unless it was a nonperforming loan.) I welcome comments from readers of this blog on this point, or on any other point in this or other posts.

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Donna Fisher said...

Regarding Mr. Trott's quote: It is true that the current value of collateral is important, but only if the primary method of payment --cash flows -- fails. Bankers are primarily concerned with cash flows, just as this should be the primary measurement for traditional banking activities, as banks earn income from cash flows --not mark to market.

Edith Orenstein said...

Donna, thank you for your comment. FYI for our readers: Donna Fisher is Director of Tax and Accounting at the American Bankers Association.

Virginia said...

Really effective info, lots of thanks for the article.