The United States Securities and Exchange Commission (SEC) announced that James Kroeker, the governing body’s chief accountant since 2009, is stepping down.
“Jim has provided superb counsel on a range of accounting- and auditing-related matters and has always stressed the importance of accounting to our investor protection mission,” said SEC Chairwoman Mary L. Schapiro.
Kroeker served as staff director of the SEC’s study of fair value accounting standards, which Congress mandated in 2008. He has led efforts to analyze the adoption of International Financial Reporting Standards (IFRS), one step that could lead to the establishment of a global accounting standard.
Kroeker’s departure is also significant because of the timing. The SEC is currently debating and completing the full analysis of bringing IFRS to U.S. public company accounting standards. Business and governmental leaders are anticipating the SEC’s analysis and decision as it would require a large shift in standards, most notably fair value accounting.
Jim is one of the good ones. He will be missed. The SEC has not announced a timetable for his replacement.
Filed under: Fair Value Accounting, Generally Accepted Accounting Principles, Real Estate
In an opinion piece published in American Banker, president and chief executive officer of the Community Bankers Association of Georgia spoke in favor of current legislation that would “provide relief for real estate-related assets by allowing community banks to amortize losses on commercial real estate loans and ‘other real estate owned’ (repossessed properties) over 10 years for regulatory capital purposes.” The Communities First Act, first introduced to Congress in 2011, “provides a broad range of much-needed regulatory and tax relief for community banks and their customers,” said Brown.
Current mark-to-market rules under generally accepted accounting principles (GAAP) require the immediate recognition of losses.
Decoupling GAAP from regulatory accounting practices, says Brown, would allow community banks to more easily spread real estate losses over a longer period of time and give them better opportunities to work with borrowers rather than foreclose.
“Regulatory, tax and paperwork requirements disproportionately burden community banks, which lack the scale of larger institutions over which to spread legal and compliance costs,” Brown continued.
This legislation could stimulate a struggling economy by allowing small community banks to lend more easily to consumers and small businesses, many of which have limited funding options currently.
In an analysis of Public Company Accounting Oversight Board (PCAOB) data, Atlanta-based valuation and litigation consultancy firm Acuitas, Inc. found that fair value issues dominated the recent landscape of noted deficiencies in audits. The full report titled “Survey of Fair Value Audit Deficiencies,” analyzed three years of PCAOB data regarding audits and inspections.
Mark Zyla, managing director at Acuitas, Inc., said there were two significant trends that emerged from the report. First, “the percentage of audits that have deficiencies has more than doubled since 2009. Secondly, “fair value and impairment audit issues have contributed significantly to this increase in the number of these deficiencies.”
According to Zyla, “The information contained in the survey should benefit public entities and their auditors, and by extension, private entities and their auditors – by helping them understand the underlying causes of fair value measurements and impairment audit deficiencies, as reported by the PCAOB in their latest inspection reports.”
In a Wall Street Journal commentary, Max Colchester discussed The Royal Bank of Scotland’s (RBS) recent reporting of a $2.46 billion (£1.52 billion) net loss, mostly due to fair value reporting on RBS’s debt. “We wouldn’t be a bank if we didn’t have some interesting accounting charge below the line,” said RBS Chief Executive Stephen Hester. Debt valuation adjustments, as they are called, theorize that when a bank’s debt loses value, the bank could buy back its very own debt at a discount, thus making it profitable.
“The ‘fair value’ of own debt conundrum continues to haunt the banking sector, making it hard for analysts to value stocks and investors to see how profitable a bank really is,” notes Colchester.
“It’s an absolute mess,” said Mike Trippitt at Oriel Securities. “At the moment we are seeing fair value gone mad with swings of £2 billion per quarter.”
American banks have recently undergone similar paradoxical results in financial reporting. Bank of America, having posted large gains in 2011 when the price of its debt fell, now is facing setbacks due to increased investor confidence and increased debt value.
The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have discussed rule changes to fair value accounting in attempts to merge standards. The IASB has submitted new rules for debt valuation adjustments, but they are currently being held up by European Union approval.
In a Slate editorial response to Charles Lane’s “When Uncle Sam Plays Banker” piece in the Washington Post, Slate business and economics correspondent Matthew Yglesias says that the Congressional Budget Office’s (CBO) proposal to account for federal loan programs at fair value is misguided.
The CBO’s proposed budget, under fair value, would account for the cost of a federal loan program based on current market rates, taking greater account of default risks and other factors not currently used in federal lending.
Proponents of the fair value proposal suggest that using market prices will more accurately describe the true cost of some federal loan programs. Under this method, in an example used by Yglesias, the federal student loan program as it currently stands would cost the federal government billions of dollars, rather than the financial gain that’s booked under current accounting procedures.
But the problem, says Yglesias, is that the federal market should operate differently than the private market. “The interest rate on federal debt is a market price. It just happens to be the case that the market interest rate on federal government debt is lower than the market interest rate charged to private financial institutions,” he says.
In a Washington Post editorial, financial writer Charles Lane discussed the United States federal government and Congressional Budget Office (CBO) plan to apply fair value accounting to federal loan and credit programs, calling the proposed legislation “necessary.” Noting that federal loan programs “are here to stay,” Lane says that “Congress needs to be much more transparent about the costs and benefits.”
The CBO’s belief, authored in a House bill by Rep. Scott Garrett (R-NJ), is that fair value accounting could bring more transparency to the true costs and benefits of loan programs.
Congress currently bases estimates of the cost of new lending on the lowest possible level, using calculations “as though everyone were as default-proof as Uncle Sam, which understates the cost and risk to taxpayers,” says Lane.
Under fair value, programs like the federal student loan program or the Federal Housing Administration (FHA) single-family mortgage insurance programs would be projected as a multi-billion dollar loss rather than a gain. As such, “Congress would have to cut other programs or raise taxes accordingly,” Lane says.
In an editorial posted by the Fisher Investments staff on its MarketMinder website, the firm says that the 2009 Financial Accounting Standards Board (FASB) decision on fair value accounting warrants criticism, but cautions that it was not the only cause of the financial crisis. Notably, says the article, the illiquid market of mortgage-backed securities and its impact on banks played a major role.
“Fair value combined with seemingly random decisions made by the US government—regarding which firms to bail out and which not to, what to do about Troubled Assets Relief Program (TARP) and what to do with it—seem likely to have been major drivers of the bear market,” the Fisher staff says. Additionally, a weak housing market and overextended banks contributed to the uncertainty, it continues.
Regulatory proponents, says the editorial, have their side of the story as well. “Absent haphazard government policy—on the part of regulators—and a negative feedback loop created by fair value standards, it seems likely there would have been materially less uncertainty and distortion,” says the editorial. But regulators suggested that deregulation left standards setters without necessary tools to help ease the crisis.
In a recently released study by Interactive Data Corporation, mutual fund industry professionals continue to invoke fair value procedures at an increasing rate.
The survey, which covered 134 Chief Financial Officers, Chief Compliance Officers, and valuation team members, showed an increasing attention to market volatility as it relates to fair value accounting procedures.
“The heightened level of volatility in the market draws attention to the importance of fair value practices for mutual funds investing in international equities,” said Rob Haddad, director of Evaluated Services for Interactive Data. Haddad continued, “Our survey found that mutual funds are generally well-prepared for volatile market scenarios, with predefined fair value procedures in place to handle such events, and formal back-testing processes to examine how these procedures worked in practice.”
Among mutual funds, 36% reported that fair value is being applied every day, up from only 10% in 2004. The other 64% of funds reported using “triggers” — a process that pays attention to market movements and benchmarks — to apply fair value procedures for the fund. The strategy for triggers varied greatly in method, scope, and complexity, said the study.
In a contribution to the American Association of Individual Investors Journal, Minnesota State University professor Stephen E. Wilcox discussed Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE) method of valuation.
A newly popular method of valuation, CAPE relies on inflation-adjusted earnings statements as well as averaging 10 years of reported earnings to account for business cycle effects. Wilcox says that CAPE provides “an overly bearish view of the stock market” and should be used with caution.
Fair value accounting, says Wilcox, showed how a change in accounting regulations had a material impact on reported earnings and is a key flaw in Shiller’s CAPE method.
When the Financial Accounting Standards Board (FASB) issued the fair value ruling in 2006 (and up through the financial crisis in 2008), investment securities and mortgage-backed securities made up a significant percentage of banks’ assets. Wilcox says, “The move toward more fair value accounting standards resulted in security losses having a devastating effect on the reported earnings of financial institutions” in the fourth quarter of 2008. CAPE, says Wilcox, must continue to reflect the impact of a single quarter’s massive loss even though it’s unlikely it will happen again in the next 10 years.
In a Bloomberg editorial, University of Chicago Booth School of Business professor Haresh Sapra says that conventional thinking on financial regulation may not be entirely beneficial. “The view that greater transparency enhances market discipline and therefore economic efficiency holds true only in a ‘Robinson Crusoe’ economy, that is to say one in which a single decision maker is learning about a company whose decisions are taken as given and whose future cash flows or economic fundamentals are therefore fixed,” says Sapra.
Fair value accounting is one method that regulators have undertaken to improve transparency, requiring that assets be accounted for at market price (rather than purchase price) to give a more accurate view of a holding’s value to both insiders and outsiders of a company. But financial insiders point to increased volatility in financial statements, leading to unnecessary and unintended instability.
The more that a financial institution relies on short-term pricing and value changes, the more at-risk it is for a “feedback loop,” as “decisions of financial institutions are more likely to be based on second-guessing of their competitors than on perceived fundamentals,” says Sapra. “Put differently, in trying to enhance market discipline, reliance on market prices via fair-value accounting weakens market discipline,” he concludes.
Amen to that, Professor! Let’s do both–print holdings at purchase price and then footnote the exact mark-to-market effect. This attains both goals–it gives long-term decision-making room to think and operate and fully discloses the market value effects on the institution. Why isn’t this a perfect solution? It provides more disclosure and less volatility–win-win!