By the time May rolled around, and the deadline for early adoption of an accounting standard known as FAS 159 passed, American companies had, for the most part, stuck to principles-based accounting. But it was touch-and-go there for a while.
FAS 159, The Fair Value Option for Financial Assets and Financial Liabilities, was issued in February, and will become effective for most companies on November 15. The rule gives companies the option to account for certain financial assets and liabilities — including stocks, bonds, loans, warranty obligations, and interest rate hedges — using the fair value method of accounting, rather than more traditional methodologies, such as historical cost.
For corporations that wanted to try out the fair-value approach at an accelerated pace, the Financial Accounting Standards Board gave companies with a calendar-year end an April 30 deadline. Unexpectedly, the impending deadline acted like a large glowing flame to moths — which in this case were investment advisors. Over the past six weeks, corporate investment advisors flooded companies with promotional material touting a loophole sometimes referred to as the “FAS 159 Mulligan” — an accounting do-over of sorts. The aim was to get companies to sign on to their loophole strategy before the early adoption deadline ran out.
FAS 159 works 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.
However, if a company has less-than-honorable intentions, it could use FAS 159 the way many investment advisors have suggested: First identify all the losers in a company’s investment portfolio — for example, held-to-maturity stocks that are underwater or available-for-sale loans that have interest rates much higher than current market rates. Next, apply FAS 159, and elect to fair value the underwater stocks or expensive loans. Then, calculate the remeasured loss, bypass the income statement, and record the loss in retained earnings. Finally, have the company sell-off the stock or refinance the loan, and immediately turn around and purchase a replacement instrument that is valued at historical cost, dropping the fair value treatment altogether.
The move uses the transition provision of FAS 159 to shield earnings from the loss, while the company retreats from fair value accounting. Jay Hanson, national director of accounting for audit firm McGladrey & Pullen said his clients were inundated with offers from investment advisors who claimed that they could help “rebalance portfolios,” by using the FAS 159 loophole. The advisors were using “one sentence” from the transition provision to create a bright-line exception to hide losses from shareholders, surmised Hanson. But in the end, “few companies abused [the provision].”