How Bailout Loosens Accounting, Tax Rules

While the new law works to ease the credit crisis, it lets banks sidestep tax and accounting rules.

In contrast, net capital losses may only be carried back to the three taxable years preceding the year in which the loss was sustained. What’s more, a capital loss is only carried forward to the five taxable years (to offset the capital gain income) following the taxable year in which the loss was sustained.

From an accounting perspective, EESA gave participating banks more leeway than that permitted under U.S. GAAP recognition rules. The Willens report explains that EESA was not enacted until October 3, which is “shortly after the close” of the 2008 third quarter. As a result, GAAP would not have allowed the participating banks to recognize the ordinary loss and related tax benefit until the fourth quarter. That’s because the law’s passage would have been characterized as a “subsequent event” in accounting parlance, and the related tax break would have been pushed to the next quarter.

Consider that subsequent events exist in an accounting limbo. Such events or transactions take place after the date listed on the balance sheet but before the financial statements are issued. Further, subsequent events are split into two subcategories. “Recognized” subsequent events provide additional information about conditions that existed at the balance-sheet date. “Non-recognized” subsequent events provide additional information about conditions that did not exist as of the balance-sheet date.

The difference is that under GAAP, companies don’t recognize subsequent events that didn’t exist as of the balance sheet date until the following period. That’s why the EESA-related tax benefits should be booked during the fourth quarter, Willens notes. Sometimes an event is deemed “so significant” that GAAP allows pro-forma financial data to be recognized during the same period. However, he adds, it’s unclear whether the EESA event would fit the criteria.

The key to allowing banks to skirt GAAP, asserts Willens, is that bank regulators are not bound by the accounting principles. As a result, they gave the go-ahead for “banking organizations” — defined as banks, bank holding companies, and thrift institutions — to recognize the effect of the tax change in their third quarter regulatory capital calculations.

This isn’t the first time during the current credit crunch that regulators have eased the rules to fix the broken banking system. Several weeks ago, the Federal Reserve and other regulators announced that member banks could increase Tier 1 capital by the amount of any deferred goodwill tax liabilities related to a taxable merger. “The Fed is doing its part to insure that the banks under its jurisdiction present the best possible portrayal of their capital positions,” wrote Willens in the report. That portrayal may make “the rumored elimination or curtailing of ‘mark to market’ accounting for financial assets and liabilities ÂÂÂÂ… infinitely easier to achieve,” he wrote.

The EESA’s Capital Purchase Program was another instance of rule- bending for a reputed public good. Under the program, the Treasury Department will buy senior perpetual preferred stock (SPPS) from “eligible banking organizations” to infuse the banks with capital. Ordinarily, bank holding companies are banned from including in Tier 1 capital any SPPS that has a dividend “step-up” rate, says Willens. In addition, the amount of cumulative SPPS that a bank holding company may include in Tier 1 capital is limited to 25 percent.

But the Fed suspended those rules after the purchase program was announced. For example, bank holding companies may include SPPS in their Tier 1 calculation “without limit.” In addition, Willens points out, the step-up feature is designed to “compel” a stock issuer to redeem the shares as promptly as possible.

As a result, the Fed believes that the stock is properly reflected in Tier 1 capital, and the banks should see a “substantial” increase in their regulatory capital ratios, reckons the consultant. “Generally, comparable rules and regulations will be taken less seriously because of the possibility — when the next crisis takes hold — that those rules can be suspended or terminated,” he asserts.

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