Newly proposed guidance on FAS 157, the Financial Accounting Standards Board’s fair-value measurement rule, grabbed headlines this week. Some observers interpreted the guidance as a way in which FASB could re-emphasize that it was not suggesting that banks should use fire-sale prices in valuing their financial assets in inactive or illiquid markets.
But bundled with that proposed guidance was a change to another standard that could bring a more significant remedy to banks’ hurting earnings, according to accounting experts. That proposed FASB staff position would amend how companies record other-than-temporary impairments (OTTI) for debt and equity securities they have no current plans to sell.Those charges reflect the difference between the fair value and carrying value of the impaired assets.
The amended rule could reduce the OTTI charges firms have been taking in their income statements, since it allows them to split credit losses from non-credit losses such as declines in value because of changing interest rates or a lack of liquidity. The non-credit charges would be recorded in other comprehensive income (OCI) and no longer be a part of a company’s total earnings calculation.
During a hearing before the International Accounting Standards Board earlier this week, FASB technical director Russell Golden gave the following example. A company concludes it needs to record an OTTI charge on a held-to-maturity security and marks that impairment to market. Under current rules, the company would records the total impairment ($200 million, say) on its income statement. Under the new guidance, the company would subtract the non-credit portion of that loss ($190 million, for example) and put that in OCI. Only the leftover credit amount ($10 million) would hit net income.
Even though the non-credit amount would be removed from earnings, companies would still have to show that the subtraction was made, adding another line item to the income statement, explains Dennis Beresford, a professor of accounting at the University of Georgia, who supports the overall proposal. (He believes, however, that the data would be better disclosed in footnotes.)
The decision to separate credit and non-credit losses split the FASB board, with two of the five members, Thomas Linsmeier and Marc Siegel, believing OTTI charges should be “fully reflected in earnings as an unrealized loss,” according to the dissenting view included in the proposal.
The majority ruled, however. FASB released a package of proposed guidance for issues related to fair-value accounting earlier this week after lawmakers demanded immediate action from the standard-setter to help improve the financial markets. The five-member board quickly deliberated the guidelines early Monday morning and published them for a 15-day public comment period in an abnormally fast turnaround on Tuesday night. In a December 30, 2008 report to Congress on fair value, the Securities and Exchange Commission had asked FASB to modify its OTTI guidance.
FASB’s proposed OTTI guidelines would change when charges stemming from changes in the fair value of debt and equity securities are recorded in earnings. “It’s probably a good compromise,” says Jay Hanson, national director of accounting at McGladrey & Pullen, whose clients include community banks. “They have not backed off of fair value at all but provided some relief.”
Any company that holds debt securities that have been hampered by current market conditions will benefit from the changes, says Jeffrey Ellis, a managing director at Huron Consulting. However, he adds, investors’ views of banks’ capital – which have been the most affected by OTTI charges related to fair value – may not change. That’s because most investors seem instead to be zeroing in on another metric, tangible common equity (book value minus intangible assets, goodwill, and preferred equity.)
Critics of the current OTTI rules believe banks in particular have unduly had to take damaging hits to their earnings to account for their impaired assets, such as mortgage-backed securities, which they have no immediate intentions to offload and which they expect will bring in cash down the road when the financial markets improve. The current rules don’t take into account an asset’s expected cash flows, a concern that some FASB members share.
Some of the language in FASB’s OTTI proposal might spawn confusion. Under the current rule FAS 115, Accounting for Certain Investments in Debt and Equity Securities, when determining whether an OTTI exists, companies are expected to predict when an impaired asset will recover in value and forecast that they intend and can hold onto it during that time period – a judgment call that can easily be second-guessed by auditors. FASB has now flipped the positive wording into a negative, which could be misconstrued as creating a new loophole, some think. The FASB proposal says, “management would be required to assert that (a) it does not have the intent to sell the security and (b) it is more likely than not that it will not have to sell the security before recovery of its cost basis.”
Hanson, a member of FASB’s Emerging Issues Task Force, says he first read this to mean companies that do intend to offload an asset could say they do not and not take any impairment charge until they sell it, presumably when its market recovers. This interpretation would likely result in a sharp decrease in OTTI charges — an interpretation the proposal’s supporters on the board may not intend. Depending on the feedback it gets in comment letters, the board will likely change the proposal to make its intentions clearer, according to Hanson.
If approved, the OTTI guidance would become effective for interim and annual periods ending after March 15, 2009. FASB has issued the proposal for a 15-day comment period, ending April 1, an unusually short time frame to consider all the feedback the board will receive. The board will vote on its proposals, including the new guidance for FAS 157, on April 2. Late last year, the last time the board proposed changes to OTTI guidance, it received nearly 300 letters.