Rule Change Lets Banks Reinvent the Past

Without directly changing fair-value rules, a new FASB rule allows banks to "roll forward" noncredit losses and avoid a hit to earnings.

In a three-to-two vote Thursday, the Financial Accounting Standards Board approved an accounting-rule change that allows banks with impaired financial securities to move billions of dollars in losses off of their income statements, which will benefit their regulatory capital calculations.

“Banks got a birthday present,” says Jay Hanson, national director of accounting at McGladrey & Pullen.

The ability to boost earnings and shore up regulatory capital did not involve rolling back fair-value accounting rules — something bankers and their lobbyists have been clamoring for since last year. Instead, the FASB amendments related to an accounting convention called other-than-temporary-impairments.

The rule revision addresses how companies account for assets whose market value has fallen below the reported balance-sheet value, but it doesn’t change the accounting treatment with regard to fair-value measurement. Although companies will still record the paper loss, it will no longer affect their bottom line. If, for example, a mortgage-backed security drops in market value but the underlying mortgages are still largely sound, banks can split off that noncredit loss. As a result of the change, companies can now reach back, grab all the impaired financial assets they still hold, and dump the noncredit losses into a balance-sheet bucket called other comprehensive income, says Hanson.

The noncredit losses that wind up in the OCI sit on the balance sheet, but are not run through the income statement. That means those losses never hit earnings, and are excluded from a bank’s regulatory capital calculation. That’s important during a credit crunch, says Hanson, because in theory, if banks can reduce the amount of regulatory capital they have to set aside in reserves, they will have more money to lend.

Whether an accounting rule can restart sagging credit markets remains to be seen. However, FASB reasoned that this kind of “truing-up” needs to happen to give investors a meaningful way to compare noncredit loss going forward, adds Hanson. FASB also added a slew of disclosure requirements related to noncredit losses that must be presented in a separate appendix.

The disclosure requirements include the “roll forward” amounts that will be recognized in the OCI, disaggregated information based on the nature and risk of the securities, a cost basis of available-for-sale and held-to-maturity securities, and examples of key inputs that may have been used to measure credit losses or underlying assets in the case of complex financial instruments.

The amendment, which is expected to be fully drafted and issued next week, allows companies to apply an old FASB loan loss rule — FAS 114 — to securities that have dropped in value. The rule revisions, which tweak both FAS 115 and FAS 124, will work like this: Impaired securities will be measured at fair value and booked separately for accounting purposes. The credit loss portion of the asset will be posted to the balance sheet and also run through the income statement. Meanwhile, the noncredit loss portion will be dumped on to the balance sheet in the OCI and completely bypass the income statement.

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