TMT'S BLOG: Accounting

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Monday, 24 August 2009

Dear CFO: Watch Your Loan Loss Reserves

The SEC issues a new letter aimed at financial institution CFOs, emphasizing the need to "reassess" loan loss reserves in light of the economic slump.

Marie Leone - CFO.com | US

August 21, 2009

The latest "Dear CFO" letter from the Securities and Exchange Commission focuses on how to account for loan loss reserves, a thorny issue the regulator is spending more time reviewing.

The letter, which was publicly released this month, was generic in nature in that it was not addressed to a specific company; rather, it went out to all CFOs of public companies that may have questions on the topic. In this case, the SEC emphasizes that the letter does not change accounting rules or provide new guidance: it is a reminder that companies — primarily banks and financial institutions — may want to "reassess" their valuation of loan loss reserves in light of the "current economic environment."

Setting loan loss reserves has been a hot topic for the SEC during the past several years. Since 2006 the commission and companies have written 814 comment letters and responses, respectively, on the subject of loan loss valuation, according to data provided by research firm Audit Analytics, which tracks public financial data on the 5,600 largest companies registered with the SEC. The total rises to 850 when letters that mention loan loss accounting rules — specifically the disclosure provisions in FAS 141R and SOP 03-03 —are included in the count.

In that bevy of company-specific comment letters, banks such as Wells Fargo, Wachovia, and Suntrust have received missives on the topic from the SEC, while other financial institutions, such as GMAC, e-Trade, Countrywide Financial, and Bear Stearns, have also exchanged comment letters with the commission on accounting for loan losses.

Estimating the value of loan losses so corporate reserves can be established has been a controversial issue since the subprime crisis blindsided investors, as many financially troubled banks and financial institutions were caught with inadequate reserves to keep up with the pace of defaults.

Regulators and standard-setters have been trying to figure out a fix to the problem of inadequate reserves, and to that end, the SEC's chief accountant James Kroeker told an audience at an industry conference sponsored by Baruch College in April that the accounting treatment for loan loss reserves, as well as for off-balance-sheet items, would become a major area of focus for the regulator in the coming months.

At the same conference, Robert Herz, chairman of the Financial Accounting Standards Board, said new loan loss accounting guidance would likely require companies to disclose the economics of the transaction and record the early capture of losses.

Also, the Financial Crisis Advisory Group, an advisory group to FASB and the International Accounting Standards Board, believes the two standard-setters should seek ways to use more forward-looking information for calculating bad debts with respect to loan loss reserves, and find ways to rein in so-called cookie-jar reserves that can be used to manage earnings.

What's more, during the past year, the Public Company Accounting Oversight Board found several accounting firms lacking in their reviews of clients' loan loss reserves. In its annual inspection reports, the PCAOB criticized, among other firms, Deloitte, KPMG, and McGladrey & Pullen for not doing adequate testing on their clients' reserves.

The August "Dear CFO" letter notes that additional information about "high-risk loans" — such as junior lien mortgages, interest-only loans, subprime loans, and loans with initial teaser rates — may be useful to investors, and should be disclosed in the management's discussion and analysis sections of corporate annual reports. The letter also warns companies that if they change their practices with regard to how they calculate loan loss reserves, then that change, as well as changes in collateral value and key ratios, must be disclosed, too.

The SEC posts "Dear CFO" letters from time to time to help companies better comply with disclosure requirements, and to provide "real-time" guidance. "In light of the issues facing financial institutions related to the prolonged problems in the lending markets, we want to make sure that lenders were focused on good disclosure practices regarding loan loss reserves in drafting their upcoming MD&As," the SEC told CFO.com.

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Will Bank Regulators Diverge from GAAP?

The FDIC will discuss new accounting rules at its board meeting next week, and once again, the idea of slipping free of bothersome rules is likely to be on the table.

Marie Leone - CFO.com | US

August 20, 2009

Bank regulators are set to discuss accounting standards next week, with an aim toward determining the potential affects that off-balance-sheet rules may have on some financial institutions. During the past year, bankers have fretted about new accounting rules that would force them to bring back on their balance sheets billions of dollars worth of assets — a move bankers have argued will throw regulatory capital ratios into chaos.

As a result, the Federal Deposit Insurance Corp., the federal agency that insures bank deposits, announced it would discuss "the impact of modifications to generally accepted accounting principles" during its August 26 board meeting. What that likely means is board members will debate the practical implications of the rules known as FAS 166 and FAS 167, which beginning in January 2010 will change the way banks and other financial institutions account for securitizations and special-purpose entities (SPEs).

The projects that eventually became FAS 166 and FAS 167 were initiated by FASB at the request of investors, the Securities and Exchange Commission, and the President's Working Group on Financial Markets. The working group was originally formed by then-President Ronald Reagan in response to the "Black Monday" stock-market crash of 1987.

The new standards revise older accounting rules — specifically FAS 140 and FIN 46(R) — changing the way, for example, companies define control over financial assets and liabilities, thereby causing some off-balance-sheet transactions to be consolidated back on to company financial statements. The rule would likely have a large impact on banks, which frequently package up loans into securities.

The impact of the accounting rules on banks came to a head in May, when the Federal Reserve Board released the results of its so-called stress tests, which were performed on the 19 largest bank holding companies in the United States. The unprecedented stress testing, officially dubbed the Supervisory Capital Assessment Program, incorporated several accounting changes into its modeling, including the potential effects of FAS 166 and FAS 167. In its summary report, the Fed concluded that the new FASB rules would require banks to reconsolidate off-balance-sheet assets tied to securitizations and SPEs.

So far, the estimates of how many billions of dollars would have to be reconsolidated vary, with the Fed guessing that an aggregate $700 billion worth of assets would be brought back on the balance sheets of the largest bank holding companies. News reports have estimated the impact to be closer to $1 trillion worth of assets.

The problem for banks is that as they consolidate the assets, they also will be required by law to increase their capital cushion, something that could prove undoable during a credit crisis.

Banks do have reason to hope, however. While banking regulators usually require GAAP-based reporting from financial institutions, which would include the use of FAS 166 and FAS 167, they can ignore GAAP for regulatory capital purposes. Indeed, that is exactly what happened when banks protested an earlier effort to improve securitization accounting. In 2005, to help quell a bank backlash against FASB's FIN 46, the Fed announced that accounting rules need not apply to banks.

"Although [generally accepted accounting principles inform] the definition of regulatory capital, the Board is not bound to use GAAP accounting concepts in its definition of tier 1 or tier 2 because regulatory capital requirements are regulatory constructs designed to ensure the safety and soundness of banking organizations, not accounting designations established to ensure the transparency of financial statements," said the Fed. "In this regard, the definition of tier 1 capital since the Board adopted its risk-based capital rule in 1989 has differed from GAAP equity in a number of ways."

Thus, there is precedent for holding banks to different standards.

Next week's meeting at the FDIC will no doubt address the issue of whether banking regulators should avoid FAS 166 and FAS 167 for capital cushion purposes. Bankers are keeping their fingers crossed.

"We do feel the timing of the standards couldn't be worse," says Donna Fisher, senior vice president of tax, accounting, and financial management at American Bankers Assn., a trade group. She says the idea of forcing banks to raise large amounts of capital during the current economic crisis "doesn't make sense." If bank regulators do require GAAP reporting, then the ABA would like to see the Fed and others mandate a "net presentation" of assets and liabilities for capital requirements, rather than a "gross up" of the items. In that way, regulators would have the gross numbers to assess, but regulatory capital would be based on the bank's assessment of its risks, rather than all the assets and liabilities it holds. For instance, the gross number would include all the assets and liabilities the bank has a piece of, regardless of whether it sold off a controlling interest to another entity.

But the problem with the net presentation, according to critics, is that before FAS 166 and FAS 167, complex transaction contracts made it difficult to determine who the controlling party was when the owners of SPEs teetered close to bankruptcy. At worst, banks purposely kept the assets off their balance sheet until the vehicle needed to be bailed out at the expense of bank shareholders.

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Audit Overseer Faults BDO, Grant Thornton

The PCAOB says BDO had trouble testing revenue-recognition controls, while Grant Thornton did not adequately identify GAAP errors. Both firms complain that the board criticized judgment calls.

Marie Leone - CFO.com | US

July 13, 2009

Annual inspection reports for BDO Seidman and Grant Thornton, released last Thursday by the Public Company Accounting Oversight Board, criticized some of the audit testing procedures and practices at the two large accounting firms.

The review of BDO focused mainly on issues related to testing controls around revenue recognition, while Grant Thornton was chastised for not identifying or sufficiently addressing errors in clients' application of generally accepted accounting principles with respect to pension plans, acquisitions, and auction-rate securities.

With regard to BDO, the inspection staff reviewed seven of the company's audits performed from August 2008 through January 2009 as a representation of the firm's work.

The report highlighted several deficiencies tied to what it said were failures by BDO to perform audit procedures, or perform them sufficiently. According to the reports, the shortcomings were usually based on a lack of documentation and persuasive evidence to back up audit opinions. For example, the board said, BDO did not test the operating effectiveness of technology systems that a client used to aggregate revenue totals for its financial statements. The systems were used by the client company for billing and transaction-processing purposes.

The inspection team also reported that BDO's audit of a new client failed to "appropriately test" the company's recognition of revenue practices. Specifically, the audit firm noted that sales increased in the last month of the year but it failed to get an adequate explanation from management. Also, the report concluded that BDO reduced its "substantive" revenue testing of two other clients, although more thorough testing was needed.

And while BDO identified so-called "channel stuffing" as a risk of material misstatement due to fraud, at another client, its testing related to whether the client engaged in the act was not adequate, said the inspectors. (Channel stuffing is the practice of accelerating revenue recognition by coaxing distributors to hold excess inventory.)

Other alleged problem spots for BDO included a failure to design and perform sufficient audit procedures to test: journal entries and other adjustments for evidence of possible material misstatement due to fraud; valuation of accrued liabilities related to contra-revenue accounts; a liability for estimated sales returns in connection with an acquisition; and assumptions related to a client's goodwill impairment of a significant business unit.

In response to the inspection report, BDO performed additional procedures or supplemented its work papers as necessary. It also noted in a letter that was attached to the report that none of the clients cited had to restate their financial results.

In the letter, BDO acknowledged the importance of the inspection exercise, commenting that "an inherent part of our audit practice involves continuous improvement." However, the firm also said the report does not "lend itself to a portrayal of the overall high quality of our audit practice," since it reviews only a tiny sampling of audits. What's more, BDO pointed out that many of the issues reviewed "typically involved many decisions that may be subject to different reasonable interpretations."

Deficiencies highlighted in the inspection report on Grant Thornton, meanwhile, included failures to "identify or appropriately address errors" in clients' application of GAAP. In addition, inadequacies were said to have been found with respect to performing necessary audit procedures, or lacking adequate evidence to support audit opinions. The Grant Thornton inspections were performed at on eight audits conducted between July 2008 and December 2008.

In five audits, the PCAOB said inspectors found deficiencies in testing benefit plan measurements and disclosures. In four of those audits, Grant Thornton was said to have failed to test the existence and valuation of assets held in the issuer's defined-benefit pension plan. In one audit, the board said, the accounting firm failed to test the valuation of real estate and hedge fund investments and a guaranteed investment contract held by the client's defined-benefit pension plan.

One client amended three of its post-retirement benefit plans to eliminate certain benefits, and Grant Thornton "failed to evaluate whether the issuer's accounting" was appropriate, said the report. In another audit, the accounting firm allegedly did not perform sufficient procedures to evaluate whether the assumptions related to the discount rate and long-term rate of return on plan assets — provided by the client's actuary — were reasonable.

In a separate audit, a client acquired a public company that was described as having six reporting units. The client recorded the fair values of the net assets of each reporting unit according to the valuations provided by a specialist. But according to the inspection report, Grant Thornton did not audit the acquisition transaction sufficiently.

In particular, the firm neglected to evaluate which of the fair-value estimates represented the "best estimate" with regard to two units that were hit with an economic penalty for having a lower total fair value than their net assets, the inspectors said. They also concluded that Grant Thornton did not do a sufficient auditing job when it failed to note whether it was appropriate for the specialist to use liquidation values for two other units.