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The Politicizing of Accounting Standards

Mary-Jo Kranacher, MBA, CPA, CFE

For many years, U.S. GAAP has been the bible by which CPAs have lived their professional lives. Convergence with, or adoption of, International Financial Reporting Standards (IFRS) has met roadblocks along the way, in part because of criticism regarding questions concerning the International Accounting Standards Board's (IASB) independence from political influence, or lack thereof. Lately, however, U.S. politicians and lobbyists have resorted to bullying standards setters into submission by public humiliation.

The recent hearings held by the House Financial Services Committee were an eye-opening experience. As reported in the Washington Post, Representatives Randy Neugebauer (R-Tex.) and Gary L. Ackerman (D-N.Y.) pressured Robert Herz, chairman of the Financial Accounting Standards Board (FASB), to change the mark-to-market standard quickly amid accusations by banking lobbyists that the standard helped exacerbate the current financial crisis. Neugebauer told Herz: “Just do it. Just get it done.” Ackerman added: “If you don't act, we will.”

Is it possible that Neugebauer and Ackerman really believe that by changing SFAS 157 to allow financial institutions to avoid reporting losses caused by the precipitous drop in value of some illiquid assets, we can revive the banking industry and the economy?

Herz and the board responded with FASB Staff Position (FSP) FAS 157-4 “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.” It has been characterized as a “clarification” of SFAS 157 and emphasizes that the objective of fair value—to provide an exit price in an orderly transaction between market participants as of the measurement date under current market conditions—has not changed. As part of its guidance, FSP FAS 157-4 clarifies that an entity may decide to change its valuation technique and apply various models to determine fair value. Yet, it is precisely the amount of “judgment” left to management in applying this standard that continues to undermine investor confidence. Management's intent to hold certain investments until the market rebounds cannot be verified and might be used to fraudulently manipulate the financial statements. And now investors have an additional concern: that the regulators and the (due) process they've trusted to protect them from unscrupulous individuals are being compromised by politicians and the banking lobbyists pressuring them.

FASB also issued FSP FAS 115-2 in response to the congressional hearings. It modifies existing “other than temporary impairment” (OTTI) rules for investments in debt securities. The revised OTTI model applies if 1) an entity intends to sell the security, 2) it is more likely than not that it will be required to sell the security before recovery, or 3) it does not expect to recover the entire amortized cost basis of the security. Furthermore, if the only reason for OTTI recognition is a credit loss, then the new FSP changes the income statement presentation so that the credit loss component of the impairment charge is recorded in earnings, while the balance of the loss is recorded in other comprehensive income (OCI). Net profit (or loss) is no longer the bottom line at which investors should be looking. In fact, unless they read all the way to the end—OCI—they might be missing an important part of the story.

The Requirements of GAAP vs. the Needs of Investors

If financial institutions follow the guidelines developed by FASB, they will be in conformity with GAAP but they'll be out of touch with what investors want and need. The usefulness of financial reporting goes beyond merely satisfying the FASB's letter of the law, to providing information on which investors can base economic decisions. Banks argue that current market prices overstate losses because they believe those losses are temporary. Only time will tell. As long as there is little or no sales activity for certain types of assets or liabilities, the amount of losses might be difficult to determine and will exist only on paper. But investors will be hesitant to buy these assets and debt securities if they believe that the financial reports aren't worth the paper they're written on.

In case regulators and legislators haven't gotten the message, here it is: Investors want greater transparency in financial reporting, not less; they want more controls on management discretion and judgment, not less. An investor will put her money where her mouth is. Maybe it's time for standards setters to resist pressures by lobbyists and political interests and, instead, listen to what investors are saying.

As always, I welcome your comments.

Mary-Jo Kranacher, MBA, CPA, CFE. Editor-in-Chief.

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