Of course, with such a significant change, there are bound to be questions and concerns. Here are a few that have occurred to me.

1. One of the debates we had in the early days of this project was whether to define revenue, or just address how revenue should be recognized. As this exposure draft makes clear (see paragraphs 1-2), the boards ultimately decided not to define revenue, but instead only to address when revenue is recognized in contracts with customers. This made me wonder whether the boards will be happy with revenue being recognized in the absence of contracts with customers. Does revenue recognition require a customer? Apparently not. Revenue is recognized today for changes in the value of some mineral, biological or agricultural assets (IAS 41), even in the absence of a contract with customers. Why do we get a difference for revenue recognition principles across various industries or types of assets? The proposed new standard scopes out non-contractual situations (such as biological and agricultural assets) as well as contractual situations (such as leases, insurance, financial instruments, and guarantees). Conspicuously absent from the exposure draft is any rationale for scoping these areas out of the proposed standard. From experience working on this project, I’m guessing that’s because there was no general agreement about WHY these would be scoped out. There is simply a consensus that they should be scoped out. Wouldn’t it be great if the boards could provide some rationale for scoping out particular types of transactions?
2. The exposure draft states that an entity shall account for each promised good or service as a separate performance obligation only if that good or service is distinct (see paragraph 22). A good or service is distinct if either (a) an entity  sells an identical or similar good or service separately, or (b) the entity could sell the good or service separately because (i) it has a distinct function AND (ii) it has a distinct profit margin. My question–how do you know whether something has a distinct profit margin unless you (or someone else) actually sell that something separately? And if you already sell it separately, then there’s no need for condition (b). The exposure draft states that a distinct profit margin exists if that good or service is subject to distinct risks and the entity can separately identify the resources needed to provide the good or service. This is one area of the proposed new standard that I think people may have some difficulty with—determining whether a potentially separate good or service has distinct risks. If there’s anything our recent past has taught us, it’s that people are pretty bad at identifying and quantifying risks. Who knows, perhaps it won’t be so hard to do for revenue recognition purposes! (By the way, don’t misinterpret my tone here…I actually like the direction the boards have gone with this guidance, but I think it will be a little perplexing at first.)
3. Determining the transaction price in a contract receives lots of attention in the exposure draft. The boards decided that the transaction price should be adjusted based on the time value of money (if financing is a significant component of the arrangement), customer creditworthiness, collectibility, any non-cash consideration received from the customer, and any consideration payable to the customer (such as rebates). I don’t really have a question here, but I do want to highlight how this will be a significant departure from past practice in some situations. Previously, revenue would not be recognized in some situations if certain criteria were not met, for example in real estate sales. If the criteria were met, revenue for the full contract amount would be recognized. Instead of asking whether to recognize revenue, this standard moves more toward asking how much revenue to recognize. So, for instance, if you have sufficient history selling real estate to particular classes of customers, and your history suggests to you that 60% of the time customers follow through with their promises to pay over time, then either through discounting with a high interest rate or through an adjustment due to collectibility, you would recognize the sale of real estate at a drastically reduced amount. Any amount received beyond the original revenue recognized would be treated as a gain or loss. Personally, I think this is an improvement over the criteria approach, but it has its own problems as well, including the estimation process required to determine the amount of revenue to recognize in such a sale.

I’ll stop here for now. I still want to go through the application guidance with a finer tooth comb, but I’m pretty impressed with most of what I’ve read. As much as the project was originally conceived to be a general standard on revenue to replace all other revenue standards, I think the boards have appropriately scaled back their ambitions to focus strictly on settings where a contract with a customer exists. This represents the lion’s share of situations in which revenue is recognized today, and the proposed new guidance will not change most accounting out there. However, what it does change could be pretty significant—including construction contracts, real estate sales, and software revenue recognition. I look forward to reading the comment letters over the next few months!

The basic argument tying fair value accounting to amplified procyclicality is that auditors required banks to write down affected assets to unrealistically low values as reflected by ABX index prices. Because the Financial Crisis caused a drop in liquidity, ABX index prices allegedly reflected distressed prices rather than prices from an orderly market. Bank managers contended that ABX prices, being artificially low relative to the bank managers’ perceived asset values, caused unnecessarily large impairment charges. That is, impairment charges would have been lower had bank managers been permitted to use their personal assessments of value, and the economy would have suffered a less severe downturn.

Although, in principle, an “excessive” fair value-related impairment charge could have amplified procyclicality of bank asset prices, we believe this is unlikely for two reasons. First, this claim can only apply to those bank assets that were either measured at fair value or for which fair values apply when determining impairment. The proportion of bank assets for which this is the case is limited. Laux and Leuz (2010) reports that during the 2004 to 2006 period banks held approximately of 50% of their assets in loans and leases, which are not subject to fair value accounting and are not impaired to fair value. Although, for the 14 largest US commercial banks, Shaffer (2010) reports the decline in Tier 1 capital during the Financial Crisis arising from impairments of loans averaged 15.6%, those impairments were based on an incurred loss model and not on fair value. Therefore, as discussed in section 6, although impairments of loans, i.e., loan loss provisioning, during the Financial Crisis likely had procyclical effects, fair value accounting played no role relating to loans.

In other words, there was a downward spiral in loan values, but fair value accounting played no role in it because loan values are not calculated using fair value. They are calculated using the incurred loss model.

The authors go on to explain that fair value accounting may have played some small role in the devaluation of other assets, however, bank regulators apply a prudential filter to neutralize some fair value gains and losses when calculating Tier 1 capital requirements. In fact, “Prudential filters neutralized the effect on Tier 1 capital of some fair value losses and the larger effect on Tier 1 capital arose from loan losses that were not determined using fair value.”

The authors also discuss the role that asset securitization, derivatives, and loan loss provisioning played in the financial crisis. The paper is forthcoming in the European Accounting Review.

“June 30, 2011, is an arbitrary deadline and it’s not one that’s been put in place by the SEC or by our road map,” said Kroeker. Citing FIN 46(R) as an example of an accelerated project that later needed to be reworked, Kroeker said that what’s most important is to ensure through the exposure process that the final standards are a “long term, sustainable solution.”

I suspect the FASB is not all that surprised by Kroeker’s view, given how good the lines of communication typically are between the FASB and the SEC. However, I suspect the IASB and other supporters of a single, global accounting standard will be a little surprised and will interpret Kroeker’s comments as (further) evidence that the US will not be adopting IFRS any time in the near future. They may even increase the volume on their arguments that the IASB should not give so much preferential treatment to the FASB and SEC in its standard setting activities. Should make for some interesting articles over the next few weeks!

Stephen Ryan (NYU) joins FASRI to talk about his recent research on the fair value option in the banking industry.  Stephen is one of the most respected accounting academics studying banking and financial instruments these days, so I expect people will have plenty of questions beyond the research study that will form the heart of the discussion. From his web page, we learn that:

Stephen has been actively involved in financial accounting standards setting. He currently serves on the Financial Accounting Standards Board’s Liabilities and Equity Resource and Financial Institutions Advisory groups. Until 2003, he was a member of the Financial Accounting Standards Advisory Council, the advisory body for the Financial Accounting Standards Board. He has also previously chaired the American Accounting Association’s Financial Accounting Standards and Financial Reporting Issues Conference committees. Professor Ryan has served as the editor of the Review of Accounting Studies since 2006.

Definitely take a look at his SSRN author page.

Here is the abstract of the paper we’ll be discussing, with Chi-Chun Liu and Yao-Lin Chang:

We examine the determinants of the timing of and financial instruments involved in banks’ initial fair value option (“FVO”) elections upon their adoption of SFAS No. 159. We focus on regular (in 2008:Q1) adopters of the standard, and distinguish their FVO elections from those of early (in 2007:Q1) adopters. Song (2008), Henry (2009), and Guthrie, Irving, and Sokolowsky (2009) find that early adopters’ elections exploited SFAS No. 159’s transition guidance to manage their accounting numbers. These studies provide essentially no evidence that either early or regular adopters complied with the standard’s intent that FVO elections remedy accounting mismatches for economically offsetting positions. In contrast, we hypothesize and provide evidence that regular adopters complied with that intent, having learned from guidance the SEC and others provided about that intent and from the scrutiny early adopters’ FVO elections received. Specifically, we predict and find that variables related to accounting mismatches explain regular adopters’ FVO elections but not early adopters’ elections. We predict and find that variables related to the management of accounting and regulatory capital numbers explain early adopters’ FVO elections but not regular adopters’ elections.

We also examine banks’ initial FVO elections for the three most frequently elected types of financial instruments: AFS securities and debt for early adopters and loans held for sale for regular adopters. We provide four distinct economic and accounting reasons why banks’ FVO initial elections for AFS securities and debt were both amenable to exploitation of SFAS No. 159’s transition guidance and likely to create accounting mismatches, whereas banks’ initial FVO elections for loans held for sale were both not amenable to exploitation of the standard’s transition guidance and likely to remedy accounting mismatches. Based on these reasons, we predict and find that regular adopters’ FVO elections for loans held for sale remedied accounting mismatches and did not exploit SFAS No. 159’s transition guidance. We predict and find the opposite for early adopters’ FVO elections for AFS securities and debt.

Our findings are consistent with regular adopters’ FVO elections, particularly for loans held for sale, complying with SFAS No. 159’s intent. Our findings are broadly consistent with Henry’s (2009) evidence that some early adopters rescinded or revised their FVO elections because of informal mechanisms that arose to help firms interpret and implement SFAS No. 159.

I hope you will join us on Tuesday to hear Stephen’s thoughts, and remember that you can attend Round Table Discussions in Second Life (instructions here) or on the web at our LIVE page.

As many of you may have already been aware, it turns out loan loss accounting is anchored firmly in the language of SFAS 5 (ASU 450). As the project update for Credit Quality and the Allowance for Credit Losses points out “Losses are not recognized before it is probable that they have been incurred (referred to as an incurred model), even though it may be probable based on past experience that losses will be incurred in the future.”  I hope 2010 developments move us away from an incurred model and closer to an expected model.

We just finished a great Roundtable with Jim Leisenring from the IASB. We will get the video online as soon as we can. In the meantime, here’s a brief synopsis of what was discussed:

• How do we use standards to eliminate or mitigate transaction structuring? It’s a great goal, and something we’d all like to see, but unfortunately there’s not much we can do about it. Often bright lines invite people to approach the line, and unfortunately substance over form doesn’t fix the problem very often. A good example of this is derivative accounting and embedded cash derivatives.
• Jim discussed his thoughts about “management’s view” and “business models” in disclosure, presentation, and recognition. He also gave some of his reasoning as to why he dissented on IFRS 9.
• Jim listed some things that he thinks are particularly important topics right now including hedging, impairment, consolidations, derecognition, and the distinction between debt and equity. Basically anything that has to do with financial instruments is important right now.
• With regards to convergence of IFRS and US GAAP, the biggest challenge is to get it all done. The challenge will be getting everything done on time but still keeping the quality high. There’s a lot of due process involved and a lot is learned during the exposure time period. The financial crisis has added a new challenge to the timetable, but the 2011 date is still firm.
• There was a good discussion about entry price, value-in-use, and exit price with regards to fair value accounting. Jim said that he believes that exit prices will be the basis of fair value accounting.
• Jim concluded with giving some thoughts about academic research. He recommended two articles, both in the December 1994 issue of Accounting Horizons: (1) “Academic Accounting Research and the Standard Setting Process” by Katherine Schipper and (2) “Accounting Research: On the Relevance of Research to Practice” by James Leisenring and Todd Johnson.

For more information about Jim and his background, visit here.

Additionally follow-up comments on this Round Table event can be found here.

The new International Financial Reporting Standard (IFRS) 9 for financial instruments accounting will “inevitably lead to abuses and accounting arbitrage”, according to Jim Leisenring, a member of the International Accounting Standards Board (IASB).

The first part of the new directive, approved at the end of 2009 and to be expanded to encompass hedging and impairment issues in 2010, would allow the valuation of financial products at amortised cost, rather than fair value, in management of businesses whose “objective… is to hold [it] to collect the contractual cash flows”, regardless of whether they sold it before term.

“IFRS9 doesn’t have a prohibition on how many sales you can make before they stop you valuing products under this option,” Leisenring told Life & Pensions. “How many sales can you have and still say you intend to collect the cash? Can I sell every day?”

The article goes on to discuss Jim’s view of whether abuse of the standard’s objectives would be transparent:

Leisenring acknowledged the argument of defenders of the directive – due to come in force in January 2013 – that abuses would be “obvious” because of a clause forcing companies to acknowledge discrepancies between previous accumulated profit and sale price as a loss, although he said he was “not particularly convinced”.

Maybe Russell Lundholm could find a way to convince Jim one way or the other on the ability of ex-post reporting to mitigate abuses of reporting discretion ex ante.  Lundholm proposed this type of solution in his 2001 Accounting Horizons piece:

[From the Abstract]:  I propose that the financial reporting model be amended to report on the ex post accuracy of a firm’s prior estimates. Doing so will identify firms who have abused their reporting discretion in the past and provide valuable information about the expected credibility of the firm’s disclosures in the present. Firms will also have a greater incentive to make accurate estimates and accruals if they know that opportunistic estimates will be explicitly revealed in the future.

This seems like a good opportunity for laboratory research, and in a few years we might have enough archival data to know how investors respond to firms that repeatedly sell assets they had  “intended” to hold.

Read the full article to see Jim’s views on the “look-through” provision, embedded derivatives and transaction structuring, and hopefully Jim will elaborate on his views at next week’s Round Table discussion.

Securitization certainly seem to be a hot topic!  We had a big turnout for yesterday’s Round Table Discussion, with over 20 people coming in-world for the discussion and even more than that streaming the event live from the web.  I think people were hoping to hear lots of informative and stimulating discussion and, if they were like me, they were not disappointed!  Special thanks to Cathy Shakespeare and Akwasi Ampofo for taking the time to share their highly specialized knowledge and insight with the rest of us.  If you didn’t get the chance to catch the discussion live, be sure to check out the archived version, which is now available here.

Despite all of the high-powered brains in the room, there were still some questions left unresolved.  In particular….

1.    Why is the concept of ‘participatory interest’ important?

2.    Why should the legal form of an arrangement matter so much?  Paragraph 26.C.b suggests that economically equivalent arrangements can be accounted for differently depending on, for example, whether a firm retains an interest-only strip (transferring the rest to others) or buys an interest-only strip (with the remainder still being held by others).

We are hoping to get some feedback/insight on these issues from the FASB staff, so be sure to check back here in a day or two to read what we have been able to find out.

In the meantime, feel free to weigh in on how you thought the session went.  What were the insights that you took away?  What topics sparked your interest?

One of the topics of discussion that I found particularly interesting was the discussion of the three basic philosophies in deciding the appropriate accounting treatment for securitizations – namely, taking a 1) risk and rewards, 2) control, or 3) financial components approach.  Historically, the FASB has adopted more of a control approach, whereas the IASB has taken a risk and rewards approach.  I think the FASB would benefit from some insight on the positive and negative aspects of emphasizing the risks and rewards as opposed to control.  What would be helpful are clear examples of how differences in accounting treatment will arise when based on one approach vs another.  If you have any such examples or, if you just want to weigh in with your opinion, please do so by commenting below!

Again, be sure to check back on updates to this post and/or to check out the archive if you haven’t seen it yet – or maybe you just want to revisit a particular part of the discussion that didn’t get completely absorbed in your head the first time around!

Disclaimer: The views expressed here are my own and do not represent positions of the Financial Accounting Standards Board. Positions of the FASB are arrived at only after extensive due process and deliberations.

If you saw the essential crisis as one of liquidity, this meant that Fed-injected funds into the markets would allow the necessary breathing space for market participants to discover and incorporate new information that, in a true liquidity crisis, would show that things were not as bad as feared and the panic could stop. A liquidity crisis, in other words, is a crisis of information. Full information will either show investors (or depositors) that the institution is not in trouble, or that a guarantor stands behind it. Full information stops the panic; the injection of funds is to provide a space for full information to develop.

I strongly recommend these thoughtful articles, but I would like to add my accountants’ two cents.  Financial innovation, even when exceedingly complex, seems likely to be good if the goal is actually to share risk in better ways, provide people with access to liquidity and capital they couldn’t otherwise get, and so on–even for securities that seem on the face of it no better than gambling (like weather derivatives).  But innovations that are constructed entirely to circumvent regulatory requirements or get off-balance-sheet financing impose a lot of costs (like complexity) without many societal or economic benefits.

This is a point that is pretty obvious to accountants, but the economists don’t place all that much emphasis on the distinction

Are Asset Securitizations Sales or Loans?

Abstract: This study addresses whether asset securitizations are really asset sales or a form of secured borrowing, by estimating cross-sectional equity valuation regressions to assess whether the stock market treats securitized assets and liabilities held by a special purpose entity (SPE) as assets and liabilities of the sponsor-originator (S-O). Overall, we find that the market views the SPE assets and liabilities as belonging to the S-O, i.e., the risk and rewards of ownership of the transferred assets reside with the S-O and not the SPE. Results from a boot-strapping simulation that controls for scale by randomly assigning SPE assets and liabilities from one S-O to another provide evidence that scale bias is an unlikely explanation for finding the market views SPE assets and liabilities as belonging to the S-O. Findings from specifications in which we permit coefficients to differ for S-O firms with high and low relative levels of retained interest indicate that whereas the market views asset securitizations by low retained interest S-O firms as sales, i.e., risk transfer has taken place, it views asset securitizations by high retained interest S-O firms as secured borrowings, i.e., risk transfer is incomplete. We also show that although the market views securitizations by regulated and unregulated S-Os as secured borrowing, there is suggestive evidence that regulated firms have greater incentives to use securitizations to achieve off-balance sheet financing.

To understand how managers use securitization to achieve earnings goals, take a look at this recent paper Cathy wrote with Patty Dechow and Linda Myers:

Fair Value Accounting and Gains from Asset Securitizations: A Convenient Earnings Management Tool with Compensation Side-Benefits

ABSTRACT:  We provide evidence that managers use the discretion afforded by fair-value accounting rules to manage the size of reported securitization gains. We show that the ambiguity allowed in discount rate choice is one way that managers can influence these gains. We investigate whether CEO compensation is less sensitive to securitization gains than to other earnings components in the presence of proxies for how independent (outsiders, females, fewer CEO-selected directors) and informed (financial expertise) directors are. We find weak evidence of less earnings management in firms with more independent boards, but find no evidence that our director characteristics influence CEO pay-sensitivity to the gains. Thus, boards do not appear to intervene and adjust compensation for implementation problems related to fair-value accounting rules for securitizations.

For a broader overview, U of M’s public relations department has done a nice job of summarizing some of the key issues Cathy has been looking at lately.

We will update this post shortly with some more readings, since I haven’t even mentioned FAS 166.

The first relates to the conditions under which management can avoid considering an impairment to be OTT.  Currently, impairments are OTT if management does not have the intent or ability to hold an impaired security long enough for its value to recover.  The proposed FSP would shift from intent and ability to intent and probability, in that management would now need to assert that it does not intend to sell the impaired security and that it is (merely?) more likely than not that it will not have to sell the security prior to its recovery. 

The second change relates to how/when a recognized impairment finds its way onto the income statement.  Currently, OTT impairments are recognized in earnings in the period incurred.  This FSP would not change the measurement for impaired securities that management either intends to sell or will likely have to sell prior to their recovery.  Those OTT impairments will be recognized completely in earnings.  However, if the 2-pronged test is met, the Proposed FSP requires management to carve out of the impairment loss the credit loss component (which relates to the cash that would not be recovered if the impaired security were held to maturity).  This portion of the loss would be recognized in earnings, with the remaining loss recognized in other comprehensive income and amortized through earnings over the remaining life of the security.

In other words, if it is more likely than not that the entity will not sell an impaired debt security before recovery of its cost basis, but it is also probable that the investor will be unable to collect all amounts due according to the contractual terms of the security, then the security will be written down to fair value with the writedown split into its credit and non-credit components.  (In that case, if the decline in value were due solely to non-credit losses, then the entire loss would be recognized in OCI).

Proposed presentation in the income statement would be something like the following: 

The rule passed with a 3-2 vote, in part, because two board members believe that the FSP is likely to lead to fewer write-downs, resulting in delayed recognition of impairment losses in earnings.  They also question, among other things, whether bifurcating the fair value write-down into credit and non-credit components will be useful to investors and whether it is even practical to ask management to make such distinctions.

These are interesting and researchable questions. Personally, I am particularly interested in the question of whether users bifurcate losses (or gains, for that matter) into credit and non-credit components (or perhaps there are other distinctions that users find useful).  Does anyone know of relevant research that might speak to this issue or to the other questions posed in the FSP?