When financial institutions securitize assets and elect off balance sheet accounting treatment they are pretending that neither their securitized assets nor their related secured debt exists. Like a deadbeat dad denying paternity, securitization accounting is designed to avoid admitting responsibility by securitization sponsors.

Most securitizations are a form of secured borrowing executed by banks and other financial institutions. However, “form over substance” securitization accounting encourages securitization sponsors to act as if secured borrowings are really asset sales and thereby decrease the reporting of both their asset size as well as their debt.

When institutions use off balance sheet accounting for secured debt transactions financial ratios are distorted, and transparency is destroyed. No one can tell if securitizing institutions are well capitalized or not and whether their operating performance is consistent given the scope of their operations.

As a result of securitization accounting financial institutions like Bear Stearns, Lehman Brother, Citigroup [C: 4.20, -0.06 (-1.41%)] and Merrill Lynch appeared much less leveraged, and much more profitable, than they really were. The “granddaddy” of securitization shops, Citigroup, at one time had more than $1 trillion of assets that it reported as “off balance sheet”.  Citigroup pretended that the $1 trillion of off balance sheet assets were orphans; they just appeared one day on Citigroup’s doorstep.  Simple financial measures such as net interest spread and asset quality and profitability ratios were vastly distorted by Citigroup’s orphans.

The securitization accounting rules also facilitated the “originate for sale” shadow banking system that lead to sub-prime and other consumer and commercial lending abuses.

The new securitization accounting rules are supposed to enhance transparency and make it much tougher for financial institutions to pretend that they don’t own their assets. But, no one is really sure how the changes will play out in the real world marketplace. The new rules may enhance transparency.  On the other hand, mechanical application of new and complicated rules may confuse already incomprehensible reporting. Retro-active application of the rules may highlight how dangerously undercapitalized some financial institutions remain and may spark a new round of loss of confidence. Simplifying the rules may help restart the securitization marketplace and help the economy, but then again they may be another nail in the capital markets coffin.

I don’t know what this all means because I never understood the old rules and don’t know what the new rules will do to financial reporting. There is a Wall Street sub-culture that holds itself out to be “securitization accounting” experts. Personally, I never bought the “snake oil” that these guys were selling. I don’t think that the so called experts have a clue what is going to happen when the new rules are enacted and if they don’t know the media certainly has no clue which is why there hasn’t been much reporting of this accounting change.

It’s a good idea to fix securitization accounting rules and I support the effort; just not the way that reform is playing itself out. In fact on December 4, 2008, I wrote a letter to then President Elect Obama suggesting that reforming securitization accounting needs to be a cornerstone of financial institutions reform. The following is from my December 4^th letter:

If accounting rules matter, bad regulatory accounting rules matter even more. About 20 years ago bad regulatory accounting rules were enacted that apply to all banks and have the unintended side effect of encouraging the worst excesses of the securitization market. These rules reward banks that use the OPM model (i.e., “other people’s money”) to finance assets and penalizes banks that want to create well capitalized investment structures. These bank regulatory rules virtually mandate the “originate and sell” model of finance and need to be fixed immediately. Generally accepted accounting practices have run amok trying to work around the bad bank regulatory rules. The accounting industry is about to “reform” the rules relating to securitization accounting in FAS rule 140 but the new rules continue to make a mess of things. An interagency initiative is needed to fix this mess. And, interagency cooperation will only happen with Presidential leadership.

The problem with the current securitization accounting reform initiative is that it isn’t interagency reform but rather unilateral work of the Financial Accounting Standards Board which has at best mixed motivations. Until securitization reform is a joint effort of all constituencies that are affected it won’t work.

The U.S. needs a joint task force to address this issue including the SEC, OCC, FDIC, Federal Reserve and state insurance commissioners. Regulatory and statutory accounting rules must be conformed to financial accounting and disclosure. Securitization reform is needed but ad hoc and piecemeal reform is probably worse than no reform and what we are getting is ad hoc reform.

-Mark Sunshine

Disclosure: This article is taken from the website Sunshine Notes with the permission of the original author.  All questions regarding disclosure should be referred to the original author.

Background

Since 2005, the convergence to IFRS was apparent with the European Union requiring companies listed on the EU regulated stock exchanges to file consolidated statements using IFRS.  The SEC responded to this in 2007, agreeing to accept these IFRS statements from the foreign issuers without forcing reconciliation to GAAP.  This proved the SEC’s acceptance and belief that the international standards were in fact high quality.  Throughout this time, strong debate evolved regarding the United States adopting IFRS.  FASB and IASB were working together, and in September of last year, they both reaffirmed their commitment to converge all major accounting standards by 2011, the year in which every capital market except the US will be using IFRS as a basis for financial reporting.  The SEC again came into play just recently, proposing a roadmap for IFRS adoption that concludes with a 2011 decision on whether the international standards will become mandatory for all US issuers.

SEC’s proposed roadmap consisted of a timeline towards a mandatory conversion in FY 2014, with companies being able to voluntary convert as soon as this FY 2009.  Regardless of when they choose to make the switch, they must begin their IFRS reporting in the annual 10-k, where they must file audited IFRS statements for the year of adoption and the two preceding years.  For example, a company that decides to wait until the mandatory conversion at the beginning of FY 2014 must file their 2012 and 2013 statements under IFRS as well as 2014.

While there are many similarities, there are also quite distinct differences between US GAAP and IFRS that need to be illustrated.  Of utmost importance, GAAP standards are highly rules-based, consisting of over 17,000 pages of detailed guidance.  IFRS, however, is much more principles-based with its 2,500 pages, requiring the managers to exercise much more judgment in their valuations.  For example, revenue recognition is one of the most complex elements of GAAP accounting due to its comprehensive guidance on industries and different types of contracts.  Under IFRS, revenue recognition is based on a single standard with general principles applicable to different transactions. The reasoning behind this is put forth by Tom Jones, Vice Chairman of the International Accounting Standards Board (IASB) that develops IFRS.  He responds to criticisms on the lack of rules by claiming, “When you write rules, smart people can get around them.”

The debate has been intense regarding whether the SEC will mandate a complete switch to IFRS or a convergence between IFRS and GAAP.  Recent evidence leads to the belief that the adopted IFRS will be more of a convergence.  A few weeks ago FASB changed its GAAP guidelines on fair value measurements and mark-to-market accounting.

As a result, EU banks under IFRS have been expressing concern that the US banks have an advantage.  The IASB is expected to issue guidance on the subject that is very similar to FASB’s, showing agreement between the two boards and a converging of GAAP with IFRS.  Public comments to the proposed roadmap show the agreement among companies that negotiations like these need to happen to lessen the cost of adoption, a prominent concern regarding the switch.  At this point in time, the IFRS still needs development, but once the certain areas the SEC deems weak are taken care of (ex; accounting insurance contracts), the standards will be ready for adoption.

It Will Happen Before You Know It

Although SEC Chair Mary Schapiro has stated that a transition to IFRS in the United States “will take a back burner” due to the overhaul of the regulatory system, the rebound of the global economy needs to bring with it a global accounting standard.  With Brazil, Canada, Chile, India, China, Japan, and Korea all committed to adopting IFRS, as well as the current EU members already under the standards, IASB member John Smith recently told a European audience that “it is in the interest of the United States to adopt IFRS in the next five years,” and that the “cost to the US of failing to adopt will be high.”  This makes sense, considering the fact that if every other country in the world is using the international standards, how would the US maintain credibility in the accounting realm?  With the inevitable trend towards globalization that has been hitting the economy, not adopting IFRS would weaken American companies’ strength in the global capital markets.

Committees and groups are in place to make the convergence happen in the most efficient way possible.  The Financial Crisis Advisory Group (FCAG) was established by FASB and the IASB to give guidance to the two boards about the implications of the global recession and the changes that may need to be made as a result.  Their job is to recognize where reform needs to be made and ensure the proper improvements are enforced.  The FCAG fully supports IFRS, and have written letters to the G-20 summits expressing the urgency.  The topic made it into the G-20 discussions in London, with the world leaders conveying that a global standard needs to happen.

Why It Matters to Investors

Throughout the next few years, companies will be making the steps towards filing their statements under IFRS.  Certain aspects of the statements will change.  Revenue recognition will be different, along with specific standards regarding pensions, leases, loan provisions, and many other items.  To give an example, under US GAAP an operating lease must be expensed through the income statement and cannot be recognized on the balance sheet, thereby reporting lower earnings.  Under IFRS, an operating lease need not be expensed as it may be held by a lessee as an investment property if certain conditions are met.  It is specific differences like these, as well as the extra judgment that comes along with a principles-based system, that has resulted in companies under IFRS often not reporting higher earnings.  Additional expenses, however, will definitely occur.  When the EU companies in 2005 made the switch from local GAAP to IFRS, the Institute of Chartered Accountants in England and Wales estimate that European companies spent about .05% of revenues in the first year on making the switch.  Performance based compensations and dividends will be affected.  The entire education process will need to be changed, all the way from accounting students to senior executives (under Sarbanes-Oxley the CEO and CFO must attest for the accuracy of the statements).  Each statement will be affected, and investors need to stay aware and educated about the implications.

What Investors Need To Do

Stay in tune with FASB and IASB’s agenda to be up to date on what is happening next.  Understand the differences between US GAAP and IFRS and their impacts on financial reporting.  Make sure to read through the full disclosures, as a move from a rules-based system to a principles-based system will result in more detailed footnotes.  By staying educated and knowledgeable of what is happening in the accounting world, when the time comes investors will be able to focus on the company’s operations instead of the change in accounting standards.

-Phillip J. Harper

Disclosure:  None

Values will be based on what the assets would sell in an “orderly” transaction in a non-distressed environment.  This may turn out to be quite dangerous, as the banks are now able to give a market value for toxic assets with no actual market. Banks are now also able to only have to write down part of their impairments if they plan on holding the asset to maturity. In the traditional mark to market rules, an asset that suffers an impairment would have to be written off completely, accounting for the write-down as a realized loss. With the loosening of rules by FASB, assets will only have to be partly written off due to impairment. This does not show the true value of the asset, resulting in less transparency within the balance sheet.  Anyone who follows the markets knows that losses have occurred, and knows the “garbage” is still on the balance sheet, hidden or not.  This will ruin the confidence investors have in their assessments of the risks involved in a bank.  With the banks able to hide these markdowns, how can we have the trust to buy?

Auditors’ Reactions

It will be interesting to see how auditors portray the new standards, especially since there was a strong opinion among financial reporting directors that auditors took fair value accounting too far, forcing firms to provide proofs that the assets were indeed valued fairly.  Auditors are known to be very conservative in their opinions of the financial statements of a company to prevent lawsuits or damages to their own reputation.  That being said, the accounting changes are another way for banks to paint a better condition of their statements.  Auditors will be stricter regarding their valuations, especially since the split in losses will be difficult to verify.  More experience is necessary for auditors to feel comfortable signing off on the banks’ valuations using the new standards, leading to the possibility of some banks still using fair value accounting to avoid complications.

Going Forward

Going forward, it is tough to say how the accounting changes will effect the capital markets.  With the common belief that reactions due to speculation were reflected in the markets before any changes were even made, there may not be an impact at all.  Many say confidence will be restored in the markets, since investors know banks will be able to almost “hide” losses using their own valuation models.  Also, even though an impairment occurred, firms will not be forced to write off the entire impairment, so the balance sheet won’t be hit nearly as hard. The true health of the firm will not be accurately shown, leading to much less transparency within the statements. This is surprising, since the recent goals of the FASB has been the push for more transparency. To big bankers, it’s exactly what they’ve been pushing for, as banks will be able to recover billions of dollars in losses. So far, Wall Street has reacted favorably to the new standards, with analysts predicting that some banks will increase quarterly earnings by up to 20 cents.  However, it has become all too familiar to see firms valuing assets above their true market value. This may in fact prove to be the completely wrong move by FASB.

What To Look For

Look for second quarter earnings to reflect these changes.  Expect big banks to report higher earnings as a result, while other banks stick to the traditional mark to market rules, and possibly suffer from the disadvantage.  For global multinationals, the convergence of US GAAP and IFRS will definitely have an impact on the long run, as the IASB is considering also loosening it’s mark to market and impairment standards. If this does in fact happen, global markets will most likely react just like the US markets have, and will cause these standards to be a permanent fixture in the balance sheet. Other countries’ standards outside the IFRS are also considering following suit. Canadian banks are pushing for the adoption of the U.S. mark to market rules, so as to not have a disadvantage in the North American capital markets.  The global recession has forced the notion that all countries should be under the same accounting standards (IFRS), so it is necessary for the IASB and FASB to agree, and have a joint approach regarding the financial crisis.  This will prove to be a prominent evolution in accounting, especially after the G20’s call for the reduction in the complexity of the financial instrument accounting.  Immediately after FASB announced the changes in early April, IASB began a 30-day discussion process to ensure the meeting of the urgent demands of the issue.  IASB meets April 20-24, so look for changes to IFRS that will impact the global markets in a similar manner to FASB’s impact on the US markets.

-Phillip Harper

Disclosure: None