Following a year of pondering, listening, and reviewing, the Financial Accounting Standards Board has decided to eliminate the concept of qualified special purpose entities, commonly known as "Q's." FASB has been troubled by the existence of Q's for some time, and last year proposed eliminating the accounting device, which allows banks and other financial companies to hold many asset-based securities off-balance sheet. FASB's move may not have a dramatic impact on income statements across the entire banking sector, but it will dent Tier 1 capital levels at institutions that sold mortgage and other loans into such securities.
These assets will now show up on the balance sheet at the start of the upcoming fiscal year — Jan. 1, 2010, for most institutions. "Much of the exposure might be overstated," says Michael Gullette, vice president of accounting and financial management at the American Bankers Association, although some banks "will have more of a charge." Still, banks should have already made provisions for the some of the losses. FASB expected to finalize the rule changes by the end of June.
Lisa Filomia-Aktas, partner and practice leader of Ernst & Young's accounting advisory services, says there may be some differences in banks' profit-and-loss statements, but potentially "much more significant effects on the balance sheet" and capitalization levels. Most likely they will be required to add to reserves — though by how much won't be known until they receive guidance from the regulators.
Gullette says bankers hope that the regulatory bodies will look at the true level of risk before asking banks to add to reserves. They are also concerned about conflicting guidance from different regulators. The agencies were still formulating the guidance reflecting the Q changes as of the second week of June; comment periods will commence once the positions are published.
Rick Martin, head of technical accounting at Pluris Valuation Advisors is critical of the FASB and the Q change. He complains that the rule had been allowed to run "on autopilot" until the financial market meltdown. "When all heck broke loose, the government needed some way to deal with bad assets," Martin says. FASB's reaction was just "another example of the current economic environment driving accounting rules. The accounting is not consistent, not comparable, and not relevant," he argues.
The timing of the proposal last year was widely condemned, since financial institutions held large quantities of the assets covered by the rule. The yanking of the exemption would further destabilize banks already deeply in the red, detractors said.
FASB postponed the move and asked for comments. In a letter to FASB chairman Robert Herz last July, the ABA and the ABA Securities Association urged the board to hold off because the "project may create significant unintended consequences, including further harming the nation's securitization industry."
Other financial market participants were still voicing disapproval last month. In a letter to Treasury Secretary Timothy F. Geithner, 16 groups — including the Mortgage Bankers Association — warned that the changes will "undoubtedly impact both the U.S. financial sector and securitized credit markets," and asked policymakers to address this issue through a joint project with the International Accounting Standards Board. The group's lobbying will not delay the finalization of the rule change, according to FASB.
The ABA did not attach its name to the latest letter; it is focusing its energy on achieving further adjustments to FASB's mark-to-market accounting rule and the treatment of other than temporary impairments. In April, the FASB staff granted financial institutions more discretion in applying mark-to-market standards to assets caught in illiquid markets.
Several financial-sector groups, including the ABA, pressed for more flexibility on mark-to-market in a letter delivered in May to Rep. Barney Frank (D-Mass), chairman of the House Committee on Financial Services and Rep. Spencer Bachus (R-Ala.) ranking member of the committee. Market-to-market accounting fails to offer the most accurate measurement for many transactions, the letter said: it is appropriate for cash flow based on assets firms expect to sell, but not for cash flow based on assets firms expect to hold. Not only that, the exit-price definition of fair value does not consider what sellers are willing to accept and creates a downward bias in valuations, according to the letter.