You've heard it before: An accounting change doesn't get much attention when standards setters approve it, but months later, as implementation looms, auditors start preparing their clients for it. And that's when the trouble starts.
This time the change affects how companies account for investment securities. That's a matter near and dear to banks and thrifts, given that securities make up about a fifth of the industry's $9.6 trillion of assets. They may be left with the choice of sacrificing liquidity or taking hits to earnings and regulatory capital.
Worse yet, that decision may depend on how auditors interpret their clients' intent.
At issue is when banks must record impairment of their securities, which has generally occurred only if a bank had reason to doubt the likelihood of repayment. A more recent question is whether interest rates alone can cause damage that banks should recognize in their earnings.
It's a pressing question as the industry eyes long-term rates nervously. After staying at or near historic lows for the past couple of years, most observers presume there's only one direction that rates can conceivably head: up. That inevitably will make fixed-rate securities paying relatively lower rates less valuable.
The decline in value, many bankers and accountants contend, is temporary. As long as the bank intends to hold the security and receives contractual interest and principal repayment, they claim the security is not impaired.
But the Financial Accounting Standards Board designs generally accepted accounting principles so that financial statements will best represent economic reality. The reality is that, all other things being equal, a security that pays a lower fixed rate than another security is worth less. That difference between carrying value and market value, FASB figures, represents an economic loss that companies should recognize.
Enter the Emerging Issues Task Force, a group that operates under the auspices of FASB to resolve accounting problems by interpreting existing standards. In March, it completed work on Issue 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments."
Most companies will implement the change for their third-quarter financial statements, and with the third quarter creeping to a close, banks and their trade groups are starting to protest. In the past two weeks, the American Bankers Association, America's Community Bankers, and the Mortgage Bankers Association have sent letters to FASB and the task force asking for a delay in the effective date of the change, as well as for wholesale revisions to the statement. Freddie Mac joined the chorus Friday with its own letter.
All of a sudden, other than temporary impairment is the hottest topic in the admittedly strange world of bank accounting.
Lawrence Smith, the task force's chairman, said the uproar is due to a confluence of events.
The change "wasn't applicable until this quarter, interest rates have increased, and companies have been talking to their auditors in light of the increase in interest rates - and perhaps some companies have taken action now that they have heard their auditors' view of how to apply it," he said.
The EITF sought to clarify FAS 115, a 1994 accounting pronouncement on debt and equity securities that split portfolios into three categories: held to maturity, available for sale, and trading. Securities held to maturity are carried at cost; securities in the trading portfolio are carried at market value.
But it's a bit trickier for securities in the available for sale portfolio, where the industry keeps $1.7 trillion, or 90%, of its investment securities. Though companies must mark to market the value of the securities held in the AFS portfolio, the marks don't run through income. As long as the company can demonstrate its intent and ability to hold the securities until recovery or maturity, unrealized gains or losses are reflected as direct adjustments to equity without a corresponding hit to earnings.
Perhaps more important to banks and thrifts, regulators do not consider unrealized gains or losses in calculating regulatory capital. But if the new rule requires banks to recognize what previously were unrealized losses - as some companies fear - the losses will flow through income, hitting regulatory and GAAP capital alike.
What banks now face is a harsh eye on actions that could cause an auditor to make a different assessment of its intent. The risk is that auditors could interpret sales of AFS securities as a pattern that taints the entire portfolio, requiring immediate recognition of losses on all underwater securities.
It's a relatively easy question with securities held to maturity. With very few exceptions, a company that sells HTM securities has contaminated the entire portfolio and must mark to market the entire portfolio. The rules are less certain for AFS.
"The problem that all of us are going to have is figuring out where to draw the line that is softer and gentler than a 'One sale and you're out' standard," said a partner at a major accounting firm who asked not to be identified.
Banks hold securities in the available for sale portfolio for precisely the kind of flexibility they worry they might be losing.
"This threatens the mere ability of a bank to change its intentions for an available for sale security," said Dennis Hild, the vice president for accounting policy at America's Community Bankers. "It takes away a lot of the flexibility that these banks need to adjust their financial strategies to compensate for unanticipated market forces."
But if bank managers say their intention is to hold underwater securities until the value recovers - as is required to avoid recognizing impairment - and management subsequently sells some of those securities, auditors justifiably might ask questions.
An auditor might say, "Help me understand your assertion relative to the rest of your portfolio," Mr. Smith said. "I'm not saying one sale necessarily creates a pattern, but at the same time, it's not evidence that an auditor can ignore."
That's why accountants are urging public companies to document the "facts and circumstances" of how they manage their securities. With the proper documentation, a company might be able to offer a reasonable explanation for why the sale of some underwater securities does not taint other similar securities they hold.
"You need to have a reasonable explanation for what caused you to sell the underwater security," the accountant said. "Auditors might ask, 'Does the story have applicability to other similar situations in your portfolio?' If so, maybe that's the group that should be tainted: the ones that play to the same story."
Regulators, too, have a stake in this argument. They presumably would argue against any accounting change that threatens liquidity, especially if the price tag for liquidity is a hit to earnings and regulatory capital. They were reluctant to comment, given the tricky stage of their discussions with FASB, audit firms, and the SEC.
"We are listening to the current concerns and issues that banks have raised on this subject, and as with all accounting issues that affect banks and banking organizations, we have an ongoing dialogue with FASB and the SEC," a Fed spokesman said.
Mr. Smith said the task force and FASB will listen to regulators and banks and "determine whether there is anything we need to do, but we're not at the point where we've made that determination." Similarly, the board has heard the requests to delay the effective date, but the matter has not yet been discussed.
