Freshman Senator Sherrod Brown (D-Ohio), on May 5, 2010, offered an amendment to S. 3217: Restoring American Financial Stability Act of 2010. On May 7, 2010, a joint letter from seven prominent organizations was sent to the Senate, objecting the Brown’s excursion into accounting standard setting.
What’s going on, ProfAlbrecht?
Thanks for asking. I’ll lay it out for you. Senator Brown is a voice of reason on this issue and the seven prominent organizations are blowing smoke.
First, let’s start with Senator Brown’s proposed amendment, SA 3853. It is co-sponsored by Senator Edward Kaufman (D-Delaware). It deals with the accounting for financial investments and off-balance sheet liabilities, which has led some to speculate that Senator Brown would be interested in chairing the FASB after Robert Herz gets done mucking it up. SA 3853 reads:
On page 976, between lines 4 and 5, insert the following:
SEC. 919C. FINANCIAL REPORTING.
Section 13 of the Securities Exchange Act of 1934 (15 U.S.C. 78m), as amended by this Act, is amended by adding at the end the following:
“(o) Standard Balance Sheet Calculation for Reports.–
“(1) STANDARD ESTABLISHED.–Not later than 1 year after the date of enactment of the Restoring American Financial Stability Act of 2010, the Commission, or a standard setter designated by and under the oversight of the Commission, shall establish a standard requiring each that each issuer that is required to submit reports to the Commission under this section record all assets and liabilities of the issuer on the balance sheet of the issuer.
“(2) CONTENTS.–The standard established under paragraph (1) shall require that–
“(A) the recorded amount of assets and liabilities reflect a reasonable assessment by the issuer of the most likely outcomes with respect to the amount of assets and liabilities, given information available at the time of the report;
“(B) each issuer record any financing of assets for which the issuer has more than minimal economic risks or rewards; and
“(C) if an issuer cannot determine the amount of a particular liability, the issuer may exclude that liability from the balance sheet of the issuer only if the issuer discloses an explanation of–
“(i) the nature of the liability and purpose for incurring the liability;
“(ii) the most likely loss and the maximum loss the issuer may incur from the liability;
“(iii) whether any other person has recourse against the issuer with respect to the liability and, if so, the conditions under which such recourse may occur; and
“(iv) whether the issuer has any continuing involvement with an asset financed by the liability or any beneficial interest in the liability.
“(3) COMPLIANCE.–The Commission shall issue rules to ensure compliance with this subsection that allow for enforcement by the Commission and civil liability under this title and the Securities Act of 1933.”.
The essence of the proposed amendment is to require the SEC and/or FASB to establish a rule that publicly traded companies list all assets and liabilities on the balance sheet, and these be recorded at fair value. It appears to be motivated primarily by (1) the recent financial crisis that eroded the value of financial assets despite their recorded value remaining at historical cost as per FASB rule, and (2) Repo 105/108 types of off-balance sheet financing transactions that removed liabilities from the balance sheet, effectively improving leverage ratios (again, a legal treatment as per FASB rule).
Senators Brown and Kaufman have done a pretty good job here. The accounting rules for financial securities are a mess. They contain a compromise allowing financial institutions to record investments at historical cost instead of market values, and most financial institutions take full advantage of it. Although the FASB reportedly is trying to move to a basis of fair value, the IASB has sold out to European banks and is firmly committed to historical cost accounting. If the FASB and IASB cannot converge, then the SEC will simply adopt IASB standards based on historical cost. The Brown/Kaufman amendment provides sophisticated guidance to the SEC and its standard setter to remain focuses on fair value.
Accounting standards have historically permitted off balance sheet financing via leases and repurchase agreements (i.e., Repo 105/108). It has recently surfaced that Lehman Brothers used this repurchase accounting, with the full knowledge and support of Ernst & Young, its auditor. We now know that many financial institutions use this accounting rule to remove liabilities (and a like amount of assets) from the balance sheet in a maneuver to increase leverage ratios and deceive investors. Of course, there are many types of 0ff-balance sheet financing methods. After decades of discussing the practice, the FASB (and now the IASB) still shows little desire to eliminate the practice.
Given the severity of the problems, and the inability of today’s standard setters to gird their loins and solve the problems, is it appropriate for Congress to pass a law directing the SEC and its standard setter to produce a desired outcome? Absolutely. Accounting standard setting is an inherently political process, as I explained in my popular essay, “Economic Consequences and the Political Nature of Accounting Standard Setting.” Because the SEC has passed on its legislative charge to establish accounting standards that adjudicate between competing economic interests, and because the private standard setters follow their own political agendas when preparing accounting standards, it behooves Congress to step in when things get too far out of whack with national priorities. Such is the case here. It is in the national interest of the U.S. to provide better information to investors and for the government to regulate the financial markets to reduce the amount of unconscionable abuse. I tip my hat to Senators Brown and Kaufman for their astute and important amendment.
[Before continuing, I must confess to voting against Senator Brown in the 2006 general election. I am pleasantly surprised with his performance. If his amendment is successful, I might vote for him next time.]
In response, a group of all the usual suspects has chimed in to oppose this Congressional foray into accounting standard setting. In a letter to key members of the Senate, the leaders of seven visible organizations (AICPA, Center for Audit Quality, CFA Institute, Council of Institutional Investors, Investment Company Institute, Financial Executives International, U.S. Chamber of Commerce) object to Brown’s amendment. Their main, but unstated, reason is the often accurate stereotype of Congressmen as financial ignoramuses. Their stated reasons are:
We believe … the process by which accounting standards are developed must be free – both in fact and appearance – of outside influences that inappropriately benefit any particular participant or group of participants in the financial reporting system … We believe political influences that dictate one particular outcome for an accounting standard without the benefit of a public due process that considers the views of investors and other stakeholders would have adverse impacts on investor confidence and the quality of financial reporting, which are of critical importance to the successful operation of the U.S. capital markets.
As such, we strongly support an independent standards-setting process, subject to public scrutiny and free of undue pressures. Public due process procedures, appropriate oversight, technical expertise, and independence are important to ensure the legitimacy of the standards-setting process, and to protect the goals of transparency, relevance, and usefulness in financial reporting that are critical to the success of the U.S. capital markets.
Unfortunately, these groups fail to recognize that the ultimate arbiter in accounting standard setting is the U.S. government. Moreover, accounting standards derive their legitimacy from the authority of the elected government. Given that Congressional members are elected and represent all U.S. citizens as well as all economic interests, and that Congressional debate offers the ultimate due process, these groups fail to acknowledge that this situation offers the ultimate in due process. Perhaps these groups secretly acknowledge that their lobbying, designed to influence the SEC and the FASB, will be relatively less effective when directed toward the U.S. Senate.
In short, Senators Brown and Kaufman are legitimately offering responsible and wise direction to the SEC and the FASB, and the seven groups are being obstructionist in objecting. If we are fortunate, SA 3853 will be approved by the U.S. Senate, and will be ratified by the U.S. House of Representatives.
Debit and credit – - David Albrecht