Lawmakers Rap FASB on Sub-prime; More

A Senate sub-committee is pressing the Financial Accounting Standards Board for information on what additional action the Board plans to take to curb off-balance-sheet accounting that obscures financial risks from investors’ views.

Sen. Jack Reed, D-R.I., chairman of the Senate Sub-committee on Securities, Insurance, and Investments, sent letters to FASB Chairman Robert Herz asking for some answers. “While recent efforts of FASB to remedy shortcomings in financial reporting for off-balance-sheet transactions are to be applauded, they appear so far to have fallen short of what investors need,” he wrote to Herz. “After the decline in investor confidence brought on first by Enron and then other corporate scandals, and now the sub-prime-related issues, further disruption of the markets caused by a lack of transparency and failure to address some of these issues is unacceptable.”

Reed

Reed also wrote to Sir David Tweedie, chairman of the International Accounting Standards Board, asking similar questions about how International Financial Reporting Standards address off-balance-sheet transactions. Spokesmen for FASB did not respond to Compliance Week requests for comment. IASB spokesman Mark Byatt says his Board is in contact with Reed’s office “to organize a response.”

Collapsing credit markets have exposed a weakness that remains in accounting rules, even after Enron’s collapse first underlined the need for more transparency around off-balance-sheet activity, Reed says. His letter asked FASB for a laundry list of updates on how FASB plans to address off-balance-sheet issues such as structured investment vehicles or special-purpose entities, structured transactions that raise questions as to whether a true economic sale has occurred, collateralized debt obligations, and valuation.

Herz

Regulators and the financial services industry have been abuzz in recent months over how to apply both brand new and long-standing accounting rules to the tailspin in loan values these days. Most of those loans have been repackaged and sold into the market as various kinds of collateralized debt securities. That sort of transaction typically is held off the balance sheet, raising questions about if and how the terms of troubled loans can be worked out before default, and how securities based on troubled and worked-out loans should be valued.

Reed says losses related to failed sub-prime loans are estimated at $300 billion to $400 billion, highlighting the need for timely, complete financial information related to off-balance-sheet activities. “Those losses have been reported in the investments and stocks of various financial institutions, mutual funds, public pension funds, and even the investment funds of local school districts and municipalities,” Reed wrote. “Given uncertainty and increased volatility in the capital markets, investors seem to be seeking more timely and high-quality information about off-balance-sheet architecture.”

In addition to off-balance-sheet accounting issues, Reed also takes a swipe at FASB’s direction around the move toward more fair value in accounting. The adoption and implementation of Financial Accounting Standard No. 157, Fair Value Measurements, and FAS 159, Fair Value Option for Financial Assets and Financial Liabilities, have been fraught with questions about how companies should value assets and liabilities that have no readily apparent market-based value, or values that have lately been highly volatile.

“The Sub-committee would like to understand what steps FASB is taking to ensure that investors are provided consistent, comparable, and reliable data on which they can base important financial decisions as opposed to aspirational or hypothetical statements that describe circumstances management merely hopes will materialize,” Reed wrote.

Study: Better Audit Committee Means Lower Audit Fees

It may be required by Sarbanes-Oxley to get some financial expertise on your audit committee, but it pays—literally—to make sure some of that expertise is in accounting.

A recent study suggests companies may enjoy an average discount of around $700,000 to $900,000 in audit fees when someone on the audit committee has specific expertise in accounting. The study, titled “Do Auditors Price Audit Committee’s Expertise? The Case of Accounting vs. Non-Accounting Financial Experts,” sought to determine whether auditors place more value on accounting expertise than on general financial expertise when pricing their audit services. And they do, says Gopal Krishnan, an accounting professor at George Mason University who—along with other accounting experts—conducted the study.

Krishnan warns that the $700,000 to $900,000 is a broad estimate, because the research was focused on establishing that a discount is given, not quantifying the discount. The study also established, however, that auditors only reward accounting expertise on the audit committee if it’s found in an organization with an environment of overall strong governance.

Krishnan

“It is accounting expertise that is valued by the auditors,” Krishnan says. “But if they happen to have accounting expertise with overall poor governance, it doesn’t help. When you have a weak board, it can undermine whatever value the audit committee might be adding.”

Krishnan notes that the distinction between “financial” expertise and “accounting” expertise proved to be a contentious issue at the outset of SOX implementation. He said the Securities and Exchange Commission originally called for accounting expertise, which is more specific to financial reporting than an expertise in finance, when establishing SOX implementation rules, but ultimately established a broader requirement for financial expertise on the audit committee.

“So it is the SEC’s initial definition that seems to be correct,” Krishnan says.

In separate research published last fall, the same authors examined whether the distinction between financial expertise and accounting expertise on an audit committee affected the conservatism of financial reporting, and the conclusions were similar.

Findings were consistent with the notion that accounting expertise contributes to greater monitoring by the members of the audit committee, which in turn enhances conservatism, Krishnan says. In this study, the outcome also depended on the firm’s overall corporate governance, showing that accounting expertise could not overcome a weak board in promoting conservative accounting.

New Pension Provisions Demand CFO Attention

Now that the significant provisions of the Pension Protection Act are in force, chief financial officers must be up to speed on how the rules affect their company’s pension and corporate finances, according to a recent summary report from consulting firm SEI.

The report highlights three main implications that should take priority for CFOs in early 2008: the change in lump-sum calculations, reduced smoothing allowances, and new funding requirements—which will have varying effects on valuation volatility, lump-sum payouts, and funding flexibility.

Waite

“There probably are some areas where CFOs and plan sponsors might still be learning about changes,” SEI Chief Actuary Jon Waite says. “It’s important to make sure their partners and providers understand all aspects of plan management as we go into this new PPA world. With all these changes—new rules and certainly new investment tools and plan management tools—it’s contingent on the plan sponsor to understand all aspects of the plan, the investments, the liability and the compliance. This is tying plan management much more tightly together.”

The report says beginning in 2008 lump-sum payment calculations and subsequent plan liabilities will move away from the 20-year Treasury bill rate toward a yield-curve interest rate based on corporate bond yields, resulting in a decrease in lump-sum payments and a decrease in valuation volatility. At the same time, the PPA requires smoothing of plan assets and liabilities over the long term, and valuations will reflect increased volatility because of much faster recognition of gains and losses.

Overfunded plans can expect little effect from the provisions of the PPA in 2008, but that’s not the case for most pension plans. For plans that are less than 100 percent funded, the PPA rolls in funding requirements to achieve 100 percent funding by 2011. Plans with low funding could face limits on lump-sum payments, greater funding requirements, and less flexibility in funding, according to the report.