This article originally appeared in The Safety & Soundness Report.
FASB's plan to value all loans at "mark-to-market" makes little sense for nearly all credit unions, the FFIEC argues. Instead, the consortium of regulators, which includes the NCUA, wants improved asset impairment models to pair with amortized cost - and a new way to calculate allowance for loan and lease losses (ALLL).
Nearly every credit union that sent a comment letter to FASB objects to the new proposal to bring "mark-to-market" accounting to financial instruments. In a 26-page letter, dated Sept. 30, the FFIEC weighed in, saying that mark-to-market accounting would heap compliance costs on lending institutions without providing anything close to commensurate value.
The FFIEC has it right, says Rick Childs, a partner in the Indianapolis office of Crowe Horwath.
"Financial institutions don't make a loan with the idea of exiting it the next day," Childs says. "They make the loan or grant a deposit with the idea that it will be a long-term asset or a long-term funding source. I agree with the chief accountants of the five regulatory agencies: Amortized cost is a better indicator of what's going on with the loan."
The FFIEC didn't stop there, however. Insisting that form should in fact follow function, the FFIEC proposed an alternate, binary valuation method. The regulators suggest that a financial institution use either fair value or amortized cost, depending on whichever method best fits a given institution's business model.
"The primary business strategy for the vast majority of financial institutions that we supervise is a long-term strategy for financial intermediation that is based on maturity transformation," the FFIEC's letter states. "Fair value measurement would not faithfully reflect these institutions' financial position because their business strategies are not predicated on the sale or transfer of these instruments, but rather on the collection and payment of contractual cash flows."
That doesn't mean that the FFIEC is content with the status quo. The financial regulators want to preserve amortized cost for lending institutions, but only if coupled with a much improved asset impairment model.
Could CUs use a new, more robust process for asset impairment? Sure, says Bryan Mogensen, a CPA and CU practice leader in the Phoenix office of Clifton Gunderson. "The current process is based on historical data and that's not a good predictor of the future."
A new method for ALLL
In the run up to the economic crisis, there were clear signs of increased credit risk in loan portfolios, but those indicators didn't bring an adequate increase in loan loss allowances, the FFIEC's letter states. "We believe that a move to an expected loss model will result in the earlier recognition of expected credit losses and would be an improvement over the current incurred loss approach."
The FFIEC is really just saying that, when it comes to amortized cost, there should be no changes to basic accounting practice, says Sydney Garmong, a partner in the Washington, D.C. offices of Crowe Horwath. But the regulators also want to see several changes to GAAP that involve ALLL practices, including the addition of forward-looking trends or an expected loss approach, she adds.
"FASB says we only want known losses today," she says. "When you can't look to the future, you can't consider any changes to the economy. We know the economy is recovering, but according to GAAP, financial institutions have to assume that factors like unemployment will stay right where they are. That's why the FFIEC wants GAAP to allow for forward-looking trends."
Contrary to GAAP, the FFIEC feels that "reasonable and supportable forward-looking information" does absolutely belong in any assessment of ALLL.
Ideally, the FFIEC would like to see GAAP include an expected loss approach, which would require financial institutions to forecast losses for the total portfolio and reserve appropriately, but its unlikely FASB will go that far, Garmong says.
"There's risk inherent in the act of making a loan, but current GAAP standards mean I can only set up an allowance if I know I'm not going to get paid," she says. "I'd need evidence that the customer won't pay. Financial institutions aren't sticking to GAAP. They aren't waiting for a customer to walk in and tell the bank they can't make the payments before setting aside allowances, but they aren't using an expected loss approach either. Current practice sits somewhere in the middle."
FASB likely won't accept an expected-loss approach, says Garmong. It's too worried about financial institutions using the method to manipulate its accounting. "FASB thinks that when times are bad, net income should look bad," she adds. "Financial institutions shouldn't be able to hold back or over accrue to manage earnings."
The FFIEC does want GAAP to recognize current practice and, with the addition of forward-looking information, move beyond it, she says.
If the FFIEC gets its way, it could arguably result in an increase in ALLL, but financial institutions probably shouldn't get too upset, she adds. "This may sound scary, but we're not talking about losses from 20 years down the road," Garmong says.
The FFIEC's alternate plan would not only better match the valuation method to the business model, but it would also help FASB move toward a more comprehensive and useful accounting standard for all financial institutions, the FFIEC letter argues.
FASB's fair value proposal draws criticism
Designed to improve transparency for investors, the FASB proposal would make fair value the default measurement for nearly all financial instruments. All financial institutions would have to report substantially all of their financial instruments at fair value on the balance sheet.
"The global economic crisis has highlighted the ongoing concern that the current accounting model for financial instruments is inadequate for today's complex economic environment," FASB explains. The new standard would provide investors with a "more timely, transparent, and representative depiction of an entity's exposure to risk from financial instruments... Today, there also is arguably too high a threshold before an entity is required to record credit impairments resulting in a delayed recognition of losses."
FASB has pushed for similar measures in the past, but this proposal would be much more painful, says Bill Astrab, a CPA with Thompson, Greenspon & Co., P.C., Fairfax, VA.
"There was similar resistance, although not as strong, when SFAS 107 came out [requiring] disclosures about fair value of financial instruments," Astrab says. "This basically required institutions that exceed a certain asset size - in this case, $150 million - to disclose the fair value of their financial instruments: cash, loans, investments, deposits, etc. This information was disclosed only in the financial statement footnotes. It was a pain at first, however most institutions developed models in which to reasonably estimate the fair value of their financial instruments fairly quickly. This is different. The balance sheet will reflect amortized cost and fair value in many cases - with changes in fair value often impacting net income."
Many CUs don't issue full financial statements in accordance with GAAP, but they wouldn't be exempt from the new FASB standard. All balance sheets and income statements filed for the NCUA or any of the other financial regulators in the FFIEC would be subject to the new standard, even if those institutions don't issue a full set of statements.
The proposal had already received plenty of criticism from around the industry.
The proposal would alter CU business practices for the worse, argues David Chatfield, CEO of the California and Nevada CU Leagues. "A realistic measurement for financial instruments should be determined by the business model and strategy of the entity," writes Chatfield in a comment letter. A fair value standard would "flip [a] fundamentally sound model on its ear, making the accounting the driver of the business model, instead of the other way around."
Because of industry capital restrictions, the FASB standard would hit CUs especially hard, argues Francisco Nebot, CFO of Schools First FCU ($8.4 billion), Santa Ana, Calif. in a comment letter. "This proposal will result in an instant reduction of capital and endangering regulatory capital ratios without the ability to acquire alternative capital as a remedy," he wrote. "This fictional reduction in our capital position will not appropriately reflect the value of our credit union and will unnecessarily undermine our members' confidence."
Article Reprinted with Permission from The Safety & Soundness Report.