More Accounting Changes

The Addiction to Off-Balance Sheet Accounting

In the wake of the Enron scandal, the FASB had addressed the accounting for special purpose entities (SPEs) and issued FASB Interpretation No. 46,² in 2002 and FASB Interpretation No. 46 (revised December 2003).³ Although they may have put an end to the types of off-balance sheet structures that Enron engaged in, it became clear from the financial crisis that they did not stop companies, particularly certain major financial institutions, from engaging in such activities. As I will discuss in this section, in my view and with the benefit of hindsight, at least some of these off-balance sheet treatments seemed to have resulted from a stretching or even violation of the accounting rules in FASB Interpretation No. 46(R) and FASB Statement No. 140.⁴

What caused certain major financial institutions to go to such lengths to try to get off-balance sheet treatment for securitizations and other financial structures? From a financial reporting perspective, the treatment of a securitization as a sale of financial assets versus a secured borrowing can result in recording of gains and a smaller balance sheet in terms of reported debt and total assets. Those results boost reported earnings, earnings per share, and returns on assets and lower the reported leverage and debt-to-equity ratios. However, beyond the attractions from a financial reporting perspective, getting off-balance sheet treatment had potentially significant benefits on their regulatory capital requirements (i.e., off-balance sheet accounting lowers the amount of capital the bank regulators require a regulated institution to maintain). Having to maintain additional capital is costly and lowers actual and reported earnings and reported return on equity. From a systemic point of view, I believe the off-balance sheet treatments became an enabler in the growth of the “shadow” banking system. The July 2010 (revised February 2012) staff report no. 458 Shadow Banking of the Federal Reserve Bank of New York defined shadow banks as “financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees.” That report discusses the rapid growth of the shadow banking system in the United States in the years leading up to the financial crisis and provides various measures of the size of the shadow banking system, which by 2008 was significantly larger than the official U.S. banking system. As subsequently discussed, such entities included securitization vehicles of various types, including asset-backed commercial paper (ABCP) conduits, structured investment vehicles (SIVs), and qualifying special purpose entities (QSPEs).

The Financial Crisis Inquiry Report of the FCIC describes some of these motivations and the lobbying by banks of bank regulators to obtain off-balance sheet treatments for regulatory capital purposes. For example, in discussing the ABCP conduits sponsored by major financial institutions, the report states the following:

When the Financial Accounting Standards Board, the private group that establishes standards for financial reports, responded to the Enron scandal by making it harder for companies to get off-balance-sheet treatment for these programs, the favorable capital rules were in jeopardy …. In 2003, bank regulators responded by proposing to let banks remove these assets from their balance sheets when calculating regulatory capital. The proposal would have also introduced for the first time a capital charge amounting to at most 1.6% of the liquidity support banks provided to ABCP programs. However, after strong pushback … regulators in 2004 announced a final rule setting the charge at up to 0.8% …. Growth in this market resumed.

Additionally, and as discussed in the FCIC report and in other papers and reports on the financial crisis and, as discussed below, in light of some of the accounting issues that surfaced during the crisis relating to securitization transactions and SPEs, I am sympathetic with those who assert that securitization and structured finance practices went very awry in the years leading up to financial crisis. Perhaps this view was best summed up on page 10 of the FCIC report by James Rokakis, treasurer of Cuyahoga County, Ohio, who stated “Securitization was one of the most brilliant innovations of the 20th century. It freed up a lot of capital …. It worked for years. But then people realized they could scam it.”

Off-Balance Accounting 101

So, exactly where and how, rightly or wrongly, did certain major financial institutions get these off-balance sheet treatments for financial reporting purposes? Subsequently discussed are three areas where off-balance sheet accounting was used by major financial institutions: accounting for securitizations involving QSPEs, accounting for certain variable interest entities (VIEs), and accounting by Lehman Brothers for the Repo 105 and Repo 108 transactions. Not surprisingly and quite appropriately, in my view, these matters were the subject of Congressional inquiries. Although the following provides an overview of each of these off-balance sheet accounting issues, I would refer those seeking a more in-depth understanding of the first two subjects to my letter dated March 31, 2008, to Senator Jack Reed, then-chairman of the Subcommittee on Securities, Insurance, and Investment of the Senate Committee on Banking, Housing, & Urban Affairs, and to FASB Statement No. 166,⁵ and No. 167,⁶ both of which are now codified in FASB ASC 860 and 810, respectively, which I subsequently discuss. For additional information on the third issue, I would refer readers to the March 11, 2010, Report of Anton R. Valukas, Examiner for the United States Bankruptcy Court Southern District of New York and to my letter dated April 19, 2010, to Chairman Barney Frank and Ranking Minority Member Spencer Bachus III of the House Committee on Financial Services.

Did They Qualify?

The concept of the QSPE was introduced into the accounting literature by FASB Statement No. 125,⁷ which was issued in 1996. It was carried forward with certain amendments in FASB Statement No. 140, which was issued in 2000 and replaced FASB Statement No. 125. FASB Statement Nos. 125 and 140 distinguished two types of SPEs: QSPEs and nonqualifying SPEs. The concept of the QSPE was created to consider, in certain transactions, that the assets in a securitization entity are effectively the assets of the investors that hold beneficial interests in the entity. A SPE qualified as a QSPE only if the beneficial interest holders in the entity can sell or pledge their interests, and there were significant restrictions around the powers and activities of the entity. Accordingly, in order to qualify as a QSPE, the entity had to meet a number of specific requirements around the types of assets it could hold and the types of activities it could engage in. These were designed to ensure that the assets held by the entity would not require the servicer to make significant decisions or actively manage the assets, and the activities of the entity were very limited and entirely specified in the legal documents establishing the entity, and that the entity could only sell or dispose of assets in automatic response to the occurrence of a narrowly defined set of events. Because they were supposed to comply with these strict requirements, QSPEs were described by some as being on “autopilot” or “brain dead” entities, in effect as lockboxes in which the cash flows from the high-grade and passive financial assets in the entity were collected by the servicer and then remitted to the holders of the beneficial interests in the entity. The bottom line was that if a securitization of financial assets was effected using a QSPE, provided it met certain other criteria, it was treated as a sale, and the assets transferred into the QSPE were removed from the transferor’s balance sheet.

Although the FASB received certain implementation and interpretation questions relating to QSPEs and had a project from 2003 onward to address these and other issues relating to FASB Statement No. 140, the requirements relating to QSPEs seemed to generally work as intended for a number of years. That was the case when the FASB addressed issues relating to the use of SPEs in the wake of the Enron scandal. Accordingly, in developing FASB Interpretation No. 46 and FASB Interpretation No. 46(R) in 2002–2003, we decided to carry forward the special provisions relating to QSPEs, effectively exempting such structures from consolidation.

In the years leading up to the financial crisis, however, trillions of dollars of mortgages and other loans with nontraditional features were originated and securitized. In addition, it has been asserted in numerous reports and official inquiries on the financial crisis that many of these loans had been originated based on lax or even fraudulent underwriting practices.⁸ Nevertheless, securitizations of these loans had often been accounted for as sales of the transferred assets to QSPEs and accorded off-balance treatment.

What seems clear to me with the benefit of hindsight is that some, if not many, of these entities were effectively ticking time bombs. As the loans contained in them increasingly experienced credit problems during the course of 2007, all sorts of actions and active management by the servicers became necessary, including attempting to proactively modify the terms of many of the mortgages held in these entities under government-encouraged programs and, in a mounting number of cases, foreclosing on the underlying properties. These actions went beyond those contemplated by the requirements to qualify as a QSPE and beyond the activities that had been specified in the documents establishing the entities. Not surprisingly, we and the SEC staff received increasing requests to clarify and expand the range of permissible activities of a QSPE in order to enable these activities to be conducted without jeopardizing the off-balance sheet treatment of these entities.

To me, it seemed clear by late 2007 that the concept of the QSPE had been stretched to the point where it was no longer workable. So, as stated in paragraph A33 of FASB Statement No. 166, which replaced FASB Statement No. 140

The Board believes that because the range of financial assets being securitized and the complexity of securitization structures and arrangements, the application of the conditions of a qualifying special-purpose entity have been extended in some cases beyond the intent of Statement 140, thus effectively rendering the conditions no longer operational in practice …. As a result, the Board decided to remove the concept of a qualifying special purpose entity.

In other words, in light of the evidence of what had been happening, we decided to “kill the Q.” The exposure draft Amendments to FASB Interpretation No. 46(R) proposing that and other amendments to FASB Statement No. 140 was issued in September 2008. FASB Statement No. 166 was issued in June 2009 and effective in 2010. As an important interim step and in order to quickly increase the transparency around the use of SPEs by companies, we issued new disclosure requirements that took effect starting with 2008 calendar year-end financial reports. These new disclosures significantly expanded the information in the footnotes to a company’s financial statements on its involvements with QSPEs and other SPEs.

The removal of the QSPE from U.S. GAAP literature was also a step toward convergence with International Financial Reporting Standards (IFRSs) in this area because IFRSs did not contain a QSPE concept. In developing FASB Statement Nos. 166 and 167 on VIEs, which is subsequently discussed, we proactively reached out to, and consulted with, many parties, including the U.S. banking regulators.

SIVs, Conduits, and Other VIEs

So much for QSPEs. Starting in the second half of 2007, significant reporting issues also began to surface with certain other SPEs that had not been treated as QSPEs for accounting purposes. These entities, which included SIVs and ABCP conduits established and run by major banks, involved the active management of financial assets and the related (often, short-term revolving) financing of these assets. Therefore, these entities clearly did not qualify as QSPEs and, accordingly, had been accounted for under FASB Interpretation No. 46(R). As previously noted, that standard was issued in the wake of abuses with off-balance entities by Enron and others under the prior set of rules. The basic concept in FASB Interpretation No. 46(R) was that for thinly capitalized entities that did not meet the QSPE requirements, the party holding the majority of risks or rewards of the entity was deemed to be the primary beneficiary and had to consolidate the entity. The determination of which party, if any, was the primary beneficiary was generally implemented through the use of mathematical modeling techniques to calculate what were called expected losses.

In some cases, the sponsoring banks had entered into support arrangements as a back-stop for investors in the securities issued by these entities. These included liquidity puts and asset buy-back arrangements. Some institutions also sought to structure around FASB Interpretation No. 46(R) by creating and selling so called expected loss notes to hedge funds and other investors in order to transfer a majority of the expected losses of an entity to a third party if and when such losses materialized. By doing so, they asserted they were no longer the primary beneficiary and, therefore, avoided consolidating such entities in their financial statements.

Starting in fall 2007, certain of these entities began to experience credit problems with their assets and difficulty in continuing to issue financing for these assets, thereby triggering or threatening to trigger the support arrangements provided by the sponsoring banks. Perhaps the most noteworthy of these occurred with entities sponsored by Citigroup that eventually had to take tens of billions of dollars of problem financial assets and related financing onto its books.

How had these entities received off-balance sheet treatment under FASB Interpretation No. 46(R)? Again, with the benefit of hindsight, it seems the calculations of the expected losses by the sponsoring institutions either did not always include all the relevant risks or severely underestimated these risks, including the potential credit risks of the assets held by these vehicles and the liquidity risk surrounding the vehicles. A more in-depth discussion of the apparent fallacies in the assumptions used to model such risks can be found in the Financial Crisis Inquiry Report.⁹ At the FASB, we did not have any regulatory review or enforcement powers, but I also wondered whether the expected loss notes actually transferred a majority of the real risk in these vehicles to third parties. If not, was this just a case of poor estimation or was that by design (e.g., through reverse engineering of the terms of these securities to be able to claim they transferred over 50 percent of the expected losses)?

All of this, plus the knock-on effects of eliminating the QSPE, led us to conclude that we also needed to revisit FASB Interpretation No. 46(R). So, during 2008 and into 2009 and in conjunction with our development of FASB Statement No. 166, we also worked on revising and improving the consolidation rules relating to VIEs. The new standard, FASB Statement No. 167 was issued in June 2009 at the same time as FASB Statement No. 166 and also became effective in 2010. FASB Statement No. 167 introduced a more qualitative approach to assessing whether an SPE should be consolidated that requires evaluating both the economics of the entity and who directs its activities. It resulted in the consolidation of trillions of dollars of SPEs, perhaps most notably by the government-sponsored entities (GSEs) Fannie Mae and Freddie Mac, for the trusts that issue mortgage-backed securities guaranteed by the two GSEs.

The Lehman Repo 105 and 108 Transactions

The failure of Lehman Brothers in September 2008 was one of the many noteworthy events that shook the global capital markets during that unforgettable month. In March 2010, the court-appointed examiner Anton Valukas issued his report, Report of Anton R. Valukas, Examiner, on the bankruptcy of Lehman Brothers. That report describes in a fair amount of detail the accounting and (lack of) disclosure by Lehman Brothers for Repo 105 and Repo 108 transactions (collectively referred to as Repo 105 transactions in the examiner’s report). According to the examiner, Lehman Brothers structured transactions around the ends of reporting quarters to temporarily remove securities inventory from its balance sheet, thereby reducing the leverage it reported in its quarterly financial information. The report states that “Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet” and that “Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transitions had on the firm’s publicly reported net leverage ratio.”

When the news broke about this, I was asked by staff to the House Committee on Financial Services to provide my views on the matter, in particular whether the accounting for these transactions by Lehman Brothers prior to its bankruptcy violated U.S. GAAP. My response to that request is contained in the aforementioned April 19, 2010, letter to Congressmen Frank and Bachus III. As noted in my letter, the FASB does not have regulatory or enforcement powers; therefore, my views were necessarily based on only publicly available information at the time. So, without further information, I was not in a position to conclude whether the treatment by Lehman Brothers had violated U.S. GAAP, which generally requires repurchase transactions to be accounted for as secured borrowings, not as sales, which Lehman Brothers had done in this case.

The FASB does not have regulatory or enforcement powers. However, whenever there are reports of significant accounting or financial reporting issues, we monitor developments closely to assess whether standard-setting actions by us may be needed. In some cases, a misreporting is due to outright fraud and/or violation of our standards, in which case accounting standard-setting action is not necessarily the remedy. Other cases reveal weaknesses in current standards or inappropriate structuring to circumvent the standards, in which case revision of the standards may be appropriate. In some cases, there are elements of both.

At this point in time, while we have read the report of the Lehman Bankruptcy Examiner, press accounts, and other reports, we do not have sufficient information to assess whether Lehman complied with or violated particular standards relating to accounting for repurchase agreements or consolidation of special-purpose entities. Furthermore, we do not know whether other major financial institutions may have engaged in accounting and reporting practices similar to those apparently employed by Lehman.

In that regard, we work closely with the SEC. We understand that the SEC staff is in the process of obtaining information directly from a number of financial institutions relating to their practices in these areas. As they obtain and evaluate that information, we will continue to work closely with them to discuss and consider whether any standard-setting actions by us may be warranted.¹⁰

However, as noted in my letter, from the report of the examiner and press accounts and other public information on the matter, it did seem to me that Lehman Brothers had purposefully attempted to structure the Repo 105 and 108 transactions so as to try to support the sales treatment. My letter discusses the steps Lehman Brothers seemed to have taken in order to attempt to meet two specific U.S. GAAP requirements for the transactions to be accounted for as sales, not secured borrowings, and raises some questions about whether those steps achieved their intended objective. I also noted in my letter that “[w]hen there are material structured or unusual transactions, disclosure is also very important” and that according to the examiner’s report, Lehman Brothers had incorrectly disclosed that it accounted for all repos as secured borrowings.

Unfortunately, history has repeatedly shown that companies do sometimes attempt to structure transactions solely or mainly to achieve desired financial reporting outcomes. I know this all too well from my “Bad Bob” days. This poses a real challenge for just about everyone in the financial reporting supply chain: accounting standard setters; auditors; audit committees and boards of directors; regulators and enforcers; and, most importantly, the investing public. Like outright financial reporting fraud, reports of attempts to loophole accounting requirements, particularly in connection with the failure of major companies, sap public confidence in the integrity of published financial information. I touch upon this very important topic again in Chapter 6.

Whenever there are reports of significant accounting or financial reporting issues, accounting standard setters closely monitor developments to assess whether standard-setting actions may be needed. In some cases, a misreporting is due to outright fraud or violation of the standards, in which case accounting standard-setting action is not necessarily the appropriate remedy. Other cases reveal weaknesses in current standards or inappropriate structuring to try to circumvent the standards, in which case revision of the standards may be appropriate. In some cases, there are elements of both.

Before I left the FASB, we added a project to address one of the provisions in U.S. GAAP that Lehman Brothers seems to have tried to structure around the Repo 105 and 108 transactions. That project resulted in a final standard, FASB Accounting Standards Update 2011–2003,¹¹ that was issued in April 2011, removing the provision in question from U.S. GAAP. In March 2012, the FASB added a project to undertake a broader review of the accounting and disclosure requirements relating to repurchase agreements, in part because of concerns about the accounting by MF Global that went bankrupt in October 2011 for repo-to-maturity transactions. That Project resulted in the issuance of FASB ASU 2014-11 in June 2014 which modifies the guidance in ASC 860 on repos and similar transactions.

Fair Value, Mark-to-Market Accounting, and Impairment of Financial Assets

I now move on to discuss the subject of accounting for financial instruments, a complex and challenging subject that came to the forefront during the financial crisis in terms of the debate between amortized cost and fair value accounting and the controversy over mark-to-market accounting and its role in the crisis. This could well be the subject of another entire book, one that would hopefully shed more light than heat on a very important subject. During the financial crisis, there was certainly a spotlight on this topic, one that brought a lot of heat on us as accounting standard setters.

I will certainly not be able to do justice to this very important topic in the discussion that follows because it involves one of the oldest; longest-running; most controversial; and, in my view, yet to be properly resolved issues in accounting and financial reporting: how particular assets and liabilities should be measured. For purposes of this discussion, I will confine myself to accounting for financial assets and liabilities, itself a complex and controversial topic.

Some History

I could go way back in time, but let me start with the savings and loan (S&L) crisis from over two decades ago. Accounting practices by financial institutions, both under U.S. GAAP and as prescribed by banking regulators, were heavily criticized as having contributed to the crisis. Significant questions were raised about whether the use of amortized cost methods of accounting for financial instruments had enabled S&Ls and other banks to inappropriately defer recognizing losses on underwater loans and investment securities while also generating reported earnings through selective gains trading of appreciated securities.

On September 10, 1990, then-Chairman of the SEC Richard Breeden spoke publicly before the Senate Committee on Banking, Housing, & Urban Affairs about the shortcomings of reporting investments at amortized cost and stated that “serious consideration must be given to reporting all investments securities at market value” for banks and thrift institutions. Similarly, in 1991, the Government Accountability Office (GAO) issued the report Failed Banks: Accounting and Auditing Reforms Urgently Needed to Congress. That report concluded that “[t]he key to successful bank regulation is knowing what banks are really worth.” The report urged the immediate adoption for both U.S. GAAP and regulatory reporting of mark-to-market accounting for all debt securities and rapid study of the potential merits of a comprehensive market value-based accounting and reporting system for banks in order that “banks’ true financial condition could be reported promptly.”

The FASB was already working on a major project on accounting for financial instruments and accelerated its review of accounting for loan impairments and accounting for investments in debt and equity securities. This resulted in the issuance of FASB Statement No. 114,¹² and No. 115,¹³ in May 1993. FASB Statement No. 114 requires impaired loans that are not held for sale to be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. Under this standard, a loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan. Under FASB Statement No. 115, debt securities held as investments can be accounted for in one of three ways: at amortized cost subject to impairment for debt securities that are being held to maturity, at fair value with unrealized changes in the fair value of the debt and marketable equity securities that are available for sale being recorded in other comprehensive income outside of reported earnings, or at fair value with the unrealized gains and losses being recorded in earnings for debt and marketable equity securities classified as being held for trading purposes. These different treatments were intended to reflect the different purposes and business models used by financial institutions in originating loans and making investments in debt and marketable equity securities.

Both FASB Statement Nos. 114 and 115 passed by a 5-2 vote of the FASB Board, with the dissenting Board members arguing for more use of fair value in measuring impairments of loans and in accounting for investments in debt and equity securities. For example, the opening sentence of the dissent to FASB Statement No. 115 states

Messrs. Sampson and Swieringa disagree with the accounting treatment prescribed in paragraphs 6–18 of this Statement because it does not resolve two of the most important problems that caused the Board to address the accounting for certain investments in debt and equity securities — namely, accounting based on intent, and gains trading. They believe that those problems can only be resolved by reporting all securities that are within the scope of this Statement at fair value and by including unrealized changes in fair value in earnings.¹⁴

Commenting on FASB Statement No. 115, noted accounting historian Professor Stephen Zeff stated

In the first of three successful lobbying sorties (1990–93), the American Bankers Association (ABA) — abetted by letters sent by the chairman of the Federal Reserve Board, the chairman of the Federal Deposit Insurance Corporation, the Secretary of the Treasury, and two United States Senators — pressured the FASB either directly or indirectly. Even though the FASB had strong SEC support, the ABA pushed the FASB to retreat from a position that it was considering, namely that all marketable securities be shown at fair value and that the year-to-year change in fair value be taken into earnings.¹⁵

Of course, depending on one’s point of view on a particular accounting subject, a specific standard may represent either a retreat or compromise versus a worthwhile improvement.

However, FASB Statement Nos. 114 and 115 would be tested as accounting for financial instruments again came under stress during the financial crisis of 2008–2009. In the intervening years, the FASB (before, during, and after my tenure) issued a number of pronouncements that impacted accounting for financial instruments and improved the disclosures on a company’s use of, and risks relating to, financial instruments. Perhaps most notable of these were FASB Statement No. 133,¹⁶ issued in 1998 and now codified in FASB ASC 815, Derivatives and Hedging, and FASB Statement No. 157, Fair Value Measurements, issued in 2006 and as subsequently amended and now codified in FASB ASC 820, Fair Value Measurement.

In issuing FASB Statement No. 133, which requires derivatives to be measured at fair value, paragraphs 221 and 222 state

221. The Board believes fair values for financial assets and liabilities provide more relevant and understandable information than cost or cost-based information. In particular, the Board believes that fair value is more relevant to financial statement users than cost for assessing the liquidity or solvency of an entity because fair value reflects the current cash equivalent of the entity’s financial instruments rather than the price of a past transaction. With the passage of time, historical prices become irrelevant in assessing present liquidity or solvency.

222. The Board also believes fair value measurement is practical for most financial assets and liabilities. Fair value measurements can be observed in markets or estimated by reference to markets for similar financial instruments. If market information is not available, fair value can be estimated using other measurement techniques, such as discounted cash flow analyses and option or other pricing models, among others.

Contrary to the assertions of some during the financial crisis, FASB Statement No. 157 did not require any new fair value measurements or new uses of fair value in financial reporting and did not change the accounting for loans or for investments in debt and marketable equity securities, including the requirements relating to impairments of these financial assets. Rather, FASB Statement No. 157 was issued to provide a more consistent definition of, and framework for, measuring fair values of both financial instruments and other items and to expand and improve the disclosures about fair value measurements included in the financial statements.

However, at the urging of many parties, including major financial institutions, in early 2007, the FASB also issued FASB Statement No. 159,¹⁷ now codified in FASB ASC 825, Financial Instruments, that, similar to the existing provisions of IFRSs, provided a fair value option for financial assets and liabilities. A number of entities, mainly larger financial institutions, voluntarily chose to begin measuring certain financial items at fair value starting in 2008.

Then Came the Crisis

Soon thereafter, with the onset and rapid deepening of the financial crisis during 2008 and into the first quarter of 2009, the fair values of many, if not most, financial assets fell significantly. For financial assets accounted for as trading or under the fair value option, these declines were recorded in earnings. For available-for-sale debt and equity securities, they were recorded in other comprehensive income, subject to an assessment of whether the decline in value was other than temporary. For debt securities that had been classified as held to maturity, no loss was recorded unless and until the loss was judged to be other than temporary. For loans that were not held for sale, additional impairments, either in the form of additional reserves for loan losses or write-downs in loan carrying amounts, followed the provisions of FASB Statement No. 114, which, as previously described, does not generally require a fair value approach to accounting for impairments of loans.

With the falling values and growing concerns over the quality of the collateral backing such securities, liquidity in the markets for many asset-backed securities dried up. Securities that had previously been valued using quoted prices (level 1 valuations under FASB Statement No. 157) became increasingly difficult to value. FASB Statement No. 157 provided guidance on valuing assets in illiquid markets (level 3 valuations under FASB Statement No. 157), involving the use of various techniques, including discounted cash flows. However, prior to the financial crisis, these techniques had generally been used for valuing nonfinancial assets, such as intangibles, and their use in valuing financial assets had generally been confined to valuing private equity investments and illiquid, long-dated derivatives. As market participants became increasingly aware of the problems with the loans backing many mortgage-backed and other asset-backed securities, the markets became less and less active. As a result, there were hundreds of billions, if not trillions, of dollars of these “toxic” securities and credit defaults swaps and other over-the-counter (OTC) derivatives related to these securities for which current trading prices and quotes became increasingly difficult to obtain. Under these circumstances, it was probably not surprising that a number of parties, including financial institutions holding these financial assets, started to publicly blame mark-to-market and fair value accounting as exacerbating or even causing the financial crisis.

These complaints reached a crescendo in late September 2008 as Congress debated emergency legislation in the wake of the near meltdown of the financial system. Some, primarily financial institutions and their industry associations, lobbied for a repeal or suspension of fair value accounting requirements. Vocal support for this came from a variety of recognized political and economic commentators. For example, commenting in the September 22, 2008, Washington Times, Lawrence Kudlow of CNBC stated, “Bad accounting rules like this (mark-to-market) are sinking the financial system.” In the September 29, 2008, issue of Forbes, former Speaker of the House Newt Gringich said, “Because existing rules requiring mark-to-market are causing such turmoil on Wall Street, mark-to-market accounting should be suspended immediately so as to relieve the stress on the banks and corporations.”¹⁸

However, many others saw it quite differently. For example, in testimony before the Senate Committee on Banking, Housing, & Urban Development on October 16, 2008, former SEC Chairman Arthur Levitt stated

One of the biggest steps we can take to light a fuller picture of companies’ financial health would be to expand fair-value accounting to cover all of the financial instruments … . Yet in recent weeks, fair-value accounting has been used a scapegoat by the banking industry — the financial equivalent of shooting the messenger. If financial institutions were accurately marking the books, they would have seen the problems they are experiencing months in advance and could have made the necessary adjustments — and we could have avoided the current crisis.

Many, including investors and investor organizations and the major accounting firms and Financial Accounting Foundation (FAF) Chairman Robert Denham, wrote letters to Congress opposing any legislation that would suspend the fair-value requirements, warning that it could severely undermine investor confidence.

Meanwhile at the SEC and FASB, although not inclined to suspend the requirements, we also recognized the need for additional guidance in what was clearly an emergency situation. Accordingly, we issued a joint SEC-FASB press release on September 30, 2008, that provided additional guidance from our staffs on valuing securities in illiquid and inactive markets.¹⁹ As promised in that release, the Board, following an expedited comment period, issued additional clarifying guidance on these matters on October 10, 2008, in the form of FSP FAS 157-3.²⁰ I recall that some of the comment letters we received on the proposal that resulted in this document were from individuals making impassioned pleas on both sides of the fair value debate. Exhibit 5.1 shows four of these letters, the first two from people strongly against fair value and the second two urging us to hold the line on fair value. Many more such letters and e-mails were to follow in the months ahead, as well as hundreds of lengthier and more detailed letters addressing the technical accounting aspects of the various proposals we were to issue regarding financial reporting matters arising from the crisis.

Letters of Comment

Letter of Comment No. 10

From: XXX

May the souls of all of those who developed FASB 157 burn in the 7th circle of Dante’s hell. The statement does not reflect economic reality and in fact converts statements to liquidation statements, distorts periodic measurement of income, distorts capital and cause bankruptcies where in fact paper entries create a situation the opposite of cash flow. Perhaps this was the intended consequence. I am old CPA and an investor and I will tell you academics never done anything but contemplate your navel types that this statement does not help me evaluate investments because in fact distorts the most important investor issue which is earnings and earnings growth. You have made the income statement a garbage dump of no meaning in favor the balance sheet. Rule bound, every single member of this group and their staff are solely responsible for this non meltdown, meltdown. You are garbage.

XXX

CPA

Letter of Comment No. 12

From: XXX

I’ve read FAS 157 and your proposed FASB staff position on FAS 157. I’ve been a CPA for 40 years and I cannot believe what the FASB has done to me personally and to the country as a whole. You’ve destroyed the retirement of me and my wife and millions of other Americans. Your lame attempt to correct the problem is way too little and way too late. Your arrogance and self-righteous approach has cost millions of Americans their financial independence and their futures. I hope you can’t sleep at night, because I know I can’t. How do I tell my wife that our equity income funds that were to provide our retirement have been decimated because of an accounting rule that makes financial institutions, on paper, insolvent (essentially bankrupt) and makes their stock, even if they have positive cash flow, essentially worthless? You continue to do a great disservice to our country. Shame on you. I hope you can live with yourselves and all of the destruction you’ve caused.

XXX, CPA (Not very proud of it)

Letter of Comment No. 8

From: XXX

It is time to draw the line in the sand on the mark-to-market rules. I am deeply ashamed that you would even consider softening these rules when you know that the lack of regulations got us into this financial mess!!!! The lack of enforcement and changes in regulations by the SEC are to blame: changing the leverage rules for investment banks from 12 to 1 and letting them go up to 40 to 1 that is why there are none left, lack of enforcement in short selling rules, reversal of the up-tick rule, reversal of computer program trading restraints on a very bad day, etc. In my opinion I want to know how all these problems happened to the banks with SOX in place and what were the public accounting firms doing????? Why is no one going to jail — no material internal control weaknesses??? DO NOT GET CAUGHT UP IN POILITCS — WE ARE SUPPOSED TO BE INDEPENDENT!!!!! WHAT DO YOU WANT THE TREASUY DEPARTMENT TO HAVE AN EXCUSE TO PAY HIGHER PRICES FOR THIS TOXIC DEBT ON THE F/S ON US AND FOREIGN BANKS!!!! THIS IS A DISGRACE!!!!

XXX

Letter of Comment No. 17

From: XXX

I am concerned that the proposed revisions to the rule could further exacerbate the current financial crisis, rather than help it, by essentially making the financial health of a company that has non-performing assets on its books seem better than it actually is. What the rule is essentially doing is allowing a company to assign a value that is based on “assumptions” to an asset that has no market and is therefore actually, in the real world, worthless.

Furthermore, if a consumer applied for credit and showed a portfolio of securities that had no market as collateral, I don’t believe they would be extended the same leeway in interpretation.

XXX

In response to the controversy, as part of the Emergency Economic Stabilization Act of 2008 (EESA), Congress mandated that the SEC conduct a study on mark-to-market accounting in conjunction with the Treasury and the Board of Governors of the Federal Reserve System. The EESA further authorized the SEC to suspend mark-to-market accounting if it deemed such a move necessary or appropriate in the public interest. As part of its study, the SEC received numerous comment letters; held several public roundtables; and reviewed the effects of the use of fair value accounting on financial institutions, including whether and how it might have impacted the 22 banks that had failed during 2008 (including the three largest failures: Washington Mutual, IndyMac, and Downey Savings and Loan), and on other major failed or distressed financial institutions (including Bear Stearns, Lehman Brothers, and AIG). During fall 2008, we, together with the IASB, held public roundtables — one in London; one in Tokyo; and one in our offices in Norwalk, CN — to gather input and views from constituents on reporting issues emanating from the financial crisis that needed standard-setting action.

The report by the SEC staff to Congress,²¹ was issued on December 30, 2008. Its overall conclusion was

Rather than a crisis precipitated by fair value accounting, the crisis was a “run on the bank” at certain institutions, manifesting itself in counterparties reducing or eliminating the various credit and other risk exposures they had to each firm … . The Staff observes that fair value accounting did not appear to play a meaningful role in bank failures occurring during 2008. Rather, bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence. For the failed banks that did recognize sizable fair value losses, it does not appear that the reporting of these losses was the reason the bank failed.

The report noted that investors generally believed that fair value accounting increases financial reporting transparency and that the information it provides helps result in better investment decision making. Accordingly, the SEC staff recommended against suspending FASB Statement No. 157 or existing requirements relating to the use of fair values in financial reporting. However, the report did contain a number of recommendations for potential improvements to the guidance on fair value, as well as some broader recommendations on the need (a) to simplify accounting for investments in financial assets and (b) for enhancements to the accounting standard-setting process.

I would note that other studies²² have similarly concluded that the use of fair value accounting was a not a contributing factor to the financial crisis. In that regard, I found a study conducted by an economist at the Federal Reserve Bank of Boston and published on January 31, 2010, to be particularly interesting. That study,²³ looked at whether, as contended by some, the use of fair value accounting and markdowns of financial assets to fair value during the height of the financial crisis in 2008 was a major contributory force to the financial crisis because it caused a procyclical contagion effect that then led to a downward spiral in financial asset prices because financial institutions had to sell these assets at ever-falling distressed prices in order to prevent a further destruction of regulatory capital. The study focused on the largest U.S. bank holding companies: those over $100 billion in assets because these were the most prone to such write-downs and had the highest amounts of the troubled financial assets. The conclusion of this study states

Based on this simple analysis it would appear that fair value accounting had a minimal impact on the capital of most banks in the sample during the crisis period through the end of 2008. Capital destruction was due to a deterioration in loan portfolios depleted by items such as proprietary trading losses and common stock dividends. These are a result of lending practices and the actions of bank managements, not accounting rules. Furthermore, the data suggests that banks were not raising significant capital through asset sales; rather they were relying on government programs as well as debt and equity markets. There was no clear observable evidence to back the assertion that fair value accounting, linked to regulatory capital rules, caused banks to sell investments at distressed prices and thus promote a pro-cyclical effect that accelerated the decline in investment asset prices.

Nevertheless, the assertions that fair value accounting exacerbated or even caused the financial crisis continued, as evidenced by some of the comment letters the FASB received on its May 2010 proposed Accounting Standards Update (ASU)²⁴ and by the dissenting statement of Commissioner Peter Wallison in the Financial Crisis Inquiry Report, who, in discussing his views on factors contributing to the financial crisis, stated

The Commission majority did not discuss the significance of mark-to-market accounting in its report. This was a serious lapse, given the views of many that accounting polices played an important role in the financial crisis. Many commentators have argued that the resulting impairment charges to balance sheets reduced the GAAP equity of financial institutions and, therefore, their capital positions, making them appear financially weaker than they actually were if viewed on the basis of the cash flows they were receiving.

However, the majority opinion of the FCIC seems to dismiss this view in commenting in the Financial Crisis Inquiry Report, “Determining the market value of securities that did not trade was difficult, was subjective, and became a contentious issue during the crisis. Why? Because the write-downs reduced earnings and capital, and triggered collateral calls.”

At the time, however, some seemed to have a “shoot the messenger” approach to trying to address what was a very difficult and challenging situation. Being the chairman of the body that was at the center of these assertions and attacks was not always the most comfortable of roles during this period. I recall my then 23-year-old daughter Nicole, who is not an accountant or steeped in finance, observed from reading news accounts and watching cable news shows, “Daddy, there seems to be a lot of people mad at you and the FASB over this mark-to-market thing,” and asking, “Why are they so against banks showing what their assets are worth?” I was buoyed by the professionalism and dedication of my fellow Board members and our staff and by the support we received from many quarters, including our trustees, many investors and investor organizations, the accounting profession, the academic community, and others, both for maintaining a line on not suspending the use of fair value and for the importance of independent standard setting. The support of then-Treasury Secretary Paulson, then-SEC Chairman Cox, and then-SEC Chief Accountant Conrad Hewitt who stood firm in favor of these principles was also important in weathering the storm against fair value and independent standard setting in fall 2008. Paulson would later write in his book On the Brink

Some people have also blamed the use of fair-value accounting for causing or accelerating the crisis. To the contrary, I am concerned that had we not had fair value — or as it is sometimes known, mark-to-market- accounting, the excesses in our system would have been greater and the crisis would have been even more severe. Managements, investors, and regulators would have had even less understanding of the risks embedded in an institution’s balance sheet.²⁵

However, that was certainly not the universal view, and there was more to come in this controversy.

The Year 2008 Draws to a Close

Although the problems in the credit markets seemed to have been at their height during November 2008, neither a rebound in those markets in December 2008 nor the issuance of the SEC report at the end of 2008 dampened the calls from financial institutions and their trade groups for major changes to accounting standards relating to the valuation of investments and, in particular, the standards relating to write-downs of debt securities for what are called other-than-temporary impairments. Under FASB Statement No. 115 and related guidance issued by the SEC staff and the Emerging Issues Task Force (EITF), both held-to-maturity debt securities carried at amortized cost and available-for-sale debt securities carried at fair value through other comprehensive income need to be written down through earnings when an other-than-temporary impairment occurs. Determining what constitutes an other-than-temporary impairment requires judgment based on an assessment of the length and severity of the decline in value of the debt security. Rules of thumb had developed in practice, such as if a security had fallen by more than 20 percent in value below amortized cost for a period of at least one year, it should be written down to its current fair value. Until that point, however, no charge to earnings (and no reduction in regulatory capital) needed to be made for the decline in fair value in the hope there would be a recovery in value.

The declines in the values of many debt securities had begun in the second half of 2007 and continued through much of 2008, with a bit of rebound in some debt securities coming in December 2008. By December 31, 2008, many debt securities had been underwater for more than one year and had significantly declined in value. So, it was not surprising that pressure mounted on us and the SEC to do something to mitigate the resulting write-downs that would need to be taken in the year-end financial statements of financial institutions. The institutions argued that credit markets had become dislocated and dysfunctional, such that the fair values were not representative of the underlying fundamental or true values of the debt securities, and that many of these securities with severely depressed fair values were actually “money good,” meaning they were expected to pay off in full. They also argued that auditors were taking an overly conservative approach in forcing their clients to mark these assets down to unrealistic “fire-sale” prices.

I must admit that I had some sympathy for some of these arguments, particularly for the one that auditors may have been requiring overly excessive write-downs based on unrepresentative trades or “non-binding” broker quotes rather than allowing institutions to use other techniques to value what had, in many instances, become illiquid debt securities. In that regard and as we tried to clarify and emphasize in FSP FAS 157-3, the definition of fair value in FASB Statement No. 157 is the price that would be received to sell an asset in an orderly transaction and not what would be received in a forced sale or liquidation. The markets for many securitized debt securities had become illiquid. Therefore, I supported and voted in favor of FSP EITF 99-20-1,²⁶ that we issued on January 12, 2009, and that modified the rules relating to determining impairments of certain securitized debt interests to make them more consistent with the approach to impairment on other illiquid debt securities by allowing the use of management’s cash flow estimates instead of market estimates of cash flows in computing the fair value and resulting impairment of these interests. It was effective for December 31, 2008, financial statements and passed by a 3-2 vote of the Board, with Tom Linsmeier and Marc Siegel dissenting to what they felt was an inappropriate change in the impairment requirements for these assets.

Into 2009 — Congress Weighs In

In January and February 2009, we met with many constituents, including our Valuation Resource Group, to discuss further actions we might take in light of the SEC staff’s recommendations in their report to Congress and ongoing requests for additional guidance on determining fair values and impairments of financial assets. As a result, on February 18, 2009, I announced in a press release that we added two projects to our agenda: one to provide further application guidance on a number of areas, including when markets had become inactive and on determining when a transaction is distressed, and the other on improving disclosures about fair value measurements used in the financial statements. We had already issued for public comment certain proposed enhanced disclosures in interim reports relating to the fair values of financial instruments. We began work on the two additional projects, with a goal of finalizing the additional guidance on determining fair values in inactive markets and distressed transactions in time to be applied for 2009 second quarter financial reports.

Apparently, that was neither quick enough nor enough of a change for some financial institutions and their trade groups, as well as for certain broader business groups, such as the U.S. Chamber of Commerce (Exhibit 5.2). Now, my experience has been that when companies and business groups oppose particular proposed changes in accounting standards, they often complain the proposal needs more vetting, that FASB needs to slow down and conduct field tests and additional cost-benefit analyses, and so on. However, in this instance, which was certainly not the ordinary course of business and which, as many have said, was unprecedented, these groups lobbied for the changes. They wanted standards to be done on an emergency basis, with little or no due process by us, the SEC, or Congress.

Multi-Industry Letter on Mark-to-Market Accounting: Practices and Implications.

Release Date: Wednesday, March 11, 2009

March 11, 2009

The Honorable Paul Kanjorski

Chairman

Subcommittee on Capital Markets,

Insurance and Government

Our Response

In any event, later that day and on my return to Norwalk, CN, the next day, I conferred with my fellow Board members and senior staff about whether and how we might respond to the demands from the subcommittee. As I have said before and will reiterate many times in this book, I was very blessed with fellow Board members and staff who, despite differences in views on particular technical matters, were dedicated to our mission and properly fulfilling that mission. So, we decided that with a lot of hard work, we could quickly issue for public comment two documents: one proposing additional guidance on determining fair values in inactive markets and another proposing changes in the accounting for, and presentation of, impairments of debt. We had also already exposed for public comment a proposal to increase the frequency of disclosure of fair values from annually to quarterly.

The next three weeks were to be very challenging, with Board members and staff working very long hours and through weekends to issue the proposals; discuss the proposals with many constituents; carefully review and analyze the over 700 written comment letters we received during the two-week comment period; and revise the proposal and issue three final documents on April 9, 2009, so they were available for 2009 first quarter reporting. It was a real team effort, and I offer special thanks and my deep appreciation to three members of the FASB staff who worked tirelessly on these documents: Practice Fellows Adrian Mills and Diane Inzano and Valuation Fellow Kristofer Anderson.

FSP FAS 157-4,²⁸ provided guidance on determining fair values when there is no active market or when the price inputs being used represent distressed sales. It reaffirmed what FASB Statement No. 157 states as the objective of fair value measurement: to reflect how much an asset would be sold for in an orderly transaction (as opposed to a distressed or forced sale). It also reaffirmed the need to use judgment to determine if a formerly active market has become inactive and to determine fair value in such circumstances. FSP FAS 115-2 and FAS 124-2,²⁹ provided for a more consistent approach to the timing of impairment recognition and greater clarity on the credit and noncredit components of impaired debt securities that are not expected to be sold. The measure of impairment remained at fair value, but it was required to be split into the estimated credit component, which is charged to earnings, and the remaining noncredit component, which is charged to other comprehensive income. Although not one of our specific goals in establishing this approach, an important practical effect of it for the banks was to take some pressure off their regulatory capital because only the portion of the impairments in debt securities relating to credit would now be charged to regulatory capital. That FSP also expanded the disclosures sought by investors regarding expected cash flows, credit losses, and an aging of securities with unrealized losses. Finally, FSP FAS 107-1 and APB 28-1,³⁰ extended the annual disclosures of fair values of financial instruments to quarterly financial reports. All Board members voted in favor of the first and third documents. Tom Linsmeier and Marc Siegel dissented to the second document that they viewed as an inappropriate change in the impairment requirements.

Reaction to the issuance of these three documents was strong but mixed. Critics of fair value generally said it was a positive step but did not go far enough. Supporters of fair value saw it as a weakening of the standards and as allowing banks and other financial institutions too much latitude in determining fair values and in deciding what portion of an impairment to charge to report in earnings. We received strongly worded letters and e-mails from both camps: those who saw fair value as the root of all evils and those who, having read some press accounts, believed we had “caved” to the “evil banks” and their water carriers in Congress.

To me, the documents represented a genuine attempt by us to provide helpful guidance at a very challenging juncture for the capital markets and economy while preserving the underlying principles of fair value and greatly expanding the disclosure of information that professional investors had been seeking. Most of all, I will remember the sheer hard work and dedication we put into the efforts, making sure we also preserved our public due process. I take pride in the effort, but I certainly do not recommend it as a permanent mode for setting accounting standards.

Some Lessons Learned

For me, many lessons were learned, and some were relearned. I say relearned because as the title of my June 2009 speech at the National Press Club states, “History doesn’t repeat itself, people repeat history.” Clearly, some of the key lessons from this financial crisis are not new, including the perils of excess leverage and inadequate capital, the importance of liquidity, particularly in a crisis, and the importance of incentives in driving the behavior of corporate managers and market participants. I also think some other important lessons were learned from this crisis. The following are some of my key takeaways.

First, as I have already said but cannot say too often, I was often amazed and constantly uplifted by the sheer dedication, professionalism, and willingness of my fellow Board members and staff to put in long hours in what sometimes seemed like an endless barrage of difficult issues we needed to deal with during the crisis. Having had the opportunity to work with people at the SEC and the Treasury, particularly during the height of the crisis, I can also attest to their dedication and tireless work on behalf of our country. People band together in a crisis in order to try to respond to the challenges and to try to get through it.

I was also very much impressed by, and learned a great deal from, the deliberations of the FCAG that we and the IASB formed to consider and advise us on financial reporting issues emanating from the crisis. The FCAG was co-chaired by former SEC Commissioner Harvey Goldschmid and Hans Hoogervorst, the head of the Netherlands Authority for the Financial Markets. (Hans subsequently became the Chair of the Monitoring Group over the IFRS Foundation and, in 2010, was named to succeed Sir David Tweedie as the chairman of the IASB starting on July 1, 2011.) The FCAG consisted of 18 recognized leaders from around the world from financial institutions and other major corporations and from the investment, accounting, and regulatory communities, with various official observers from major regulatory bodies and the FASB’s and the IASB’s main advisory councils. It met six times between January and July 2009, addressing a broad array of issues relating to effective financial reporting, the limitations of financial reporting, convergence of accounting standards, and standard setters’ independence and accountability, providing important recommendations to us and policymakers.³¹

Reflecting the global scale of the financial crisis, the FCAG was, by design, a group comprising senior people from around the world. I believe the financial crisis clearly demonstrated the many linkages between financial markets and economies around the world and the increasing need for international cooperation and coordination in addressing issues that arise in financial markets.

I am very grateful to the members of the FCAG for their willingness to serve on such a body at a time of crisis and for their candid views and constructive recommendations. Certainly, I learned a great deal from listening to, and participating in, the deliberations of this group. For example, I think the problems with QSPEs provide a clear example to standard setters of the perils of creating exceptions, however narrowly constructed, that confer highly desirable reporting outcomes. I believe that history has shown that in an effort to avail themselves of the exception, over time, it gets stretched and abused to the point where standard setters or regulators have to shut it down. It happened with fixed-price employee stock options, pooling of interests accounting for business combinations, and the QSPE.

I also believe that the crisis reinforced the importance of understanding the potential behavioral effects of standards. The rather simple definition of fair value as the price a holder would receive in a sale of an asset in an orderly transaction may work just fine in normal times. It came under real stress during the crisis as markets broke down, and important questions arose over what constituted an orderly transaction versus a distressed one. Although FASB Statement No. 157 provided guidance for valuing illiquid assets, it did not contemplate what happened in the financial crisis, so we had to provide several rounds of additional guidance to help preparers, auditors, and regulators deal with the situation in order to obtain reasonable valuations that were consistent with the principles of fair value.

That brings up what I believe to be one of the major lessons learned from the crisis: that we (politicians, regulators, and the private sector) cannot again allow there to be trillion dollar markets that lack proper infrastructures in terms of price discovery, clearing mechanisms, transparency of financial information, and appropriate regulation. Balanced and effective regulation, oversight, and enforcement are also key ingredients of sound markets as is the appropriate exercise of due diligence and proper risk management by financial institutions. Although regulation should not stifle innovation and risk taking, it should help create needed infrastructures, standards of conduct, and transparency in markets. Unfortunately, in the years leading up to the crisis, the exploding markets for asset-backed securities and OTC derivatives lacked the most basic of infrastructure elements and “rules of the road” that, as a country, we worked hard to put into place over many decades in our public equity and debt markets. In modern times, the effective operation of capitalism depends on the existence of infrastructures that support transparency and the orderly functioning of markets. Far from constraining markets and capitalism, these are essential elements in its effective operation and in public trust in the system. So, it is not surprising and is, in my view, appropriate that the Dodd-Frank Wall Street Reform and Consumer Protection Act contained a number of provisions aimed at addressing these issues.

In terms of financial reporting, some of the most difficult accounting and reporting issues emanating from the financial crisis stemmed, at least in part, from the lack of proper information infrastructures around the “dark markets” for structured credit products and derivatives. Under such conditions, accounting and valuation are significantly challenged. Proper accounting and valuation require that companies and market participants are able to identify, understand, and reasonably calibrate risk and returns emanating from financial assets and obligations and to ascertain transaction prices in exchange markets. Thus, it is not surprising that in the financial crisis, there were significant issues surrounding the determination of fair values in inactive and dislocated markets, the recognition of impairments of financial assets in such markets, and the quality and timeliness of disclosures of risk.

To me all, this reinforces the fundamental importance of transparency and accountability. A lack of transparency makes it more difficult to spot growing problems. Even when the problems become evident, the lack of transparency and proper information makes it harder to understand, pinpoint, and address the problem. It also makes it harder to identify who to hold accountable. In short, transparency is not just a buzz word or cliché. It is a fundamental and an absolutely essential attribute of sound financial markets. Relevant, trustworthy, and timely information is the oxygen of financial markets. It engenders trust and confidence in markets, promotes market liquidity, and reduces costs to market participants. Depriving markets of relevant, trustworthy, and timely information, or polluting the information, can have very adverse consequences on individual companies and their stakeholders and on overall confidence in the financial system.

Now, in regard to the merits of providing greater transparency in a crisis, what I am about to say may be a big oversimplification of a complex subject, but at times, during the crisis, it seemed to me that the mindset of some bank regulators was that greater disclosure by banks could be harmful, whereas the approach of accounting standard setters and securities regulators was that more public disclosure is important and helpful. As former SEC Chairman Arthur Levitt stated in testimony on March 26, 2009, before the Senate Committee on Banking, Housing, & Urban Development, “What serves the health of banks may run exactly counter to the interests of investors — and we have seen situations where bank regulators have kept information about poorly performing assets from the public in order to give a bank time enough to dispose of them.” This difference in perspectives would seem to stem from, and reflect some fundamental differences in, the role of bank regulators on the one hand and the role of securities regulators and accounting standard setters on the other hand. Bank regulators are charged with overseeing the safety and soundness of the institutions they regulate and with the stability of the financial system. The roles of accounting standard setters and securities regulators is to provide investors and the capital markets with the information they need to make informed investment decisions in order to promote efficient allocation of capital across the economy. Both missions are critical to the operation of a sound financial system and healthy economy. The work of bank regulators, securities regulators, and accounting standard setters can be very challenging, all the more so during a major financial crisis.

During the crisis and, perhaps, even now there seemed to be some confusion in the media and elsewhere between the accounting standards used for financial reporting to investors and the capital markets and the regulation of financial institutions. For example, accounting standards do not prescribe or directly determine the levels of capital that banks are required to maintain; the bank regulators do. However, under the laws enacted by Congress in the wake of the S&L crisis, the determination of regulatory capital by the bank regulators starts with the U.S. GAAP numbers. The bank regulators have some discretion to make adjustments in computing regulatory capital, and they have other tools to address capital adequacy and safety and solvency issues of financial institutions. For example, it was the long-standing policy of bank regulators to exclude unrealized gains and losses included in other comprehensive income from the computation of regulatory capital.

Thus, the regulators have a natural interest in accounting standards; likewise, investors have an interest in both accounting standards and the impact of regulatory requirements and actions on the institutions in which they invest. In that regard, I publicly commended the U.S. bank regulators on the transparency they provided on the results of the “stress tests” of major U.S. bank holding companies in spring 2009. I believe it was well received by the markets and contributed to helping stabilize the financial system at a critical juncture. I would encourage this type of transparency by prudential regulators on an ongoing basis and applaud the efforts of the Federal Reserve to provide this under the annual Comprehensive Capital Analysis and Review (CCAR) program for the largest U.S. bank holding companies.

It is important for accounting standard setters and prudential regulators to work together to share information and to try, whenever possible, to develop common solutions to reporting issues arising in the financial system, particularly in times of financial and economic stress because it helps minimize unnecessary differences between financial reporting and regulatory reporting and the additional costs to regulated institutions resulting from such differences. However, because of the differences in the roles and missions of accounting standard setters and prudential regulators, it is also important that both be able to conduct their work in an independent manner, without one being subordinated to the other. Thus, in my view, the regulators should not be handcuffed by accounting standards developed with a different purpose in mind nor should the needs and perspectives of the regulators drive accounting standards because to do so could degrade the financial information available to investors and reduce public confidence in the capital markets. Post the financial crisis, the bank regulators now have a much a greater ability to obtain information tailored to their needs from the banks they regulate. Moreover, through the stress testing and CCAR programs, the Recovery and Resolution Plans that larger financial institutions are required to develop, and other tools, the bank regulators now have the ability and authority to review and approve the levels of dividends, share buybacks and other capital actions of the institutions they regulate.

The importance of maintaining independently established accounting standards was tested in fall 2009 as the House of Representatives debated the financial services reform bill. Congressmen Perlmutter of Colorado and Lucas of Oklahoma planned to introduce an amendment that would have allowed the new Financial Stability Oversight Council (FSOC) to effectively override and modify accounting standards and reporting to investors and the capital markets to achieve bank regulatory and financial stability objectives. That possibility generated a quick, strong, and broad-based response against such a measure from the FAF trustees and others in the business, investor, and accounting communities such that it was modified to allow the FSOC to comment on financial accounting and reporting matters but not override or modify the standards. In the end, I believe that episode served to reinforce the importance of independent accounting standard setting. Certainly, when push came to shove, I felt very good about the level of support for that principle and for the need for sound financial reporting and transparency as important public policy goals.

Measuring Financial Instruments — Amortized Cost versus Fair Value

I think that the fact that it got to this point also evidenced the continuing controversy and debates over how to measure and report financial instruments. So, what are my thoughts on that important subject? Well, first, let me make it clear that I am neither a fair value zealot nor an ardent defender of amortized cost accounting for most financial instruments. At times, depending how I voted on a particular document, I was characterized in some of the business press as caving to the banks and their arguments against fair value; at other times, I was painted as a champion or strong advocate of mark-to-market accounting for everything. Neither characterization accurately captures my perspectives on what I view as a complex subject. So, I will expound a bit further both on the arguments for and against the use of amortized and fair value for financial instruments and on my views on this subject. As previously noted, the subject of measurement in accounting is a complex one and one on which informed and reasonable people can and do disagree. My own view is that there are pros and cons to both amortized cost and fair value, depending on the facts and circumstances, and as I will discuss shortly, I believe that other measurement attributes may be appropriate in certain circumstances. I think most people agree that fair value is the most appropriate measure of financial assets that are being traded or held for sale in the relatively near term, for financial liabilities that are part of a trading activity, and for derivatives. Most of the disagreement seems to focus on financial assets and financial liabilities with fixed principal amounts (i.e., debt securities and loans) that are being held for collection or payment of contractual cash flows. For example, banks and other financial institutions originate loans and, in some cases, debt instruments as part of their ongoing lending and financing activities and will often hold these for collection of cash flows rather than selling or securitizing them. Companies may invest part of their treasury activities in fixed income instruments and hold them for collection of cash flows. Similarly, most companies obtain loans and debt financing for their operations, making interest and principal payments over the life of the instruments and either cannot or do not intend to sell or otherwise transfer such obligations to third parties.

Some Arguments for Using Amortized Cost

In such circumstances, supporters of amortized cost believe it produces the most relevant and reliable reporting. They argue that showing a financial asset at what it could be sold for today is not relevant when the company does not intend to sell it and can result in unnecessary and misleading volatility and “noise” in reported results and financial position. Thus, for example, if a bank makes a 10-year $300,000 loan at, say, a five percent annual interest rate and expects to collect all the contractual cash flows on the loan over its life, it should carry the loan on its balance sheet at $300,000 despite any interim changes in the value of the loan due to changes in market interest rates and other market factors. It will report $15,000 of interest income each year and the loan at the $300,000 due at maturity. Only credit risk matters such that the carrying value of the loan should be reduced only to the extent it becomes impaired and is not expected to pay off in full.

Some also argue that, counter to the efficient market theory, markets are far from always being rational such that basing values on current market prices can lead to significant overstatement of underlying economic values of assets in times of irrational exuberance and significant understatement of the economic values of assets in times of financial crisis. Therefore, they assert and are concerned that reporting based on fair values can have significant procyclical effects that accentuate market bubbles and market downturns. They view the recognition of unrealized “paper” gains and losses as distorting reported income; stockholders’ equity; and other key metrics, such as leverage. They are also concerned that it can cause undesirable behavior by financial institutions, including in times of market run-ups to the payment of excess compensation to management and excess dividends and stock buybacks. Ultimately, they fear it could potentially cause banks to curtail making long-term fixed-rate loans and mortgages in an effort to avoid having to report volatile financial results arising from having to fair value their financial assets. When active markets do not exist for particular financial instruments, as was the case in the financial crisis for certain debt securities and is the case for many loans, coming up with fair values is highly subjective, difficult to audit, and costly, often requiring the involvement of valuation specialists. They also note the counterintuitive result of reporting gains on financial liabilities measured at fair value of financially distressed companies, as was the case with Lehman Brothers in the months leading up to its demise.

Some Arguments for Using Fair Value

On the other hand, supporters of using fair value to measure and report all financial instruments believe it produces the most relevant and useful reporting because it provides for a more consistent and comparable approach based on current market and economic conditions, not on past costs and prices. They point to a number of academic studies that support this view. They also believe that the measurement of financial instruments should not depend on a company’s intent or business model. Rather, they view fair value as the measure most consistent with the objective of financial reporting to provide information that is useful to predicting the amounts, timing, and uncertainty of future cash flows. Also, some believe that by showing the opportunity cost of not selling financial assets, fair value measures are better at holding managements accountable and, therefore, better accomplish the stewardship role of financial reporting. Amortized cost measurements, they believe, do not accomplish this because they are based on past transactions and do not reflect changing circumstances and opportunities.

They also believe fair value measurements incorporate and, therefore, better reflect the various risks that financial institutions face — credit risk, interest rate risk, and liquidity risk — than do amortized cost measurements that reflect only credit risk and then only management’s view of credit risk, which history has proven often lag and underestimate actual credit risks. In that regard, it is interesting to note that in the recent financial crisis, as was the case two decades earlier in the S&L crisis, many, if not most, of the hundreds of banks that failed reported positive net worth and regulatory capital just prior to their failure. That seemed due, in considerable measure, to the apparent overstatement of their capital resulting from the use of historical cost accounting methods and highly subjective, potentially biased and inadequate loan loss reserves as determined by banks’ managements. The 1991 GAO report on the S&L crisis, Failed Banks: Accounting and Auditing Reforms Urgently Needed, stated

Accounting rules are flawed in that they allow bank management considerable latitude in determining carrying amounts for problem loans and repossessed collateral. Recognizing decreases from historical cost to market value has an adverse effect on a bank’s reported financial condition. This gives bank management an incentive to use the latitude in accounting rules to delay loss recognition as long as possible.

Also, because fair value reflects the effect of all risks inherent in financial instruments, some proponents of fair value believe that broadening its use would promote better risk management practices by financial institutions.

So, Who Is Right?

I could further elaborate on the arguments asserted on either side of this debate, but who’s right? To some degree, I think they are both right. There are pros and cons to both amortized cost accounting and fair value measurements and reporting, many of which I believe were in evidence during the financial crisis. I have been involved in the accounting and auditing of financial instruments financial reporting by financial institutions most of my career and have seen a variety of issues and problems depending on particular instruments and economic and market conditions. During the financial crisis of 2007–2009, it seemed to me that amortized cost measures of financial assets with impairments based on management estimates generally lagged market prices in reflecting the growing breadth and severity of the crisis. The other-than-temporary threshold also, in my view, resulted in delays in recognizing impairments of investments in debt and equity securities. However, once the credit markets started to freeze, it also seemed to me that the fair values based on exit prices of certain financial assets may have overstated the extent of impairment. In any event, starting in 2008 and continuing into 2009, the lack of ready price discovery for many asset-backed securities, coupled with the sheer complexity of instruments such as investments in collateralized debt obligations (CDOs) and CDOs squared and derivatives tied to these assets, as well uncertainty about the magnitude of the contagion effects and in regard to the effect of government actions and policies during the crisis, made valuation of many financial assets very challenging in terms of determining fair values and the extent of impairments under amortized cost accounting.

The real questions for standard setters are, “What set(s) of information will be most useful to investors in understanding the performance, financial condition, and risks and opportunities of reporting enterprises and be capable of being provided by companies at a reasonable cost and effort? In a crisis, should the required or allowable measurement approaches change, or are additional or special disclosures needed?” It is also important to understand the inherent limitations of the information that can captured by any accounting model that deals with single-point, point in time measurements and the limitations of the information that can be reasonably provided in financial reports regarding the often complex and dynamic nature of the risks faced by major financial institutions, particularly during a financial crisis.³²

During the crisis, both the FASB and the IASB made certain targeted changes in the accounting standards relating to specific types of financial instruments and added a variety of new disclosures requirements. In our November 2009 MoU update with the IASB,³³ we agreed on a number of principles to guide our broader work on accounting for financial instruments. The fourth of those principles stated, “For financial instruments with principal amounts that are held for collection or payment of contractual cash flows rather than for sale or settlement with a third party, information about amortized cost and fair value is relevant to investors.” That statement was agnostic and left open how to present the information on amortized cost and fair value. It could be done, consistent with current requirements, by using amortized cost in the financial statements and disclosing fair values either parenthetically on the face of the balance sheet or in the footnotes, or vice versa. It could also be done by incorporating both amortized cost and fair value measurements in the financial statements, which was the approach proposed in our May 2010 proposed ASU.³⁴ It might be done by providing two sets of financial statements: one on an amortized cost basis and another using fair values, which is what some parties have recommended from time to time. Each of these alternatives has pros and cons and potentially different costs and benefits.

Another Alternative

Those who closely follow the deliberations of the FASB will know that I actually favored using a present value of cash flows approach (i.e., projected cash flows discounted at current interest rates) to measure the value of assets and liabilities with contractual principal amounts that are being held for cash collection or payment, with the interest income or expense on such instruments being reported in net income, but with other changes in the present values of these instruments being reported in other comprehensive income, not in net income or earnings. Under this approach, floating rate loans and debt securities and floating rate liabilities would generally continue to be reported at their principal amounts, but the carrying value of fixed-rate loans and debt securities being held for collection of cash flows and fixed rate borrowings would change as market interest rates change, but those changes would not be included in reported earnings or earnings per share.

To me, at a conceptual level, both amortized cost and fair value, although providing important information, miss the mark in terms of measuring the value of financial assets and financial liabilities that are being held for collection or payment of contractual cash flows.

In my view, in reporting the financial condition of an entity or as between entities amortized cost fails to properly distinguish between different instruments with different cash flows. For example, consider the following four high credit-quality loans that are being held for collection of contractual cash flows: loan A with $100 principal due in 15 years and annual interest of $4; loan B, a 30-year loan that was originated 21 years ago at the then prevailing interest rate, with $100 principal due in nine years and eight percent annual interest; loan C with $100 principal due in six years and five percent annual interest; and loan D, a variable rate loan with $100 due in three years. The total cash to be collected on each of these loans is quite different: $160 for loan A, $172 for loan B, $130 for loan C, and say $112 for loan D based on the current three-year yield curve. The discounted present values of each of these loans based on current rates is also quite different: approximately $90 for loan A, $125 for loan B, $103 for loan C, and $100 for loan D. Under amortized cost accounting, all four loans are measured and reported at $100, the amount of the principal, even though the four loans are very different in terms of interest rates, total cash flows, present values, term, and duration because under amortized cost accounting for these loans, contractual cash flows are discounted at the contractual interest rates of each loan (i.e., for loan A, the cash flows are discounted at four percent; for loan B, they are discounted at eight percent; and so on). Now, it is also important to note that whether one uses amortized cost or fair value or discounted cash flows to measure the loans, the two financial statements that are intended to present period flows, namely the income statement and statement of cash flows, will properly reflect the actual interest income and cash income received on each loan (i.e., $4 for loan A, $8 for loan B, and so on). That’s good and properly reflects the differences in interest income and cash flows for each of the loans, but the balance sheet, which is supposed to be a statement of financial condition, does not reflect the fact that each of these loans is very different. It shows them all at $100. To critics of amortized cost, this seems to violate basic principles of finance and economics.

To the supporters of fair value, the preceding suggests that fair value is the remedy for this problem. In my view, fair value, which represents the amounts each of the loans could be sold for today, can sometimes overcorrect for the problems inherent in amortized cost measurements. To illustrate this, consider the following example that contrasts a 15-year high credit-quality marketable debt security with principal of $100 and annual interest of $4 with the preceding loan A. The timing and amounts of contractual cash flows on both instruments are the same and both are high credit quality, but the fair value of the debt security is likely to be a bit higher than the fair value of the loan, reflecting the fact that the debt security is marketable and can be easily sold in the market, whereas the loan is illiquid and cannot be easily sold. The fair value of the debt security may also be affected by other factors and forces in the market. The key question is whether those differences should matter in valuing the two instruments if both are being held for collection of contractual cash flows. At a conceptual level, I think not because the amounts and timing of cash flows that will be derived from holding both instruments is expected to be the same.

When we also consider the liabilities that fund interest rate-bearing assets held for collection of contractual cash flows, I think further useful information can be derived from using discounted cash flows versus amortized costs. For example, consider the following two hypothetical cases involving the funding of the preceding loan A. First, assume loan A is funded with a fixed-rate borrowing with principal of $100 due in 15 years and requiring annual interest payments of three percent. In other words, the bank has “matched funded” loan A with a borrowing of the same amount and with the same maturity, effectively locking in a spread of one percent per annum for the next 15 years. Each year for the next 15 years, the bank will report $4 of interest income, $3 of interest expense, and net interest income (NII) of $1 under both the discounted cash flow approach and amortized cost. However, the discounted cash flow approach to valuing both loan A and the borrowing will also reveal the value (i.e., the present value) of the locked-in spread, whereas using amortized cost does not capture this. Now, let’s assume that loan A is funded with a three-year certificate of deposit bearing two percent annual interest. The bank’s current NII is now two percent, but that is only locked in for the next three years. After that, the bank will need to find new funding for the remaining 12 years it will holding loan A (i.e., the bank has a duration mismatch between its asset and the liability funding that asset). It is therefore exposed to interest rate risk, and if interest rates have risen three years from now, it will report a lower and potentially negative NII going forward. Under amortized cost accounting, the balance sheet of the bank looks the same in both cases, with loan A and the funding relating to loan A both shown at $100. However, using discounted cash flows to measure loan A and the funding reflects the differences in the present values of the future cash flows between the two situations and can help reveal the difference in the sustainability of the current NII and the differences in the exposures to interest rate risk between the two situations.

The preceding examples are very simple ones, and in the real world, financial institutions may have a myriad of loans and debt securities they are holding for cash collection and that are funded in various ways. I think that real-world complication only makes the arguments even more compelling for measuring the value of such financial assets and liabilities using a common yardstick of discounted cash flows. In my view, discounted cash flows provide a common yardstick without introducing some of the conceptual issues and practical challenges associated with developing fair value exit prices for illiquid instruments that are not being traded or held for sale.

Supporters of fair value note that its use would also help reveal duration mismatches and exposures to interest rate risk. Moreover, they believe that fair value provides a better a common yardstick for measuring financial instruments because it captures all the attributes of a financial instrument, including its liquidity and the impact of other current market factors on its value. They also believe that in valuing a financial instrument, it should not matter what a company plans to do with it or what its business model is, noting these can and sometimes do change (e.g., in response to liquidity needs or changes in market conditions). They are concerned that allowing the use of anything short of fair value or mark-to-market for financial assets can result in “mark-to-make-believe accounting.” (Although it seems that even a requirement to carry particular financial assets at fair value does not always result in such accounting, as suggested in the August 4, 2011, letter from Chairman of the IASB Hans Hoogervorst to the European Securities and Markets Authority regarding the apparent accounting, counter to the requirements of IFRSs, by certain major European financial institutions for holdings of distressed sovereign debt, including Greek government bonds, classified as available for sale at values in excess of prevailing market prices.)

In any event, the potential use of discounted cash flows to measure the current value of financial assets and liabilities an entity intends to hold for collection of cash flows is discussed in paragraphs BC61–BC68 of the proposed ASU.³⁵ For the reasons stated in paragraphs BC66–BC67 and based on feedback from a majority of constituents that current value was not sufficiently defined, the Board decided not to pursue trying to further develop that approach.

BC66. The Board obtained feedback from users, preparers, auditors, and others about the potential operationality and usefulness of a current value measurement method. Although there was some support for current value, a majority of the input received was that current value was not sufficiently defined, resulting in wide-spread confusion about what it was meant to represent. Overall, there was little support for its use as an alternative to either fair value or amortized cost.

BC67. The Board believes that to implement current value measurement, it would need to develop a robust definition for consistent application, similar to the exercise undertaken in defining fair value in Topic 820. The Board decided not to undertake a project to further define current value because of the perceived limited usefulness of current value as an alternate to fair value or amortized cost. Therefore, the Board decided that it would consider only amortized cost as a potential alternative to fair value measurement for financial instruments.

In other words, I was unable to persuade my fellow Board members of the merits of doing so, although, as previously noted, there was some support among constituents for that kind of approach. As I quipped in public Board meetings when this subject was discussed, “I don’t seem to be selling many tickets for this approach.” So, reflecting on that input and the very extensive feedback received on the proposed ASU,³⁶ the FASB continued to focus on fair value and amortized cost as the principal measurement approaches in accounting for financial instruments, trying to delineate the circumstances under which different accounting methods should apply.

And, as discussed in Chapter 4 on international convergence for a number of years the FASB and the IASB had been working together to try to develop a common approach for classifying and measuring financial instruments that incorporates both amortized cost and fair value measurements depending on the type of financial instrument and a company’s business models. In recent years, the two boards parted ways on the joint effort, with each board developing and issuing new standards that continue the use of a mix of amortized cost and fair value in accounting for financial instruments. In January 2016 the FASB issued Accounting Standards Update (ASU) No. 2016-01, Financial Instruments — Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. It retains the mixed attribute approach to measuring financial assets and liabilities, with some targeted changes in U.S. GAAP, including requiring equity investments (except those accounted for under the equity method or that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income, requiring separate presentation of financial assets and financial liabilities by measurement category on the balance sheet or in the notes to the financial statements, requiring separate presentation in other comprehensive income of the portion of the total change in the fair value of a liability resulting from the change in the instrument-specific credit risk (“own credit risk”) when the reporting entity has elected to measure the liability at fair value under the permitted fair value option for financial instruments, and eliminating certain existing disclosure requirements.

ASU No. 2016-01 represented the culmination of almost a decade of work by the FASB on this subject, initially with the IASB and then separately. During this period, the FASB issued a discussion paper in 2008, and exposure draft in 2010, a revised exposure draft in 2013, held various public roundtables with and without the IASB, discussed the issues at meetings of the FCAG in 2009, and discussed this topic at scores of public board meetings. As noted above, the result of all this work was a number of targeted changes to the existing requirements.

The ASU passed by a four-to-three vote of the FASB. I encourage those interested in this subject to read the Background Information and Basis for Conclusions section of ASU No. 2016-01 which discusses in detail the course of the project, the many issues the FASB addressed, stakeholder input received, and the majority Board members’ bases for concluding as they did on particular issues. I would also encourage reading the lengthy and strongly worded dissents of the three Board members (Tom Linsmeier, Marc Siegel, and Hal Schroeder) explaining their reasons for voting against the issuance of ASU No. 2016-01, including the retention of the mixed attribute model (vs., e.g., measuring all or most financial instruments at fair value) which, in their view, neither improves the decision usefulness of reported information about financial assets and financial liabilities nor reduces the complexity in accounting for financial instruments, two of the key original objectives of the project. And, as they also note, it fails to achieve convergence on this important subject between U.S. GAAP and IFRS.

The day the FASB issued ASU No. 2016-01 I was called by a reporter for my views on the new standard, in particular whether I would have voted for it to be issued. I decided not to provide the reporter with any comments. On the one hand, in reading the dissents, I found myself agreeing with a number of the views expressed by the three FASB board members that voted against issuing the new standard. And overall, I have some sympathy with the view expressed by Tom Linsmeier and Marc Siegel in their dissent that the outcome of the project represented a “lost opportunity” when viewed against the three key desired objectives of (1) improving the decision usefulness of reported information on financial instruments, (2) reducing the complexity of the accounting in this area, and (3) achieving convergence between U.S. GAAP and IFRS, that we had established at the outset of the project. On the other hand, as I did not participate in the Board’s discussions on this project for the last five plus years and have not had the benefit of all the input they received, I do not know how all that might have affected my thinking. Nonetheless, and as discussed below, I do feel that, notwithstanding all the work and discussion on this subject, the fact that there are still strongly divided views evidences, at least in part, a continuing need to address and to better “wrestle to ground” a number of fundamental conceptual issues.

The FASB and IASB had also been working together, with the help of experts, to develop better approaches to accounting for credit impairments of loans and debt securities than the incurred loss model under which such impairments are not recorded until they become probable. Pointing to the financial crisis, critics of the incurred loss approach maintain it had procyclical effects by inappropriately forcing banks and other financial institutions to delay recognizing expected credit losses and to not being able to build a proper level of reserves in the “good years” as a buffer against the losses they suffered when the crisis occurred. The boards, initially working together, but then separately, developed approaches to accounting for impairments of loans and debt securities that would result in earlier recognition of expected credit losses, with some important differences in the approaches by each board.

And they have developed somewhat different approaches to hedge accounting. In November 2013 the IASB amended its requirements relating to hedge accounting.³⁷ These no longer require that a hedging relationship be highly effective to qualify for hedge accounting, only that there be an “economic relationship” between the hedging instrument and the hedged item and that the relationship not be dominated by credit risk. This broadened the realm of instruments and techniques that may qualify for hedge accounting. The amended rules also permit greater flexibility to apply hedge accounting to a specified risk within a hedged item as long as that risk is separately identifiable and measureable. However, the IASB rules continue to limit hedge accounting treatment to the effective portion of a hedging relationship, with any ineffectiveness having to be immediately recorded in net income.

For its part, the FASB plans to issue an exposure draft in the second quarter of 2016 proposing a number of changes to the U.S. GAAP rules on hedge accounting. While these would retain the highly effective threshold for a hedging relationship to qualify for hedge accounting, both the effective and ineffective portions would receive hedge accounting treatment. The proposed new rules would allow companies to apply hedge accounting to an identified risk within a hedged item, but only where that risk is contractually specified.

The Financial Crisis

Accounting Did Not Cause the Financial Crisis, and Accounting Will Not End It

Were There Warning Signs?

The Addiction to Off-Balance Sheet Accounting

Off-Balance Accounting 101

Did They Qualify?

SIVs, Conduits, and Other VIEs

The Lehman Repo 105 and 108 Transactions

Fair Value, Mark-to-Market Accounting, and Impairment of Financial Assets

Some History

Then Came the Crisis

The Year 2008 Draws to a Close

Into 2009 — Congress Weighs In

Our Response

The World Goes On, But It’s Not the Same

Some Lessons Learned

Measuring Financial Instruments — Amortized Cost versus Fair Value

Some Arguments for Using Amortized Cost

Some Arguments for Using Fair Value

So, Who Is Right?

Another Alternative

Continuing Conceptual Challenges