Divided FASB Clears Final Staff Guidance On Impairment of Certain Debt Securities

By Steve Burkholder and Denise Lugo

NORWALK, Conn.—The Financial Accounting Standards Board Jan. 7 decided by a vote of 3-2 to issue final staff guidance on impairment accounting for certain debt securities that critics say could permit banks and other companies to avoid having to record losses on those investments in the fourth quarter.

The FASB hopes to issue a slightly revised version of the guidance — a FASB staff position (FSP) EITF 99-20-a, Amendments to the Impairment and Interest Income Measurement Guidance of EITF Issue No. 99-20—Jan. 9 or Jan. 12, a FASB spokesman told BNA.

The guidance would take effect immediately for interim and annual financial periods ending after Dec. 15, 2008, but the board voted specifically Jan. 7 to prohibit retrospective application. The FASB had agreed during a Dec. 15 meeting to fast-track guidance on the topic, partially in response to requests from the Securities and Exchange Commission (See related article in this issue on the Dec. 15 meeting). FASB proposed the FSP Dec. 19, with a Dec. 30 comment deadline.

FASB board members Thomas Linsmeier and Marc Siegel voted against issuing the guidance, raising due process concerns as well as citing widespread investor community opposition to the proposed guidance. They plan to dissent in the published FSP, an unusual step for such staff guidance. At the Jan. 7 meeting, Linsmeier reiterated a concern he has raised repeatedly recently: that tough economic times increase pressure to permit companies to delay or hide losses, and the FASB ought not to bow to such pressures.

In contrast, FASB Chairman Robert Herz, and member Leslie Seidman cited benefits of the fast-track guidance—such as bringing more consistency to accounting for impairment of financial assets.

Herz and Seidman, together with FASB member Lawrence Smith, who all voted in favor of the plan, suggested the guidance is timely during the current financial turmoil.

Relatively Narrow Scope; ‘No Amnesty.'

The FSP would address application of impairment guidance in EITF Issue 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets, by making that guidance consistent with Statement of Financial Accounting Standard 115, Accounting for Certain Investments in Debt and Equity Securities.

The FASB staff guidance was requested by the staff of the Securities and Exchange Commission, which received letters from U.S. bankers seeking changes or interpretations of current guidance on impairment accounting.

The relatively narrow scope of the FSP includes interest-only strips and other beneficial interests accounted for as debt securities.

The specific securities at issue are not reported on a fair value basis, unless they are determined to be other-than-temporarily impaired. A finding of other-than-temporary impairment (OTTI) triggers marking the values of the securities or beneficial interests to fair value, with losses recorded in earnings.

As emphasized by Herz and others, the narrowly scoped guidance on the instruments addressed in the EITF issue will also seek to make clear general principles lying behind proper application of impairment guidance. FASB also sought to emphasize what Herz and board member Leslie Seidman called important footnote disclosure requirements, such as those that call for explanations of nonimpairment conclusions in particular situations.

“I don't think this represents amnesty on other-than-temporary impairment in the fourth quarter,” Seidman said, arguing in support of the “modest clarification” represented by the planned guidance.

“It still requires an assessment of the collectability of cash flows and under the modest change that I would propose we make, it would still require on some securities that are not expected to perform in the future that an impairment be recognized in earnings,” she added.

By contrast, Linsmeier argued that the issues raised by pursuing the topic would be better addressed in the “expedited,” more general project on simplifying and improving reporting of financial instruments. FASB added that agenda project, to be carried out with the International Accounting Standards Board, during its Dec. 15 meeting.

“The vast majority of investors do not prefer this change,” said Linsmeier, making a point that was generally echoed by Siegel. However, Herz rebutted that point, citing input from security analysts “who actually manage money” and who “are not the same ones who write us letters.”

Linsmeier argued, “The OTTI model is consistent with investors' views of the values of assets of companies, as indicated by the majority of banks' stocks being traded below tangible book value,” he said, referring to recent market research.

“Therefore, I believe this change is a movement in the wrong direction,” he added. Linsmeier also said he doubted the revised guidance “can be implemented well”; that FASB was “hurrying to get this done so that preliminary earnings released this week can follow this guidance”; and that the change “will simply allow the deferral of losses for many, many financial institutions and insurance companies.”

In response, Herz said, “I think there's a beneficial aspect to doing this.” He cited his concern about “the broader population” of securities accounted for under FAS 115 and for which “impairments weren't going to be recognized.”

“That's probably a bigger population,” Herz added.

Performing Assets May Be Impaired

FASB Chairman Robert Herz, who cast the deciding fifth vote on the main question Jan. 7, emphasized that a statement of principles on impairment accounting will be included in the final guidance, including a reference to SEC Staff Accounting Bulletin Topic 5M on impairment, from which Herz quoted at length. Herz, Seidman and Smith observed that some companies are misapplying impairment existing accounting rules by labeling instruments “performing” if cash-flow is as expected.

Underscoring that assets that are performing currently may still be impaired, the board agreed to emphasize that view in the revised final FSP. FASB members said staff will include an explanation that entities should look to a range of accounting literature and all available information in gauging whether an adverse change in estimated cash flows has occurred. Such a change warrants a recognized impairment.

Companies should not view the new guidance “as a license to not recognize impairment in the fourth quarter,” FASB member Leslie Seidman told BNA in a brief interview after the meeting. Seidman added that enterprises “might well” record an impairment of assets under the revised guidance.

Transition: No Retrospective Application

On the issue of transition, the board voted Jan. 7 to prohibit retrospective application. That means that companies can not reverse other-than-temporary impairments reported in previous periods under FAS 115.

Under current accounting rules, an other-than-temporary impairment of financial assets requires write-downs to fair value, with losses recorded in the income statement.

The American Bankers Association, in a comment letter to FASB on the proposal Dec. 28, said that the application of guidance on other-than-temporary impairment in a “a dysfunctional market” has resulted in “an overstatement of impairment” of financial assets.

FASB received over 300 comment letters on the proposal, many of which seemed to be form letters drafted by the ABA, Linsmeier observed.

ITAC Concerns

The day before FASB's meeting, members of FASB's Investors Technical Advisory Committee raised concerns about both the content and due process involved in the proposed staff position, and warned that the revised impairment guidance would be detrimental to investors.

Speaking on behalf of the ITAC, Jack Ciesielski, president of R.G. Associates Inc., said the advisory group was troubled by the timing of the proposal and the very brief due process, “although we do appreciate that a due process was given.”

ITAC, which also filed a comment letter on the proposal, said the application of the Statement 115 model to securities and retained interests within the scope of EITF 99-20 would result in the delayed recognition of losses and less investor-useful information.

Citing its Dec. 30 comment letter, Ciesielski reiterated the group's general concern that the current market environment induces companies to promote new ways to avoid reporting known losses and thereby bolster their capitalization.

Further, the group believes the proposed FSP was an indication of long-standing problems with inconsistent impairment guidance produced by FAS 115 and its entire mixed-attribute foundation. Amending EITF 99-20 would diminish the quality of financial reporting by further gravitating away from fair value, the ITAC argued.