The banks demanded that the accountants give them leeway in how they report losses to investors. The accountants responded by giving away their souls.
Last week, the Financial Accounting Standards Board (FASB) unveiled what may be the dumbest, most bankrupt proposal in its 36-year history. If it stands, the FASB ought to change its name to the Fraudulent Accounting Standards Board. It’s that bad.
Here’s what the board is floating. Starting this quarter, US companies would be allowed to report net-income figures that ignore severe, long-term price declines in securities they own. Not just debt securities, mind you, but even common stocks and other equities, too.
All a company would need to do is say it doesn’t intend to sell them and that it probably won’t have to. In most cases, it wouldn’t matter how much the value was down, or for how long. In effect, a company would have to admit being on its deathbed before the rules would force it to take hits to earnings.
So, if these rules had been in place last year, a company that still owned shares of American International Group Inc or Fannie Mae, for instance, could exclude those stocks’ price declines from net income entirely. It would make no difference that the companies were seized by the government last year, or that both are penny stocks. The loss would get buried away from the income statement, in a balance-sheet line called “accumulated other comprehensive income.”
Desperate bankers
These are the earnings we get when the people who write accounting standards give in to desperate bankers. And it’s no mystery why the three FASB members who voted for this — Leslie Seidman, Lawrence Smith and Chairman Robert Herz — did so.
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Since the credit crisis began, the board’s members have been under assault by the banking industry and its wholly-owned members of Congress. The most recent display came last week at a House Financial Services Committee hearing, where Democratic Representative Paul Kanjorski and other lawmakers beat Herz like a dog. A FASB spokeswoman, Chandy Smith, confirmed my understanding of how the rule change would work.
The banks want unfettered licence to value their assets however they see fit, and to keep burgeoning losses out of their earnings and regulatory capital. The FASB had been holding its ground, for the most part. Now, though, the board has assumed the foetal position.
Differing treatment
Under the current rules, securities get differing accounting treatments depending on how they are classified on the balance sheet. When labelled as trading securities, they must be assigned marked-to-market values each quarter, with all changes flowing through to net income. Otherwise, changes in value don’t hit the income statement, unless the securities have suffered what the accountants call an “other-than-temporary impairment.”
While the term may be cumbersome, the idea is that companies need to show losses in net income once they no longer can pretend that an asset’s plunge in value is only fleeting. Think of a man who gets sent to prison for 20 years. That’s not necessarily a permanent sentence. Yet it’s definitely not temporary.
The board’s proposal tosses the old principle aside. Even if a loss is deemed not temporary, companies still would be allowed to keep it out of net income. There’s one exception: If a company holding debt securities concludes some of the decline is due to credit losses, that portion would need to be included on the income statement. Otherwise, the losses stay off.
Debt holders will say their losses almost always are due to something other than credit losses, such as liquidity risk, because it’s impossible to prove their judgements wrong. So the dents to net income will be minimal. That’s exactly what the FASB is trying to accomplish.
Investor protection
There is something investors can do to protect themselves: Ignore net income and start focusing on the real bottom line, a term called comprehensive income, which is found on a company’s statement of shareholder equity. General Electric Co, for example, reported $17.4 billion of net income for 2008 —and a comprehensive loss of $12.8 billion.
For years, the FASB has used comprehensive income as a dumping ground for losses that it has decided are too politically radioactive to be included on the income statement. These include changes in the values of corporate pension plans, foreign currencies, certain derivative instruments, and securities classified as available for sale. That’s why investors should stop giving credence to net income.
They have done this already with Tier 1 capital, the government’s main solvency measure for banks, which ignores lots of losses and treats some types of debt as if they were assets. Nowadays, bank investors are obsessed with a no-frills capital benchmark called tangible common equity. This leaves out intangible assets which acts like debt and must be repaid before common stockholders can claim any share of a company’s assets.
What’s good for the balance sheet is also good for the income statement. Enough with the fluff. Net is dead. The FASB might be, too, if it keeps this up.