In the arcane world of accounting standards, "short and simple" should be a virtue. Instead, it has opened the door for some vice.
There's little doubt the accounting standards need to be simplified. Even the most honest of bean counters are tripped up by the more than 10,000 pages of technical regulations governing the current system, which some argue inhibits
U.S. competitiveness in the global marketplace. Frustrated by the complexity and cost of following the rules, executives are pushing for standards that lay out basic principles. But as a recent example shows, a principles-based approach, which leaves lots of room for interpretation, has its own challenges. Back in February, rulemakers put out a new, simpler standard for valuing financial instruments, known as FAS 159. Yet some companies may have seen it as a free pass to off-load money-losing securities without taking a hit to earnings. Now regulators are crying foul.
For years, financial institutions have essentially priced many of the assets and liabilities on their books at the original cost instead of the current, or "fair," value. The goal of FAS 159 is to count more of those items at fair value. Companies that made the switch before the end of April had a one-shot opportunity to mark down securities without affecting earnings. More than 60 companies quickly adopted the standard.
The Securities & Exchange Commission is worried that some companies may have done so selectively to hide losses in their portfolio. What's raising red flags? For one, several securities dealers in March pitched FAS 159 as a way to dump underwater assets without hurting profits. One marketing letter from FTN Financial, entitled "The FAS 159 Mulligan," referring to the term in golf for a do-over on a flubbed shot, asserted that such a move "isn't necessarily within the spirit" of the rules but technically is O.K. These activities "are disappointing to me, my staff, and the commission," says Conrad Hewitt, chief accountant at the SEC. FTN portfolio strategist Mike Heflin stands by the piece, but he faults the SEC for not being clear about its views from the start.
Certainly, executives aiming to defraud investors will do so even when rules are black and white. But when standards are gray, as in principles-based accounting, it's not always apparent who's applying reasonable judgment and who's gaming the system. So companies push for clarity from regulators, who in turn are reluctant to give additional interpretations; after all, extra details fight the goal of simplicity. Although no companies have been accused of wrongdoing in the case of FAS 159, the SEC is forcing some to justify the changes and in some cases unwind them.
The standard lured Seacoast Banking Corp. of Florida (SBCF) into a financial reporting fiasco. Under FAS 159, Seacoast didn't need to report $3.7 million in losses related to some mortgage-backed securities it sold. But with the SEC leaning on others, Seacoast felt it was on shaky ground and reversed the decision. As a result, it retracted its initial earnings announcement, which showed a 9.6% quarterly gain over the previous year, and reported a 52.8% drop instead. Five other firms--CIT Group, Colonial BancGroup (CNB), First United (FUNC), Frontier Financial, and Leesport Financial (FLPB)--have also retreated on FAS 159, citing new comments from auditors or the SEC. "It seemed straightforward, which is why we adopted it," says Seacoast Chief Financial Officer William R. Hahl. "The standard became unclear when the SEC got involved."
In contrast, Atlanta's SunTrust Banks Inc. (STI), is standing by its decision. By applying fair value to some of its assets and lia-bilities, SunTrust got a pass on $400 million in losses but also a 10 cents-a-share, or 7.5%, boost to earnings in the first quarter. Given all the controversy, SunTrust CFO Mark A. Chancy went out of his way during a conference call to defend the action: It "has a substantive business purpose and results in real change in our balance-sheet management strategies."
Finding the right balance between simple and specific will be a challenge for rulemakers as they move toward this approach. Ultimately it won't work unless all the players involved vigilantly promote the spirit of the standards. Says David Bianco, an analyst at UBS (UBS): "We've got to develop a strong culture of companies, auditors, investors, and the SEC calling foul when they see foul. With principles-based accounting comes responsibility."
By David Henry and Dawn Kopecki