BDMP Newsletter

Vol. 3 No. 4

CONTROVERSIAL RULING ON HOLD

By: Janice D. Latulippe, CPA

The Financial Accounting Standards Board (FASB) delayed implementation of a controversial new rule on accounting for debt securities in September. Banking and investment industry leaders are hopeful that the delay and public comments will prompt FASB to modify the rule, Emergency Issues Task Force (EITF) Issue 03-1, which industry leaders fear could severely impact financial institutions’ risk-management processes regarding securities.

The controversy stems from interpretations of EITF 03-1 that several financial industry leaders say could amount to a fundamental change in the accounting for available-for-sale (AFS) securities. This change would consider sales of AFS securities at a price below cost as an establishment of a pattern that would make it very difficult for enterprises to purport that they have the intent to hold other securities in their AFS portfolio to recovery.

Investors typically manage their AFS portfolio without regard to recovery of market value as a condition for sale, according to a letter from representatives of the Bond Market Association to FASB. An AFS portfolio can easily consist of many thousands of individual securities and amount to many billions of dollars worth of high quality assets. As a result, most enterprises could not in good faith represent that they have the intent and ability to hold until the forecasted recovery period, and that is why they chose the AFS category, critics of the proposed rule say. Imposing held to maturity (HTM) criteria on AFS securities trading below cost would make the management of an AFS portfolio untenable, the Bond Market Association says.

The association urged FASB to modify the proposed regulation so that only investments that are significantly below cost for an extended period of time should be considered impaired. FASB postponed the implementation of the rule, and sought public comments through November 1.

For details, visit the FASB web site at: www.fasb.org, or contact Janice Latulippe at (207) 775-2387, or jlatulippe@bdmp.com.

ARE CURRENT ECONOMIC

CONDITIONS AFFECTING YOUR

PENSION FUND?

Low interest rates and a sluggish stock market are having an impact on the discount rate and expected long-term rate of return on investments earmarked for pensions and other post-employment benefit obligations (OPEB) for many companies. As a result, some companies may face under-funded pension and OPEB arrangements requiring them to recognize additional minimum liabilities and/or make additional contributions to pension funds.

The Securities and Exchange Commission (SEC) is scrutinizing this issue closely, according to a recent Business Week article. It seems the Commission is investigating how a number of companies calculated assumptions for their post-retirement benefits to determine whether they manipulated the bottom line. Companies typically use a discount rate based on high-grade corporate bonds to calculate their benefits liabilities, and with large pension plans, even small changes in the rate can amount to huge swings in calculations. Companies that set an unrealistically high discount rate to lower projected liabilities could also make the company’s balance sheet look better, generate accounting gains that increase income, and possibly boost executive compensation. An SEC official reportedly said such manipulations could be fraudulent.

The SEC does have guidelines for setting discount rate assumptions, though companies have some leeway. These assumptions should be compared to interest rates on high quality bonds — rated AA or higher — with maturity dates that roughly correspond with expected retirement dates of employees. Callable bonds should usually be excluded from this portfolio, as their effective interest rate will typically include a premium due to the call feature that allows bondholders to redeem bonds prior to maturity. When making assumptions on long-term rates of return on investments, companies should estimate the average long-term rate of earnings on investments earmarked for pensions and OPEBs. After the accelerated investment climate of the 1990s, many companies have had to adjust their assumptions to reflect the less favorable conditions of the past few years.

The SEC advises companies to back up their rate assumptions with hard evidence such as credible interest rate indices or setting up a portfolio of high quality instruments with maturities that match pension obligations. Simply using rates used by other companies or relying on in-house actuaries does not constitute acceptable evidence according to the SEC.

With the potential for abuse still present due to the leeway given companies in supporting their discount rate assumptions, some industry experts expect the SEC to tighten these rules. Although Statement of Financial Accounting Standards (SFAS) No. 132 implemented last year requires companies to disclose descriptions of investment strategies and targets, asset allocations, expected benefits payments going forward five years, and estimated cash contributions for the coming fiscal year, it is still too vague for some.

In an August 2004 CFO magazine article, a Goldman Sachs managing director says that the four categories in which assets must be grouped — equities, fixed income, real estate, and other — are too vague for analysts to adequately compare expected rates of return against market rates. For example, one category is real estate, but that leaves open the question of whether the investment is a REIT (real estate investment trust), or a property, or some other property-related investment. And there is no requirement to highlight certain areas that can be volatile investments such as hedge funds or high-yield bonds.

After the widely publicized accounting scandals of the past few years, it’s quite possible that regulators will continue to tighten reporting regulations regarding pensions and OPEBs. Accordingly, it’s a good time for companies to give this area close scrutiny if they haven’t already done so.

Please contact your BDMP Financial Services Industry advisor for more information or Janice Latulippe at (207) 775-2387, jlatulippe@bdmp.com.