The European Commission’s Green Paper on auditing represents an important opportunity to enhance the role of the statutory auditor.

Stimulate Telecom Audit Services in Europe towards the highest quality and best standards in the world. European auditors have always pursued this aim of excellence, and will continue to do so in the future. FEE has affirmed this to the Commission on behalf of its 34 member institutes in 22 European countries; it has therefore welcomed the Commission’s initiative and will work with the Commission to help it succeed.

The Commission’s task is to complete the single market. It wants an efficient market, effective allocation of capital and European companies able to compete strongly in world trade. It sees transparent financial reporting and sound control by directors as powerful tools for this purpose. It sees that statutory audit provides pressure to use these tools well, so it wants the conduct and reporting of audits in Europe to converge and auditors to have the freedom to practise within Europe. The focus of the initiative is to remove barriers to the single market, leaving only restrictions that are needed to protect the public interest in audit. But, of course, convergence is not enough. The single market looks for the highest quality at a fair, competitive price. Quality must be maintained and enhanced. The mutuality of interest in quality between government, companies and auditors is clear.

The Commission therefore commissioned a study to identify barriers to auditing services in Europe. By doing so, it attracted submissions from others, including FEE. These inputs enabled the Commission to issue its Green Paper.

FEE has now submitted its response to the Commission. In doing so, it was speaking with the authority of the European accounting profession - it has worked with a core team from major institutes, supported by working parties of over 50 national representatives, for the last 18 months to bring together our profession’s view.

The team concludes that the public interest will be best served if the profession continues to manage its affairs within a general legal framework.

The law should require statutory audits, but leave the detail of how audits should be accomplished to the professionals. A remarkably high convergence of audit methodology, reporting and quality control has already been achieved.

Generally, national requirements reflect those in place elsewhere in Europe and the world. Going forward, adapting to rapidly changing business conditions and meeting the reasonable expectations of knowledgeable people requires flexibility exercised by a responsible profession accountable for its actions.

Two examples show how this has worked up until now. Twenty years ago, Europe’s auditors recognized that auditing and ethical standards agreed internationally were needed. Their representatives therefore took a large part in developing International Standards on Auditing. Since they helped to draft them, it was easy for FEE members to agree to apply these standards nationally. One of the Commission’s important concerns is for audit reports in each country to say and mean the same thing. This is covered by ISA 700 and progress in implementing it in Europe has gone a long way to meeting the concern. FEE believes that the course charted two decades ago continues to be the best route to today’s single market objectives.

Having standards is one thing. Enforcing them and demonstrating to the public that they are enforced is another. Corporate financial failures have focused the mind. Even if the causes of failure have nothing to do with the audit, the public is justified in wishing to know that audit safeguards are properly in place. Most European countries have therefore established quality control structures in recent years. The inter-relationship of the profession and public authority varies according to each country and its juridical background, but it remains the profession’s task to make the structures work and be seen to work. Giving confidence in quality control requires unceasing vigilance, and FEE’s members are considering how this might be raised to the Europe-wide level, with due regard to ’subsidiarity’.

These comments imply that the work of the Commission and of FEE and others so far has revealed few barriers and few impediments to the quality of audit likely to require legislation at the European level. FEE thinks this is so. European intervention may be needed to give group auditors access to information held abroad by affiliated entities, but this was the only clear example. Obviously, there is work to be done by both the legislator and the profession to achieve proper convergence at the national level. But this may best be achieved by encouragement. ‘Stimulate’ is the right word. By examining the auditor’s role and suggesting that legislative pressure could possibly follow, the Commission has succeeded in provoking reflection and action. We may hope that the action will be common action.

At the national level there is much to be done. The legislator has to define what each person engaged in business is required to do, and the reporting or other conditions under which he or she should do it. Legislation is needed mainly to clarify responsibilities and to undo inappropriate legislation in the past. From the auditors’ viewpoint, this relates mainly to putting them into a position where they can meet the public’s proper expectations, either by setting out the area of expectation - for example reporting on fraud or going concern - or by making progress on auditors’ exposure to liability.

This becomes more and more important as auditors’ new responsibilities move further from historic fact towards judgmental or future-based information.

Once the question of ‘what to do’ has been clarified by the legislator, the task of the profession - not the public authority - should be to decide ‘how to’ accomplish the task and demonstrate that it has been completed.

FEE sees the Commission’s audit initiative as an important opportunity to clarify and enhance the statutory auditor’s role. The public interest - that is to say the whole array of mutual interests involved in developing a single market in which everybody is an economic winner - makes the task immensely worthwhile. FEE and its members have every intention of working together to make the initiative a success. The shoulder is already to the wheel.

An accounting proposal that bankers feel could significantly dampen the future earnings of merged companies (See FMR 4/12/99, p.1) may, practically speaking, not be so bad after all.

The Financial Accounting Standards Board’s business combinations project is currently on path to limit the life of goodwill–the premium paid in an acquisition–to 10 years and not more than 20 under certain circumstances. Currently, the limit is 40 years for most companies and 25 years for banks, which means the goodwill would have to be amortized in most cases in less than half the time period, significantly increasing the hit to earnings and making the mergers appear less attractive for investors.

Investors, however, may not care about goodwill, after all. The first official sign of that arose last week when First Call Corp., which forecasts companies’ earnings, said it would emphasize earnings without goodwill adjustments for five high-tech companies and may do so for 15 more. Called “cash EPS,” the new number reflects technology analysts’ priorities, said Chuck Hill, director of research at First Call. He added that the number will be extended to other industries if there is investor demand.

Robert Willens, managing director and accounting expert at Lehman Brothers, said he thinks that is a likely outcome. “I don’t think there would be much opposition to it. Everybody wants to see higher earnings,” he said.

Practically speaking, Willens noted, a shift in investors’ priorities toward cash EPS would largely limit the relevance goodwill information to 10Ks and 10Qs, and leave earnings per share untouched. “You know that this is going to happen in the banking arena, where analysts are very attuned to this kind of thing.”

The Financial Accounting Standards Board’s recently released technical plan reveals expectations of a heady year remaining, with a slew of exposure drafts and final drafts of proposals slated to be released. The following proposals and their status are listed according to their relevance to banks.

Business Combinations–Banks and other financial institutions appear to be those most opposed to FASB’s efforts to simplify and harmonize accounting for mergers and acquisitions. The board will be addressing the issue of when it is appropriate to use the pooling and purchase methods of accounting next week (See story on p.1). An exposure draft is anticipated in the third quarter.

Financial Instruments–The grand project to develop a standard to account for all financial instruments at fair value is still viewed as some way off, but bankers will have a chance to comment on the board’s early deliberations later this year. A document providing preliminary views is expected to be released for comment in the fourth quarter.

FAS 125 Amendment–Of most interest to credit card issuers, although also affecting repurchase agreements which banks use for funding, the proposed amendment to recently released FAS 125, accounting for transfers of assets, is expected to be released for comment in June.

Interpretation 25–Fine tuning the accounting for stock compensation, an exposure draft of the proposal was released for public comment March 31.

Consolidation–Dealing with the issue of control of affiliate companies, the longstanding and controversial proposal was recently issued in exposure draft form–comments due May 24–and is scheduled to come out as a final standard in the fourth quarter.

Asset Impairment and Disposal Issueso Addressing the accounting for the impairment and disposal of assets including bank branches, the proposal is now anticipated in exposure-draft form in the fourth quarter, bumped back a quarter from previous expectations.

Disclosure requirements related to a new law affecting consumers’ options to cancel private mortgage insurance under Regulation Z, or Trust-In-Lending (TILA) laws, were tightened and clarified last week when the Federal Reserve Board staff issued new commentary.

The new staff commentary also increases the tolerance level for loans to qualify for the special rules dealing with high yield credits. Other issues touched on include treatment of combined credit/debit or credit/stored value cards, and required periodic disclosures for open-end credit.

The changes to Reg Z were prompted by the new homeowners protection law, which was passed by Congress last year. It allows borrowers to cancel private mortgage insurance (PMI) under some circumstances and requires lenders to terminate PMI automatically when other conditions are met.

The new staff commentary explains that the cost of PMI must be reflected in the payment schedule disclosure through the time of automatic termination under the new law, or other applicable law, and no further. The new commentary also makes clear that any assumptions required to be made in order to calculate the time of automatic termination for adjustable-rate mortgages should be made consistently with assumptions made for other TILA purposes, according to an industry lawyer.

In another provision dealing with mortgage practices, the commentary establishes new tolerances for the points-and-fees test for loans qualifying as "high-yield." The new figures reflect cost-of-living adjustments, and require that loans with associated points and fees which are the greater of $441, or 8% of the total loan amount, are subject to high-yield disclosure provisions.

The new commentary also notes that in making disclosures for open-end credit, prior-cycle finance charge adjustments can be calculated into the annual percentage rate (APR) for the subsequent period, or they can be disclosed as a separate item and not included in the calculation of the APR for the subsequent period.

Regarding combined credit/debit or credit/stored-value cards, the new commentary expands the definition of credit card to include cards with both credit and non-credit features. The lawyer said that issuance of a card with credit features at the time of issuance, even if such a card also has noncredit features, may not be unsolicited.

On the other hand, the lawyer said, issuance of a card with non-credit features that the consumer later activates as a credit card may be unsolicited.

The fate of the pooling method of accounting, the favored approach in the mergers of banks using their high stock prices as acquisition currency, will start to be addressed April 21 by the Financial Accounting Standards Board, which may do away with it altogether.

FASB will be looking at either eliminating or, at best, restricting its use, according to Kim Petrone, a FASB project manager. Such a move could dramatically affect the ongoing consolidation of the banking industry. And, in fact, banks have been some of the most vocal opponents of the proposal to date, which until recently has focused on accounting for goodwill, an integral part of the project.

In the most recent outburst of criticism, eight banks–including Chase, Citibank, KeyCorp, First Union and Bank One–and five banking trade groups submitted comments on a position paper to account for mergers by the G4+1, a consortium of international accounting standard setters. The paper is relevant because part of FASB’s goal in the business combinations project is to harmonize accounting standards internationally, and because it advocates eliminating the pooling method of accounting. FASB will be considering the paper and the comments in its deliberations.

The American Bankers Association, which has objected to most of the major accounting changes proposed recently by FASB, states high up in its comment letter that both the pooling and purchase methods of accounting should be retained. That’s in part because the "pooling method better reflects the long-term interests of shareholders and the long-term contribution of each (merged) entity to the performance of the combined entity than the purchase method," it says.

Bonnie Zoccola, vice president of accounting policy at First Tennessee, which greatly expanded its mortgage lending operations in recent years through acquisitions, tied the possible elimination of pooling more closely to banks.

"Purchase accounting is prohibitive especially in the banking industry because of the intangibles created–intangibles reduce capital on a one-to-one basis," he said.

A number of companies, largely excluding banks, have expressed reserved support for the business combinations project as long as accounting for goodwill is rejiggered to simplify and standardize it. FASB just finished addressing how to determine the measurement and life span of goodwill and intangible assets–tentatively deciding to limit the life span of goodwill to 10 years with a maximum of 20 years, down from the current 25 years for banks–and concluded that it must reconsider its deliberations later. The current version of the proposal would significantly increase merging banks’ amortization costs.

"Higher amortization would be prohibitive (for mergers). A couple of large banks have done mergers on a cash basis of accounting instead of accrual, and it’s been a bumpy ride," Zoccola said.

The comment letters did provide FASB with some alternatives to make goodwill less burdensome. Although he was averse to eliminating pooling, Princeton, N.J.-based Summit Bank’s comptroller Paul V. Stablin noted in his bank’s comment letter that treating goodwill as a one-time acquisition expense, or amortizing it into comprehensive income, would make the purchase method of accounting more attractive.

Not all bankers oppose eliminating the pooling method of accounting. Craig Dabroski, accounting specialist at America’s Community Bankers, said, "Several of our members would not be upset with purchase accounting, depending on how to measure goodwill."

He added that while he ultimately sees "a train down the track that’s going to intercept goodwill," the biggest problem today with purchase accounting is the ambiguity measuring goodwill and intangible assets.

"Now it’s very difficult to come up with, for example, fair value for core deposit intangibles," he said. He noted that another controversial FASB project dealing with accounting for all financial instruments at fair value, while now scheduled to be finished long after the business combinations project, would ultimately answer a number of questions.

Lenders were blessed and burned last week when the Financial Accounting Standards Board addressed implementation issues for its new standard to account for derivatives that affect their ability to hedge risks.

One issue followed shortly after a letter received from the Mortgage Bankers Association that expressed the trade group’s concern about a tentative decision by the Derivatives Implementation Group (DIG), an independent group that analyzes issues stemming from the new proposal and suggests solutions for FASB’s approval. That issue concerned accounting for combinations of options to hedge market risk, especially from mortgage servicing rights in the case of mortgage lenders.

The DIG decided that a combination of options can only be designated a net-purchase option, and so receive the desired hedge accounting if it meets four criteria. The MBA said in its letter that most mortgage lenders using such an instrument to hedge mortgage servicing rights would, due to the nature of the business, be unable to meet the criteria, and so would have to account for it as a net-written option. Such designations can only be accounted for as hedges under very specific and limited circumstances.

Jim Edwards, vice president of capital markets for Homeside Lending and a member of the MBA’s Hedge Accounting Task Force, said that while task force participants did not believe accounting for hedging instruments drove the mortgage lending business, the new accounting would have ramifications.

"Members acknowledged that there will be additional documentation and analytical work required to demonstrate an expectation of hedge’s effectiveness," he said. "The MBA was concerned that the conditions in DIG’s response may limit the use of certain combination option strategies being used or contemplated by some mortgage bankers," Edwards said. Edwards added, however, that such strategies are only a small part of hedging choices.

While FASB did not give mortgage lenders reprieve last week on the combination of options issue, it did ease up on the timing restriction the DIG initially required to receive hedge accounting and defer the gains or losses of a cash flow hedge of a forecasted transaction, if it appears the forecasted transaction will occur after originally specified. The DIG said that in order to receive hedge accounting, the transaction must occur within an addition period that is no more than 10% of the originally specified time period, or 60 days. The mortgage industry, according to Tim Lucas, technical director at FASB, noted that the 10% limit was excessively strict for many mortgage cash flow hedges, so the board "blew the 10% away."

Reaching out in an attempt to limit the damage of new accounting for intercompany swaps, which banks have used to hedge risk at least in the near term, the Securities Industry Association (SIA) requested a grandfather clause last week for transactions prior to this year. If the transactions are not grandfathered, banks will have to unwind them, and some fear that could result in a flood of swap contracts in the market.

SIA sent a letter stating its view to the Financial Accounting Standards Board, which had already rejected the idea when deliberating on its new standard to account for derivatives, FAS 133.

"These transactions were entered into in good faith and they shouldn’t be penalized," said a source at a large Wall Street bank.

Large banks routinely will have one part of the bank enter into a hedge with its own trading desk, with the intent of eventually unloading the risk to a third party. However, that intent can be difficult to verify, and the risk can appear to stay within the bank seeking to hedge it–one FASB staffer described the transactions as "shifting (risk) from your left pocket to your right."

The standard setter and the Securities and Exchange Commission, which enforces the accounting standards, have both issued guidance requiring the banking community to unwind intercompany hedges, with the exception of those done for foreign currency exposure–or the swap doesn’t qualify as a hedge. However, the SEC said intercompany transactions entered into prior to the start of this year could be grandfathered.

In February, the Derivatives Implementation Group (DIG), an independent group tackling FAS 133 implementation issues, concluded those swaps should not be grandfathered.

SIA’s letter, addressed to Robert Wilkins, a project manager at FASB and the standard setter’s representative at DIG, and FASB’s chairman and technical director, requests that the issue and DIG’s conclusion be reconsidered.

The letter notes "financial institutions acted in good faith in applying the deals under current accounting literature" and "the inordinate costs that would be imposed upon firms having to replace large numbers of existing hedges with third party transactions"

Kristine Smith, vice president of accounting policy at Lehman Brothers and one of the crafters of SIA’s letter, explained that banks see risk as "fungible." Instead of offsetting each defined risk with a derivatives transaction, risks can be aggregated and hedged with a third party as a whole or cut up into pieces. At least, that has been the practice, which presents a considerable obstacle in unwinding the transactions.

"It will be costly to companies and difficult because you’ll need to cancel the existing basket of trades and enter into a one-to-one trade for every trade done before, and entities have hundreds if not thousands of these on their books," she said. She said banks would have to retransact the volume of trades entered into before Jan. 1, 1999, to achieve direct offsets, needlessly grossing up the books, or cancel out the trades altogether. Lehman Brothers alone has $30 billion of debt swapped to fixed on an intercompany basis, according to Smith.

FASB’s project manager for the DIG, Robert Wilkins, said last week that the SIA’s letter was not received in time to give it the required weeklong analysis to bring it up at last week’s board meeting.

In the wake of a deluge of negative comment letters from the public, the Financial Accounting Standards Board decided last week to rethink how to account for goodwill in its business combination proposal.

The board heard an analysis of the public response to the recommendations of the G4+1’s position paper on business combinations at its March 24 meeting. The international body’s views on pooling and other aspects of business combinations, such as accounting for goodwill, are much stricter and more literal than those in practice in the U.S. today. FASB’s proposal for business combinations is similar, in an attempt to harmonize standards internationally. Currently, companies of virtually any size can merge using the pooling method of accounting, whereas in most other countries, the merging entities must have very similar market capitalizations.

Such was the corporate disapproval of the paper that the board decided to give all of its tentative decisions on goodwill thus far a re-think at the next meeting in which it addresses the issue.

Of the 124 respondents, approximately 40% did not support the G4+1’s position–primarily banks, securities firms and corporations. Almost 30% of the respondents expressed unqualified support for the positions–predominantly academics, public accountants and other corporations. Another approximately 25% of respondents had "qualified" support for the G4+1’s position paper, depending on FASB "fixing" the accounting for goodwill or on FASB retaining the pooling method for mergers of companies of approximately equal size. The re-think will come after the board decides when it is appropriate to use the pooling or purchase method of accounting. That meeting is tentatively scheduled for April 21, with the possibility of having an educational meeting before, perhaps on April 14, according to project manager Kim Petrone.

A relatively inexpensive source of funding for banks, which an amendment to a new accounting standard appeared to threaten, was secured last week when the Financial Accounting Standards Board decided against a move that would have inflated the funding provider’s balance sheet.

The decision affected so-called repurchase agreements, or repos, in which a bank or other borrower pledges collateral in the form of securities in order to receive a relatively inexpensive loan. In what was expected to be its last meeting March 24 on the controversial amendment to Statement 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, the board decided against making the party holding the collateral book it as an asset.

The board had been leaning toward that method, which caused a flurry of protest letters from Wall Street (see FMR 3/15/99 p. 5). The board reasoned that if the collateral holder–usually broker/dealers and large commercial banks–could use the securities and profit from them, the collateral should be accounted for somehow.

Firms complained that making banks and others record the collateral as an asset and the obligation to return it as a liability would create unforeseen effects on other types of collateral arrangements that the board had not considered. Further, "grossing up" the balance sheet would deplete capital, perhaps limiting repo lenders’ ability to do the transactions and tightening an inexpensive source funding for many banks.

"It would make everybody’s balance sheet look larger and more leveraged," said Patricia Brigantic, senior associate general counsel for the Bond Market Association. She explained that besides limiting repo lenders lenders’ ability to do the transactions, a bigger balance sheet would cause frowns among rating agencies, counterparties, and others analyzing the credit.

The board reconsidered the issue last week and after looking at seven different options, decided the holder of the collateral–the "secured party"– would have to report the value of the right to use the collateral during the period it has been pledged. Halsey Bullen, FASB project manager, explained that the amount to be recorded will be relatively small under the new plan, compared with having to book the entire asset.

Several bankers were pleased to hear of FASB’s change of heart, saying that the new accounting should mean a big difference in their repo market activity. John Spiegel, chief financial officer of SunTrust, said the change sounded positive and added that he thought the collaboration of the FASB staff and the banking community is "a good thing."

Although staffers have some draft language for this section of the amendment, the board asked them to check with the Wall Street community "to see how the ideas might best be articulated," Bullen said. Brigantic’s accounting committee and representatives from many Wall Street firms will meet this week to discuss how to allocate a value to the gains from using the collateral for the period it is held. Brigantic added that the new guidance doesn’t just apply to repo transactions, but securities lending, margin loans and collateralized derivatives transactions–in short, any situation in which financial instruments are used as collateral.

Bullen added that apart from possible minor language changes to the proposed amendment, which could result in another meeting, the board now only must review the amendment in its entirety. Five board members indicated at the meeting they would support the statement.

The financial engineers behind the recently announced merger between Fleet Financial Group and BankBoston Corp.have chosen the pooling method of accounting, which avoids the creation of goodwill and any unsightly recurring charges to earnings. That probably wouldn’t be possible, however, if the Financial Accounting Standards Board’s current proposal to account for business combinations comes to fruition.

FASB is dealing with the question of when merging institutions must choose the pooling or purchase methods of accounting in the last week of March or first of April. However, FASB representatives have clearly stated that the standard setter is seeking to better harmonize accounting rules worldwide, and that bodes for much tighter restrictions on the use of pooling. International accounting standard setters generally permit pooling only when institutions are very close in size in terms of market capitalization. Fleet’s market cap, at about $23 billion last week, is nearly twice BankBoston’s at $13 billion.

"It’s hard to say because FASB hasn’t addressed the question yet, but it seems likely that pooling wouldn’t be permitted in this case," said Robert Willens, Lehman Brother’s accounting expert.

Assuming the newly merged bank, to be called Fleet Boston Corp., is denied the pooling method of accounting and must resort to the purchase method, the proposed standard would result in approximately $11 billion in goodwill. BankBoston Controller Terry Jefferson estimated that separating straight goodwill and core deposit intangibles, and then merging their typical 25-year and seven-year lives, respectively, would result in an average life of 15 years. Dividing that into a total of $11 billion in goodwill would result in a $733 million hit to earnings each year under current accounting. That hit would increase at least slightly for banks under the proposal because it presumes goodwill to have a life of 10 years or less, and sets a cap of 20 years, down from 25 years today. Other companies have a 40-year cap today, which under the proposal would double amortization in many cases.

The good side of being forced to use purchase method of accounting, however, is that it would give the new bank about $16 billion to reinvest in other business or stock repurchases, with restrictions on capital management.

There are complications, however. The proposal requires the merged entity to measure the value and useful lives of the various intangibles–such as brand, customer lists, trademarks, core deposits–and amortize them accordingly. Kim Petrone, FASB’s project manager, explained that there is more flexibility with intangibles, and that some may have lives over 20 years, or even indefinite lives eliminating the need for amortization all together–"If you can presume indefinite renewal, and there’s an observable market–like an FCC license–then you wouldn’t have to amortize it," she said.

Accounting sources fretted, however, that the proposal, particularly with respect to intangibles, not only may be difficult and burdensome to implement, but perhaps impossible.