Under pressure from lawmakers to cooperate, federal banking and securities regulators reached a deal Wednesday that should head off future disputes over excessive loan-loss reserves.

As part of the agreement, the Securities and Exchange Commission said it would not require a bank to restate earnings, even if it believes the institution has inflated reserves or failed to adequately document the size of the fund.

Instead, the agencies said they would work with banks to improve disclosure and documentation of loan-loss reserves. Banks also could be required to cut reserves in future years.

"This is a joint recognition that the best way to address any problem is to do it prospectively," said Kevin Bailey, deputy comptroller for core policy at the Office of the Comptroller of the Currency.

The SEC began cracking down on earnings management last fall. This included delaying SunTrust Banks Inc.’s acquisition of Crestar Financial Corp. until the company agreed to reduce loan-loss reserves by $100

million and restate earnings.

The SunTrust case outraged the industry, which charged that it was unfair for the SEC to punish a bank for holding excessive reserves at the same time banking regulators were urging them to bolster reserves.

Regulators issued a joint statement in November vowing to work more closely on loan-loss provisioning, but industry officials continued to complain about a lack of coordination.

The agreement, which was reached late Wednesday afternoon, also commits the SEC, OCC, Federal Reserve Board, Federal Deposit Insurance Corp., and Office of Thrift Supervision to establishing a joint working group on accounting issues. This group will issue guidelines on how banks should make "reasoned assessments of losses" in their portfolios and how they should document these expected losses, according to the agreement.

The new agreement, however, won rave reviews from industry officials and legislators. Rep. Marge Roukema, chairwoman of the House Banking Committee’s financial institutions subcommittee, was one of several lawmakers who had promised to introduce amendments to the financial reform bill to end the controversy over loan loss reserves. She dropped the amendment, however, after regulators announced the deal.

Long-awaited guidance from the Securities and Exchange Commission on materiality, which sources expect out in the next week, may not impact bankers in the short term, but it could increase their auditing costs in the long term.

The forthcoming guidance is expected to discuss qualitative things like important ratios or subtotals in the financial statements, and the net interest margin rather than just net income. The guidance reflects the SEC’s increased scrutiny on what it calls earnings management, which bankers will have to consider going ahead. A celebrated example of the SEC’s concerns are what it identified as excessive loan-loss reserves, ones that the bank regulators saw instead as prudent. That issue has the attention of a newlyformed joint working group of the SEC and banking regulators (see story, p. 2).

"The SEC believes some companies are using the cover of materiality to record improper entries," said Robert Herz, a partner at PriceWaterhouseCoopers and the chair of the American Institute of Certified Public Accountants’ SEC Regulations Committee, and formerly an SEC advisor. Many bankers said they do not have a problem with the SEC’s disapproval on that score, having heard warnings in SEC officials’ speeches for a long time.

But they do wonder if the issue will become a problem for the auditors because the implication behind the forthcoming guidance is the SEC’s guidance dips to a lower materiality threshold than the auditing firms have in their own internal policies.

"The problem is they have to do more work," one banker said. He said the issue has made auditors so nervous that over time it will drive up the cost and work level required to complete a bank’s annual audit. The idea of the materiality guidance in the first place is to reduce the work and cost of the audit. For example, if revenue and expense are both overstated by $5 million, the net is not overstated at all because the two offset each other. The auditors might choose to say it is not material because the net income is not misstated. But bankers fear that the SEC may call it a misstatement because the revenue was misstated.

"It’s not absolute assurance; it’s fair presentation. The implication there is (that) it’s reasonable and you can rely on it," said Roger Dean, controller at Fifth Third.

Tom Ray, director of audits and attest standards at the American Institute of Certified Public Accountants, agreed that the new guidance could have an effect on the audit, but said he did not expect it would force auditors to go looking for items that are smaller and less material than they do now. Rather, he said, the guidance should help auditors and bank management to evaluate the matters that the audit tests identify.

Dean said that he believed the SEC has gotten overly concerned about sensitivity of markets to trends and high (price-to-earnings) ratios. While the idea of making sure investors know what is material to the business is admirable, he said, the SEC is painting the picture of abuses with too broad a brush. Because the question of what is material can be argued to be in the eye of the beholder, and the audience he and most bankers deal with–analysts– will not easily be swayed by the kind of alterations the guidance might prevent, it could be less than useful.

"The analyst community we deal with usually looks at us over time and at long-term performance, and (it looks for) good long-term management. So I don’t have any motivation to paint some rosy picture of one item in my financials because you can’t sustain it and that’s not what my audience is worried about. The issue is what does it take to change somebody’s opinion of your performance. The answer to that is it depends on the investors." Dean said that his investors do not care so much about revenue as they examine expenses.

The idea of what is material to shareholders has been loosely understood as anything that would affect earnings between 3% and 5%. If not material, an item or piece of news does not have to be disclosed.

The ball is now in the FDIC’s court on the topic of whether the agency has the right to unwind asset securitization deals once a bank that is a party to the deal goes bankrupt.

The agency, which announced a proposal to waive many of its rights of receivership in January, is sifting through the many letters that came in by last week’s comment deadline. Many letters were fired off by the banking community and a special task force of the American Institute of Certified Public Accountants (AICPA) set up to deal with the controversial accounting standard dealing with securitization deals.

The letter from the AICPA’s ad hoc working group on Financial Accounting Standard 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, came with an informal note from several attorneys indicating they were concerned that the agency’s promise to keep its hands off any securitized deals could come unglued. The worry is a future FDIC board could reverse what is now only a statement of policy by the current FDIC board, and further, the about-face might not grandfather existing deals. Given that, the note said, the attorneys cannot give an opinion that is satisfactory to the auditors. And the auditors really want to rely on counsel’s opinion before advising bankers if deals should receive sales treatment.

Bill Leiter, consultant to Banc One’s accounting department, said the AICPA’s letter reflects what a lot of major firms are concerned with in the FDIC policy. He said that the topic has been the talk among big bank accountants when they compare notes on major worries in the industry now.

A major banking trade group, The Mortgage Bankers Association, is voting today via teleconference on whether to lobby the Financial Accounting Standards Board on an issue that could restrict banks’ ability to use a hedge prevalent in the mortgage lending arena.

The group failed to reach an consensus Feb. 25 on which issues stemming from FAS 133–the new standard to account for derivatives–to lobby the standard setter about, and will discuss the numerous issues in the next month or so. However, the 50-or-so representatives did decide to hold a teleconference meeting today to decide on the immediate fate of one issue: accounting for a combination of options used to hedge some market risk, especially mortgage servicing.

The issue first arose when the Derivatives Implementation Group (DIG)–a consortium of accounting experts mandated to analyze conflicts in FAS 133 and provide possible solutions–tentatively decided in January that a combination of options can only be designated a net-purchase option if it meets four strict criteria. Net-purchases receive hedge accounting treatment under the general rules laid out in the standard. DIG’s decisions are subject to approval by the Financial Accounting Standards Board, which has yet to address the option combination issue.

Due to the nature of mortgage banking, according to Allison Utermohlen, senior director of accounting and tax policy at the MBA, most mortgage lenders using the instruments to hedge risk would be unlikely to meet the four criteria, and so would have to designate the option combination as a net-written option. Such designations can only accounted for as hedges under very specific and limited circumstances, Utermohlen said, meaning many mortgage lenders would be unable to use what has proven to be an effective hedging strategy.

"Combinations of options are often used to hedge servicing rights, deemed to be one of the most cost-effective ways of hedging servicing. Given DIG’s consensus, some mortgage lenders won’t qualify."

Utermohlen said the MBA would likely have a letter ready to send to FASB on the issue a week after any decision. The combination option issue is one of many issues the MBA is concerned about–including the definition of a hedged portfolio and measuring the effectiveness of hedges– and may seek to lobby FASB into providing clarification or some relief.

The Financial Accounting Standards Board busily set about tying up loose ends last week on a number of projects, including further defining fair value in its project to account for all financial instruments at that measure.

The board decided that quoted market prices in active markets are the best evidence of fair value and should be used as the basis for the measurement, if available. If a quoted market price is available, the fair value is the product of the number of trading units times the market price. If a quoted market price for an asset or a liability with essentially the same characteristics, including the same expected cash flows, is available, that price generally should be the basis for fair value. If a quoted price for fair value is not available, the estimate should consider prices for similar assets or similar liabilities and the results of the valuation techniques. Information from market sources is presumed to be superior to valuation techniques based on discounting of internally estimated cash flows.

The board also decided that potential blockage factors and control premiums should not be considered in determining the fair value of financial instruments.

In other news, the board approved the Accounting Standards Executive Committee’s (AcSEC) exposure draft of a statement of position on Accounting and Reporting for Certain Employee Benefit Plan Investments and Other Disclosure Matters. The proposed accounting changes, which define benefit plans and what has to be disclosed about the investments the plans make, will be published in about a month for public comment. Then the board must reexamine the proposal in light of comments and decide whether or not to approve the statement. The final statement is expected to be out by the summer.

In the continuing project on stock compensation, the Financial Accounting Standards Board decided Feb. 24 that if companies retain shares in excess of the required withholding amount for tax purposes, they get stuck with a stripe of accounting that leaves them open to the vagaries of the stock market when it comes to compensation costs.

A company usually accounts for an employee’s exercised stock option as fixed if it can be recognized the day the option is granted. The companies will often make the exercise price of the option equal to the stock price on the day the option is granted, which means no compensation cost to the company, because there is no difference between the two. Fixed-award accounting is the typically desired approach.

If this is not possible, the award is called variable and the compensation cost is the amount of intrinsic value at a later measurement date, which could vary depending on the price of the stock.

The board decided that if a company has a stock compensation plan that allows for withholding of more shares than the minimum number required for tax withholding, the plan should be accounted for as a variable award. FASB allowed one loophole if the employee makes an irrevocable election at the date of the grant not to withhold more than the minimum number of shares–then the company can retain the fixed-award accounting.

If the plan does not specify that additional shares are withheld, but that is the company’s regular practice, then the company would have to use variable accounting.

"It’s clear now if you’ve got a plan that specifies this and you do it–withhold an excess of the minimum required amount–that the shares have to be accounted for as variable options," said Lailani Moody, senior manager, assurance services in Grant Thornton’s national office. She said that the area had long been gray, but that she did not think many companies used the excess withholding practice.

FASB’s interpretation of Opinion 25 is due out for comment by the end of March, and it is expected to be out in final form by September.

The Financial Accounting Standards Board approved the staff’s wording of a tentative decision in January for its amendement to Statement 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. At that time the board decided after a close vote that bankers could continue to treat removal-of-account provisions with a free hand. The board said bankers can get back accounts in three instances: if they are chosen at random, if they default, and if they are in an affiliate account and the affiliation is lost. Tim Lucas, FASB’s technical director, said there was some doubt that the staff would be able to "capture what the board had in mind" after its last meeting. The board approved the staff’s general direction, tinkered with some wording, and moved some other language from the body of the amendment to the implentation guide at the end. Another paragraph due for some tinkering was put off to a later time, Lucas said.

The much-awaited amendment has been controversial and is not expected to make its first-quarter deadline.

In a much-awaited meeting last week, the Financial Accounting Standards Board decided that purchased intangibles, which formerly had to be amortized over a useful life that could not exceed 40 years, now do not necessarily have to be amortized, and placed a 20-year cap on some intangible items.

The board said that intangible items presumed to have a life of 20 years or less can overcome that if they have clearly identifiable cash flows that will continue for more than 20 years, and must have either legal rights that extend beyond the 20 years, or an observable market.

It is possible to overcome the presumption enough to say it has an indefinite life, but it would be subject to annual review for impairment and that would be based on a fair value test, said project manager Kim Petrone. The test would prove the carrying amount of assets are not recoverable based on the fair value of the asset.

Other intangibles do not have an indefinite life, such as a copyright good for the life of an author or inventor. Those intangibles should be amortized over the life of the author. Then with legal rights that are renewable indefinitely but not marketable the company has to be able to figure out the fair value, and if not, amortize it over whatever the economic life might be. Another category of assets are the identifiable intangible assets that are not reliably measurable, such as customer relationships. Those would be recognized as part of goodwill.

Dennis Garmer, business combinations expert at PWC, said the board’s decision sounded a lot like the current international standards for intangible assets. The board has said it wants to harmonize business combinations accounting internationally.

Many U.S. companies have fought the move toward the international accounting standard because it only permits merging using the pooling method of accounting if the companies are very nearly the same size. So, if more companies have to combine using the purchase method of accounting, how much goodwill is allowed to be amortized, and over how long, becomes critical.

Bankers were recently reminded by the FDIC that starting sometime this year they have to stop using an accounting method for tax purposes that the IRS considers improper for certain short-term consumer loans. The punchline is the IRS-preferred method gives bankers more time to hold onto their money.

Many small banks use the so-called "rule of 78s" to account for interest on self-amortizing installment loans of five years or less. The rule means the interest recognition is front-loaded and more tax is paid at the beginning of the year, compared to the constant yield method, preferred by the IRS. Although the taxpayer loses some of the value of money, the rule of 78s is an easier method of bookkeeping, and popular with smaller banks.

The IRS said in 1997 bankers should stop using the improper method of accounting, but did not specify when the change should take place. Late last year the agency said any banks which had not switched methods in 1997 would have to do it by the 1999 tax year. For banks on the calendar year, that meant redoing the bookkeeping starting last month, but there are some who may not begin until later this year.

Some accountants see the new rule as a blessing for small banks which will not have to worry about keeping two sets of books anymore–one for regulatory purposes, and one for taxes.

"It’s really kind of a relief," said John Ziegelbauer, senior manager in charge of coordinating financial institution tax at Grant Thornton.

Others are simply amused that the IRS is forcing bankers to keep their money longer.

"Taxpayers using the rule of 78s were leaving dollars on the table, but they continued doing it as a matter of simplicity. What’s interesting about this is the IRS is saying a method less favorable to taxpayers is less permissible. But the IRS is interested in purity in this case," said Marc Levy, a tax expert at Deloitte.

In the quiet meeting before the storm, the Financial Accounting Standards Board tidied up a few loose ends in its business combinations project before getting down to the contentious business on Feb. 3 of how to account for purchased intangible assets.

The board clarified some points on when to review goodwill impairment indicators after a company has acquired another company. It said that if there are certain indicators that goodwill is potentially impaired at the date of acquisition, it should be reviewed no later than two years after acquisition and only if more than one indicator is present at acquisition.

Other issues included the question of whether an impairment indicator is specific to an individual asset group to which goodwill can be allocated, and should the goodwill other than that allocable to the specific asset group be reviewed for impairment? The board decided it should not.

The board also decided that an impairment indicator specific to goodwill that can be allocated to individual asset groups should be reviewed for impairment at the individual level. That approach is sort of a "bottom up" approach, rather than the "top down" approach, which requires that the goodwill be reviewed at the aggregate asset-group level. The board continued with the bottom up approach, deciding that review should begin with individual asset groups if an impairment indicator is specific to goodwill and to an individual asset group.

The board added that there is no need to review at the aggregate asset level if all goodwill can be allocated to individual asset groups.