Independent Oversight is Critical for Long-Term Solution to Financial Crisis

Oct. 21, 2008 - PRLog -- Greed and unethical behavior are certainly behind the sub-prime mortgage crisis and the resulting credit freeze. The reality is that greed and poor ethics will always be present as no legislation can ever be successful in its eradication. While Congress, and indeed the world, is debating solutions to this latest global financial crisis, the key is to identify root causes to pave the way for effective solutions.

The primary breakdown leading to today’s crises is nothing new; it is simply the lack of a truly independent board to question risks and hold management accountable for full and accurate disclosures. Unfortunately, many are pointing to misguided fixes, such as scrapping mark-to-market accounting. Let’s explore the condition, cause and potential solutions from the perspective of public companies under the regulatory eye of the Securities and Exchange Commission (SEC).

Market Transparency Required

The SEC’s mission is to protect investors by ensuring a steady flow of timely, comprehensive, and accurate information. To achieve this mission the SEC has issued an abundance of rules and regulations regarding disclosure. One such rule requires companies to provide material historical and prospective disclosure. This rules requires the management of companies to discuss in their SEC filings uncertainties that will result in, or that are “reasonably likely” to cause, the reported historical financial information not to be indicative of future operating results or financial condition. This goes well beyond the historical context of U.S. GAAP by requiring the disclosure of forward-looking information that could reasonably have a material impact on the future.

More Surprises to Come?

Despite these SEC disclosure requirements, the long parade of asset writedowns continues to surprise the investing community. A viscous cycle ensues as credit rating agencies downgrade the debt collateralized with these impaired assets, leading to a loss of investor confidence and a tightening of the credit markets. Investor fear and herd mentality kicks-in leading to a stampede of extreme market volatility.

To make matters worse, a significant portion of financial assets are traded, pooled and repackaged for sale as complex derivatives. Many of these financial instruments were collateralized with real estate. The securitization leading to these complex vehicles was a popular way to achieve growth and hefty returns for several years. With the passage of time came more creativity and risk, while loan quality decreased. The U.S. real estate market simply could not support the valuations given to these increasingly risky securities. Add in credit default swaps (CDS), which are insurance-like contracts that cover potential losses on securities in the event of a default, such as mortgage-backed securities, and you have a toxic soup that no one is sure how to digest.

SEC Chairman Cox noted on September 26, 2008 (SEC Release 2008-230) that the approximately $60 trillion CDS market “is regulated by no agency of government.” This is the same SEC release that quotes Chairman Cox as saying “the last six months have made it abundantly clear that voluntary regulation does not work” in response to the SEC ceasing a voluntary regulatory program for global investment bank conglomerates. Expect more market volatility, pain and regulation.

Managing Risk in the Boardroom

Board of Directors should be asking; why weren’t these risks identified and disclosed? It appears that management did not honestly deal with these risks and disclosures in lieu of the quest to maximize short-term returns. Indeed, the age-old culprits of short-term thinking and the lack of holding top executives accountable are at the forefront of the market turmoil.

Corporate America’s persistence to not separate the chairman and CEO positions from being held by the same individual is the single greatest hindrance to strong governance and risk management. It is an indefensible conflict of interest for one person to lead both the board and management team when the primary objective of the board is to hold management accountable. However, the vast majority of the companies making head lines this year, such as Lehman Brothers, AIG, Freddie Mac, Wachovia Bank, Washington Mutual, and many others had one person as both their chairman and CEO according to 2008 SEC filings.

Mark-to-Market Accounting

Federal regulation tends to be reactionary and riddled with unintended consequences. Few like regulation, but most agree it is necessary to some degree. While the recently enacted Emergency Economic Stabilization Act (EESA) provides $700 billion to restore liquidity and stability to the financial system by authorizing the U.S. Treasury Department to purchase troubled assets of financial institutions, it is the controversy of mark-to-market accounting that is especially intriguing.

There is a lot of finger-pointing these days and the assault on fair-value accounting is one of the louder victims. The EESA calls for a study on markto- market accounting standards as provided under Financial Accounting Standard No. 157 (FAS 157). The legislation also grants the SEC the authority to suspend the application of FAS 157. Fair-value accounting is also referred to as “mark-to-market” accounting. It simply means that financial assets and liabilities are disclosed at market prices as of the balance sheet date. The objective is improved transparency by reflecting the current market value of assets and liabilities in determining a company’s financial position rather than the historical transaction price. This seems logical as a company’s balance sheet should ideally reflect the true value of assets and liabilities rather than a historical number that may be nowhere close to its market value. Recent clarification from the Financial Accounting Standards Board (FASB) on FAS 157 also provides new flexibility to re-price assets in an inactive market, such as what we are experiencing today with complex financial assets being very difficult to value.

Some members of Congress and many others are calling for a suspension of FAS 157 since it is now leading to asset write-downs during these economic challenging times. However, to roll-back the progress of FAS 157 will not create greater transparency, but in fact lesson transparency. It’s interesting that we did not hear these cries during the economic good times. In a recent FASB meeting, Bob Herz, the Chairman of FASB, said that financial reporting is “not there for regulatory capital, or to boost the balance sheets of financial institutions.” This is absolutely correct as financial reporting should call it as it is and not be used as a pawn for distorting disclosures. The concept of adjusting impaired assets downward has long been imbedded in U.S. GAAP and is consistent with accurate and transparent disclosure.

For the conclusion to this article, please go to: http://www.candelasolutions.com/ace-files/Long-Term-Solut...

Ronald Kral is the Managing Partner of Candela Solutions. He leads our SEC and SOX practice. Ron can be reached at rkral@candelasolutions.com. Candela Solutions LLC is a new breed of CPA firm building value for clients through strong governance and SEC advisory services. Visit our website at www.candelasolutions.com for more information.

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