SEC Warns of Investment Loss Manipulation by Firms

U.S. regulators are growing increasingly concerned that financial companies may be manipulating a change in accounting rules to avoid recognizing investment losses in their earnings.

U.S. Securities and Exchange Commission staff warned auditors in conference calls this week about improper selling strategies that the regulator believes are designed to take advantage of the new rule, auditors say.

The rule, known as the "Fair Value Option" or FAS 159, allows companies to irrevocably choose to record the value of a financial instrument on their balance sheets based on the price the instrument could fetch in a current market transaction.

But regulators at the U.S. Securities and Exchange Commission are concerned the rule change may give banks and other financial companies a one-time chance to run losses through retained earnings on their balance sheets, rather than their more visible income statements.

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For example, a financial company could opt to mark an underperforming asset to market on its balance sheet, sell the security, then repurchase the same security but choose not to mark it to market in the future. Such a transaction would allow a company to avoid recognizing losses on the asset in income.

"The SEC staff is very concerned about engineered transactions designed to get an accounting result," accountants at McGladrey & Pullen said in an alert on its Web site this week. "They are very skeptical of a strategy that lacks substance or that would involve electing the fair-value option for a financial asset or liability with an intention of disposing of the asset or settling the liability."

NOT INCREASING TRANSPARENCY

The SEC staff says companies that pursue this kind of strategy may be violating the spirit of the accounting rule, which the Financial Accounting Standards Board actually intended to increase transparency by showing the market value of the assets that the banks hold.

Perhaps adding to regulators' worries, the early adoption period for the rule coincides with the recent fallout in the subprime mortgage sector, which could motivate financial institutions to hide their losses.

Analysts in the mortgage-backed securities market suspect the rule has already sparked as much as $20 billion worth of sales in recent weeks as companies have sought to exchange low-yielding securities for high-yielding securities to take advantage of the rule. But it is unknown how many of the sales relate to the strategies the SEC is concerned about.

Auditors are already springing to action. The Center for Audit Quality, which is affiliated with the American Institute of Certified Public Accountants, issued an alert on Tuesday, warning auditors to be skeptical about the way companies adopt the new standard.

Deloitte & Touche (DLTE.UL), one of the Big 4 accounting firms, told its auditors in an alert this week that they should consult with the firm's national office if they encounter one of these strategies.

The SEC has not yet cited any specific company for such a transaction, the auditors said. An SEC spokesman would not comment further on its meetings with the accounting firms.

However, the warnings to auditors followed comments earlier this month by SEC Deputy Chief Accountant Jim Kroeker that the SEC was interested in transactions related to the adoption of FAS 159.

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