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The Emerging Issues Task Force of the Financial Accounting Standards Board is looking at some accounting changes that will have potentially dramatic consequences for insurance companies’ earnings, credit ratings, and financial leverage.
The Georgia Tech Financial Analysis Lab wanted to foretell the possible impact of the EITF’s plan to recommend that insurance companies should expense rather than capitalize certain costs associated with getting new insurance business. The EITF is looking at recommending new guidance in Issue No. 09-G, “Accounting for Costs Associated with Acquiring or Renewing Insurance.”
To ascertain the possible impact, the Georgia Tech lab studied 2007 and 2008 financial statements for 28 entities that would be affected and determined the rules would boost their average ratio of liabilities to equity, a key metric of financial leverage, from 9.88 to 63.91. That would be enough to damage credit ratings and require infusions of new equity, the study determined.
While leverage generally would increase under the proposed new approach, the result for pre-tax earnings is not as consistent. The proposed rules generally would require companies to expense rather than amortize certain acquisition costs, which intuitively suggests a reduction in earnings, says Charles Mulford, director of the Georgia Tech research operation and author of the study.
Some entities in fact would see declines in pretax income of 20 percent or more, but some would see similar increases in pretax income, he says. “We found plenty that would report lower earnings, but some would report higher earnings,” he adds.
Mulford says the primary objective of the research was to ascertain whether a change in accounting rules would have a material impact for affected companies. “When it comes to the balance sheet, we find significant reduction in assets and shareholder equity pretty much across the board,” he says. “The impact on financial leverage is quite dramatic.”
If FASB is looking for other instances where acquisition costs are capitalized, it might also take interest in the retail practice of capitalizing certain marketing costs related to direct response advertising. Currently, retailers who mail coupons and catalogs, for example, are allowed to capitalize those costs if they have historical evidence that they lead to revenue, says Mulford.
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