Cadence Will Restate, Slash Q1 Earnings; Cites Accounting Error

Cadence Financial Corp., a small financial services provider in the southern US, said late yesterday that it will restate its first quarter earnings due to an accounting error. The restatement will slash first quarter earnings by a whopping 97 percent, moving first-quarter net income to $103,000, or 1 cent a share, from a previously-reported net income of $3.7 million, or 31 cents a share. But it’s not so much that Cadence is restating that’s of real interest here – the restatement won’t affect book value or cash flow, according the company — it’s what is being restated as well as why. Here’s the why:

Cadence said it will rescind its early adoption of a rule governing the fair value option for financial assets and liabilities [SFAS 159] … Cadence said the action was prompted by a recent alert from The Center for Audit Quality of the American Institute of Certified Public Accountants and comments by the Securities and Exchange Commission about the proper application of the rules governing the securities.

And here’s the what, from the press release:

As part of Cadence’s adoption of SFAS 159, it reclassified approximately $168 million in fixed rate collateralized mortgage obligations (CMOs) and adjustable rate mortgage-backed securities from ‘available for sale’ to ‘held for trading’ and recorded a $726,000 mark-to-market gain in the first quarter of 2007, as reported in its press release on April 24, 2007. In accordance with SFAS 159, Cadence also reclassified $3.1 million as an ‘unrealized loss on investment securities’ from ‘other accumulated comprehensive income (loss)’ to retained earnings as of January 1, 2007.

Essentially, what the above says is that Cadence’s adoption of the new accounting rules allowed it to push losses on CMO and other MBS investments it held from asset categories that would negatively impact earnings into categories that (conveniently) would not. What’s not quoted above, but is in the press release, is that Cadence also decided it would reclassify its losses on ABS and CMO investments right before it sold those assets (therefore keeping losses off of its balance sheet). Once sold, the company went ahead and bought agency-backed paper with the proceeds of the sale, which it then conveniently decided not to reclassify using SFAS 159 — presumably because it wanted the investment income to actually show up on its balance sheet. Cadence is blaming the regulators for a “lack of clarity” on the new accounting rule, but I personally think anyone with half a brain would have had questions about a company’s apparently self-serving and selective adoption of an accounting standard. The losses also raise the question — exactly what sort of “CMO and ABS” securities was Cadence really holding that lost value and forced a sale at loss? And have other financial services organizations with larger balance sheets tried a similar trick?

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