ACCT 405 Saudi Electronic University Accounting Worksheet

College of Administration and Finance SciencesAssignment (2)
Deadline: Sunday 03/06/2023 @ 23:59
Course Name: Accounting of Financial
Student’s Name:
Institutions
Course Code: ACCT 405
Student’s ID Number:
Semester: 3rd
CRN:
Academic Year: 1444 H
For Instructor’s Use only
Instructor’s Name:
Students’ Grade:
/15
Level of Marks: High/Middle/Low
Instructions – PLEASE READ THEM CAREFULLY
•
The Assignment must be submitted on Blackboard (WORD format only) via allocated folder.
•
Assignments submitted through email will not be accepted.
•
Students are advised to make their work clear and well presented, marks may be reduced for
poor presentation. This includes filling your information on the cover page.
•
Students must mention question number clearly in their answer.
•
Late submission will NOT be accepted.
•
Avoid plagiarism, the work should be in your own words, copying from students or other
resources without proper referencing will result in ZERO marks. No exceptions.
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All answers must be typed using Times New Roman (size 12, double-spaced) font. No
pictures containing text will be accepted and will be considered plagiarism.
•
Submissions without this cover page will NOT be accepted.
College of Administration and Finance Sciences
Assignment Question(s):
(Marks 15)
Q. 1) Fair Value Accounting is argued to be conceptually and practically preferable to
Amortized Cost Accounting for most financial instruments. But there are some
arguments that are against fair value accounting. Understanding these arguments are
important because they speak directly to the strength and weakness of fair value
accounting. You are required to discuss these arguments in detail.
(5 Marks)
(Week 9 ,Chapter 6 )
Q. 2) Mortgage banks are exposed to interest rate risk on their mortgage-related asset
through prepayment and discounting effects that are not entirely distinct. Discuss the
Prepayment and Discounting Effects of Mortgage Banks in detail.
(Marks 5)
(Week 9 ,Chapter7 )
Q.3) Accounting for Securitization under SFAS No. 140 (2000) is a limited attempt to
describe complex transactions that are structured to yield desired economic and
accounting outcomes. This accounting raises three issues for users of financial reports.
State these three issues.
(Marks 5)
(Week 10 ,Chapter 8 )
Chapter 1
Financial Instruments and Institutions
Financial Instruments and Institutions
Fair Value Accounting
• According to the text, financial instruments defined by
the FASB
“includes financial assets and liabilities but not the firm’s own
equity.”
“The firm’s equity is a financial instrument, just not one for which
direct fair valuation generally is contemplated.”
“Financial assets are contractual claims to receive cash or
another financial instrument on favorable terms or ownership
interests in another firm.”
Financial Instruments and Institutions
Fair Value Accounting
• According to the text, fair value is defined as:
“the price that would be received to sell a financial asset or to
transfer a financial liability in an orderly transaction between
market participants at the measurement date, and so it reflects
current expectations of the cash flows and priced risks of the
financial instrument.”
Financial Instruments and Institutions
Fair Value Accounting
• Full fair value accounting involves three features:
➢ Balance sheet: Involves recognition of financial instruments at
fair value.
➢ Income statement: Involves the recognition of unrealized
gains and losses on financial instruments in net income in the
period they occur.
➢ Income statement: Involves calculating interest revenue or
expense as the fair value of the financial instrument times the
applicable current market interest rate during that period.
Financial Instruments and Institutions
Fair Value Accounting
• The alternative to fair value accounting is amortized
cost accounting.
• Amortized cost accounting uses:
➢ “Expectations of cash flows and priced risks determined at
initiation to account for financial instruments throughout their
life.”
Financial Instruments and Institutions
Fair Value Accounting
• Amortized cost accounting has three features that are
not desired.
➢ Uses old information and provides untimely measures of the
value of financial instruments on the balance sheet.
➢ Provides measures of the values of these instruments that
reflect expectations of cash flows and priced risks at different
times.
➢ Provides firms with the ability to manipulate net income
through realizing gains or losses on the sale of financial
assets or repurchase of financial liabilities.
Financial Instruments and Institutions
Estimation Sensitivity and Risk Disclosures
• According to the text:
➢ “Subjectivity and noise in estimating fair values, even when leveraged
through the retention of risky residual claims, can be mitigated through
clear disclosure of estimation assumptions and the sensitivity of fair
values to those assumptions.”
➢ “Fair values are point estimates of the current value of financial
instruments.”
➢ “Limitations arising from fair valuation of less than all aspects and
liabilities can be mitigated through separate presentation of unrealized
gains and losses on the income statement and through management
discussion of the existence of economic hedges of non-fair-valued
exposures.”
Financial Instruments and Institutions
Gross and Net Evaluation
• Financial instruments exhibit the following risks:
➢ Market – are offset across the instruments in a
portfolio
❖ Interest rates
❖ Exchange rate
❖ Commodity price
➢ Nonmarket – hard to offset across instruments
❖ Credit
❖ Performance
❖ Insurance
Financial Instruments and Institutions
Gross and Net Evaluation
• “Structured finance transactions that include multiple
legs raise the gross and net evaluation issue in a
similar fashion as portfolios of financial instruments.”
• “The market risks of the various legs of the transactions
are more likely to offset than are their nonmarket risks.”
• “In contrast, individual derivative financial instruments
raise the gross and net evaluation issue in mirror-image
fashion to portfolios of financial instruments.”
Financial Instruments and Institutions
Financial Transactions Are Financial
• Financial transactions should be classified and
measured in financial reports.
• Some financial transactions are operating under current
accounting standards.
➢ These transactions include:
❖ Operating leases
❖ Traditional insurance
Financial Instruments and Institutions
Funds Aggregation
• Financial institutions raise funds from:
➢ Depositors
➢ Investors
➢ Customers that reinvest larger amounts of money
• Funds may be liquid (deposit) or not so liquid
(annuities).
• “Funds aggregators exist to exploit some form of
economy of scale in investing.”
Financial Instruments and Institutions
Trading and Investment
• “Financial institutions often trade or invest in financial
assets on their own accounts.”
• “A financial institution usually holds a trading portfolio
because it believes it has some advantage over its
trading partners in valuing financial instruments that will
yield trading gains.”
• “It also may hold a trading portfolio to facilitate or as
result of its other activities.”
Financial Instruments and Institutions
Yield Curve Speculation
• Fixed-rate financial instruments are sensitive to
changes in interest rates.
• “The value of a fixed-rate financial instrument varies
inversely with interest rates, with the absolute
magnitude of the value change rising with the financial
instrument’s duration, a measure of the weightedaverage time to the cash flows or next repricing of the
instrument.”
Financial Instruments and Institutions
Risk Management
• Often, risk managers adjust risk exposures for their
clients downward.
➢ Adjustment happens by absorbing the risks
themselves.
➢ Diversifying across clients and time.
➢ Transferring the risk to a third party.
• Risk managers include:
➢ Insurers
➢ Commercial banks and securities firms
Financial Instruments and Institutions
Risk Management
• Risk managers attempt to generate income by:
➢ Charging a premium for absorbing risk.
❖ Risk premium should fall within the risk
manager’s ability to diversify the risk.
➢ Generate income by implicitly or explicitly charging
fees.
❖ “A portion of a property-casualty insurance
premium is an implicit fee for setting up the
policy and for expected future claim adjustment
services.”
Financial Instruments and Institutions
Other sources of fee income include:
➢ Syndication, securitization, and reinsurance
❖ Reverse the investment activities of financial institutions
➢ Market making and brokerage
❖ “Securities firms and large banks may make markets in or
broker the trading of financial instruments.”
➢ Deal making
❖ “Securities firms and large banks may execute or advise
on various financial deals and receive commissions.”
Financial Instruments and Institutions
➢ Asset management and investment advice
❖ “Many financial institutions manage or provide advice
regarding clients’ investment for fees.”
➢ Transaction processing
❖ “Performance of any financial institution with a high
transactions volume depends on its ability to process
transactions efficiently in its “back office”.”
Financial Instruments and Institutions
Valuation of Financial Institutions in Practice
• Value of financial institutions comes from two sources:
➢ Portfolio of financial instruments that are or will be
valued on the balance sheet at fair value.
➢ Set of future streams of noninterest income and
expense with various degrees of risks and
persistence.
Chapter 2
Nature of Regulation of Depository Institutions
Nature of Regulation of Depository
Institutions
Activities of Depository Institutions
• “Depository institutions are intermediaries between depositors, a
specific type of lender of capital, and borrowers of capital.”
• For depositors, “Depository institutions provide uniquely liquid,
convenient, and safe investments.”
• Deposits can be withdrawn at will from locations.
• For borrowers, “depository institutions provide an alternative to
the public issuance of securities, which can be costly or
cumbersome under certain conditions.”
Nature of Regulation of Depository
Institutions
Activities of Depository Institutions
Nature of Regulation of Depository
Institutions
Bank Regulation
Bank regulation includes:
• Chartering
➢ Dual banking system:
❖ Thrift banks and commercial banks are state or federally
chartered.
➢ Federal charters:
❖ Granted by the Comptroller of the Currency (COC) for
commercial banks and the Office of Thrift Supervision
(OTS) for thrift banks.
❖ In the U.S., these two agencies are part of the Treasury
Department.
Nature of Regulation of Depository
Institutions
Bank Regulation
• Regulatory supervision
➢ Federal Deposit Insurance Corporation (FDIC)
❖ Regulates any financial institution for which it provides
deposit insurance.
❖ “Regulatory examinations and other general regulation
are performed by:
▪ COC: federally chartered commercial banks
▪ Federal reserve and state authorities for statechartered commercial banks
▪ OTC, FDIC, and state authorities for state-chartered
thrift banks.”
Nature of Regulation of Depository
Institutions
Bank Regulation
• Branching
➢ Foreign banks in the U.S. are subject to the same regulation
as domestic banks.
➢ Subject to regulation at the holding company level by the
Federal Reserve under Regulation K which also applies to
U.S. banks.
➢ “State authorities determine the ability of banks to branch
within a state.”
Nature of Regulation of Depository
Institutions
Bank Regulation
• Reserve requirements
➢ “Banks must hold vault cash or non-interesting bearing
deposits with the Federal Reserve as a percentage of their
transaction deposits.”
• Capital requirements
➢ Three main capital ratios
❖ Leverage ratio
▪ Pertains to banks’ credit risk.
❖ Tier 1 risk-based capital ratio
▪ Pertains to banks’ credit risk for banks with significant
market risk.
❖ Total risk-based capital ratio
Nature of Regulation of Depository
Institutions
Bank Regulation
• Regulatory cycles
➢ “Historically, bank regulation has cycled between periods of
increasing and decreasing regulation. It is currently a period
of deregulation.”
➢ “Main types of regulation subject to these trends have been
interest rate ceilings, restrictions on providing nonbanking
services (securities and insurance), and geographical
restrictions interstate banking and intrastate branching).”
Nature of Regulation of Depository
Institutions
Bank Subtypes
• Wholesale versus retail banks
➢ Wholesale banks
❖ Make large-denomination loans to businesses, governments,
and other large institutions.
❖ Raise funds through larger, higher-interest-bearing deposits
and other managed liabilities.
➢ Retail banks
❖ Lend in smaller amounts to households and small businesses.
❖ Raise funds from smaller and lower- or noninterest-bearing
“core deposits”.
❖ Extensive branch network.
❖ Thrifts and small commercial banks are usually retail.
Nature of Regulation of Depository
Institutions
Bank Subtypes
• Corporate versus consumer banks
➢ Corporate banks
❖ Focuses on developing customer-specific products.
❖ For example, Citibank is a corporate bank.
➢ Consumer banks
❖ Focuses on efficient provision a standardized product.
❖ For example, JP Morgan Chase became more of a
consumer bank after they acquired Bank One.
Nature of Regulation of Depository
Institutions
Bank Subtypes
• Money center versus superregional versus regional
versus local banks
➢ Money center banks
❖ “Large banks with a wholesale and international focus,
such as Citibank, JP Morgan Chase, and Bank of
America
➢ Superregional banks
❖ “Operate in a number of states and have a retail and
domestic focus, such as PNC Financial and Keycorp.”
❖ “Grow through acquisitions of regional and local banks.”
Nature of Regulation of Depository
Institutions
Bank Subtypes
➢ Regional banks
❖ Smaller and less geographically extended versions of
superregional banks.
➢ Local banks
❖ “Retail banks that operate in a narrowly defined
geographical area, usually in a single state.”
Nature of Regulation of Depository
Institutions
Bank Subtypes
➢ Merchant banks
❖ Take equity positions in nonfinancial firms.
❖ Provide various corporate finance services.
❖ Fee income often exceeds their net interest income.
❖ “Under GLBA, financial holding companies’ investments
in nonfinancial firms must be made as part of a bona fide
underwriting or merchant banking or investment banking
activity.”
❖ “Investment in nonfinancial firms must be held in by a
subsidiary of the financial holding company, not by a
bank or its subsidiaries.”
Nature of Regulation of Depository
Institutions
Recent Trends
• Important trends affecting banks include:
➢ Loss of market share
❖ “Can be attributed to specific types of competitors taking
away specific types of borrowers from banks.”
➢ High profitability and increasing fee income
❖ “Fee income is becoming a relatively bigger determinant of
profitability compared to interest margin.”
➢ Increasing risk tolerance and diversification
❖ “After the bank crisis of the late 1980s, banks were cautious
in making lending decisions in the early 1990s.”
❖ “Working to reduce their risks, banks are better diversified
than they were before the bank crisis.”
Nature of Regulation of Depository
Institutions
Recent Trends
➢ Increasingly backup sources of funds
❖ Banks have become backup sources of funds rather than
primary sources.
➢ Industry consolidation and regulation
❖ “Banking and the other financial services industries are
consolidating through mergers and acquisitions.”
❖ “The consolidation and diversification of the financial
services industries poses problems for regulators interested
in maintaining a level playing field for financial institutions or
in assessing their risk.”
➢ Technological change and cost structure
❖ ATM’s and internet banking have changed the way banking
is conducted.
Chapter 3
Thrifts
Thrifts
• According to the text, there are three types of financial
analysis for thrifts and other financial institutions.
These are:
➢ Analysis of disclosures of interest rate risk and net
interest earnings
➢ Analysis of disclosures of credit risk and losses
➢ Analysis of fair value accounting and disclosures
for financial instruments
Thrifts
Financial Statement Structure
• Balance sheet
➢ Unclassified – no distinction between current and
noncurrent accounts
➢ Reflects liquid nature of financial assets and
liabilities
• Income statement
➢ Reflects the historical primacy of net interest
income
➢ Diminished over time because of thrifts shift of
focus to loan origination and servicing
Thrifts
Financial Statement Structure
• Cash flow statement
➢ “Principal cash flows on the loans it intends to
retain are classified as investing while the principal
cash flows on the loans it intends to resell are
classified as operating.”
Thrifts
Main Risk-Return Trade-Offs and Financial Analysis
Issues
• Main risk-return trade-offs
➢ Interest rate risk
❖ “Thrifts bear interest rate risk when their financial assets
and liabilities are imperfectly matched on duration.”
❖ Thrifts are exposed to interest rate risk for the following
reasons
▪ “Thrifts still find the interest rate spread associated
with speculating on an upward-sloping yield curve to
be worth the risk.”
▪ It is often difficult or costly for thrifts to eliminate all
interest rate risk.”
Thrifts
Main Risk-Return Trade-Offs and Financial Analysis
Issues
➢ Liquidity risk
❖ “Bears liquidity risk as the cash inflows on their
assets may come more slowly or less certainly
than the withdrawals.”
❖ “Interest rate and liquidity risks tend to go
together for imperfectly marketable fixed-rate
assets; both risks rise with the maturity of the
assets.”
Thrifts
Main Risk-Return Trade-Offs and Financial Analysis
Issues
➢ Credit risk
❖ Bears credit risk because their loans and
securities may not be repaid.
❖ Exacerbated because they are not often well
diversified.
❖ “SEC requires extensive disclosures useful for
the assessment of loan credit quality.”
Thrifts
Main Risk-Return Trade-Offs and Financial Analysis
Issues
➢ Persistence of noninterest income
❖ Thrifts profitability depends on noninterest
income.
❖ Types of noninterest income includes:
▪
▪
▪
▪
▪
Account fees
Mortgage origination
Servicing fees
Gains on the sale or securitization of mortgages
Impairment of mortgage servicing rights
Thrifts
Main Risk-Return Trade-Offs and Financial Analysis
Issues
➢ Operating efficiency and operational risk
❖ “Thrifts typically operate retail branch networks
that involve large fixed costs in order to raise
low-interest-rate core deposits.”
❖ “High fixed cost nature of branch networks
leads to operating leverage that magnifies the
effects of thrifts’ other risks.”
Thrifts
Main Risk-Return Trade-Offs and Financial Analysis Issues
➢ Core deposit intangibles
❖ Core deposits pay lower than wholesale market interest
rates.
❖ Very likely when interest rates have risen recently.
❖ Core deposits are “sticky” which means that depositors do
not withdraw their funds from nonterm deposits immediately
when interest rates rise.
❖ “In valuing a thrift, it is necessary to value its core deposit
intangible.”
❖ “This is an inherently difficult task, because the value of the
intangible depends on the behavior of both the thrift and its
depositors.”
Thrifts
Main Risk-Return Trade-Offs and Financial Analysis Issues
➢ Other financial analysis issues
❖ Intense competition from larger financial
institutions
❖ “Thrifts may derive economic rents from their
superior knowledge of or a presence in local loan
and deposit markets.”
❖ Rents are hard to maintain because of
competitive markets.
❖ Growth can be restricted by capital and reserve
requirements.
Chapter 4
Interest Rate Risk and Net Interest Earnings
Interest Rate Risk and Net Interest
Earnings
• Interest rates
➢ Prices for borrowing money for defined periods of
time.
➢ Depend on macroeconomic factors and factors
specific to the borrower.
➢ Macroeconomic factors include:
❖ Term of fixed-rate borrowings
❖ Repricing characteristics of floating-rate borrowings
❖ Credit risk of the borrower
➢ “Changes in interest rates yield changes in the
values of financial instruments.”
Interest Rate Risk and Net Interest
Earnings
➢ Financial institutions can reduce its interest rate
risk by:
❖ “The financial institution could hold only shortterm or floating-rate financial assets and
liabilities.”
❖ “The institution could try to match the amount
and timing of its cash inflows on fixed-rate
assets with those of its fixed-rate liabilities.”
Interest Rate Risk and Net Interest
Earnings
• Views of interest rate risk
➢ Two alternative views of interest rate risk
❖ “Interest rate risk is defined as the variability of
the value of a financial instrument or firm that
results from uncertainty about interest rates.”
❖ “Interest rate risk is defined as the variability of
the cash flows of a financial instrument or firm
that result from uncertainty about future interest
rates.”
Interest Rate Risk and Net Interest
Earnings
• Interest rate risk concepts
➢ Maturity, repricing interval, and duration
❖ Maturity
▪ Two limitations
o “The values of many financial instruments are
attributable in part or even predominantly to cash
flows prior to maturity.”
o “Many financial instruments accrue interest using
a floating interest rate, which reduces or even
eliminates interest rate risk, regardless of
maturity.”
▪ Weakly greater than repricing interval, which
is greater than duration.
Interest Rate Risk and Net Interest
Earnings
❖ Repricing interval
▪ Time until the interest rate on a financial
instrument next resets or its maturity.
▪ “Complete repricing may not occur,
however, because floating-rate financial
instruments often include contractual
provisions that restrict the magnitude of
repricings or involve repricing using interest
rates that lag market rates.”
Interest Rate Risk and Net Interest
Earnings
❖ Duration
▪ Addresses both limitations of maturity.
▪ “Assuming repricing is complete when it
occurs, duration is the weighted-average
repricing interval of the individual expected
net cash flows on a financial instrument.”
Interest Rate Risk and Net Interest
Earnings
➢ Yield curves
❖ Is the function relating the yields to maturity for
a defined class of financial instruments to their
maturities.
❖ Tend to slope upward.
❖ “Tendency for upward slope reflects the fact
that longer-duration instruments have more
interest rate risk, consistent with the view of
interest rate risk in terms of the variability of
value, not the variability of net cash flows.”
Interest Rate Risk and Net Interest
Earnings
➢ Spot interest rates
❖ “Spot” interest rates are needed to discount
expected cash flows at specific points in time.”
❖ “Can be calculated directly from observable
market values for comparable zero-coupon
instruments.”
❖ “These rates can be inferred from the yields on
comparable coupon-paying instruments.”
Interest Rate Risk and Net Interest
Earnings
➢ Spot interest rates
❖ “Spot” interest rates are needed to discount
expected cash flows at specific points in time.”
❖ “Can be calculated directly from observable
market values for comparable zero-coupon
instruments.”
❖ “These rates can be inferred from the yields on
comparable coupon-paying instruments.”
Interest Rate Risk and Net Interest
Earnings
• Analysis of net interest earnings
➢ Two required disclosures about net interest
earnings include:
❖ Rate-volume analysis
▪ SEC requires banks disclose net interest
earnings due to:
o Pure volume effects
o Pure interest rate effects
o Interactive volume/rate effects
Interest Rate Risk and Net Interest
Earnings
❖ Repricing gap disclosures
▪ “Report the entire book value of each main
type of interest-earning asset and interestpaying liability that reprices in various
intervals.”
▪ Provides an indication of the sensitivity of
banks to movements in interest rates at
points on the yield curve.
Interest Rate Risk and Net Interest
Earnings
❖ Repricing gap disclosures
▪ According to the book, “gap” refers to
differences in the amounts of financial
assets and liabilities repricing in a given
interval, in two different senses:
o Referring to a specific time interval.
o Referring to early versus late time
intervals, or, equivalently, to whether a
financial institution assets reprice quicker
or slower than its liabilities.
Chapter 5
Credit Risk and Losses
Credit Risk and Losses
• Economics of credit risk
➢ According to the text, the required credit risk or fee
depends on four main determinants:
❖ The probability that the borrower will default
❖ The expected loss conditional on default
❖ The variability of the loss
❖ The institution’s ability to diversify losses within
its own portfolio or to transfer them to a third
party.
Credit Risk and Losses
• Accounts for loans and loan losses
➢ Depends on whether the bank intends to hold the
loans in portfolio or for sale.
➢ “It also differs for purchased loans for which it was
probably at the time of purchase that the bank
would receive all of the contractual payments on
the loans due to the lack of credit-worthiness of the
borrower.”
➢ “Loans outstanding increase with the principal
amount of new loans, whether initiated or
purchased by the bank.
Credit Risk and Losses
• Accounting and disclosure rules for unimpaired loans
➢ “Estimated credit losses are calculated differently
for unimpaired and impaired loans.”
➢ “Individual loans are deemed impaired when they
meet certain criteria.”
Credit Risk and Losses
➢ Recognition and measurement
❖ “The overarching standard that deals with credit
losses is Statement of Financial Accounting
Standards (SFAS) No. 5, Accounting for
Contingencies (1975), which states that loss
contingencies should be recognized on the
balance sheet if they are probable and the
amount of the losses can be “reasonably
estimated”.”
Credit Risk and Losses
➢ Importance of loan type
❖ Two loan types used to estimate credit losses
for unimpaired loans:
▪ Individually small and homogenous loans.
o Credit card receivables
o Other consumer loans
▪ Individually large and heterogeneous loans.
o Commercial and industrial loans
o Commercial and real estate loans
Credit Risk and Losses
➢ Disclosures
❖ SEC requires banks to disclose loan losses by
type of loan.
❖ Banks must distinguish the losses between
domestic and foreign loans.
❖ “Historically, the disclosure of the unallocated
portion of the allowance was useful because
discretion over the allowance for loan losses
often was concentrated in that portion of the
allowance.”
Credit Risk and Losses
• Accounting and disclosure rules for impaired loans
➢ Impaired loans
❖ Impaired loans are riskier than an unimpaired
loan.
❖ Interest rate used is still too low.
❖ “SFAS No. 118 requires that banks disclose the
amount of impaired loans, the portion of
allowance for loan losses devoted to impaired
loans, and any interest revenue recorded on
impaired loans; some banks go further and
provide separate accounts for unimpaired or
impaired loans.”
Credit Risk and Losses
➢ Nonperforming loans
❖ “Industry Guide 3 requires banks to disclose the
amounts of nonaccrual loans, past-due loans,
loans subject to troubled debt restructurings,
and potential problem loans for each of the past
five years.”
❖ Past due = loans more than 90 days delinquent.
❖ “Nonperforming loans are the sum of
nonaccrual loans, past due loans, and
restructured debt.”
Credit Risk and Losses
• Loan portfolio quality and loan loss reserve adequacy
➢ According to the text, “loan portfolio quality” refers
to:
❖ Credit risk of the loan portfolio as to whether the
value of the portfolio has deteriorated or is
prone to future deterioration.
➢ According to the text, “loan loss reserve” adequacy
refers to:
❖ Refers to the appropriateness of the allowance
and provision for loan losses as stock and flow
measures, respectively, of credit losses, given
the quality of the loan portfolio.
Credit Risk and Losses
➢ Alternative benchmark measures of credit losses
❖ Two most common benchmarks:
▪ Net loan charge-offs
o “Net loan charge-offs are relatively
nondiscretionary because they should be
recorded when a loan is known to be
uncollectible with high probability.”
o “An issue with net loan charge-offs is that a bank
that wants to store income for future periods
without being too noticeable about it might adopt
a fast charge-off policy, so that allowance for loan
losses does not build up suspiciously high.”
o Can be relatively untimely.
Credit Risk and Losses
▪ Loan portfolio quality
o Depends on the bank’s credit risk
management skill, loan portfolio
composition, and economic conditions
which apply to the situation.
o Can be assessed using information
outside the bank’s financial report.
Credit Risk and Losses
• Research on banks’ loan loss reserves
➢ Two important findings of banks’ loan loss reserves
include:
❖ “While the results are not uniform across
studies, research generally shows that banks
exercise discretion over the allowance and
provision for loan losses to smooth earnings
across the business cycle, to raise regulatory
capital when needed, and to reduce taxes.”
❖ “The market often reacts positively to increased
allowances and provisions for loan losses.”
Chapter 6
Fair Value Accounting for Financial Instruments:
Concepts, Disclosures, and Investment Securities
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
• Fair value accounting for financial instruments
➢ Fair value
❖ SFAS No. 157 defines fair value as:
▪ “The price that would be received to sell an
asset or paid to transfer a liability in an
orderly transaction between marketplace
participants at the measurement date.”
▪ Fair value if defined this way is know as exit
value.
▪ Distinctive from the price that would be paid
to purchase an asset.
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
➢ Fair value hierarchy
❖ “SFAS No. 157 contains a hierarchy of the types of inputs that
may be used to estimate fair value, giving higher priority to
observable inputs that use market data more fully.”
❖ These inputs include:
▪ Quoted prices
▪ Other observable market data
o Quoted prices for similar assets or liabilities in active
markets
o Interest rates, yield curves, volatilities, prepayment
speeds, loss severities, credit premia, and default rates
▪ Unobservable inputs
o Inputs derived from or corroborated by market data
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
➢ Full fair value accounting
❖ According to the text, full fair value accounting has
three specifics:
▪ On the balance sheet, economic gains and losses are
recognized through adjustments to the carrying values of
assets and liabilities each period.
▪ On the income statement, economic gains and losses are
recorded as they occur, not when they are realized.
▪ On the income statement, interest is recognized on a fair
value basis, as the weighted-average fair value of a
financial instrument during the period times the
corresponding weighted-average market interest rate.
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
➢ Argument against fair value accounting for financial
instruments
❖ Fair value accounting yields unnecessary income
❖ Gains and losses are nonrecurring
❖ Financial instruments are involved in economic hedging
relationships
❖ Fair values are not reliably measurable for some financial
instruments
❖ Some financial instruments are coupled with customer
relationships or other nonfinancial items.
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
• Disclosures of the fair value of financial instruments
➢ SFAS No. 107
❖ “Requires that firms disclose the fair value and the
carrying value of both on- and off-balance sheet
financial instruments.”
❖ Exceptions to disclosure requirements
▪ Mortgage-servicing rights
▪ Core deposit intangibles
▪ Leases
▪ Insurance contracts
▪ Investments
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
➢ SFAS No. 157
❖ Disclosures which are useful:
▪ “Fair value measurements are the reporting
date and the level within the fair value hierarchy
where they all must be disclosed.”
▪ “Fair values are estimated using Level 3 inputs
on a recurring basis.”
▪ “When fair values are estimated using Level 3
inputs on a nonrecurring basis.”
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
➢ Adjusting financial statements to reflect the fair value
of financial instruments
❖ “Fair value is the preferred valuation basis for
financial instruments, it is generally useful to adjust
financial institutions’ reported financial statements
to reflect the fair value of their financial instruments
using SFAS No. 107 (1991) disclosures.”
▪ Balance sheet
▪ Income statement
▪ Adjusting Golden West’s financial statements
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
• Investment securities
➢ Restrictions on reclassifying securities and the
possibility of gains trading
❖ “SFAS No. 115 (1989)
▪ Allows firms to exercise discretion to obtain desired
accounting treatments, including gains trading.
▪ Allows securities to be transferred out the HTM portfolio.
▪ “Requires that transfers of securities among the three
types be recorded at fair value in some fashion.”
➢ Other-than-temporary impairment
❖ “SFAS No. 115 (1989)
▪ Requires that the firm determine whether the impairment
is “other than temporary”.
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
• Investment securities
➢ Disclosures and the assessment of gains trading
❖ Gains trading takes place in two forms:
▪ “The firm holds a portfolio of securities that have
appreciated or depreciated since purchase, from which it
chooses to sell selected securities.”
▪ “The firm holds securities that appreciate or depreciate
during the year, but its realization of gains and losses
during the year is not representative of this appreciation
or depreciation.”
Chapter 7
Mortgage Banks
Mortgage Banks
• Mortgage banking industry, major players, and
activities
➢ Begin in the 1950s originating mortgages by
federal government agencies.
➢ Took off in 1970, when the Government National
Mortgage Association (Ginnie Mae) sponsored
securitization of government mortgages.
➢ “Ginne Mae currently sponsors securitization of
mortgages insured by these government agencies:
❖ Federal Housing Administration (FHA) within HUD
❖ Department of Veterans Affairs (VA)
❖ Rural Housing Service (RHS) within the Department of
Agriculture
❖ Office of Public and Indian Housing (PIH) within HUD”
Mortgage Banks
➢ Fannie Mae and Freddie Mac are federally
chartered government-sponsored enterprises
(GSE)
❖ Regulated under the Federal Housing
Enterprise Safety and Soundness Act of 1992
➢ “Mortgage servicing entails various activities, such
as
❖ Billing
❖ Collecting and processing payments
❖ Dealing with defaulted mortgages
❖ Providing customer services”
Mortgage Banks
• Financial statement structure
➢ Balance sheet
❖ According to the text, mortgage banks have
three assets
▪ Mortgages and MBS held for sale, which are
valued at the lower of cost or market, like
inventory
▪ Retained securities from securitizations
▪ Mortgage servicing rights (MSRs)
➢ Income statement
➢ Cash flow statement
Mortgage Banks
• Financial statement structure
➢ Income statement
❖ Main revenues are:
▪ Fees for mortgage origination and servicing
▪ Gains on the sale of mortgages
❖ Main revenue line items are highly and differentially
associated with fixed-rate mortgage commitment rates.
➢ Cash flow statement
❖ “Mortgage banks’ main adjustment to net income in the
operating section of the cash flow statement is usually
the change in mortgages and MBS held for sale, which
are treated like inventory with respect to cash flow
statement classification.”
Mortgage Banks
• Main risk-return trade-offs and financial analysis
issues
➢ Interest rate and prepayment risks
❖ “Mortgage banks are exposed to interest rate
risk on their mortgage-related assets through
prepayment and discounting effects that are not
entirely distinct.”
❖ “Prepayment effect reflects the fact that most
residential mortgages give mortgages a call
option to prepay.”
❖ “Prime residential mortgages usually are
prepayable without penalty.”
Mortgage Banks
❖ Mortgage banks have three types of exposure
to interest rate and prepayment risks include:
▪ Have an inventory of unsold fixed-rate
mortgages and MBS.
▪ “Mortgage origination fees reflect a base
level that occurs due to people moving or
refinancing for non-interest-rate-motivated
reasons.”
▪ Hold MSRs and two types of retained
securities.
Mortgage Banks
• Main risk-return trade-offs and financial analysis
issues
➢ Credit risk
❖ “Mortgage banks bear credit risk on their mortgages and
MBS held for sale, mortgage commitments, retained
interests from securitizations, including MSRs, and any
recourse obligations they assume.”
➢ Liquidity risk
❖ Cash flow-based business
❖ Funds must be available to lend
➢ Persistence and growth of fee income
❖ Sources of fee income are concentrated in distinct
economic conditions.
Mortgage Banks
• Main risk-return trade-offs and financial analysis
issues
➢ Cross-selling and diversification
❖ Banks attempt to cross-sell other products.
❖ “Cross-selling opportunities exist because obtaining or
refinancing a mortgage is a relatively infrequent but very
important decision for their customers.”
➢ Operating efficiency
❖ Banks have different cost structures depending on how
they originate or acquire mortgages.
❖ Banks may originate mortgages through retail branches
or the internet.
Mortgage Banks
• Accounting fees and costs
➢ Most important accounting issues affecting
mortgage banks are:
❖ Securitization
❖ MSRs
❖ Retained securities
Chapter 8
Securitizations
Securitizations
• Accounting for securitizations
➢ According to the text, under SFAS No. 140 (2000),
three issues for users of financial reports
❖ Despite SFAS No. 140’s (2000) focus on control, it is not
clear that issuers are affected substantially by whether
surrender control over the underlying financial assets.
❖ Certain retained interests concentrate the risk of the
underlying financial assets.
❖ Some retained interests are sensitive or illiquid
instruments that require expertise and judgment to value.
Securitizations
• Motivations for and alternatives to securitizations
➢ According to the text:
❖ Issuers have various motivations for securitizations.
❖ Securitizations provide funds for future organizations of
financial assets.
❖ They allow issues to diversify their holdings of financial
assets and to transfer or transform the risk of those
assets in diverse ways.
❖ Loan sales and syndications are common alternatives to
securitizations.
❖ Loan syndications can be structured legally as
participations or assignments.
Securitizations
➢ Residential Mortgages
❖ Was the first and remains the most important
type or securitized financial asset.
❖ Residential mortgage securitizations are
sponsored.
❖ Ginnie Mae and other government-sponsored
enterprises are the sponsors of securitizations.
▪ Ginnie Mae sponsors but does not issue
securitizations of mortgages.
▪ Ginnie Mae provides timing insurance.
Securitizations
➢ Securitizations of other financial assets
❖ “Are important to a wide class of financial
institutions that securitize an increasingly wide
range of loans, securities, and lease
receivables.”
❖ Almost any type of financial asset can be
securitized.
➢ Asset-backed commercial paper
❖ “Asset-backed commercial paper (ABCP) is a
type of short-term financing (less than 270 days
in the United States) that is employed by both
financial institutions and nonfinancial firms.”
Securitizations
• Securitization structures
➢ Pass-through securitizations
❖ Simplest form of securitization
➢ Estimation of prepayment risk
➢ Tranched securitizations
❖ Yield distinct tranches of securities with
different prepayment, interest rate, credit, or
other risk.
❖ Collateralized mortgage obligations (CMOs)
▪ Tranched securitizations for residential
mortgages
Securitizations
• SFAS No. 140
➢ “Defines transfers of financial assets as
conveyances of noncash financial assets by and to
someone other than the issuer of the assets.”
➢ These transfers include securitizations.
➢ Scope exclusions
❖ Transfers of some types of financial assets.
▪ “Specifically, transfers of financial assets associated
with pension and other postemployment benefit
plans, leveraged leases, and insurance contracts are
excluded.”
Securitizations
➢ Three concepts to determine if the transfer is a
sale or secured borrowing:
❖ Financial components concept
▪ Reflects the sequence of transactions
leading up to a given position.
❖ Control concept
▪ Reflects legal and effective notions.
❖ Fair value concept
▪ “Uses fair value in two ways in accounting
for transfers of financial assets for which the
transferor has surrendered control over the
assets as sales.”
Securitizations
➢ Disclosures
❖ Requires minimal disclosures for
securitizations.
❖ According to the text, the issuer must disclose
▪ A description of the economic characteristics of
securitizations, including the nature of each retained
interest.
▪ The policies used to account for and the methodology
and significant assumptions used to estimate the fair
values of each retained interest, or the reason why it
is not practicable to estimate their fair value.
▪ Sensitivity tests indicating the hypothetical change in
the fair value of each retained interest or two or more
unfavorable changes in each significant assumption
used to estimate its fair value.
Securitizations
➢ Disclosures
▪ The gain or loss on sale during a period.
▪ The various cash flows between the issuer and the
securitization SPEs during the period.
Securitizations
• Financial analysis issues
➢ The text states, three financial analysis issues
❖ Is sale accounting applied when the issuer still
bears most of the risks and rewards on the
financial assets?
❖ Are the amounts recorded for retained interests
and thus gains on sale appropriate?
❖ Are these gains persistent, or are they timed to
manage income?
Securitizations
• Servicing and prepayment-sensitive securities
➢ Servicing rights
❖ “Are recognized separately from the remainder
of the financial assets only when those rights
are retained in a securitization or other transfer
or are purchased in the open market.”
❖ Servicing rights are most often assets.
❖ Servicing liabilities occur when the cost of
servicing exceeds the fees.
Chapter 9
Elements of Structured Finance Transactions
Elements of Structured Finance
Transactions
• Special-purpose/variable-interest entities
➢ Economic purposes and the ineffectiveness or prior
consolidation rules
❖ “SPEs are entities that are restricted by contract
or corporate charter to engage in specified and
generally limited economic activities.”
❖ “SPEs do not have the same ongoing control
issues as ordinary firms, and their equity
holders’ voting rights often are of little or no
importance.”
Elements of Structured Finance
Transactions
➢ FIN No. 46 (R)
❖ Govern the consolidation of SPEs and other
entities.
❖ “Adopts a risk-and-rewards-based approach to
consolidation, but it includes considerably more
stringent criteria for consolidation and more
generally applicable language than the prior
standards.”
❖ Does not include control as a requirement for
consolidation.
Elements of Structured Finance
Transactions
• Related Transactions
➢ Netting agreements and FIN No. 39
❖ Most common form of contractual relationship
relating multiple transactions.
❖ “Multiple transactions among two or more
counterparties settle by net rather than gross
payments being made among counterparts in
some or all circumstances.”
❖ Most useful when counterparties engage in
repeated transactions.
Elements of Structured Finance
Transactions
• Related Transactions
➢ Transactions entered into contemporaneously and
in contemplation of one another
❖ Four accounting rules
▪ EITF 98-15
o Considers two structured notes with
mirror-image contractual terms
▪ EITF 00-4
o Considers minority interest in a
subsidiary and a sold put option on that
minority interest.
Elements of Structured Finance
Transactions
• Related Transactions
▪ Derivatives implementation group
o DIG K1
o DIG F6
❖ “All rules require that the multiple transactions
in the fact patterns under consideration be
accounted for “as a unit”.”
Elements of Structured Finance
Transactions
• Hybrid financial instruments
➢ Type of structured finance product.
➢ Must be desirable to a large group of investors.
➢ Serves two economic purposes:
❖ “Bundle desired features of multiple simple
instruments into a single instrument and/or
eliminate the undesired features of single
instruments.”
❖ “Settling as a single net instrument, hybrid
financial instruments can mitigate credit risks
compared to multiple single instruments in
much the same way as a netting agreement.”
Elements of Structured Finance
Transactions
• Hybrid financial instruments
➢ Two accounting issues:
❖ “Should hybrid financial instruments be
decomposed into their constituent
components?”
❖ “Hybrid financial instruments in their entirety do
not fall neatly into the usual characteristicbased classifications of financial instruments,
yielding both accounting standard setters have
not resolved in a comprehensive fashion.”
Elements of Structured Finance
Transactions
• Hybrid financial instruments
➢ Three main accounting approaches
❖ Decomposition into components
❖ Fair value option
❖ Improved financial statement classification or
enhanced disclosure.
Elements of Structured Finance
Transactions
• Recent SEC decisions regarding structured finance
transactions
➢ According to the text:
❖ Structured finance transactions often have accounting
motivations, such as off-balance sheet financing and
income management.
❖ If properly accounted for or inadequately disclosed, these
transactions can impair the transparency of financial
reports.
❖ The SEC issued a final rule in 2003 that expands
mandated disclosure of off-balance sheet financing
arrangements, and it issued a special report in 2005 that
puts forth proposals for the development of accounting
standards and provides cautionary words about
accounting-motivated structured transactions.
Elements of Structured Finance
Transactions
• Recent SEC decisions regarding structured finance
transactions
➢ According to the text:
❖ Structured finance transactions often have accounting
motivations, such as off-balance sheet financing and
income management.
❖ If properly accounted for or inadequately disclosed, these
transactions can impair the transparency of financial
reports.
❖ The SEC issued a final rule in 2003 that expands
mandated disclosure of off-balance sheet financing
arrangements, and it issued a special report in 2005 that
puts forth proposals for the development of accounting
standards and provides cautionary words about
accounting-motivated structured transactions.
Chapter 10
Commercial Banks
Commercial Banks
• Commercial banks
➢ Tend to be more like securities firms by:
❖ Focus more on generating fee or other
noninterest income
❖ Less focused on generating interest income.
❖ “Largest U.S. commercial banks are extensively
involved with derivatives as dealers, traders,
and hedgers.”
❖ Analysis of a commercial bank places more
weight on income or cash flow statement-based
valuation approach.
Commercial Banks
• Balance sheet
➢ Balance sheets are unclassified – no distinction
made between current versus noncurrent
accounts.
➢ Reflects liquid nature of financial assets and
liabilities.
➢ Assets and liabilities are listed in order of liquidity.
❖ Reflects a combination of intent to order and
term to maturity.
Commercial Banks
• Income statement
➢ “Order of commercial banks’ income statements
reflects the historical primacy of net interest
income.”
➢ Interest revenue is at the top of the income
statement.
➢ Income statement varies across size classes.
Commercial Banks
• Cash flow statement
➢ “As with thrifts, the distinction among operating,
investing, and financing cash flows is arbitrary on
commercial banks’ cash flow statements, since
most of their cash flows relate to financial
instruments.”
Commercial Banks
• Cash flow statement
➢ “The same cash flow statement classification issue
arise for commercial banks’ trading portfolio.”
➢ “In analyzing a commercial bank, it usually wise to
ignore its cash flow statement classifications and
focus instead on what the cash flow statement
indicates about the banks’ new investments and
sources of funding during the year.
Chapter 12
Market Risk Disclosures
Market Risk Disclosures
• FRR No. 48 (1997)
➢ Defines risk as the “possibility of loss, not gain”.
➢ “Requires that market risk disclosures be made
once a year in firms’ Form 10-K filings.”
➢ Significant limitations
❖ Need not be comparable across firms
❖ Exposures for a given firm
❖ Time
Market Risk Disclosures
• FRR No. 48 (1997)
➢ Four reasons FRR no. 48 is limited:
❖ “Firms may define loss in terms of reduction of
value, earnings, or cash flow, and the three
definitions of loss are not identical and can be
inconsistent.”
❖ Firms may disclose their exposure to each type
of market risk using:
▪ Tabular format
▪ Sensitivity approach
▪ Value-at-risk approach
Market Risk Disclosures
• FRR No. 48 (1997)
❖ “Period over which loss is measured in the
sensitivity and VaR approaches varies across
firms and across different risks for a given firm.”
❖ “The size of the market price movements in the
sensitivity approach and the confidence level
used in the VaR approach vary across firms.”
Market Risk Disclosures
• Tabular format
➢ “Requires that fair values and information sufficient
to estimate the expected cash flows over each of
the next five years and beyond five years be
disclosed for derivatives and other financial
instruments grouped based on common
characteristics for each market risk.”
➢ “Users of financial reports should be aware that
this information is not always tabulated in the same
way by different firms.”
Market Risk Disclosures
• Tabular format
➢ Estimating repricing gap
❖ According to the text, three steps are involved
in estimating the repricing gap
▪ Treat fixed-rate financial investments as a
set of zero-coupon instruments with
repricing intervals that correspond to the
timing of principal cash flows in the tabular
format disclosure.
Market Risk Disclosures
▪ Treat floating-rate financial instruments as
repricing within the next year, unless there is
reason to believe these instruments reprice
more slowly.
▪ Treat derivatives as the closest available
portfolio of cash instruments, and apply
steps 1 and 2.
Market Risk Disclosures
➢ Estimating duration
❖ According to the text, three steps in estimating duration using
tabular format disclosures
▪ Estimate the expected cash flows in each interval for each
type of fixed-rate financial instrument.
▪ Unless there is reason to believe otherwise, assume that
floating-rate financial instruments pay off in full in the 0- to 1year interval and that payment of principal and half a year’s
accrued interest occurs halfway through the interval.
▪ Treat derivatives as the closest available portfolio of cash
instruments and apply steps 1 and 2.
▪ Expected cash flows determined in steps 1-3 can be used to
estimate duration.
Market Risk Disclosures
➢ Strengths and Weaknesses
❖ Provides unprocessed and disaggregated data.
▪ Used to assess market risk on an ex ante
basis
▪ Used to estimate market risk on ex post
effect of changes in market prices.
❖ Two main weaknesses for tabular format
▪ Static portrayal of firms’ exposures
▪ Does not clearly indicate the covariances
across different exposures or market risks.
Market Risk Disclosures
• Sensitivity approach
➢ “Requires that the firm provide an estimate of loss of
value, earnings, or cash flow caused by a specific
adverse movement in each market price or rate.”
➢ “Firm can choose the size of the movement, although
it should be at least 10% of the current market price
or rate.”
➢ Most common form of market risk disclosure.
Market Risk Disclosures
➢ Strengths and weaknesses
❖ Strength
▪ Simplicity and ease of interpretation compared
to the tabular format.
❖ Weakness
▪ “May not provide users of financial reports with
a good sense for complex or nonlinear
exposures.”
Market Risk Disclosures
• Value-at-risk approach
➢ “Requires that the firm provide an estimate of the
loss of value, earnings, or cash flow that is expected
to result with a specified probability over a specified
time interval for each market risk.”
➢ VaR approach is statistical and confidence bound.
➢ Confidence bound
❖ Distinguishes normal from abnormal realizations
of risk.
Market Risk Disclosures
• Value-at-risk approach
➢ Three main statistical approaches:
❖ Delta-normal method
▪ “Firm assumes that the return to each of the
financial instruments it holds is distributed
normally, so the returns to all its financial
instruments are linearly related.”
❖ Historical simulation method
▪ “The firm observes the multivariate empirical
distributions of the returns to its exposures
and, through repeated sampling from these
distributions, simulates the distribution of the
returns to its portfolio of exposures.
Market Risk Disclosures
❖ Monte Carlo method
▪ “The firm assumes return distribution that it
believes apply to its various exposures –
most commonly, smooth distributions that
resemble the empirical distributions but
abstract from the idiosyncrasies of the
historical data – and uses these distributions
to simulate the distribution of returns to its
portfolio.”
Market Risk Disclosures
• Effect of Suntrust’s derivatives and hedging on its
market risk
➢ Four types of distinct hedging relationships
❖ Cash flow asset hedges using swaps
❖ Fair value asset hedges using forwards
❖ Cash flow liability hedges using swaps
❖ Fair value liability hedges
Chapter 13
Lessors and Lease Accounting
Lessors and Lease Accounting
• Competitive advantages of leasing
➢ According to the text, there are five competitive
advantages
❖ Leases deemed to be true leases rather than conditional
sales under federal tax law allow lessees that cannot
efficiently use the tax benefits associated with the
purchase of capital assets to sell those benefits to
lessors.
❖ Leasing mitigates risks for or partitions risks among
lessees, lessors, and third parties that provide or
guarantee the residual value of the leased assets.
Lessors and Lease Accounting
• Competitive advantages of leasing
❖ Leasing often provides 100% financing of the
cost of capital assets.
❖ Leasing provides a variety of conveniences for
lessees.
Lessors and Lease Accounting
• Lease structures and contractual terms
➢ “Large-ticket leases often structured to obtain desired
economic effects and to exploit tax and financial reporting
rules for the lessee, lessor, and possible a number of third
parties, and so they can be very complex contractually.”
➢ SPEs – two main roles in leasing
❖ “Help protect the parties to the lease against the
bankruptcy or nonperformance of any of the other
parties.”
❖ “Can be structured in various ways to yield desired
economic, tax, and financial reporting outcomes for the
various parties to the lease.”
Lessors and Lease Accounting
❖ “Leases can result from two sequences of events”:
▪ Standard leases: Lessor owns the asset originally and
leases it to the lessee.
▪ Sale-leasebacks: Lessee owns the asset originally sells it to
the lessor, and then leases it back.
❖ According to the text, expected lease payments and term may
be much greater than these minimum lease payments and term,
for two reasons
▪ Leases may include renewal options, and various aspects of
the lease contract, the lessee, and the nature and market for
the leased asset may work individually or together to make
the exercise of renewal options probable but not necessarily
reasonably assured.
▪ Leases may involve various kinds of contingent payments.
Lessors and Lease Accounting
• Lessors’ risks
➢ According to the text, lessors are exposed to risks
which include:
❖ Residual value of leased assets can be highly uncertain.
❖ Tax advantages of leasing are susceptible to unexpected
changes.
❖ Lease receivables whose payments do not float with
interest rates yield interest rate risk.
❖ Lessors’ ability to securitize lease receivables to raise
funds and recognize gains on sale vary with economic
conditions.
Lessors and Lease Accounting
❖ Lease receivables are subject to credit risk, since lessees
are often sub-prime credits and since the lessee is more
likely to default when the leased asset value deteriorates.
❖ Lessors are exposed to industry and macroeconomic
cycles.
❖ Leasing is a competitive business.
Lessors and Lease Accounting
• Lease accounting methods
➢ Primarily governed by SFAS No. 13 (1976).
➢ Standard has been amended repeatedly.
➢ “Most accounting observers view lease accounting as an
unsatisfactory patchwork that sometimes yields complex lease
transactions structured to obtain nondescriptive accounting
outcomes.”
➢ Can be difficult to determine if contracts constitute leases of
capital assets governed by SFAS No. 13 (1976) or service
contracts governed by other accounting methods.
Lessors and Lease Accounting
➢ Lease term and minimum lease payments
❖ Lease term is defined as:
▪ “The fixed noncancellable term of the lease plus all
periods up to and including:
o Covered by bargain renewal options
o Failure to renew the lease imposes a penalty
o Governed by renewal options in which the lessee
guarantees, directly or indirectly
o The lease can be renewed at the lessors’ options.”
Lessors and Lease Accounting
❖ According to the text:
▪ A lease is deemed noncancellable if it is cancellable
only upon the occurrence of a remote contingency, only
with the permission of the lessor, only if the lessee
enters into a new lease with the same lessor, or only if
the lessee incurs a cancellation penalty such that
continuation of the lease is reasonably assured at
inception.
▪ Minimum lease payments for the lessee are defined as
the payments the lessee is required to make over the
lease term in connection with the leased property.
Lessors and Lease Accounting
➢ Determining the lease accounting method
❖ According to the text, four criteria for classifying
leases include:
▪ The lease transfers ownership of the leased asset to the
lessee at the end of the lease term.
▪ The lease contains a bargain purchase option.
▪ The lease term is 75% or more of the estimated
remaining economic life of the leased asset, unless the
lease term begins in the last 25% of the total estimated
economic life of the leased asset.
▪ The present value of the minimum lease payments is
90% or more of fair value of the leased asset.
Lessors and Lease Accounting
• Analysis issues regarding lease accounting methods
➢ Balance sheet amounts
❖ “The balance sheet of a lessor using operating
lease accounting includes a fixed asset, while the
balance sheet of a lessor using direct financing
lease accounting includes a net lease receivable.”
➢ Income statement amounts
❖ Operating lessor depreciates the leased asset to
its residual value over the lease term.
Lessors and Lease Accounting
➢ Income statement timing
❖ “Operating lessors record lease revenue equal to
the lease receipts applicable to the period as well
as depreciation expense on the leased asset.”
➢ Cash flow statement classification
❖ “The lease accounting method used for financial
reporting does not affect the amount or timing of
cash flows, but it has a dramatic effect on the
classification of cash flows.”
Lessors and Lease Accounting
• Special lease transactions
➢ Leveraged leases
❖ “A leveraged lease is a direct financing lease in which the
lessor obtains financing collateralized by the leased asset
from a third party.”
➢ According to the text, leveraged leases are direct
financing which meets three criteria:
❖ The third-party financing must be for at least 50% of the fair
value of the leased asset (it is usually for considerably
more).
❖ The third-party financing must be nonrecourse to the lessor.
❖ The lessors’ net investment in the lease must first fall and
then rise over the lease term, as well described.
Lessors and Lease Accounting
➢ Sale-leasebacks
❖ “Lessors often buy leased asset from lessees and
then lease it back to them.”
❖ “Lessors become lessees by selling and leasing
back the assets that they lease.”
➢ Synthetic leases
❖ “The tax accounting and financial accounting for
lessors are usually by not always the same.”
❖ “The most important difference between tax and
financial accounting is embodied in “synthetic
leasing”.”
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Financial Instruments
and Institutions
Accounting and
Disclosure Rules
Second Edition
STEPHEN G. RYAN
John Wiley & Sons, Inc.
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Financial Instruments
and Institutions
Accounting and
Disclosure Rules
Second Edition
STEPHEN G. RYAN
John Wiley & Sons, Inc.
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For John and Arlene, my parents,
and Lisa and Jacob, my life
This book is printed on acid-free paper.



Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey
Published simultaneously in Canada.
Wiley Bicentennial Logo: Richard J. Pacifico
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Library of Congress Cataloging-in-Publication Data
Ryan, Stephen G.
Financial instruments and institutions : accounting and disclosure rules /
Stephen G. Ryan. — 2nd ed.
p. cm.
Includes index.
ISBN 978-0-470-04037-9 (cloth)
1. Financial instruments —Accounting. 2. Financial institutions —
Accounting. I. Title.
HF5681.F54R93 2007
657′.76 — dc22
2006036780
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
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Contents
Preface
ix
Acknowledgments
xvii
CHAPTER 1
Financial Instruments and Institutions
1
Main Ingredients of the Analysis of Financial Instruments
Activities and Risks of Financial Institutions
Valuation of Financial Institutions in Practice
4
11
16
CHAPTER 2
Nature and Regulation of Depository Institutions
19
Activities of Depository Institutions
Bank Regulation
Bank Subtypes
Recent Trends
19
22
35
38
CHAPTER 3
Thrifts
45
Financial Statement Structure
Main Risk-Return Trade-Offs and Financial Analysis Issues
46
56
CHAPTER 4
Interest Rate Risk and Net Interest Earnings
63
Views of Interest Rate Risk
Interest Rate Risk Concepts
64
66
iii
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iv
Analysis of Net Interest Earnings
Rate-Volume Analysis
Repricing Gap Disclosures
CONTENTS
78
81
84
CHAPTER 5
Credit Risk and Losses
93
Economics of Credit Risk
Accounts for Loans and Loan Losses
Accounting and Disclosure Rules for Unimpaired Loans
Accounting and Disclosure Rules for Impaired Loans
Loan Portfolio Quality and Loan Loss Reserve Adequacy
Research on Banks’ Loan Loss Reserves
Appendix 5A: SunTrust Banks —After the Restatement
95
97
100
107
110
118
119
CHAPTER 6
Fair Value Accounting for Financial Instruments:
Concepts, Disclosures, and Investment Securities
131
Fair Value Accounting for Financial Instruments
Disclosures of the Fair Value of Financial Instruments
Investment Securities
Appendix 6A: Washington Federal’s Big Gap
133
141
149
158
CHAPTER 7
Mortgage Banks
161
Mortgage Banking Industry, Major Players, and Activities
Financial Statement Structure
Main Risk-Return Trade-Offs and Financial Analysis Issues
Accounting for Fees and Costs
162
167
174
186
CHAPTER 8
Securitizations
189
Why and What?
Securitization Structures
SFAS No. 140
192
196
204
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Contents
Financial Analysis Issues
Empirical Research on Securitizations
Servicing Rights and Prepayment-Sensitive Securities
Appendix 8A: Doral Financial’s Interesting
Interest-Only Strips
v
216
221
222
224
CHAPTER 9
Elements of Structured Finance Transactions
235
Special-Purpose/Variable-Interest Entities
Related Transactions
Hybrid Financial Instruments
Financial Guarantees
Recent SEC Decisions Regarding Structured Finance
Transactions
236
244
248
251
253
CHAPTER 10
Commercial Banks
255
Balance Sheet
Income Statement
Cash Flow Statement
257
261
265
CHAPTER 11
Derivatives and Hedging
269
Derivatives
Hedging
SFAS No. 133 (1998), as Amended
Framework for Assessing Financial Institutions’ Derivatives
and Hedging
272
282
285
308
CHAPTER 12
Market Risk Disclosures
311
Overview of FRR No. 48 (1997)
Tabular Format
Sensitivity Approach
312
315
322
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Value-at-Risk Approach
Comparison of Disclosure Approaches
Effect of SunTrust’s Derivatives and Hedging
on Its Market Risk
Research
Appendix 12A: Bank of America’s Derivatives,
Hedging, and Market Risk
CONTENTS
326
331
332
337
337
CHAPTER 13
Lessors and Lease Accounting
347
Competitive Advantages of Leasing
Lease Structures and Contractual Terms
Lessors’ Risks
Lease Accounting Methods
Analysis Issues Regarding Lease Accounting Methods
Special Lease Transactions
Lessors’ Financial Statements
Lease Disclosures
Possible Future Changes in Lease Accounting
350
352
355
357
366
369
374
379
387
CHAPTER 14
Insurers and Insurance Accounting
389
Products
Risk-Return Trade-Offs
Regulation
Primary Insurance Accounting Standards
Accounting Standards Governing Embedded
Derivatives and Other Life Insurance Policy Features
Financial Statements
Line of Business Disclosures
Other Insurance Accounting Systems
391
396
403
405
421
423
428
429
CHAPTER 15
Property-Casualty Insurers’ Loss Reserve Disclosures
435
Loss Reserve Footnote
438
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Loss Reserve Development Disclosures
Calculating Loss Reserves by Accident Year
Calculating Loss Reserve Revisions by Accident Year
Calculating Claim Payments by Accident Year and Tail
Constructing Accident Year Loss Reserve T Accounts
Property-Casualty Expense Ratios
vii
440
444
446
448
452
453
CHAPTER 16
Reinsurance Accounting and Disclosure
457
Accounting and Analysis Issues
Reinsurance Contracts
Accounting for Reinsurance Contracts
Reinsurance Disclosures and Analysis
Evolution of Financial Reporting for Reinsurance
459
462
472
487
493
Index
497
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Preface
T
his book provides a comprehensive guide to the analysis of financial
instruments and institutions using accounting information and disclosures that are publicly available in financial reports. It is primarily written
for users of financial reports who must confront the complex, voluminous,
and changing nature of financial reporting rules for financial instruments
and institutions. My primary goal is to provide these users with the tools
necessary to construct as coherent a story as possible about how financial
institutions and also nonfinancial firms generate or destroy value using
financial instruments. I show how financial reports provide clues to the construction of such a story through fair value accounting for financial instruments and accompanying estimation sensitivity and risk disclosures that
users can, with focused effort, piece together and interpret in a consistent
and conceptually sound fashion.
Most of the major accounting standards governing financial instruments
and transactions are covered, including those for loans, investment securities, securitizations, the constituent elements of structured finance transactions, derivatives and hedging, leasing, insurance, and reinsurance. Those
instruments and transactions for which the accounting is straightforward are
excluded. The exposition of accounting standards reflects my belief that
users of financial reports do not need to know all of the myriad details of
each standard but rather only the critical features that make or break the
representational faithfulness of financial reports. For example, in securitization accounting, these critical features pertain to the valuation and risk of
retained interests; excess value assigned to risky retained interests has led
to a sizable number of large losses by securitizers of risky assets, such as those
experienced by subprime mortgage banks during the hedge fund crisis in the
second half of 1998. This book hones in on these critical features.
My perspective is that fair value provides the simplest and most natural
measurement basis for financial instruments, especially for financial institutions that hold many instruments with correlated values that hedge or
accentuate risks at the portfolio level. However, I also emphasize that, aside
from securities and other instruments that are publicly traded in liquid
markets, fair value accounting for financial instruments inevitably involves
some degree of subjectivity (and thus possibly intentional bias) and inadvertent error (i.e., random noise) in estimation. I discuss how financial report
users can assess this subjectivity and error using required disclosures of
ix
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PREFACE
estimation sensitivity, interest rate and other market risks, credit risk, and
insurance claims risk. Most of the major required estimation sensitivity and
risk disclosures are covered.
A distinctive aspect of this book is its integrated coverage of financial
reporting for financial instruments and institutions. This coverage reflects
my strong belief that financial reporting and analysis for financial instruments must reflect the economic context of the firms and transactions
involved. I examine six types of financial institutions, which were chosen
either because they reflect specific financial transactions in a clear fashion or
because they have distinctive accounting or disclosure requirements: thrifts,
mortgage banks, commercial banks, lessors, property-casualty insurers, and
life insurers. These financial institutions constitute specific understandable
contexts that are often unusually well described in financial reports because
of risk and other disclosures mandated by industry regulators. These institutions also tend to have more extensive ranges or lengthier histories of
specific financial transactions than nonfinancial firms. For these reasons,
financial institutions provide the best available settings to learn disciplined
analysis of financial instruments. Users of nonfinancial firms’ financial
reports will find learning such disciplined analysis useful in their settings.
WHY I WROTE THE BOOK
In teaching courses on financial instruments and institutions at the Stern
School of Business of New York University over the past 12 years, I have
found that the available treatments of the relevant financial reporting rules
have three weaknesses from the perspective of users of financial reports.
First, the available treatments usually target one of two audiences. Some are
written for preparers of financial statements or practicing accountants, who
naturally are concerned with how to account for specific complex transactions; these treatments tend to be poorly grounded in economic concepts and
overly detailed with respect to implementation issues. Alternatively, some
are written for the generalist student of financial analysis; these treatments
provide little of the context necessary to understand financial transactions
and institutions, discuss the relevant financial reporting rules inadequately
if at all, and apply analytical schemas that invariably have been developed
for nonfinancial transactions and firms. Either approach obscures the nature
and usefulness of the financial report information about financial instruments and institutions from the perspective of users of financial reports. In
contrast, while avoiding needless detail, I provide economically grounded
descriptions of financial transactions and institutions, thorough treatments
of the accounting standards and disclosure rules applying to financial instruments and financial institutions, and many cases drawn from the financial
reports of actual financial institutions.
Second, most of the recently propounded and likely future financial
reporting rules involve some form of fair value accounting for financial
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instruments. The available treatments do not provide sufficient discussion
of the nature, strengths, and weaknesses of fair value accounting for financial report users to be able to evaluate the information provided by these
rules. I provide a strong conceptual treatment of fair value accounting. I
supplement this with numerous cases drawn from actual financial institutions’ financial reports that illustrate when fair value accounting for financial instruments works well and when it is fragile. These cases span the
various types of financial institutions covered in the book, which allows me
to emphasize the common issues that apply across types of institutions.
These common issues arise because financial transactions inherently have
common features, but also because smart financial transaction designers
quickly import innovations developed in other settings. Moreover, the distinctions among various types of financial institutions continue to blur over
time, with the products they offer increasingly competing against each other.
For example, I discuss how the retention of residual risk raises similar financial reporting and analysis issues in securitizations, leasing, and reinsurance.
These features enable diligent readers to develop robust intuitions about fair
value accounting for financial instruments. They also imply that readers interested in a subset of the topics will benefit considerably from reading the
whole book.
Third, the available treatments give insufficient emphasis to the analysis of estimation sensitivity and risk disclosures. These disclosures are a critical complement to fair value accounting for financial instruments, since
they indicate the sensitivity of the fair value of the firm’s financial instruments to changes in risk factors and since assumptions about risk factors are
required to estimate the fair values of financial instruments. Moreover,
financial institutions are in large part and increasingly in the risk management business, and so risk disclosures are absolutely essential to the analysis
of these institutions.
ENRON, SARBANES-OXLEY, AND CHANGES IN
FINANCIAL REPORTING RULES FOR STRUCTURED
FINANCE TRANSACTIONS
The importance and limitations of financial reporting for structured finance
transactions was made apparent by the implosion of Enron, which engaged
in a diverse and complex set of those transactions, many of which were
accounted for properly but some significant examples of which were not.
Enron illustrates how these transactions, even if accounted for properly, can
place considerable stress on financial reporting, especially when they are used
to exploit existing accounting rules to obtain desired outcomes such as
off–balance sheet financing or income management. Enron along with other
accounting scandals such as WorldCom created the political pressure necessary to pass the landmark Sarbanes-Oxley Act of 2002, which has led swiftly
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to many significant changes in financial reporting rules, many of them pertaining to structured finance transactions.
For example, since the passage of Sarbanes-Oxley, the Financial Accounting Standards Board (FASB) has issued significant accounting standards on
derivatives and hedging, special-purpose/variable-interest entities, hybrid
financial instruments, financial asset servicing rights, financial guarantees,
and fair value measurements. The FASB’s agenda includes significant projects
on derivatives disclosures, transfers of financial instruments, liabilities and
equity, leases, insurance risk transfer, and the fair value option. The Securities and Exchange Commission (SEC) has issued comprehensive disclosure
requirements for off–balance sheet financing arrangements as well as a special
report that describes its approach and recommendations regarding accounting-motivated structured finance transactions. The SEC, Department of Justice, Office of the New York State Attorney General, and other regulators
have pursued their enforcement activities with unprecedented resources
and zeal.
This book provides many insights about how structured finance transactions should be accounted for and analyzed using the information provided
in financial reports. It describes the economic substance of and accounting
for some of the most important types of structured finance transactions,
including securitizations, (synthetic) leasing, and (finite) reinsurance as well
as the constituent elements of those transactions including special-purpose
entities, transactions related through netting agreements or by the intent of
the counterparties, hybrid financial instruments, and financial guarantees.
Structured finance transactions often partition the risk and value of underlying financial (and, in the case of leasing, nonfinancial) assets and liabilities nonproportionally; for example, securitizations frequently involve the
value of the securitized financial assets being disproportionately but not
fully transferred to asset-backed security purchasers while the risks of those
assets are disproportionately but not fully retained by issuers. When this is
the case, no single method of accounting for these transactions fully captures their nature, since accounting can describe either the value transfer or
the risk transfer but not both. The critical questions for financial report
users are how the accounting method chosen by the reporting firm does and
does not describe the specific transactions the firm engages in, and, given
the inevitable limitations of the accounting, how the estimation sensitivity
and risk disclosures provided by the firm can be analyzed to address the limitations of the accounting.
In the preface to the first edition of this book, published in the immediate wake of Enron, I expressed concern that Enron might provoke overreactions from accounting standards setters and regulators that would
have detrimental effects on financial reporting for financial instruments
and structured finance transactions. Thankfully, this has not been the case.
In particular, in most of its decisions the FASB has continued on a measured course toward broader fair value accounting for financial instruments.
Although fair values are judgmental for some financial instruments and this
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judgment can be abused, fair value accounting is absolutely necessary to
describe risky financial instruments and structured finance transactions,
especially at the level of portfolios of instruments, which financial institutions by their nature hold. While not all financial instruments currently
should be fair valued and errors in fair valuations will occur even for those
that should, a desirable property of fair value accounting is that it corrects
its mistakes over time, since financial instruments must be revalued each
period based on current market conditions. In this regard, many of Enron’s
problems simply would have taken longer to uncover if its accounting were
not based on fair value.
Moreover, in most of their decisions the FASB and SEC have recognized
that the proper way to deal with the stress placed on financial reporting
rules by structured finance transactions is not to jury-rig accounting standards in a futile attempt to dissuade abuse. Instead, they have worked diligently to develop conceptually sounder accounting standards, to require
enhanced disclosures about the nature and purposes of these transactions,
and to provide legal and regulatory (not accounting) disincentives to engage
in transactions with no business purpose that impair the transparency of
financial reports. For example, this approach is evident in the SEC’s disclosure rule on off–balance sheet financing arrangements and its special report
on structured finance transactions mentioned earlier.
Despite the progress made the FASB, SEC, and other accounting policymakers over the past five years, financial reporting rules for financial instruments and structured finance transactions remain highly limited in many key
respects and so will continue to evolve rapidly over the coming years. Fair
value accounting is required only for a small subset of financial instruments.
Virtually all of the major accounting standards for financial instruments
include bright-line, characteristic-based, or intent-based criteria that require
very different accounting for substantively similar instruments, providing
fertile ground for accounting-motivated structured finance transactions.
Disclosures of financial instruments, while voluminous, are disjointed and
often explained poorly or not at all by management. As a result of these limitations, users of financial reports must expend considerable effort and
make significant assumptions in order to draw conclusions about the reporting firm. This book’s conceptual approach will help financial report users
understand and cope with this evolution in financial reporting rules.
TOPICAL COVERAGE AND STRUCTURE OF THE BOOK
The structure of this book reflects my belief that it is important for users
of financial reports to recognize that the value and risk of financial instruments depends on the economic contexts in which they are embedded. I
use the six types of financial institutions mentioned earlier as the source of
context. The book is organized around these types of financial institutions,
starting with relatively simple institutions and proceeding to related but more
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PREFACE
complicated ones. I describe the activities and risks of each type of financial institution in an economically grounded yet intuitive fashion. Financial
reporting and analysis issues are discussed in the same chapter as or immediately subsequent to the chapter covering the most pertinent type of financial institution. This structure allows readers to progress naturally from
relatively simple financial institutions and associated financial reporting and
analysis issues to related but more complex institutions and issues. For readers interested in a specific topic, however, each chapter (or pair of related
chapters) is written to be as self-contained as possible.
Chapter 1 overviews the financial reporting and analysis of financial
instruments and institutions. Chapter 2 contains useful background material
on the structure and regulation of the two main types of depository institution: thrifts and commercial banks. Chapter 3 describes the activities, risks,
and financial reporting of thrifts, the simplest depository institution, which
primarily take deposits and hold residential mortgage-related assets. Most
of the material in this chapter also applies to commercial banks. Chapters
4 through 6 develop and illustrate the application of financial analyses based
on the accounting for and mandated disclosures of interest rate risk, credit
risk, and fair value of financial instruments, respectively. Chapter 7 describes
the activities, risks, and financial reporting of mortgage banks, which write
similar loans to thrifts, but which securitize or otherwise sell most of their
loans. Chapter 8 explains the financial reporting rules for financial asset securitizations and develops and illustrates the application of financial analyses of
prepayment risk and retained interests from securitizations. Chapter 9 discusses the accounting rules governing various important constituent elements
of structured finance transactions, including special-purpose/variable-interest
entities, transactions related through netting agreements or by the intent of
the counterparties, hybrid financial instruments, and financial guarantees.
Chapter 10 describes the financial reporting of commercial banks, which
do everything that thrifts and mortgage banks do but are more involved with
derivatives, hedging, and risk management activities. Chapter 11 explains
the financial reporting rules for derivatives and hedging and develops a
schema for the financial analysis of financial institutions’ derivatives and
hedging. Chapter 12 describes market risk disclosures and illustrates their
critical importance in applying that schema. Chapter 13 describes the activities, risks, and distinct financial reporting of lessors, which compete with
commercial banks for certain types of commercial lending. This chapter
also develops and applies financial analyses of lessors. Chapter 14 describes
activities, risks, and distinct financial reporting of property-casualty and life
insurers, which provide different sorts of risk management services from
commercial banks. This chapter also develops and applies financial analyses
of these insurers. Chapter 15 describes property-casualty insurers’ loss reserve
disclosures and develops and illustrates financial analyses using those disclosures. Chapter 16 describes the accounting and disclosures by ceding
insurers for reinsurance, focusing on retroactive and finite reinsurance.
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SIGNIFICANT CHANGES FROM THE FIRST EDITION
The most significant changes from the first edition are the inclusion of new
chapters on constituent elements of structured finance transactions (Chapter 9) and reinsurance (Chapter 16). Although these topics were covered
briefly in the first edition, events occurring since the publication of the first
edition made it clear that these topics demand fuller treatments. This is
especially apparent in the case of finite reinsurance transactions currently
receiving intense scrutiny from the SEC and other regulators. Both of these
chapters contain comprehensive yet accessible treatments of their topics that
are not available elsewhere.
All of the other chapters have been improved in their exposition and
updated for the many significant changes in financial reporting rules, regulation, and economic conditions that have occurred since the publication of
the first edition, only a portion of which have been mentioned. Although
the conceptual approach taken is the same as in the first edition, readers of
the first edition will find that the new edition serves as a decidedly superior reference guide.
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Acknowledgments
W
hen I began teaching a course on the analysis of financial institutions
at the Stern School of Business in 1995, I was fortunate to inherit the
materials and videotapes of the prior instructor, Gerald White, a gift that
has influenced this book in many ways. Tom Linsmeier provided me with
his materials on derivatives and hedging and wrote a valuable review of the
first edition of this book, and he continues to provide insightful answers to
obscure questions about the application of hedge accounting in practice.
I have been fortunate to have coauthors who have shared their understanding of financial institutions’ financial reporting with me. My mentor
Bill Beaver first involved me in research on banks’ loss reserving in 1985.
This led to a series of papers with Chi-Chun Liu and Jim Wahlen. Jim introduced me to Kathy Petroni, who taught me much of what I know about
property-casualty insurers in our project together. I have learned about
financial reporting in general and financial instruments in particular from
my many interactions with the members and staff of the Financial Accounting Standards Board and my colleagues on the American Accounting Association’s Financial Accounting Standards Committee and the Financial
Accounting Standards Advisory Council, especially Jim Leisenring, Dennis
Monson, Katherine Schipper, and Cathy Schrand. The book has also benefited from my interactions with many other accounting academics and practitioners, including Anne Beatty, Jeff Callen, Jack Ciesielski, Tom Frecka,
Dov Fried, Dan Gode, Lisa Koonce, Doron Nissim, Mohan Venkatachalam,
and Patricia Walters.
I am fortunate to have had hundreds of students at the Stern School with
whom I shared my ideas as they developed, who have provided suggestions
about or caught errors in my original draft chapters or in the first edition
of this book, and who have alerted me to recent developments. Particularly
notable contributions have been made by Andrew Henckler and Robert
Young. I also appreciate the financial support of the Stern School, Dean
Thomas Cooley, and Robert Stovall, who endowed my faculty fellowship.
I appreciate the capable editorial services of Sheck Cho, my executive
editor, at John Wiley & Sons. Sheck kept me moving on the second edition
of this book, which took longer than either he or I expected.
My parents believed strongly in the importance of education, and they
sacrificed considerably to provide their six children with good ones. More
important, they instilled in me the desire to learn a little more every day,
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ACKNOWLEDGMENTS
and the many improvements in the second edition of this book reflect the
gradual accumulation of knowledge over the five years since the publication
of the first edition.
Day in and day out, I come home from work to find my dear and tenacious wife, Lisa, helping our one and only son, Jacob, with his schoolwork,
which yields satisfactions and frustrations for both of them, while I get to
read to Jacob before bed, a pure pleasure for both of us. I wish for Jacob the
never-ending love of learning, in work and play, that my parents gave me,
and for Lisa the knowledge that she carries on, nobly, a family tradition.
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CHAPTER
1
Financial Instruments
and Institutions
F
inancial reporting for financial instruments and institutions is undergoing
a period of unprecedented change and salience for financial analysis. In
the past decade, the Financial Accounting Standards Board (FASB), the primary
accounting standards setter in the United States, has issued major standards
on derivatives and hedging, transfers of financial instruments including securitizations, servicing of financial assets, consolidation of special-purpose/
variable interest entities, hybrid financial instruments, financial guarantees,
and fair value measurements. These standards reflect the FASB’s attempts
to address the limitations of prior accounting and disclosure rules that
provided the settings for the huge losses recorded by firms that ineffectively
hedged using derivatives during the interest rate run-up in 1994 or that held
residual or subordinated interests from securitizations during the hedge fund
crisis of 1998. They also reflect its attempts to improve the transparency
of financial reporting for accounting-motivated structured finance transactions that provided much of the impetus for the Sarbanes-Oxley Act of
2002. During this period, the Securities and Exchange Commission (SEC)
developed extensive disclosure requirements for market risk and off–balance
sheet financing arrangements for much the same reasons.
This change will carry on for the foreseeable future, with the FASB’s agenda
including projects on the fair value option for financial instruments, transfers and servicing of financial instruments, liabilities and equity, leases, insurance risk transfer, and derivatives disclosures. All indications are that the FASB
will continue to proceed on a measured course toward fair value accounting for almost all financial instruments as well as enhanced disclosures. This
course should improve financial reporting both by providing more accurate,
timely, and relevant information about individual financial instruments and
by eliminating differences in the accounting for different types of financial
instruments. While different accounting methods for different types of financial instruments may have been appropriate historically, such differences are
increasingly arbitrary and yield noncomparability both across a given financial institution’s financial statement line items and across different types of
1
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FINANCIAL INSTRUMENTS AND INSTITUTIONS
financial institutions’ financial statements, thereby providing fertile ground
for accounting-motivated transactions.
The development of financial reporting rules for financial instruments
just described has provided users of financial reports with substantial new
information about how firms generate or destroy value using these instruments. Considerable understanding and diligence are necessary for users of
financial reports to identify and analyze this information fully, however, for
several reasons. First, current accounting for financial instruments reflects
a “mixed attribute” model, with some instruments recognized at fair value
while others (most, in fact) are recognized at amortized cost. This model
obscures the economics of natural hedges in which the two sides of the hedge
are recognized using different valuation attributes, yielding excess volatility
in owners’ equity and net income. For example, commercial banks often hold
investment securities recognized at fair value that are natural hedges of deposits
or debt recognized at amortized cost. Although financial report users can address
this problem using required footnote disclosures of the fair values of all financial instruments, these disclosures are invariably poorly integrated with the
other information in the report, forcing users to perform this integration.
Second, fair value accounting, while preferable to amortized cost accounting, does not constitute a complete description of financial instruments. For
financial instruments other than securities and other instruments that are
publicly traded in liquid markets, estimated fair values typically include nontrivial subjectivity (and thus potential bias) and inadvertent error (i.e., random
noise). Estimation subjectivity and error are of particular concern for financial instruments that are highly sensitive to valuation assumptions, such as
residual or subordinated interests from securitizations and derivatives. Thus,
the fair values of financial instruments need to be supplemented with information about their sensitivity to valuation assumptions. Relatedly, financial
instruments can be risky and financial transactions often involve complex
partitioning of risk among various parties. Thus, the fair values of financial
instruments need to be analyzed jointly with information about their market
and nonmarket risks. Although financial reports do contain some information in this regard, the quality, comparability across firms, and integration
of this information are again poor, forcing users to rework and integrate this
information.
Finally, current financial reporting for financial instruments and structured finance transactions is complex. Much of this complexity is unnecessary and should be reduced as the FASB develops a conceptually sound
and coherent set of financial instruments standards, but some of it is an…

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