Accounting for Financial Instruments Tentative Course Outline Summer 2010 Stephen Ryan Stern School of Business, New York University

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1 Accounting for Financial Instruments Tentative Course Outline Summer 2010 Stephen Ryan Stern School of Business, New York University Description of Course: This course provides a conceptually sound and comprehensive treatment of the complex, developing, and imperfectly consistent financial reporting rules for financial instruments and particularly structured financial transactions. Two related facts provide the context for this course: (1) market participants continually design new financial instruments and transactions; (2) the half-life of new financial reporting rules for financial instruments is about five years. Reflecting these facts, a primary goal of this course is to provide students with the intellectual tools to understand new financial reporting rules for financial instruments and transactions as they are written and to understand how newly developed financial instruments and transactions can stress existing financial reporting rules. Such understanding requires an awareness of the economically important features of the transactions and how these features generally are (and logically can be) only partly captured by financial reporting rules. While covering much the same material as a course I have taught in a financial analysis class in the Stern MBA program for over a decade, I have tried to focus this course on the needs of auditors rather than financial analysts. Related to this focus, the other primary goal of the course is for students to learn how to conduct GAAP research on complex accounting issues. This task involves reading the relevant GAAP rules, spending the often considerable time necessary to determine how those rules apply to the fact and circumstances of specific transactions, and addressing the ambiguity that sometimes remains regarding GAAP compliance and appropriate MD&A and other disclosures even after spending this time. Auditors reputations and legal exposures can depend on Caveats: Because this is the first time I (or to the best of my knowledge anyone else) has taught a course like this to an audience of Masters of Science in Accounting program students planning to sit for the CPA, I will be learning about what works and what does not work pedagogically as we go along during this term. No doubt some parts of the course will work better than others. Constructive feedback is welcome, will contribute to the experience of future classes, and may even be rewarded with some weight in your grade. I have expressly not over-structured the course up front and intend to remain flexible as to approach. To increase the likelihood that I am in fact flexible, I have made my book recommended rather than required reading (see below). Topical Coverage: The course begins with the three main measurement bases used in the mixedattribute accounting model for financial instruments: (1) amortized cost accounting, typically subject to impairment accounting for assets; (2) fair value accounting; and (2) FAS 5 s incurred

2 loss model for loss contingencies. We will discuss the distinct features of these measurement bases, and the problems caused by mixed-attribute accounting for portfolios of financial instruments. The course proceeds to the accounting for structured finance transactions and hybrid financial instruments that bundle and/or unbundle and repackage the risk and value of simpler financial instruments and transactions. Some structured finance transactions, such as securitizations and repurchase agreements, raise the issue of sale versus secured borrowing accounting. Others involve variable interest entities, which raise the issue of consolidation. The course will then cover the accounting for risk management activities, notably derivatives and hedging. Finally, in any time that remains, the course will cover the accounting for leases and insurance contracts. My guess is we will not get to insurance, at a minimum. While this course focuses on U.S. GAAP for financial instruments and transactions, there is considerable overlap with international GAAP. Occasionally I will mention significant differences between U.S. and international GAAP. Materials: No good textbook currently exists that covers much of the course material. Hence, the main material for the course is the relevant accounting standards. FASB standards (FASs, FINs, FTBs, FSPs, EITFs, and DIGs) issued prior to the adoption of the Accounting Standards Codification in September 2009 (see the next section) are available online either at or through the Accounting Standards Codification described below. While it may seem inconvenient to learn accounting this way, in fact it is essential skill for auditors and other practicing accountants to be able to read and understand GAAP at the source. I will summarize the most relevant aspects of accounting standards in my class presentation slides. I will hand out those slides, as well as problems, cases, and other materials in class. The Accounting Standards Codification: As of September 2009, the FASB organizes pre-existing accounting standards (from all of the primary sources, not just the FASB) and issues new standards according to the Accounting Standards Codification (ASC). New standards are issued as Accounting Standards Updates prefaced by brief summaries describing their purposes and effects. While the idea of putting all the relevant GAAP for each topic in a single place is a good one, in my opinion the ASC as currently structured and implemented is not a well-advised or userfriendly system, because it does not reliably exposit material in a coherent fashion, does not contain the important Basis for Conclusions sections of pre-existing standards, and does not provide such sections to any meaningful extent in Accounting Standards Updates. Despite these limitations, we are all going to have to get used to the ASC. 2

3 Full cross-referencing of pre-existing standards to the ASC is available to Stern accounting students on the codification website, asc.fasb.org, by clicking on Academic Accounting Access and using the username AAA51819 and the password snys520. Optional Text: I recommend but do not require you to purchase Stephen G. Ryan, Financial Instruments and Institutions: Accounting and Disclosure Rules, 2007, John Wiley & Sons. I wrote this book for my Stern MBA class B , Analysis of Financial Institutions and Financial Instruments. While that course is focused on the financial analysis of financial institutions, and the book is already somewhat out of date due to the significant standards issued since 2007 (most notably FAS 157, 159, 166, and 167), the book contains considerable material that is relevant to this course. It also reflects the way I think about the topics. For each session of this course, I indicate the portions of the book that are relevant to the session. For students interested in financial institutions, I recommend you read the book cover to cover. Prerequisites: The only prerequisite is C , Principles of Financial Accounting. C is a considerably more basic course than this one, however, and so I recommend students first take either C , Financial Statement Analysis, or C , Financial Reporting and Disclosure. Blackboard/Access to Class Materials and Streaming Videos: While I will hand out all materials needed for the course in class, I will post the materials that are in electronic form on Blackboard. These materials include files for streaming videos of each class. I do not use Blackboard for other purposes. Course Schedule: The tentative sequence of class sessions is attached. Consistent with my intent to remain flexible, some of the readings and assignments likely will change over the course of the term. 3

4 Course Schedule (Tentative) 5/18 Course Overview, Introduction to the Risks of Financial Instruments and Risk Management, and Multiple Motivations for Financial Transactions Optional reading in Ryan: Preface, Chapter 1, Chapter 4, pp , Chapter 5, pp /20 Amortized Cost and/versus Fair Value Accounting Relevant Standards: APB 21 (amortized cost accounting) [ASC ] FAS 91 (deferral of certain fees and costs and related yield adjustments) [ASC ] FAS 157 (fair value measurement guidance) [ASC ] FAS 107 (fair value disclosures) [ASC ] FAS 159 (fair value option) [ASC ] Optional reading in Ryan: Chapter 6, pp Prepare: Amortized cost accounting versus fair value accounting spreadsheet exercise Citigroup s Super-Senior CDO Write-downs during 2007 thought questions Recast Zions Bancorporation s 2009 income statement to fair value, part 1 SunTrust s Fair Value Option Adoption in 2007 thought questions 5/25 Investment Securities, Gains Trading, and the Various Impairment Accounting Models for Financial Assets Relevant Standards: FAS 115 (investment securities) [ASC ] FSP FAS and FAS (recent change in other than temporary impairment guidance) [ASC ] EITF (retained securities from securitizations) FAS 114 and 118 (loan impairment) [ASC and -40] FAS 65 (mortgage impairment) [ASC 948] SOP 03-3 (acquired impaired loans) [ASC ] Optional reading in Ryan: Chapter 6, pp Prepare: Impairment accounting numerical exercise Impairment accounting research exercise Recast Zions Bancorporation s 2009 income statement to fair value, part 2 SunTrust gains trading case 4

5 5/27 The Incurred Loss Model for Loss Contingencies Relevant Standards: The incurred loss model GAAP below is in ASC , S99, and ] FAS 5 (the incurred loss model) FIN 14 (interpretative guidance for FAS 5 s capable of reasonable estimation condition) EITF D-80 (interpretative guidance for application of FAS 5 to the estimation of Allowances for Loan Losses) Bank regulatory guidance for Allowances for Loan Losses [not in ASC except indirectly through EITF D-80] December 13, 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses Office of the Comptroller of the Currency ( OCC ) Comptroller's Handbook 13, Allowance for Loan and Lease Losses OCC Bank Accounting Advisory Series, Topic 4, Allowance for Loan and Lease Losses, September 2003 FFIEC s Uniform Retail Credit Classification and Account Management Policy dated June 12, 2000 Optional reading in Ryan: Chapter 5 Prepare: Allowance for loan losses numerical exercise Allowance for loan losses research exercise Loan Loss Reserving Based on Historical Data in 2006 thought questions 6/1-3 FAS 140 and 166: Sale versus Secured Borrowing Accounting for Securitizations and other Transfers of Financial Instruments Relevant Standards: The GAAP listed below is in ASC 860 FAS 140 (transfers of financial instruments) FAS 166 (significant amendment) Optional reading in Ryan: Chapter 8 Prepare: Sale versus secured borrowing research exercise: Repo 105 Aames Financial Case Doral Financial Case 5

6 6/8 FIN 46(R) and FAS 167: Variable Interest Entity Consolidation Relevant Standards: The GAAP listed below is in ASC FIN 46(R) (consolidation of variable interest entities) FAS 167 (significant amendment) Optional reading in Ryan: Chapter 9, pp Prepare: VIE consolidation research exercise JPMC s Support of its Credit Card Securitization Vehicles in /10 In Class Exam (The exam will be on this day regardless of where we are in the course) 6/15 (half) Contractually and Noncontractually Related Transactions Relevant Standards: FIN 39 and FIN 41 (Netting Agreements) ASC and -25 (Related derivatives) ASC (Related Transfers of Financial Optional reading in Ryan: Chapter 9, pp Prepare: Netting agreements research exercise Linked swaps research exercise 6/15 (half)-17 Derivatives and Hedging Relevant Standards: The GAAP listed below is in ASC 815 FAS 133 (main standard) FAS 138 (amendments) FAS 149 (more amendments) FAS 161 (disclosures) FSP FAS and FIN45-1 (more disclosures) Note: The FASB intends to simplify hedge accounting in the near term Optional reading in Ryan: Chapter 11 Prepare: Derivatives problems 1-4 Repo 105 thought questions SunTrust s Derivatives and Hedging Case 6

7 6/22 Leasing Relevant Standards: The GAAP listed below is in ASC 840 FAS 13 (main standard) FAS 98 (fairly significant amendment) FTB 85-3 (schedule rent increases) FTB 88-1 (miscellaneous guidance) EITF 01-8 (definition of a lease) Optional reading in Ryan: Chapter 13 Prepare: Lease accounting numerical exercise Lease accounting research exercise Structured Sale-Leaseback Case Insurance? Relevant Standards: The GAAP listed below is in ASC 944 FAS 60 (traditional insurance policies) FAS 97 (investment-oriented life insurance policies) SOP 03-1 (minimum guarantees and other features in investmentoriented life insurance policies) DIG B8, B9, B10, B25, B29, B30 (embedded derivatives) FAS 113 (reinsurance) EITF 93-6 (retrospectively-rated reinsurance) SOP 98-7 (deposit accounting) Optional reading in Ryan: Chapter