Financial Instruments and Institutions: Accounting and Disclosure Rules / Edition 2

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Overview

Praise for Financial Instruments & Institutions Accounting and Disclosure Rules, Second Edition

"Financial Instruments and Institutions is a superbly informative integrated treatment of institutional, analytical, and financial reporting issues for financial institutions. I strongly recommend the book for analysts, investors, regulators, educators, and anyone with an interest in a coherent, intellectually rigorous discussion of issues encountered in reporting on and analyzing financial institutions and their commercial arrangements, including fair value measurements, risk reporting, and structured finance."
—Katherine Schipper, Thomas F. Keller Professor of Business Administration, Duke University

"When you combine the unique risk attributes of financial institutions with the complex transactions they enter into, it can make even the most seasoned investor shudder. Dr. Ryan provides a well-structured and logical approach to the analysis of these companies, layering on explanations of the transactions they enter into and how they impact your analysis. Seasoned investors will find the book an important reference tool, especially on securitizations and derivatives and the new chapter on reinsurance."
—Janet L. Pegg, CPA, Accounting & Taxation Research, Bear, Stearns & Co. Inc.

"Stephen Ryan's book is indispensable for anyone involved with financial institutions, whether it be bankers, insurers, investment advisors, or the student. There is no better book for understanding how these institutions work and how one handles their financial statements to gain that understanding. The detailed coverage of financial instruments—and the accounting for financial instruments—is outstanding."
—Stephen Penman, George O. May Professor and Morgan Stanley Research Scholar, Columbia Business School

Praise for the First Edition

"To any professional engaged in hands-on analysis of financial institutions' financial statements, this exhaustive text is an indispensable resource."
—Martin S. Fridson, CFA, Financial Analysts Journal

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Product Details

  • ISBN-13: 9780470040379
  • Publisher: Wiley
  • Publication date: 4/20/2007
  • Edition description: REV
  • Edition number: 2
  • Pages: 528
  • Product dimensions: 9.00 (w) x 6.00 (h) x 1.31 (d)

Meet the Author

Stephen G. Ryan is an Associate Professor of Accounting and Robert Stovall Faculty Fellow at the SternSchool of Business, New York University. Prior to that position, he was an assistant professor of accounting at the Yale School of Organization and Management and has been an associate consultant with Bain & Company. He has written numerous articles that have appeared in such publications as Accounting Horizons, Financial Analysts Journal, the Accounting Review, and the Journal of Financial Statement Analysis. He is an Editor of the Review of Accounting Studies. In addition, he is on the FASB's Financial Institutions Advisory Group and its Liabilities and Equity Resource Group.

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Read an Excerpt

Financial Instruments and Institutions

Accounting and Disclosure Rules
By Stephen G. Ryan

John Wiley & Sons

ISBN: 0-471-22076-0


Chapter One

FINANCIAL INSTRUMENTS AND INSTITUTIONS

Financial reporting for financial instruments and institutions is undergoing a period of unprecedented change and salience for financial analysis. In the past five years, the Financial Accounting Standards Board (FASB), the primary accounting standards setter in the United States, has issued major standards on derivatives and hedging and on transfers of financial instruments including securitizations. Aspects of these standards reflect the FASB's attempt to address the limitations of prior accounting and disclosure rules that provided the setting for the unexpected huge losses recorded by firms that ineffectively hedged using derivatives during the interest rate run-up in 1994 (e.g., Orange County, California; Gibson Greetings; Procter & Gamble; and Metallgesellschaft) or that held subordinated residual interests from securitizations during the hedge fund crisis of 1998 (e.g., subprime mortgage banks). The Securities and Exchange Commission (SEC) developed extensive market risk disclosure requirements during this period for much the same reasons. This change will continue for the foreseeable future, with the FASB and the Joint Working Group of Standards Setters (a group of 14 international standards setters) recently proposing and providing possible frameworks for fairvalue accounting for essentially all financial instruments.

This rapid evolution of financial reporting for financial instruments has provided users of financial reports with substantial new information but with two significant drawbacks that can obscure how firms, especially financial institutions, generate or destroy value using such instruments. First, current accounting for financial instruments reflects a "mixed attribute" model, with some instruments recognized at fair value and others 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. While 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 that are publicly traded in liquid markets, fair values typically include nontrivial estimation subjectivity and noise. These estimation errors are of particular concern for financial instruments that are highly sensitive to valuation assumptions, such as subordinated residual interests from securitizations or complex 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 other risks. While 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.

The primary purpose of this book is to provide users with the tools to exploit fully the various sources of information about the fair values and risks of financial instruments provided in financial reports, in order to construct the most coherent possible story about how firms generate or destroy value using financial instruments. In serving this purpose, the focus is on financial institutions, which provide the best available settings in which to learn disciplined analysis of financial instruments for two reasons.

1. The value and risk of financial instruments depend on the economic contexts in which they are embedded. Financial institutions constitute specific understandable contexts that primarily involve financial instruments or transactions. Moreover, financial institutions frequently are required by industry regulators to provide extensive risk disclosures, which elucidate their contexts.

2. Financial institutions generally have more extensive ranges and lengthier histories of specific financial transactions than nonfinancial firms, and so are more likely to have experienced the significant issues that apply to those transactions. For example, readers interested in securitizations of trade receivables by nonfinancial firms will surely find that the examples of mortgage banks' securitizations of residential mortgages in Chapter 8 generalize to their concerns, since these examples clearly indicate the conditions under which securitization accounting works well and those under which it is fragile.

The remainder of this chapter provides important perspectives and terminology regarding financial instruments and institutions. The first section explains the four main ingredients involved in using financial report information to construct the most coherent possible story about how firms generate or destroy value using financial instruments. As discussed above, the two most important ingredients are fair value accounting for financial instruments and disclosures of the estimation sensitivity and risk of these instruments. The third ingredient pertains to financial transactions, such as securitizations, leasing, and reinsurance, in which the value and risk of underlying financial instruments are partitioned among various parties. While the simplest and most natural way to view these transactions is using a fair value partitioning (financial components) perspective, in cases of disproportionate risk retention by the firm under consideration, users need to temper this by a risk partitioning perspective. Finally, users need to describe financial transactions as financial, even though in many cases, such as leasing and insurance, they are treated as operating under current financial reporting rules. These four ingredients are applied repeatedly in the various financial analyses described in this book.

The second section describes the various activities and risks of financial institutions and mentions specific useful sources of information provided in financial reports about these activities and risks. Financial report users need to recognize that historically distinct types of financial institutions increasingly perform the same or similar activities, and so it is most important to distinguish institutions based on the activities and risks in which they engage. Financial analyses using the specific types of information described in this section are illustrated throughout this book. In the last section, the valuation of financial institutions in practice is discussed.

MAIN INGREDIENTS OF THE ANALYSIS OF FINANCIAL INSTRUMENTS

Fair Value Accounting

This section explains why and how fair value accounting describes financial instruments better than amortized cost accounting, especially when the firm under consideration is a financial institution. Definitions for financial instruments, fair value accounting, and amortized cost accounting that are used throughout the book are also provided.

The term "financial instruments" as defined by the FASB and as used in this book includes financial assets and liabilities but not the firm's own equity. The firm's own equity is a financial instrument, of course, just not one for which fair valuation is contemplated. Financial assets are contractual claims to receive cash or another financial instrument on favorable terms or ownership interests in another firm. Financial liabilities are contractual claims to pay cash or another financial instrument on unfavorable terms.

The fair value of a financial instrument is an estimate of the price at which the instrument could be traded between two willing parties at the current time, and so it reflects current expectations of the cash flows and priced risks of the instrument. Fair values can be estimated either by observing the market prices for the financial instrument or similar instruments or by using an accepted valuation model.

Full fair value accounting involves three aspects. On the balance sheet, it involves recognition of financial instruments at fair value. In the United States, this aspect of fair value accounting currently is required only for trading and available-for-sale securities, derivatives, and hedged items in designated effective fair value hedges. On the income statement, full fair value accounting involves the recognition of unrealized gains and losses on financial instruments in net income in the period they occur, which often is prior to their realization through the sale or repurchase of the instruments. This aspect of fair value accounting currently is required in the United States only for trading securities, derivatives other than those involved in effective cash flow hedges, and hedged items under fair value hedges. In particular, this aspect is not required for available-for-sale securities or derivatives involved in effective cash flow hedges, despite the fact that they are recognized at fair value on the balance sheet. Also on the income statement, full fair value accounting involves calculating interest revenue or expense as the fair value of the financial instrument times the applicable current market interest rate during the period. This aspect of fair value accounting is not required for any financial instrument under current financial reporting rules in the United States. Interest usually is calculated on an amortized cost basis; when it is not, it is combined with gains and losses, and the total change in the value of the financial instrument is reported on a single line on the income statement, as is often the case for trading securities and derivatives.

Fair value accounting for financial instruments is increasingly feasible for two reasons:

1. The markets for financial instruments have become much richer over time. For example, risky assets, such as commercial loans that previously were difficult to trade, now can be securitized.

2. Financial theory, such as options pricing, has developed and been applied successfully in many contexts by practitioners.

The fair value of most financial instruments now can be estimated with a reasonable degree of precision either through observation of the market prices of similar instruments or through the use of accepted valuation models. For financial instruments that currently cannot be fair valued with a reasonable degree of precision, the proper mind-set is not that amortized cost is unconditionally preferable to fair value accounting but rather that markets or valuation models simply need more time to develop sufficiently for those instruments to be fair valued.

Financial institutions typically hold sizable portfolios of financial instruments. These instruments often have correlated values-that is, they hedge or accentuate risks at the portfolio level. Fair value accounting for all of the financial instruments in a portfolio is the simplest way to account for these correlations. In particular, gains and losses on effective hedges of one financial instrument by another will offset in net income. In contrast, gains and losses on ineffective hedges or speculative positions will not so offset.

The alternative to fair value accounting, amortized cost accounting, uses expectations of cash flows and priced risks determined at initiation to account for financial instruments throughout their life. Amortized cost accounting has three undesirable features compared to fair value accounting. First, amortized cost accounting uses old information and so provides untimely measures of the value of financial instruments on the balance sheet. This untimeliness resolves only as financial instruments amortize or when they are sold or repurchased.

Second, since financial institutions typically hold portfolios of financial instruments initiated at different times, amortized cost accounting provides measures of the values of these instruments that reflect expectations of cash flows and priced risks at different times. This yields noncomparability problems on both balance sheet and income statement. For example, net interest income for a commercial bank may include interest revenue that is based on older interest rates than those reflected in interest expense; if so, net interest income does not reflect the bank's interest rate spread at any point in time, and so it is likely to be a poor predictor of future net interest income. Admittedly, hedge accounting may mitigate these limitations of amortized cost accounting, but hedge accounting is more complex and less transparent than fair value accounting for all financial instruments. Moreover, hedge accounting applied to specific hedging relationships within a portfolio, as is required in most cases under current accounting rules, need not capture the effects of hedging at the portfolio level.

Third, amortized cost accounting provides firms with the ability to manipulate net income through realizing gains and losses on the sale of financial assets or repurchase of financial liabilities. For all three reasons, amortized cost provides a poor basis for accounting for financial instruments and institutions, especially given the existence of increasingly complex and sensitive financial instruments whose values are subject to rapidly changing information and market prices for risk.

Advocates of amortized cost accounting for financial instruments by financial institutions usually make two related arguments on its behalf.

1. They argue that the managers of financial institutions often do not manage the fair values of financial instruments, since these values reflect changes in interest rates and other market prices that are outside their control. Instead they manage investment and financing decisions that yield income on financial assets that is expected to exceed the expense associated with financing those instruments over their whole lives.

2. They argue that these managers conceptualize financial institutions' risk not as the variability of their value over short periods but rather as the variability of their net income or cash flows over long periods.

Neither of these arguments makes much sense for most financial institutions.

Continues...


Excerpted from Financial Instruments and Institutions by Stephen G. Ryan Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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Table of Contents

Preface.

Acknowledgments.

CHAPTER 1. Financial Instruments and Institutions.

Main Ingredients of the Analysis of Financial Instruments.

Activities and Risks of Financial Institutions.

Valuation of Financial Institutions in Practice.

CHAPTER 2. Nature and Regulation of Depository Institutions.

Activities of Depository Institutions.

Bank Regulation.

Bank Subtypes.

Recent Trends.

CHAPTER 3. Thrifts.

Financial Statement Structure.

Main Risk-Return Trade-Offs and Financial Analysis Issues.

CHAPTER 4. Interest Rate Risk and Net Interest Earnings.

Views of Interest Rate Risk.

Interest Rate Risk Concepts.

Analysis of Net Interest Earnings.

Rate-Volume Analysis.

Repricing Gap Disclosures.

CHAPTER 5. Credit Risk and Losses.

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.

CHAPTER 6. Fair Value Accounting for Financial Instruments: Concepts, Disclosures, and Investment Securities.

Fair Value Accounting for Financial Instruments.

Disclosures of the Fair Value of Financial Instruments.

Investment Securities.

Appendix 6A: Washington Federal’s Big Gap.

CHAPTER 7. Mortgage Banks.

Mortgage Banking Industry, Major Players, and Activities.

Financial Statement Structure.

Main Risk-Return Trade-Offs and Financial Analysis Issues.

Accounting for Fees and Costs.

CHAPTER 8. Securitizations.

Why and What?

Securitization Structures.

SFAS No. 140.

Financial Analysis Issues.

Empirical Research on Securitizations.

Servicing Rights and Prepayment-Sensitive Securities.

Appendix 8A: Doral Financial’s Interesting Interest-Only Strips.

CHAPTER 9. Elements of Structured Finance Transactions.

Special-Purpose/Variable-Interest Entities.

Related Transactions.

Hybrid Financial Instruments.

Financial Guarantees.

Recent SEC Decisions Regarding Structured Finance Transactions.

CHAPTER 10. Commercial Banks.

Balance Sheet.

Income Statement.

Cash Flow Statement.

CHAPTER 11. Derivatives and Hedging.

Derivatives.

Hedging.

SFAS No. 133 (1998), as Amended.

Framework for Assessing Financial Institutions’ Derivatives and Hedging.

CHAPTER 12. Market Risk Disclosures.

Overview of FRR No. 48 (1997).

Tabular Format.

Sensitivity Approach.

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.

CHAPTER 13. Lessors and Lease Accounting.

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.

CHAPTER 14. Insurers and Insurance Accounting.

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.

CHAPTER 15. Property-Casualty Insurers’ Loss Reserve Disclosures.

Loss Reserve Footnote.

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.

CHAPTER 16. Reinsurance Accounting and Disclosure.

Accounting and Analysis Issues.

Reinsurance Contracts.

Accounting for Reinsurance Contracts.

Reinsurance Disclosures and Analysis.

Evolution of Financial Reporting for Reinsurance.

Index.

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