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Chapter 1

FAT Chapter 1.docx

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Wilfrid Laurier University
Bixia Xu

FAT Chapter 1 – Introduction Historical Perspective • Alternative valuation bases have become more common over the years to the point where we now have a mixed measurement system • Historical cost is still the primary basis of accounting for important asset and liability classes, such as capital assets, inventories, and long-term debt • However, if assets are impaired, they are frequently written down to a lower value • Generally speaking, standard setters have moved steadily towards current cost alternatives to historical cost accounting over the past number of years • There are two main current cost alternatives to historical cost for assets and liabilities o Value-in-use: discounted present value of future cash flows o Fair value (also called exit price or opportunity cost): the amount that would be received or paid should the firm dispose of the asset or liability • Valuations that depart from historical cost is current values • The objective of financial statements is to provide information to assist investors to make investment decisions o Stated in IASB/FASB Framework • Structured investment vehicles (SIV): often created by lenders such as banks, mortgages, and other financial institutions, to securitize their holdings of mortgages, credit card balances, auto loans, and other financial assets • SIVs pooled them into asset-backed securities (ABSs): tranches of similar quality credits • ABSs were frequently further securitized as collateralized debt obligation (CDO) which consisted of tranches of similar quality ABS tranches, a procedure that further increased diversification • To obtain cash to pay the sponsor for assets transferred, SIVs borrowed money, often by issuing asset-backed commercial paper (ABCP), which received high ratings from investment rating agencies and offered higher interest rates • Credit enhancement of ABSs was often necessary if the SIV was able to borrow at a low interest rate o Liquidity put: sponsor agreed to buy back the SIV’s asset backed securities should the market for them collapse o Retention of the lowest-quality tranche by sponsoring institution, and various explicit and implicit guarantees to reimburse purchasers for losses • SIVs could hedge their risk by purchasing credit default swaps (CDSs) from some intermediary o Credit default swaps: derivative financial instruments that would reimburse the SIV for all or part of credit losses on its ABSs • FASB expanded requirements for consolidation of a particular form of SIVs called variable interest entities (VIEs), which are SIVs under which the ownership interest varies with the fair value of SIV’s net assets • The primary beneficiary of the VIE must consolidate its financial statements with the VIEs it sponsors o Primary beneficiary: entity that absorbed most of the VIE’s expected losses and received a majority of its expected gains • Sponsors were able to avoid consolidation by creating expected loss notes (ELNs) o Expected loss notes: securities sold by sponsors to outside parties under which the purchasers contracted to absorb a majority of VIE’s expected losses and receive a majority of expected net returns o Consolidation would be with the financial statements of the ELN holder, not the sponsor • In the end, asset-backed securities lacked transparency • The risk of a continuing decline in demand due to skeptical investors’ lack of buying is called liquidity risk o Liquidity risk can result in a market value less than value-in-use • Investors lost confidence due to counterparty risk o A CDS that pays off if an ABS declines in value would increase in value o Demand for CDSs became very high o CDS were packaged into synthetic CDOs: tranches of CDS, for sale to investors and speculators • The huge amount of private trading of CDOs and CDSs, combined with the off-balance sheet nature of many VIEs, became known as shadow banking system • In the face of this collapse of liquidity and severe counterparty risk, SIVs faced either insolvency or the necessity for their sponsors to buy back their impaired assets • Many sponsors failed, raised additional capital at distressed prices, or were rescued by governments, resulting in major contraction of the financial system • The resulting reduction in market liquidity spread to the real economy, leading to worldwide recession including drastic falls in share prices • Since spreads became very high as underlying ABS values fell, the resulting fair value estimates reflected liquidity pricing in the market o Liquidity pricing: outcome of liquidity risk, under which market value is less than the value-in-use, which the institutions felt they would eventually realize if they held these assets to maturity • In summary, 4 points relevant to accountants stand out from the events just described o Financial reporting must be transparent, so that investors can properly value assets and liabilities, and firms that possess them. With respect to complex financial assets and liabilities, transparency includes full reporting of models used to determine value, disclosure of any repurchase obligations, and explanations of risk exposures and risk management strategies, including use of credit default swaps o Fair value accounting, being based on market value or estimates thereof, may understate value-in-use when markets collapse due to liquidity pricing that result from a severe decline in investor confidence. This leads to management, and even government, objections o Off-balance sheet activity should be fully reported, even if not consolidated, since they can encourage excessive risk taking by management o Since accounting standards are a for
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