afi+exam+summer+2010 (3)
Content
In Class Exam
Accounting for Financial Instruments
B10.6317
Summer 2010
June 10, 2010
Professor Ryan
Instructions (READ!):
1) The Stern Honor Code applies. Any work you submit must be your own. I have
instructed the Ph.D. student proctoring the exam to report any apparent violations of the
honor code to me.
2) The exam is open book. You may use a calculator (or laptop, if you can do so without
infringing on your neighbor’s space).
3) I have attempted to write an altogether clear exam. If anything is unclear, indicate on the
exam what you find unclear, state what you assume, and proceed. The Ph.D. student
proctoring the exam will not answer any questions.
4) You have up to three hours to complete the exam. I wrote the exam so that this amount
of time should be ample.
5) Record your answers in the blue books provided. Be sure to put your name on the blue
book. Please try to write clearly and at a normal size.
6) Show your work if you want partial credit.
7) The exam has 5 multipart questions with points indicated. The exam has 7 numbered
pages. It is your responsibility to make sure that your copy of the exam is complete.
8) Morning class only. You must hand in your exam with your blue book. It will be
returned with your graded exam.
1
Questions:
1) Multiple choice (1 points each, 10 points total)
a) Which interest rate is used to account for floating rate financial instruments at a point
in time?
i. The market rate at inception
ii. The floating rate at inception
iii. The current market rate
iv. The current floating rate
b) How may unrealized gains and losses on a financial liability be realized? Choose all
that apply.
i. Through buy back of the liability
ii. Through issuance of a new liability with similar characteristics
iii. Through accrual of interest over time
iv. Through a change in the current market interest rate for the liability
v. Through an impairment write-down of the liability.
c) The FASB has defined fair value as
i. Entry value
ii. Exit value
iii. Value in use
iv. True value
d) Which accounting system is more conducive to gains trading
i. Amortized cost accounting
ii. Fair value accounting
e) Under FAS 157, the valuation of a financial instrument based on a model and
observable market information is a
i. Level 1 measurement
ii. Level 2 measurement
iii. Level 3 measurement
f) When a firm transfers an available for sale security to held to maturity, the
accumulated other comprehensive income (AOCI) at the time of transfer
i. Remains in AOCI and is gradually recognized into income over the life of the
security
ii. Remains in AOCI forever
iii. Is eliminated and the security is recognized at the original amortized cost basis
iv. Is recorded in net income
2
g) Which conditions regarding a loss contingency are necessary—but not more easily
met than the necessary conditions—to accrue a contra asset or liability under FAS 5
(circle all that apply).
i. Possible
ii. Probable
iii. Likely
iv. Incurred
v. Certain
vi. Expected
vii. Can be estimated
viii. Can be reasonably estimated
ix. Can be precisely estimated
h) Residential mortgages are
i. Homogenous loans for which allowances for loan losses are estimated at the
individual loan level
ii. Homogenous loans for which allowances for loan losses are estimated at the
portfolio of loans level
iii. Heterogenous loans for which allowances for loan losses are estimated at the
individual loan level
iv. Heterogenous loans for which allowances for loan losses are estimated at the
portfolio of loans level
i) Loan charge-offs
i. Increase the allowance for loan losses
ii. Reduce net income
iii. Reduce net assets
iv. All of the above
v. None of the above
j) When do losses first become incurred on a loan? Pick all that apply.
i. When the bank writes the loan at an interest rate that fully incorporates the
loan’s credit risks.
ii. When the bank writes the loan at an interest rate that is too low given the
loan’s credit risks.
iii. When the borrower experiences stress on the loan that was issued at an
interest rate that fully incorporated the loan’s credit risks.
iv. When the borrower experiences stress on the loan that was issued at an
interest rate that was too low given the loan’s credit risks.
Question 2 begins on the next page.
3
2) The FASB’s May 26, 2010 Exposure Draft, “Accounting for Financial Instruments and
Revisions to the Accounting for Derivative Instruments and Hedging Activities”
(hereafter, “the ED”), proposes to make very substantial changes to the accounting for
financial instruments. Below, I describe four proposed changes and ask a related
question for each proposed change. Answer each question as concisely as you can, but
certainly in no more than two blue book pages per question. (5 points each, 20 points
total)
a) The ED proposes to (continue to) measure interest on an amortized cost basis, even
for financial instruments it proposes to recognize on the balance sheet at fair value.
Explain to the FASB why this is a poor idea, particularly for financial institutions that
hold portfolios of financial instruments.
b) For financial instruments recognized at fair value on the balance sheet with unrealized
gains and losses recorded in accumulated other comprehensive income, the ED
proposes to require firms to report both the amortized cost and the fair value of the
instruments on the face of the balance sheet. Explain why amortized costs may
convey useful information incremental to fair values, and vice versa.
c) The ED proposes to eliminate the “probable” restriction for recording credit or other
impairment losses under FAS 5 and other asset impairment accounting standards.
Explain how elimination of this restriction likely would affect the accrual of
allowances for loan losses differently for homogeneous loans versus heterogeneous
loans under FAS 5.
d) Somewhat related to the prior question, the FASB proposes to define a debt
instrument asset as being impaired when the firm expects that it will not collect all the
promised payments on the debt instrument. Assume “expects” means “on average.”
Under this proposed definition, when will most credit risky debt instruments first be
impaired? (This question can be answered in a few words.)
Question 3 begins on the next page.
4
3) BigBank invests $17.36 (this amount is rounded) in a debt security at the beginning of
year 1. The issuer of the debt security (hereafter, “the borrower”) promises to pay
BigBank $10 at the end of each of years 1 and 2. The market interest rate at the inception
of the security is 10%. The market interest rate changes to 8% immediately after the
inception of the security. For parts a-c, assume that the borrower makes the promised
payments; this assumption is changed for the remaining parts of the question. If you
prefer not to calculate numbers, you may use notation (e.g., to denote a present value);
just be sure to do so specifically and consistently. (5 points each part, 25 points total)
a) Record the journal entries for the security throughout its life using amortized cost
accounting.
b) Record the journal entries for the security throughout its life using full fair value
accounting.
c) Explain why the sum of net income across the three-year life of the security is equal
under amortized cost accounting and full fair value accounting.
d) Assume the borrower only pays $6 at the end of year 1 and it is probable that the
borrower will only pay $6 at the end of year 2. Assume the market interest rate for
the security rises to 15%. Assume BigBank has classified the security as held-tomaturity and that it has the intent and ability to hold the security to maturity. Record
all BigBank’s journal entries for the security from the time of the impairment and
market interest rate change at the end of year 1 to the end of year 2.
e) Explain why it is necessary in year 2 to accrete the AOCI recorded for the security in
year 1.
4) I attach a portion of Regions Financial’s investment securities footnote in its 2009 Form
10-K filing on the last page of the exam. (5 points each part, 20 points total)
a) Calculate the unrealized gain on Regions’ available for sale (AFS) securities during
2009.
b) Calculate the total gain on Regions’ AFS securities during 2009.
c) Evaluate whether Regions gains traded in any sense using AFS securities during
2009.
d) What is the amount of the adjustment to Regions’ pretax income for 2009 that is
necessary for its adjusted pretax income to reflect full fair value accounting for its
AFS securities?
5
5) BigBank has written $100 million of subprime mortgages with a promised yield of 8%.
BigBank transfers the mortgages to a trust that issues senior mortgage-backed securities
(MBS) with a yield of 6% for $90 million dollars. BigBank retains a junior security that
represents the right to receive anything left in the trust after the investors in the senior
MBS are fully paid off. BigBank estimates the fair value the retained security is $12
million. BigBank also retains servicing rights with a fair value of $3 million and
provides a recourse guarantee with a fair value of $1 million. Ignore the possibility that
BigBank consolidates the trust, which we will cover in the next session of the class. (5
points each part, 25 points total).
a) Assume the securitization does not meet FAS 140/166’s criteria for sale accounting.
Record the journal entry for BigBank at the time of securitization.
b) Assume the securitization does meet FAS 140/166’s criteria for sale accounting.
Record the journal entry for BigBank at the time of securitization.
c) Explain why the transaction described above does not qualify for sale accounting
under FAS 140/166, but how this failure could be easily cured.
d) What are the main limitations of secured borrowing accounting for this
securitization?
e) Assume the cure described in part c is made so that the securitization qualifies for
sale accounting. What are the main limitations of sale accounting for this
securitization?
6
Excerpts from Regions Financial’s Investment Securities Footnote in its 2009 Form 10-K Filing
NOTE 4. SECURITIES
The amortized cost and estimated fair value of securities available for sale and securities held to maturity at
December 31 are as follows:
December 31, 2009
Securities available for sale:
U.S. Treasury securities
Federal agency securities
Obligations of states and political subdivisions
Mortgage-backed securities:
Residential agency
Residential non-agency
Commercial agency
Other debt securities
Equity securities
Cost
$
$
December 31, 2008
Securities available for sale:
U.S. Treasury securities
Federal agency securities
Obligations of states and political subdivisions
Mortgage-backed securities:
Residential agency
Residential non-agency
Commercial
Other debt securities
Equity securities
Gross
Gross
Unrealized
Unrealized
Gains
Losses
(In millions)
46
44
70
22,271
33
20
22
1,132
23,638
802
1,521
755
12,060
1,627
898
21
1,178
$18,862
$
4
1
—
474
3
1
—
12
495
$
$
—
—
—
$
(61)
—
—
(3)
—
(64)
22,684
36
21
19
1,144
$24,069
Gross
Gross
Unrealized
Unrealized
Gains
Losses
(In millions)
Cost
$
$
$
$
84
175
9
276
6
1
—
1
552
$
$
Estimated
Fair
Value
—
—
(8)
(3)
(394)
(142)
(2)
(15)
(564)
50
45
70
Estimated
Fair
Value
$
886
1,696
756
12,333
1,239
757
19
1,164
$18,850
Proceeds from sales of securities available for sale in 2009 were $5.5 billion, with gross realized gains and
losses of $187 million and $118 million, respectively. Proceeds from sales of securities available for sale in 2008
were $2.1 billion, with gross realized gains and losses of $95 million and $3 million, respectively. Proceeds from
sales of securities available for sale in 2007 were $2.0 billion, with gross realized gains and losses of $41 million
and $50 million, respectively. The cost of securities sold is based on the specific identification method.
7
Accounting for Financial Instruments
B10.6317
Summer 2010
June 10, 2010
Professor Ryan
Instructions (READ!):
1) The Stern Honor Code applies. Any work you submit must be your own. I have
instructed the Ph.D. student proctoring the exam to report any apparent violations of the
honor code to me.
2) The exam is open book. You may use a calculator (or laptop, if you can do so without
infringing on your neighbor’s space).
3) I have attempted to write an altogether clear exam. If anything is unclear, indicate on the
exam what you find unclear, state what you assume, and proceed. The Ph.D. student
proctoring the exam will not answer any questions.
4) You have up to three hours to complete the exam. I wrote the exam so that this amount
of time should be ample.
5) Record your answers in the blue books provided. Be sure to put your name on the blue
book. Please try to write clearly and at a normal size.
6) Show your work if you want partial credit.
7) The exam has 5 multipart questions with points indicated. The exam has 7 numbered
pages. It is your responsibility to make sure that your copy of the exam is complete.
8) Morning class only. You must hand in your exam with your blue book. It will be
returned with your graded exam.
1
Questions:
1) Multiple choice (1 points each, 10 points total)
a) Which interest rate is used to account for floating rate financial instruments at a point
in time?
i. The market rate at inception
ii. The floating rate at inception
iii. The current market rate
iv. The current floating rate
b) How may unrealized gains and losses on a financial liability be realized? Choose all
that apply.
i. Through buy back of the liability
ii. Through issuance of a new liability with similar characteristics
iii. Through accrual of interest over time
iv. Through a change in the current market interest rate for the liability
v. Through an impairment write-down of the liability.
c) The FASB has defined fair value as
i. Entry value
ii. Exit value
iii. Value in use
iv. True value
d) Which accounting system is more conducive to gains trading
i. Amortized cost accounting
ii. Fair value accounting
e) Under FAS 157, the valuation of a financial instrument based on a model and
observable market information is a
i. Level 1 measurement
ii. Level 2 measurement
iii. Level 3 measurement
f) When a firm transfers an available for sale security to held to maturity, the
accumulated other comprehensive income (AOCI) at the time of transfer
i. Remains in AOCI and is gradually recognized into income over the life of the
security
ii. Remains in AOCI forever
iii. Is eliminated and the security is recognized at the original amortized cost basis
iv. Is recorded in net income
2
g) Which conditions regarding a loss contingency are necessary—but not more easily
met than the necessary conditions—to accrue a contra asset or liability under FAS 5
(circle all that apply).
i. Possible
ii. Probable
iii. Likely
iv. Incurred
v. Certain
vi. Expected
vii. Can be estimated
viii. Can be reasonably estimated
ix. Can be precisely estimated
h) Residential mortgages are
i. Homogenous loans for which allowances for loan losses are estimated at the
individual loan level
ii. Homogenous loans for which allowances for loan losses are estimated at the
portfolio of loans level
iii. Heterogenous loans for which allowances for loan losses are estimated at the
individual loan level
iv. Heterogenous loans for which allowances for loan losses are estimated at the
portfolio of loans level
i) Loan charge-offs
i. Increase the allowance for loan losses
ii. Reduce net income
iii. Reduce net assets
iv. All of the above
v. None of the above
j) When do losses first become incurred on a loan? Pick all that apply.
i. When the bank writes the loan at an interest rate that fully incorporates the
loan’s credit risks.
ii. When the bank writes the loan at an interest rate that is too low given the
loan’s credit risks.
iii. When the borrower experiences stress on the loan that was issued at an
interest rate that fully incorporated the loan’s credit risks.
iv. When the borrower experiences stress on the loan that was issued at an
interest rate that was too low given the loan’s credit risks.
Question 2 begins on the next page.
3
2) The FASB’s May 26, 2010 Exposure Draft, “Accounting for Financial Instruments and
Revisions to the Accounting for Derivative Instruments and Hedging Activities”
(hereafter, “the ED”), proposes to make very substantial changes to the accounting for
financial instruments. Below, I describe four proposed changes and ask a related
question for each proposed change. Answer each question as concisely as you can, but
certainly in no more than two blue book pages per question. (5 points each, 20 points
total)
a) The ED proposes to (continue to) measure interest on an amortized cost basis, even
for financial instruments it proposes to recognize on the balance sheet at fair value.
Explain to the FASB why this is a poor idea, particularly for financial institutions that
hold portfolios of financial instruments.
b) For financial instruments recognized at fair value on the balance sheet with unrealized
gains and losses recorded in accumulated other comprehensive income, the ED
proposes to require firms to report both the amortized cost and the fair value of the
instruments on the face of the balance sheet. Explain why amortized costs may
convey useful information incremental to fair values, and vice versa.
c) The ED proposes to eliminate the “probable” restriction for recording credit or other
impairment losses under FAS 5 and other asset impairment accounting standards.
Explain how elimination of this restriction likely would affect the accrual of
allowances for loan losses differently for homogeneous loans versus heterogeneous
loans under FAS 5.
d) Somewhat related to the prior question, the FASB proposes to define a debt
instrument asset as being impaired when the firm expects that it will not collect all the
promised payments on the debt instrument. Assume “expects” means “on average.”
Under this proposed definition, when will most credit risky debt instruments first be
impaired? (This question can be answered in a few words.)
Question 3 begins on the next page.
4
3) BigBank invests $17.36 (this amount is rounded) in a debt security at the beginning of
year 1. The issuer of the debt security (hereafter, “the borrower”) promises to pay
BigBank $10 at the end of each of years 1 and 2. The market interest rate at the inception
of the security is 10%. The market interest rate changes to 8% immediately after the
inception of the security. For parts a-c, assume that the borrower makes the promised
payments; this assumption is changed for the remaining parts of the question. If you
prefer not to calculate numbers, you may use notation (e.g., to denote a present value);
just be sure to do so specifically and consistently. (5 points each part, 25 points total)
a) Record the journal entries for the security throughout its life using amortized cost
accounting.
b) Record the journal entries for the security throughout its life using full fair value
accounting.
c) Explain why the sum of net income across the three-year life of the security is equal
under amortized cost accounting and full fair value accounting.
d) Assume the borrower only pays $6 at the end of year 1 and it is probable that the
borrower will only pay $6 at the end of year 2. Assume the market interest rate for
the security rises to 15%. Assume BigBank has classified the security as held-tomaturity and that it has the intent and ability to hold the security to maturity. Record
all BigBank’s journal entries for the security from the time of the impairment and
market interest rate change at the end of year 1 to the end of year 2.
e) Explain why it is necessary in year 2 to accrete the AOCI recorded for the security in
year 1.
4) I attach a portion of Regions Financial’s investment securities footnote in its 2009 Form
10-K filing on the last page of the exam. (5 points each part, 20 points total)
a) Calculate the unrealized gain on Regions’ available for sale (AFS) securities during
2009.
b) Calculate the total gain on Regions’ AFS securities during 2009.
c) Evaluate whether Regions gains traded in any sense using AFS securities during
2009.
d) What is the amount of the adjustment to Regions’ pretax income for 2009 that is
necessary for its adjusted pretax income to reflect full fair value accounting for its
AFS securities?
5
5) BigBank has written $100 million of subprime mortgages with a promised yield of 8%.
BigBank transfers the mortgages to a trust that issues senior mortgage-backed securities
(MBS) with a yield of 6% for $90 million dollars. BigBank retains a junior security that
represents the right to receive anything left in the trust after the investors in the senior
MBS are fully paid off. BigBank estimates the fair value the retained security is $12
million. BigBank also retains servicing rights with a fair value of $3 million and
provides a recourse guarantee with a fair value of $1 million. Ignore the possibility that
BigBank consolidates the trust, which we will cover in the next session of the class. (5
points each part, 25 points total).
a) Assume the securitization does not meet FAS 140/166’s criteria for sale accounting.
Record the journal entry for BigBank at the time of securitization.
b) Assume the securitization does meet FAS 140/166’s criteria for sale accounting.
Record the journal entry for BigBank at the time of securitization.
c) Explain why the transaction described above does not qualify for sale accounting
under FAS 140/166, but how this failure could be easily cured.
d) What are the main limitations of secured borrowing accounting for this
securitization?
e) Assume the cure described in part c is made so that the securitization qualifies for
sale accounting. What are the main limitations of sale accounting for this
securitization?
6
Excerpts from Regions Financial’s Investment Securities Footnote in its 2009 Form 10-K Filing
NOTE 4. SECURITIES
The amortized cost and estimated fair value of securities available for sale and securities held to maturity at
December 31 are as follows:
December 31, 2009
Securities available for sale:
U.S. Treasury securities
Federal agency securities
Obligations of states and political subdivisions
Mortgage-backed securities:
Residential agency
Residential non-agency
Commercial agency
Other debt securities
Equity securities
Cost
$
$
December 31, 2008
Securities available for sale:
U.S. Treasury securities
Federal agency securities
Obligations of states and political subdivisions
Mortgage-backed securities:
Residential agency
Residential non-agency
Commercial
Other debt securities
Equity securities
Gross
Gross
Unrealized
Unrealized
Gains
Losses
(In millions)
46
44
70
22,271
33
20
22
1,132
23,638
802
1,521
755
12,060
1,627
898
21
1,178
$18,862
$
4
1
—
474
3
1
—
12
495
$
$
—
—
—
$
(61)
—
—
(3)
—
(64)
22,684
36
21
19
1,144
$24,069
Gross
Gross
Unrealized
Unrealized
Gains
Losses
(In millions)
Cost
$
$
$
$
84
175
9
276
6
1
—
1
552
$
$
Estimated
Fair
Value
—
—
(8)
(3)
(394)
(142)
(2)
(15)
(564)
50
45
70
Estimated
Fair
Value
$
886
1,696
756
12,333
1,239
757
19
1,164
$18,850
Proceeds from sales of securities available for sale in 2009 were $5.5 billion, with gross realized gains and
losses of $187 million and $118 million, respectively. Proceeds from sales of securities available for sale in 2008
were $2.1 billion, with gross realized gains and losses of $95 million and $3 million, respectively. Proceeds from
sales of securities available for sale in 2007 were $2.0 billion, with gross realized gains and losses of $41 million
and $50 million, respectively. The cost of securities sold is based on the specific identification method.
7
