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Fair Value Hedge Accounting Z Cash Flow Hedge Accounting Dao (道) Meets Mo (魔) Accounting Challenged by Modern Banking Pierre Jinghong Liang (梁景宏) Carnegie Mellon University For presentation at Southwest University of Finance and Economics (西南财经大学) 2011.7.7 Accounting: a Brief History 2011.7 SWUFE Accounting Challenged by Modern Banking 2 Accounting: a Brief History z 8500 B.C. ClaClay tokens made in shapes to represent variou s commodities constitute first record keeping system z 200 B.C. Symbols for all Arabic numerals except zero devised by Hindus in India z 600 A.D. Zero was developed . The 10-numeral system spread by traders throughout Europe in the 800s 2011.7 SWUFE Accounting Challenged by Modern Banking 3 Accounting: a Brief History 2011.7 SWUFE Accounting Challenged by Modern Banking 4 Accounting: a Brief History z 1400s: Double-entry bookkeeping used in Italy z 1494: Italian monk and scholar Luca Pacioli published the first known tttext (Summa) on the practice of dbldouble-entry bkkibookkeeping z 1845: Business corporation law passed in England z 1887: The predecessor of AICPA founded z 1904: Association of Chartered Certified Accountants founded z 1934: Securities Exchange Act establishes the SEC and mandates audits for all listed companies z 1940: the landmark Paton-Littleton Monograph published 2011.7 SWUFE Accounting Challenged by Modern Banking 5 High Praises for Bookkeeping Bookkeeping is “one of the “Bookkeeping is one of two fairest inventions of perfect sciences.” human mind.” 2011.7 SWUFE Accounting Challenged by Modern Banking 6 Accounting: a Brief History z 1973: Current US standard-setting group, Financial Accounting Standards Board (FASB), replaced APB z 1993-1994: Controversy over Accounting for Stock-Option compensation z Downfall of Arthur Andersen after a series corporate scandals involving the storied firm z Sarbanes-Oxley Act of 2002 initiates sweeping changes in corporate disclosures (billed as a law to “improve the accuracy and reliability of corporate disclosure made pursuant to the securities laws, and for other purposes”) 2011.7 SWUFE Accounting Challenged by Modern Banking 7 Agenda for Today z Pillars of Traditional Accounting Model z Double-entry Bookkeeping z Financial Reporting Features z Challenges from Modern Finance z Stock Options Compensation z Structured Products z Tough Choices to Make z Does accounting/reporting really matter? 2011.7 SWUFE Accounting Challenged by Modern Banking 8 Accounting theory and practices z Conceptually, accounting can be understood as z A device/mechanism to measure some underlying construct (i.e., economic profit of a firm) z A provider of information (i.e., informs owners of their firm’s financial situation) z Conflict and Confusion z In practice, financial reporting has become very rules oriented. Over time, the accounting profession has developed a network of conventions, rules, guidelines, and procedures, collectively referred to as Generally Accepted Accounting Principles (GAAP). 2011.7 SWUFE Accounting Challenged by Modern Banking 9 Key Players in U.S. Financial Reporting 2011.7 SWUFE Accounting Challenged by Modern Banking 10 Supply of Accounting Information z Primary SEC filing requirements z Form 10-K: annual z Form 10-Q: quarterly z Benefits of disclosure z Lower costs of funds z Costs of disclosure z Preparation and dissemination, competitive disadvantages, litigation potential, and political costs 2011.7 SWUFE Accounting Challenged by Modern Banking 11 Interesting Balance Sheets Millions of dollars Wednesday Wednesday 11-May-11 11-May-11 Assets Liabilities Gold certificate account 11,037 Federal Reserve notes, net of F.R. Bank holdings 976,785 Special drawing rights certificate account 5,200 Reverse repurchase agreements 14 54,715 Coin 2, 166 Deposits 1, 642, 882 Securities, repurchase agreements, and loans 2,533,679 Term deposits held by depository institutions 0 Securities held outright 1 2,518,349 Other deposits held by depository institutions 1,546,654 Repurchase agreements 5 0 U.S. Treasury, general account 87,894 Loans 15,330 U.S. Treasury, supplementary financing account 5,000 Net portfolio holdings of Commercial Paper 0 Foreign official 124 Funding Facility LLC 6 Other 3,209 Net portfolio holdings of Maiden Lane LLC 7 24,812 Deferred availability cash items 1,535 Net portfolio holdings of Maiden Lane II LLC 8 14,985 Other liabilities and accrued dividends 15 20,171 Net portfolio holdings of Maiden Lane III LLC 9 24,703 Net portfolio holdings of TALF LLC 10 733 Total liabilities 2,696,088 Pre ferre d in teres ts in AIA Aurora LLC and ALICO 0 Holdings LLC 11 Capital accounts Items in process of collection 503 Capital paid in 26,282 Bank premises 2,210 Surplus 26,282 Central bank liquidity swaps 12 0 Other capital accounts 0 Other assets 13 128,625 Total capital 52,564 Total assets 2,748,652 Total Liabiliites and Capital 2,748,652 2011.7 SWUFE Accounting Challenged by Modern Banking 12 The Basics of Stocks and Flows The Firm Capital Product/Input Markets Markets Net Operating Assets Net Financial Obligations Financial Assets Financial Obligations Operating Liabilities debt- Operating Assets customers holders or issuers suppliers, share- employees, NOA NFO holders government 2011.7 SWUFE Accounting Challenged by Modern Banking 13 Pillars of Traditional Accounting Model z Entity and Continuity concepts z going concern z Asset and Liabilities z Recognition: Objectivity z Measurement: historical cost z Income Determination z Realization (and earned) z Matching z Conservatism 2011.7 SWUFE Accounting Challenged by Modern Banking 14 Organic Entities z Boundaries among economic entities reasonably clear z Rights to value and exposure to risk bundled z Measuring viewed as exogenous to the measured z Where are Special Purpose Entities? 2011.7 SWUFE Accounting Challenged by Modern Banking 15 Staying Away from future actions z Accounting Recognition z Cash, deferrals, and accruals z Assets: emphasize “past transactions” z Revenues: emphasize “realization” z What about expected future (trans)actions? z Contractual/Committed z Forecasted z How about growth option? z Where is hedging? 2011.7 SWUFE Accounting Challenged by Modern Banking 16 Operational Expediency z Accused of operationally defining accounting income instead of intrinsically. z That is: define Accounting Income to be whatever the result of applying accounting procedures (the realization and matching principles). z Offered the accounting profession the much- needed protection against potential liabilities from the law or public perception. 2011.7 SWUFE Accounting Challenged by Modern Banking 17 “Newtonian” Accounting Model z "Income finding depended on a series of interlocking assumptions which includedincluded historicalhistorical costs, continuity, conservatism, and periodicity as well as matching and realization. … It would prove very difficult to alter any one of them without changing their conglomerate effect. z Those who accepted these assumptions confronted a closed and self-justifying system which, like the laws of Newtonian physics at the turn of the century, seemed to leave little to be discovered.“ (Chatfield 1974, 260) 2011.7 SWUFE Accounting Challenged by Modern Banking 18 Here comes Modern Banking Varieties of Depository Banks z Thrifts z Interest-spread-based savings associations which receive consumer ditdeposits and make consumer morttgage loans z Typically small and retail focused z Examples: Dollar Bank, Eureka Bank, and First Federal z Mortgage Banks z Fee-based bank which specialize in mortgage origination and often sell them through securitization. z Example: Countrywide, New Century, and American Home Mortgage z Commercial Banks z Banks which offer a wide array of services both fee- and interest- spread-based. z Examples: PNC, Citi, JPMorgan Chase, and Bank of America 2011.7 SWUFE Accounting Challenged by Modern Banking 20 Main Activities by Financial Institutions z Fund Aggregation z Yield Curve Speculation z Trading and Investment z Risk Management z Other Fee-based activities z Syndication, securitization, and reinsurance z Market-making and brokerage z Deal making z Asset management and investment advice z Transaction processing 2011.7 SWUFE Accounting Challenged by Modern Banking 21 Financial Statement Analysis of Banks z IRR and analysis of NII z Credit Risk and analysis of PLL z Financial assets and Fair Value accounting z Securitization and its disclosure z Derivatives, hedging and their disclosure z Capital Arithmetic z Market-Risk Disclosure and Capital Requirement 2011.7 SWUFE Accounting Challenged by Modern Banking 22 Why are accounting and disclosure important z Financial Institutions are required by industry regulators to provide extensive risk disclosure. These disclosures mostly consist of fair value accounting and estimation sensitivity and risk disclosures. z They help the readers construct an coherent story about how financial firms generate or destroy value using financial instruments. z But … 2011.7 SWUFE Accounting Challenged by Modern Banking 23 Modern Banking Challenges Accounting z Structured Products z Financial products designed according to and anticipating certain legal and accounting treatment z “Synthetic Entities” (not organic) z Partitioning risk and, separately, value z “Bringing” future anticipated transactions to current 2011.7 SWUFE Accounting Challenged by Modern Banking 24 Varied Accounting Responses z Accounting Institutions Tested Mightily z Three Examples z Stock Option Compensation z Securitization z Hedge Accounting 2011.7 SWUFE Accounting Challenged by Modern Banking 25
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