ACCT 5341 Syllabus
Bob Jensen
at Trinity University
International Accounting Theory Helpers and Links
Reading Assignments for This Week
Please keep your answers to all possible quiz questions for the entire semester. They may reappear in future quizzes and they may help in your course project.
If a case assignment or other question points to a particular section of a textbook chapter or other reading section, you are responsible to take notes on that particular section in its entirety.
If a case assignment or other question points to a particular section of a textbook chapter or other reading section, you are responsible to take notes on that particular section in its entirety.
The Excel questions for this week are on the TUCC Drive J:\courses\acct5341\0assign\sfas133
Remember that your partnership must go over some or all
these questions with the ACCT 5341 Teaching Assistant and fill out the attest.htm form.
File 1 Question 01 (With Answer)
What is the "clearly-and-closely"
related criterion? Comment in terms of credit-indexed and commodity-indexed
embedded derivatives.
[Hint: See Paragraph 12a and Bob Jensen's SFAS 133 Glossary.]
An embedded derivative that is both deemed to be free standing and is not clearly-and-closely related" must be accounted for separately rather than remain buried in the accounting for the host contract. Relevant sections of SFAS 133 include Paragraphs 304-311 in Pages 150-153 and Paragraphs 443-450 in Pages 196-198. The FASB reversed its ED 162-B position on compound derivatives. Examples 12-34 beginning in Paragraph 176 on Page 93 illustrate clearly-and-closely-related criteria in embedded hybrid derivative instruments.
File 1 Question 02 (With Answer)
Why does Jim Leisenring state that the most
difficult thing about SFAS 133 is the definition of a derivative? Explain in terms
of embedded derivatives.
[Hint: Go to my tape31.htm
file. ]
"Actually I think the most complicated aspect of the document is in the definition of derivative. And what constitutes an embedded derivative and what would otherwise be a cash instrument? Many of you are going to say well, gees why did you bother? Let me tell you a little antidotal point that you may not realize. The ink was not dry on our exposure draft, it would have required marking to market derivatives for hedging when a certain big investment bank and an insurance company came out with a product that would insure you against changes in foreign exchange rates. Not a derivative, wasn't hedging changes in exchange rates, wasn't a derivative product. It was an insurance policy designed to pay off for changes in exchange rates. Sort of was an eye opener to us and everyone else that's been involved with the project, that if you don't get at what's an embedded derivative, all you got to do is have a one dollar cash payment going back and forth and you'd eliminate every derivative. Now you have just put a one-dollar loan on the top of any forward contract or anything else."
File 1 Question 03 (With Answer)
Explain why a "range floater" cannot usually be separated from the
hedged item and accounted for as a derivative instrument under SFAS 133 accounting rules?
[See and Bob
Jensen's SFAS 133 Glossary.]
Much of the concern in SFAS 133 accounting focuses on whether a floater-based embedded option can be separated from its host. For example suppose a bond receivable has a variable interest rate with an embedded range floater derivative that specifies a collar of 4% to 8% based upon LIBOR. The bond holder receives no interest payments in any period where the average LIBOR is outside the collar. In this case, the range floater embedded option cannot be isolated and accounted for apart from the host bond contract. The reason is that the option is clearly and closely related to the interest payments under the host contract (i.e., it can adjust the interest rate). See Paragraph 12 beginning on Page 7 of SFAS 133. An example of a range floater is provided beginning in Paragraph 181 on Page 95 of SFAS 133.
File 1 Question 04 (With Answer)
Explain why a "ratchet floater" cannot usually be separated from the
hedged item and accounted for as a derivative instrument under SFAS 133 accounting rules?
[See and Bob
Jensen's SFAS 133 Glossary.]
A ratchet floater pays a floating interest rate with an adjustable cap and an adjustable floor. The embedded derivatives must be accounted for separately under Paragraph 12. An example is provided in Paragraph 182 beginning on Page 95 of SFAS 133.
PWC q08.23 (Page 71)
File 1 Question 05 (With Answer)
Suppose a company swaps a variable rate for a fixed rate of 7% on $10 million.
Embedded in the contract is an adjustment factor that changes the rate to 8% if
LIBOR reaches 7% and reduces the rate to 6% if LIBOR drops to 5%. Can the embedded
derivative be accounted for separately under SFAS 133 rules? Explain the
FASB's reasoning on this issue.
[Hint: Look up "index-amortizing" in Bob Jensen's SFAS 133 Glossary.]
Some debt has a combination of fixed and floating components. For example, a "fixed-to-floating" rate bond is one that starts out at a fixed rate and at some point (pre-determined or contingent) changes to a variable rate. This type of bond has a embedded derivative (i.e., a forward component for the variable rate component that adjusts the interest rate in later periods. Since the forward component is "clearly-and-closely related"adjustment of interest of the host contract, it cannot be accounted for separately according to Paragraph 12a on Page 7 of SFAS 133 (unless conditions in Paragraph 13 apply). An example of a fixed-to-floating rate debt is provided beginning in Paragraph 183 on Page 196 of SFAS 133.
PWC q08.24 (Page 72)
File 1 Question 06 (With Answer)
Under what conditions can an equity-indexed embedded derivative be separated and
accounted for separately under Paragraph 12 rules of SFAS 133?
[See the term "embedded derivative" in Bob Jensen's SFAS 133 Glossary.]
An equity-linked bear note is another example of a note with a series of embedded options that can be accounted for as separate derivative instruments under Paragraph 12 of SFAS 133. For example, suppose has 5% coupon bonds that increase interest rates at certain levels of movement up or down of an index such as LIBOR or the S&P stock price index. The embedded condition that interest rates may move up based upon an index can qualify as an embedded derivative that can be separated according to Paragraph 12 on Page 7 of SFAS 133. The host contract, however, must be an asset or liability that is not itself a derivative instrument. In this example, the bonds are not derivatives and the embedded derivatives can be separated from the host contract under SFAS 133 rules. See equity-indexed.
PWC q08.26 (Page 73)
File 1 Question 07 (With Answer)
Paragraph 36 on the top of Page 24 subjects a "hedge of a net investment in
a foreign operations" to SFAS 133 hedge accounting rules. Explain this type of
hedge.
[See Bob Jensen's SFAS 133 Glossary.]
Section c(4) of Paragraph 4 is probably the most confusing condition mentioned in Paragraph 4. It allows hedging under "net investment" criteria under Paragraph 20 of SFAS 52. The gain or loss is reported in other comprehensive income as part of the cumulative translation adjustment. This is an exception to Paragraph 29a on Page 20 of SFAS 133. Reasons for the exception are given in Paragraph 477 on Page 208 of SFAS 133:For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change. Section 4(c) of Paragraph 4 of SFAS 133 amends SFAS 52 on Foreign Currency Translation, to permit special accounting for a hedge of a foreign currency forecasted transaction with a derivative. For more detail see foreign currency hedge.The net investment in a foreign operation can be viewed as a portfolio of dissimilar assets and liabilities that would not meet the criterion in this Statement that the hedged item be a single item or a group of similar items. Alternatively, it can be viewed as part of the fair value of the parent's investment account. Under either view, without a specific exception, the net investment in a foreign operation would not qualify for hedging under this Statement. The Board decided, however, that it was acceptable to retain the current provisions of Statement 52 in that area. The Board also notes that, unlike other hedges of portfolios of dissimilar items, hedge accounting for the net investment in a foreign operation has been explicitly permitted by the authoritative literature.
PWC q25.12
File 1 Question 08 (With Answer)
How did the FASB counter the argument that there are no significant differences
between forecasted transactions and firm commitments? Why is this distinction of
terms important in SFAS 133?
[See Bob Jensen's SFAS 133 Glossary.]
Differences between firm commitments versus forecasted transactions are elaborated upon in Paragraphs 320-326 beginning on Page 157 of SFAS 133. Respondents did not necessarily agree that the differences are important. The FASB argues that they are important. As a result, firm commitments do not special hedge accoutning unless there is foreign currency risk. They may need fair value hedging since values may vary from committed prices. According to Paragraph 325, forecasted transactions have fewer rights and obligations vis-a-vis firm commitments. All significant terms of the exchange should be specified in the agreement, including the quantity to be exchanged and the fixed price. A forecasted transaction has no contractual rights and obligations. Firm commitments differ from long-term purchase commitments. Generally long-term purchase agreements such as agreements to purchase timber of trees not yet planted or oil not yet pumped from the ground can usually be broken with a relatively small amount of penalty equal to damages sustained in the breaking of a contract. A firm commitment usually entails damage awards equal to or more than the contractual commitment. Hence they are less likely to be broken than purchase commitments. Firm commitments are discussed at various points in SFAS 133. See Paragraphs 37, 362, 370, 437-442, and 458-462.
File 1 Question 09 (With Answer)
Suppose that a junk bond is issued with a zero coupon rate and a principal payout
at maturity that is indexed to the price of soybeans on the CBOT. Is there an
embedded derivative that must be accounted for separately under SFAS 133 rules?
[See Paragraph 12a of SFAS 133.]
Types of embedded derivative instruments are often indexed debt and investment contracts such as commodity indexed interest or principal payments, convertible debt, credit indexed contracts, equity indexed contracts, and inflation indexed contracts. Embedded derivatives are discussed in SFAS 133, pp. 7-9, Paragraphs 12-16. Embedded derivatives such as commodity indexed and equity indexed contracts and convertible debt require separation of the derivative from the host contract in SFAS 133 accounting.
PWC 08.25 (Page72)
File 1 Question 10 (With Answer)
Paragraph 529 on Page 229 states that "if a mortgage loan has been the
hedged item in a fair value hedge, the loan's "cost" basis used in
lower-of-cost-or-market accounting shall reflect the effect of the adjustments of its
carrying amount made pursuant to Paragraph 22b of SFAS 133." Will this also be
true for unrealized holding gains on merchandise inventory (say widgets) for which a fair
value hedge has locked in $100,000 of the holding gains above original acquisition cost?
[See Paragraph 336 beginning on Page 160 of SFAS 133.]
The inventory carrying amount is the inventory booked value at inception of the hedge less the LCM change in its fair value during the hedge period ($20,000). Under SFAS 133, preexisting gains and losses on the hedged item at the inception of the hedge would not be recognized in the statement of financial position, except when a fair value type hedge relationship exists at adoption of SFAS 133 (see Paragraphs 514-524 for transition guidance). Thus, even if the fair value of the hedged inventory increases, application of the fair value hedge accounting requirements results in this inventory being carried at an amount below its fair value. In essence, if the hedge is effective, the fair value hedge accounting approach has the effect of locking in the gain or loss that existed at the beginning of the hedge
PWC q14.14 (Page 147) Also see q13.10 (Page 145)
File 1 Question 11 (With Answer)
Explain why a "fixed-to-floating" bond that starts out at a fixed rate
and then changes to a variable rate of interested cannot usually be accounted for as
having a separable derivative instrument under SFAS 133 accounting rules?
[See and Bob
Jensen's SFAS 133 Glossary.]
See Example 17 on Page 96 of SFAS 133. A fixed-to-floating note may be viewed as containing an embedded derivative (a forward-starting interest rate swap) that is referenced to an interest rate index (such as LIBOR) that alters net interest payments that otherwise would be paid by the debtor or received by the investor on an interest- bearing host instrument but could not potentially result in the investor's failing to recover substantially all of its initial recorded investment in the bond (refer to paragraph 13(a)). Likewise, there is no possibility of increasing the investor's rate of return on the host contract to an amount that is both at least double the initial rate of return on the host contract and at least twice what otherwise would be the market return for a contract that has the same terms as the host contract and that involves a debtor with a similar credit quality (refer to paragraph 13(b)). The embedded derivative is considered to be clearly and closely related to the host contract as described in paragraph 13 of this Statement. Therefore, the embedded derivative should not be separated from the host contract.
PWC q08.24 (Page 72)
File 1 Question 12 (With Answer)
Explain the mechanics of futures trading and
contrast with mechanics of entering into forward contracts. How does one go
about obtaining forward and futures contracts?
[Hint: See Chapters 2 and 3 of Managing Financial Risk (handed
out in class).]
The differences are summarized on Page 67 of Chapter 3. Forwards can usually be obtained from local bands as mentioned on Page 24 of Chapter 2. Mechanics for futures are given on Page 52 of Chapter 3.
File 1 Question 13 (With Answer)
Explain basis and maturity mismatches in futures
contracts. How might this affect SFAS 133 tests for ineffectivness of hedges?
[Hint: See Chapter 3 of Managing Financial Risk (handed out in
class). Also look up the term "ineffectiveness" in Bob Jensen's SFAS 133 Glossary.]
See Page 56 of Chapter 3. The problem arises because futures contracts are for standardized block quantities.
File 1 Question 14 (With Answer)
Look up the current prices of Euro futures
contracts and make up your own example of using interest rate futures to hedge interest
rates. Identify the sources used to obtain these prices.
[Hint: See Chapter 3 of Managing Financial Risk (handed out in
class).]
See Page 59 of Chapter 3.
File 1 Question 15 (With Answer)
Contrast strip hedges versus stack hedges.
[Hint: See Chapter 3 of Managing Financial Risk (handed out in
class).]
Discussion begins on Page 62 of Chapter 3. In a strip hedge to lock in interest rates as much as possible, but some favorable interest rate movements are sacrificed to protect against unfavorable interest rate movements. Stack hedges are somewhat similar and are preferred when futures contracts covering the entire maturity are not available.
File 1 Question 16 (With Answer)
What is the customary settlement price of a futures
contract and when is it booked in the cash account under SFAS 133? Why does this
make a futures contract a one-day forward contract?
See Page 65 of Chapter 3. Futures (strike) prices are usually different from spot prices except on the last day of trading when the futures price becomes equal to the spot price. The difference between the futures (strike) price and the spot price is call the basis. The basis is negative in normal backwardation. The basis is is postive in the normal contango. Various theories exist to explain the two convergence patterns.
File 1 Question 17 (With Answer)
What does the term "basis" mean in futures
contracting and accounting for such contracts?
[Hint: See Bob Jensen's SFAS 133 Glossary.]
The term basis depicts the difference between the forward (strike) price and the spot price of a derivative such as a futures contract or the forward component in an options contract. The difference between the futures (strike) price and the spot price is call the basis. The basis is negative in normal backwardation. The basis is is postive in the normal contango. Various theories exist to explain the two convergence patterns.
There are other definitions of basis found in practice. Some people define basis as the difference between the spot and futures price. Alternately basis can be viewed as the benefits minus the costs of holding the hedged spot underlying until the forward or futures settlement date.
File 1 Question 18 (With Answer)
Discuss the origins of GAAP in the United States prior to versus after the
Securities Acts of the early 1930s. Also discuss the key factors that have made GAAP
so much more extensive and complex in the last two decades of the 20th Century.
[Hint: See Chapter 2 of your S&C textbook.]
File 1 Question 19 (With Answer)
Distinguish positive versus normative theories of accounting. Why
does capital markets empiricism rise up from positive rather than normative theories of
accounting? Distinguish anecdotal from positive empirical evidence and speculate as
to whether normative theory or positive theory had the most influence on the setting of
SFAS 133.
[Hint: See Page 1 in Chapter 1 and Page 63 of your S&C textbook. Then go to Page 57 of Chapter 2.]
File 1 Question 20 (With Answer)
What is agency theory? Why has agency theory tended to result in
positive rather than normative theories of accounting? Can agency theory help to
explain the exponential growth of derivative financial instruments in the management of
financial risk around the world? Discuss your answers.
[Hint: See Page 64 in Chapter 2 of your S&C textbook.]
File 1 Question 21 (With Answer)
Why have behavioral (human information information processing) research
methodologies applied in thousands of academic research studies failed to have a marked
impact on standard setting in accounting? Speculate about behavioral research
impacts in particular with respect to the setting of SFAS 133.
[Hint: Start with Page 66 in Chapter 2 of S&C.]
On Your Own Review of Chapter 3 of Managing Financial Risk
You should review the various types of futures contracts and be able to answer questions
on how futures can be used to manage risk. Take notes
on all parts of Chapter 3 on Managing Financial Risk.
File 2 (EXCEL) Assignment
Provide answers to questions listed in Sheet 1 of 133ex07q.xls
in the TUCC Network Path J:\courses\acct5341\0assign\sfas133
Each student should make his or her own copy of the solution on an Excel file on a floppy
disc. A solution disc should also be turned in at the beginning of class. Only
one solution disc should be turned in for each partnership. On that disc, please
note the names of the partners on on the front of the disc and at the top of Sheet 1 in
the answer spreadsheet. Professor Jensen will place partnership solution files in
the TUCC Network Path J:\courses\acct5341\0assign\students
By Yourself Reading Reading Assignments (take hand-written notes of assigned readings)
S&C Chapter 02 pp. 53-70
SFAS 133 Paragraphs (35-42, 267-290, 320-383) and Example 7 beginning in Paragraph 144 on Page 79.
For class discussion and the quiz, carefully review Paragraphs 12-15.Chapter 3 (Futures Contracts) of Managing Financial Risk (handed out in class).
I am still in the process of preparing examination questions and answers for this course. Some of the answer hints are given in the Answer Hints section of the course Helpers.
(You are required to bring your textbooks and extra floppy discs to class)