La poesía concreta portuguesa para la infancia y la juventud

1. La poesía concreta portuguesa para la infancia y la juventud

Scott, Financial Accounting Theory, 6th Edition Instructor’s Manual Chapter 7

217

Reporting on risk is an increasingly important component of financial reporting. For example, the proposed new IASB standard on consolidation (Section 7.5.2) requires disclosure of the risks resulting from the firm’s involvement with SPEs it has sponsored but does not control, and thus has not consolidated.

Reporting on risk immediately raises the question of whether it is consistent with the principle of portfolio diversification and CAPM, which implies that a stock’s beta is the only relevant risk measure. However, the text suggests several reasons why firm-specific risk is relevant to investors. The most important reason, at least from a

theoretical perspective, is estimation risk. Investors are concerned about estimation risk since it leads to adverse selection. To the extent the firm employs astute risk

management strategies, and investors know what these strategies are, estimation risk is reduced because it is less likely that insiders will be able to exploit advance knowledge of bad, or good, state realizations. For whatever reason, empirical evidence outlined in Section 7.9.3 suggests that investors are sensitive to firm-specific risk information, at least for financial institutions.

Also, from an ex post perspective, material realizations of downside risk, such as from unfortunate dealings in derivatives, seem to draw auditors into the lawsuits that follow. It seems doubtful that an argument based on diversification (i.e., that diversified investors should offset their losses from the shares in question in the lawsuit with favourable realizations of their other investments), is a convincing defence in a court of law.

A question for discussion is whether narrative risk disclosures in MD&A, as illustrated in Section 4.8.2 for Canadian Tire Corp., can provide adequate risk information or whether they should be supplemented with quantitative risk measures such as those described in Section 7.9.4

S^UGGESTEDSOLUTIONS TO QUESTIONS AND P^ROBLEMS

1. Strictly speaking the answer is yes, since post-revenue-realization assets such as accounts receivable are valued at the net amount expected to be received.

This amount approximates present value if we accept that the time to collection is sufficiently short that discounting is not needed. Present value (i.e., value-in-use)

Scott, Financial Accounting Theory, 6th Edition Instructor’s Manual Chapter 7

218

is a version of current value, consistent with a measurement approach, not a cost approach. Complete historical cost accounting for accounts receivable would require them to be valued at cost of the inventory or services sold until cash is received.

A no answer can also be argued if we accept that the historical cost basis of accounting only holds up to the point in the firm’s operating cycle at which revenue is regarded as earned, usually the point of sale. Financial assets generated subsequent to this point can be valued at current value without violating the historical cost basis of accounting.

2. a. Under historical cost accounting, the income statement is the primary financial statement. Net income for a period represents the difference between revenue recognized during the period and the historical costs of earning that revenue. When revenue is received in advance, it is deferred to future periods when it will be matched with the costs of earning that revenue. This deferred revenue is not viewed as a liability, as it would be under a measurement perspective, but rather as revenue that is not yet earned.

Similarly, asset values on the balance sheet are not intended to represent their value, but rather the costs of those assets that have will be matched with revenues in future periods.

b. The firm would normally calculate the discounted present value of the costs expected to meet its contractual liability for updates and virus protection.

This is the amount the company would be rationally willing to pay to be relieved of this obligation.

However, if there is a market for the required services, and if the market value of the services is less than the company’s cost estimate, the obligation would be valued at the lower amount. This is now the amount that the company would rationally pay to be relieved of the obligation.

The liability would be remeasured at each period end over the three years, to show the expected cash outflows remaining.

Scott, Financial Accounting Theory, 6th Edition Instructor’s Manual Chapter 7

219

c. The approach suggested in b. is more relevant than the matching approach since it measures expected future cash flows. Under historical cost accounting, the balance sheet measure of the liability does not measure future cash flows but rather the portion of the deferred revenue remaining to be allocated to future periods.

The approach suggested in b. is less reliable than the matching approach.

Allocation over three years is a straightforward calculation, whereas an estimate of discounted future expected cash flows is subject to estimation error and possible bias.

3. Perhaps the main reason is cost. Since hedging transactions are costly, the firm may feel that the optimal cost-benefit tradeoff is not at zero risk.

Another cost-related reason is that investors can diversify firm-specific risk themselves. Investors may feel they can manage firm-specific risk themselves more cheaply through diversification than the firm can through costly hedging and natural hedging. As a result, they would object if management engaged in excessive risk-avoidance through hedging transactions.

A third reason is that perfect hedges are not always available. It may be difficult or impossible to find a hedging instrument that has a correlation of exactly -1 with the item to be hedged. As a result, firms must bear some basis risk.

Fourth, the firm may not be planning any costly internally financed capital projects, so that it does not anticipate a need to ensure a large amount of cash will be available. Consequently, the firm may feel less need to hedge its future cash flows than it would otherwise.

Finally, investors and, on their behalf, the firm’s Board of Directors, may be concerned that excessive hedging may slip into speculation, which places more risk, rather than less, on the firm. As a result, the Board may limit, or at least closely monitor, the extent of the firm’s hedging.

Scott, Financial Accounting Theory, 6th Edition Instructor’s Manual Chapter 7

220

4. a. High operating leverage in a firm’s cost structure means a high sensitivity of earnings to changes in revenues, as illustrated in the case of Yahoo Inc. Since stock prices are sensitive to earnings, high operating leverage means high stock price variability when revenue changes.

b. If firms’ betas are non-stationary, investors will want to know when and by how much they change. This is difficult to know, since it takes time to gather enough data to re-estimate beta using the market model. Even a financial

statement-based approach to estimating beta may have to wait until the next set of financial statements is available. Consequently, investors face estimation risk, and will have differing estimates of the value of a firm’s beta. Since beta is an input into investor’s decisions, non-stationarity introduces an additional source of variability into these decisions, even if all other information is the same. This variability increases share price volatility.

c. Momentum is a product of self-attribution bias, whereby good investment outcomes reinforce an investor’s confidence, leading to the purchase of more shares. This drives share price higher than it would be if all investors were rational. A stock market bubble is an extreme case of momentum trading. Over time, however, share price reverts towards its efficient market level, as it

becomes apparent that prices are too high. In the case of a bubble, the reversion can be very swift. The combination of too-high stock prices driven by momentum and subsequent reversion produces high stock price volatility.

d. No, they are not mutually exclusive. There is no reason why

non-stationarity of beta, momentum and bubbles cannot exist in the presence of high operating leverage. Furthermore, some investors are rational, and their trading behaviour may be affected by high operating leverage and non-stationarity, while other investors may be subject to self-attribution bias. Then, both types of

investors contribute to volatility. In effect, the three sources of volatility

Scott, Financial Accounting Theory, 6th Edition Instructor’s Manual Chapter 7

221 complement each other.

Note: An alternative argument can be made that high operating leverage and non-stationarity sources of volatility are consistent with rational investor

behaviour. With respect to non-stationarity, see the discussion of non-stationarity of beta in Section 6.2.3, and the discussion of Brav and Heaton (2002) in Section 6.2.10. Biased self-attribution is not consistent with rationality. If the effects of operating leverage and non-stationarity on volatility are driven by rational investors whereas the effects of momentum on volatility are driven by behavioural factors, it can be argued that they are mutually exclusive.

5. The three policies are increasing in relevance. Under IAS 39, loans are valued at their discounted expected future receipts before any provision for credit losses.

Credit losses are recognized as loans become impaired. Since the essence of relevance is to predict future cash flows, a delay in recognizing impairment until it takes place reduces relevance relative to inclusion of expected future credit losses in the original loan valuation, which is the policy under the 2009 IASB proposal.

The Basel Committee’s suggested policy is the most relevant of all, since it predicts cash flows over the business cycle, rather than over the term of the loan as in the 2009 IASB proposal. In effect, the Basel Committee’s proposal predicts cash flows over a longer period than the IASB proposal.

The three policies are decreasing in reliability. As the period over which credit losses are predicted lengthens, the potential for changes in interest rates, errors of estimation, and bias increases.

c. Fair value accounting for loans would require valuing them at their market value or, if a reasonably well-working market did not exist, at their present values discounted at a current interest rate rather than at the effective rate established at loan acquisition. This rate is subject to change as interest rates in the

economy, and the firm’s cost of capital, varies over time.

If such a market exists, valuing loans at market value would be most consistent

Scott, Financial Accounting Theory, 6th Edition Instructor’s Manual Chapter 7

222

with the measurement perspective (i.e., at fair value), and should be reasonably reliable. If a market does not exist, valuation at discounted expected value using a current interest rate should approximate fair value (e.g., Level 3 valuation), but would be low in reliability. Only if the increase in relevance of this valuation exceeded the decrease in reliability should fair value accounting be applied.

However, the most likely reason for amortized cost accounting rather than fair value is political. Fair value accounting for loans increases earnings volatility, and possible liquidity pricing during a severe recession. This results in severe

pressure from management, who object to fair valuation of loans when their intent is to hold them to maturity.

6. a. One reason is as a form of credit enhancement. By retaining an interest, hence bearing some risk, the company demonstrated its commitment to the quality of its mortgage lending procedures.

Another reason is that the company would earn interest income (i.e., accretion of discount) on the retained interests, thereby bolstering its income statement.

Third, since retained interests were valued at fair value, and since no secondary market existed for these retained interests, they were valued on a discounted present value basis. The resulting need for estimates gave New Century

considerable latitude in the discounted present value calculations. The company may have used this latitude to increase current value, thereby increasing

reported net income.

b. Again, this was a form of credit enhancement. New Century would receive a higher price for mortgages transferred. The company probably believed that house prices would continue to rise, so that mortgage delinquencies would be rare.

c. Under the new standard, derecognition would have been allowed if New Century had no continuing involvement in the transferred mortgages or, if it did have continuing involvement, investors in the transferred mortgages had the

Scott, Financial Accounting Theory, 6th Edition Instructor’s Manual Chapter 7

223

“practical ability” to further transfer the assets for their own benefit. A commitment to take back mortgages in default, plus the right to service transferred mortgages, constitutes continuing involvement. Thus the answer depends on whether the investors had the practical ability to further transfer their mortgages. If they did not, derecognition would be disallowed. This would have increased New

Century’s balance sheet leverage ratios, possibly causing the company to slow down the rate at which it was granting mortgages. However, under the new standard, New Century would likely have worded its mortgage sale agreements to allow further transfer.

Even if further transfer was allowed, New Century may have avoided bankruptcy protection since the new standard requires disclosure of any risks to which the transferor is exposed following derecognition. Such disclosure could possibly have led to earlier and stronger pressure from investors, either directly or through lower share price, for New Century to increase its provisions for mortgage losses.

This would have reduced the likelihood of bankruptcy protection. However,

information available to investors at the time suggested that housing prices would continue to rise. Given this general belief, New Century may have been able to convince investors, and its auditor, that its provisions were adequate.

Finally, much of New Century’s early revenue recognition from retained interests and servicing rights would have to be reversed as mortgages collapsed. This would have led to large reported losses regardless of whether or not it

derecognized its securitized mortgages, further increasing the likelihood of share price collapse and bankruptcy.

Overall, a reasonable conclusion is that the new standard would have not prevented New Century’s bankruptcy.

7. a. According to IAS 39, Barclays must transfer substantially all the risks and rewards of the securities in question. It is unclear from the information available if this requirement is met, since, given Protium’s high leverage, it has little equity cushion to absorb losses. Thus, if the cash flow from the transferred securities becomes insufficient to meet loan repayments, Barclays would have to absorb the loss. However, given the improving state of markets during this time, such a

Scott, Financial Accounting Theory, 6th Edition Instructor’s Manual Chapter 7

224

loss may be deemed remote. If so, derecognition seems consistent with the standard.

If Barclays should prepare financial statements in accordance with U. S.

standards, derecognition requires that Barclays must surrender control of the securities. Since control is vested in C12, and since its managers have left Barclays, this requirement seems to be met. However, it is possible that through an explicit or implicit agreement, Barclays retains some power or influence over its former employees. If so, derecognition is questionable. However, information about this possibility seems not to be publicly available.

Under the 2009 exposure draft of proposed changes to IAS 39, Barclay’s must have no continuing involvement in the transferred securities or, if it does (which seems to be the case given the $12.6 billions loan), the transferee must have the practical ability to transfer the assets for its own benefit. This ability to transfer is likely the case since management is in the hands of C12. Thus, derecognition seems consistent with the proposed standard. Again, however, information about any agreements between Barclays and its former managers is not available.

Derecognition is also questionable due to the requirement that, for regulatory purposes, Barclays did not derecognize the transferred securities. Thus, they are included in the asset base upon which Barclays’ required regulatory capital is calculated. Barclays does not explain why the regulator takes this position.

Perhaps Barclays has adopted this policy deliberately, so as to reduce any concerns the regulator may have about the deal.

b. According to IAS 27, consolidation is required when one entity controls another. Since control seems to be transferred to C12, for which Barclays pays an annual fee of $40 millions, consolidation would not be required.

ED 10 proposes to tighten up the definition of control by defining it in terms of power over the strategic operating and financing decisions of C12, and bearing of risk through a share of the profit and loss of C12. It seems that neither of these conditions is met. Thus, under ED10, consolidation would not be required either.

c. The return on the market (FTSE 100) on September 16 was 82/(5124.10 –

Scott, Financial Accounting Theory, 6th Edition Instructor’s Manual Chapter 7

225

82) = .0160. According to the market model (Section 4.5), with αj = Rf(1 – βj) = 0 and RMt = .0160, we expect Barclays’ share return on September 16 to be

Rjt = 0 + 2.1568 x .0160 = .0345

Abnormal return is actual minus expected return:

Εjt = .0290 - .0345 = -.0055

Since abnormal return is negative, it seems that the market disapproved of the deal.

8. This question does not have a clear answer, and is currently being debated by the IASB.

Arguments against fair valuing long-term debt:

 Market value of debt falls following a credit downgrade. It may seem strange to many persons that the firm record a gain following a credit downgrade.

 The reduction or increase in fair value of debt creates a wealth transfer from debt holders to shareholders. Under the equity view of financial reporting, such a wealth transfer is not a gain or loss to the entity. Thus, no gain or loss should be recognized.

 Many firm assets, such as self-developed goodwill, patents, R&D, are not valued on the balance sheet. Downgrades or increases in the credit rating of debt is frequently due to changes in the value of these assets. Yet, such changes are not recognized in current earnings, while if debt is fair valued, changes in fair value are included. This creates a mismatch situation that increases the volatility of reported earnings.

Arguments in favour of fair valuing long-term debt:

 To the extent firm assets are fair valued on the balance sheet, and changes in fair value contribute to changes in the firm’s credit rating, failure to fair value debt creates a mismatch. If so, firms should be required to fair value

Scott, Financial Accounting Theory, 6th Edition Instructor’s Manual Chapter 7

226 their debt, so as to reduce mismatch.

 If the proprietorship view of financial reporting is accepted, changes in the fair value of debt represent a gain to shareholders, which should be reflected in earnings.

 To the extent that the balance sheet is the primary financial statement, assets and liabilities should be fair valued, subject to reasonable reliability.

Inability to fair value certain assets, such as intangibles, should not be used as a reason not to fair value liabilities.

In document Núm. 11 (2013) (página 145-148)