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Accounting for Financial Instruments


Regulators, credit rating agencies and accountants have come under increased pressure to reveal why they allowed financial institutions to take huge concealed leveraged exposures, creating a price bubble and a subsequent government bail out. Already investors are calling for major changes in the way that financial instruments are regulated and accounted for.

‘Accounting for Financial Instruments’ is designed to address the practical difficulties that accountants and auditors face when dealing with complex financial instruments. Accounting rules have been slow to catch up with the advent of complex derivative instruments, while the need for an improved accounting framework in financial institutions is greater than ever in view of the current financial crisis. The author makes use of practical examples (including extracts from accounts) and case studies to give depth to his analysis of various issues in accounting for derivatives, including:

• The influence of corporate governance on accounting for financial instruments

• The impact of IFRS and IAS accounting standards on the detail and implementation of accounting procedures for financial instruments

• The differences in European and American accounting standards in tackling the problems of off-balance sheet accounting

• Accounting for credit risk

• The role of accounting and auditing in the detection and prevention of fraud

• Accounting for insurance

• Hedge Accounting

• The influence of Basel II

• Accounting and Reconciliation

This work’s combination of discussion and practical examples makes it a useful reference for accountants dealing with these products. It provides guidance on expected future regulatory changes in accounting for these instruments, and is a valuable exposé of the weaknesses in accounting procedures. It will be of interest to accountants, auditors, compliance officers, and anyone working with derivative products.

Cormac Butler (London, UK & Hong Kong) is currently an active equity and options trader and a former consultant with Lombard Risk Systems London and has also worked with Peat Marwick and Coopers & Lybrand. He has presented the Accounting for Financial Instruments course for Euromoney for 8 years and worked as a consultant on financial instruments for a major accountancy firm. He has also led seminars with major banks including Salomon Brothers, Robert Fleming and Banque Paribas. He has recently conducted in-house courses for Morgan Stanley, PricewaterhouseCoopers (Holland), Investec (South Africa) and ABB (Switzerland). In addition, he has worked for IIR and Euromoney in Singapore, Hong Kong, Thailand, America Dubai and Saudi Arabia. Cormac graduated from the University of Limerick, Ireland with a degree in Finance. He is the author of Mastering Value at Risk (Financial Times Pitman).

1 Introduction.

1.1 Introduction.

1.2 Scope of the book.

1.3 Background.

1.4 Concerns over the misuse of financial instruments.

1.5 Complexity.

1.6 Revenue recognition.

1.7 Inappropriate reward incentives.

1.8 Protection for shareholders.

1.9 Measuring the ‘traders’ dilemma’.

2 Accounting Foundations.

2.1 Introduction.

2.2 IASB improvements.

2.3 The framework.

2.4 Fair value or cost.

2.5 Artificial volatility.

2.6 Cost model.

2.7 Cherry-picking.

2.8 Subjective valuations.

2.9 Proactive vs. reactive.

2.10 Goodwill.

2.11 Market value accounting.

2.12 IFRS and its contribution to banking crises.

2.13 IFRS post-Enron.

2.14 Conclusion.

3 Corporate Governance.

3.1 Introduction.

3.2 Corporate governance.

3.3 Small vs. large shareholdings.

3.4 Traders’ dilemma.

3.5 Moral hazard.

3.6 Credit rating agencies I.

3.7 Shareholder democracy.

3.8 Structured products.

3.9 Revenue recognitio.

3.10 Non-consolidation.

3.11 Credit rating agencies II.

3.12 Accounting standards and lobbying.

3.13 Investment entities.

3.14 Conclusion.

Appendix: Constant proportion debt obligations.

4 Hedge Accounting.

4.1 Introduction.

4.2 Accounting for forward contracts.

4.3 Accounting pre-IAS 39.

4.4 Artificial volatility.

4.5 Hedge accounting rules.

4.6 Example: Forward rate agreement.

4.7 Conclusion.

5 Illustrative Examples: Hedge Accounting.

5.1 Introduction.

5.2 Illustration: Fair value hedge.

5.3 Credit spreads.

5.4 Cash flow interest rate swaps.

5.5 Time value vs. change in interest rates.

5.6 Long method fair value hedge.

5.7 Foreign exchange hedge.

Appendix: Documentation.

6 Accounting for Structured Products (Market Risk).

6.1 Introduction.

6.2 Risk adjusted return on capital.

6.3 Bifurcation rules.

6.4 The reward for risk.

6.5 Protection for shareholders.

6.6 Illustration: The structured products problem.

6.7 The accounting treatment under embedded derivative rules.

6.8 Past mistakes.

6.9 Conclusion.

Appendix 6.1: Overview of embedded derivative rules in international accounting reporting standards.

Appendix 6.2: Introduction to derivatives.

7 Accounting for Credit Risk.

7.1 Introduction.

7.2 Loan approvals.

7.3 Credit spreads.

7.4 Accounting standards.

7.5 Credit rating agencies.

7.6 Credit derivatives.

7.7 Accounting for loans.

7.8 Changes in the accounting standards.

7.9 Accounting rules on credit derivatives and financial guarantees.

7.10 Structured credit products: an extra layer of complexity.

8 Accounting for Structured Products (Credit Risk).

8.1 Introduction.

8.2 Securitisation overview.

8.3 Regulatory arbitrage.

8.4 Prepayment risk synthetic securitisations.

8.5 Accounting for credit risk.

8.6 Accountants, regulators and credit agencies.

8.7 Complexity.

8.8 Disclosure.

8.9 Credit Suisse fiasco.

8.10 Monoline insurance companies.

8.11 Accounting implications.

8.12 First to default.

8.13 SFAS 157 valuations.

8.14 Conclusion.

9 Off-Balance Sheet Accounting.

9.1 Introduction.

9.2 Off-balance sheet manipulation.

9.3 Case studies: off-balance sheet.

9.4 Accounting implications.

10 Reconciliation.

10.1 Introduction.

10.2 Middle office.

10.3 Initial and variation margin.

10.4 Example: Illustration of reconciliation.

10.5 Conclusion.

11 Moving Towards Mark-to-Market Accounting.

11.1 Introduction.

11.2 Liquidity and fair value.

11.3 Banking vs. trading book.

11.4 VaR.

11.5 Basel 2.

11.6 Accounting for VaR and IFRS 7.

11.7 Conclusion.

12 Accounting for Insurance.

12.1 Introduction.

12.2 Significance of insurance risk.

12.3 IFRS vs. embedded value reporting.

12.4 Finite insurance and unbundling.

12.5 Other aspects of IFRS 4.

12.6 Phase two embedded value.

Appendix: The collapse of AIG.

13 Conclusion.