Exam Answers and Grade Distribution

B10.6317
Accounting for Financial Instruments
Summer 2013
Professor Ryan
Grade Distribution:
I graded the two classes together. The numerical grade distribution is
Mean
Minimum
25%
Median
75%
Maximum

76.3
55.3
69.3
78.7
81.5
94.0

I do not give letter grades on individual exams. Because I invariably give

challenging exams, I curve grades to give roughly half As and half Bs, with lower
grades only for students separated from the remainder of the class. To give you a
sense for what you can expect, if I were to give letter grades on this exam alone,
they would be
A
AB+
B
B-

85.9 +
78.4 to 83.3
71.8-77.4
63.3-69.3
55.3-60.0

10 students
17 students
11 students
10 students
4 students

I emphasize that the group projects and to a lesser extent class participation can
change grades both up and down, both due to your performance and the
performance of your peers.
Brief Answers:
Question 1:
a) i, ii. Iv, v
b) ii, iii
c) i
d) ii
e) ii, vii (I did not take off or give credit for iv)
f) ii
g) ii, iv
h) ii
i) ii
j) ii, iii, iv (I gave half credit if you just gave me i)

Question 2:

loans held for investment

assets

co
st
60
60

deposits
long term debt
liabilities

45
40
85

2012
fair
value
55
55
40
40
80

co
st
50
50
50
35
85

2011
fair
value
52
52

2012

2011

2012

CURG
-5
-5

CURG
2
2

URG
-7
-7

5
0
5

5
-5
0

0
5
5

45
40
85

pretax income adjustment before AFS

securities

-2

afs securities oci

total pretax income

adjustment

Question 3:
a) loss
AFS security (cost basis)

4.98 (=24.87-19.89)
4.98

The two approaches yield the same write-down because there is no change in
discount rate
Accretable yield = 24 - 19.89 = 4.11
Nonaccretable discount = 30 - 24 = 6
b) Beginning of year 1 journal entry:
AFS security (cost basis)
Cash

24.87
24.87

End of year 1 journal entries:

Cash

9
Interest revenue
AFS security (cost basis)

AFS security (valuation allowance)

basis)
AOCI

1.99 (=19.89*10%)
7.01
2.74 (=15.62 fair value 12.88 cost
2.74

Imputed interest rate for year 2 is 25.54%.

Accretable yield is 18 12.88 = 5.12
Non-accretable difference is 20 18 = 2
End of year 2 journal entries:
Cash

7
Interest revenue
AFS security (cost basis)

3.29 (=12.88*25.54%)
3.71

Loss
2.81
fair value)
AFS security (cost basis)
AOCI

(reduce cost basis from 9.17 to 6.36

2.81

2.74 (fair value = cost basis of 6.36)

AFS security (valuation allowance)
2.74

Interest rate returns to historical rate of 10%

Accretable yield is 7 6.36 = 0.64
Non-accretable difference is 10 7 = 3
End of year 3 journal entry:
Cash

7
Interest revenue
AFS security cost basis

.64
6.36

All balance sheet accounts except for cash and retained earnings have zero
balances.
c) When expected cash flows increase after initial impairment write-downs, this
proposal would allow write-ups of assets, thereby recording economic gains
on a timely basis and eliminating the need to impute an above-market
interest rate to recognize the gain over time. It would also eliminate the
need to keep track of the accretable yield and non-accretable difference.
Extra credit:
Year 1 journal entries:
AFS security (cost basis)
Cash

24.87
24.87

Cash
9
Interest revenue
AFS security (cost basis)

2.49 (=24.87*10%)
6.51
3

Provision for credit losses

ending allowance)
Allowance for credit losses
Allowance for credit losses
AFS security (cost basis)

2.74

(= 1 charge-off + 1/1.1 + 1/1.12

2.74

(charge-off of 10-9)
1

Year 2 journal entries:

Cash
7
Interest revenue
AFS security (cost basis)
Provision for credit losses
1/1.12) change in
Allowance for credit losses
Allowance for credit losses
AFS security (cost basis)

1.74 (=17.36*10%)
5.26
3.99

(= 3 charge-off + 3/1.1 (1/1.1 +

allowance)
3.99
3

(charge-off of 10-7)
3

Year 3 journal entries:

Cash
7
Interest revenue
AFS security (cost basis)
Provision for credit losses
allowance)
Allowance for credit losses
Allowance for credit losses
AFS security (cost basis)

0.91 (=9.09*10%)
6.09
0.27

(= 3 charge-off + (0 - 3/1.1) change in

0.27

(charge-off of 10-7)
3

Because expected cash flows did not change in year 3, the provision in that year
is all interest. This interest results from the discounting of the allowance (or,
equivalently, from basing interest revenue on the amortized cost balance of the
AFS security). There is also an interest component to the provision in the other
years. An alternative way exists to implement the proposal. This approach
accrues interest on the difference between the cost basis of the AFS security and
the allowance. This alternative approach would not discount/ accrue interest on
the allowance. This alternative approach yields the same total income each year
but offsetting differences on interest revenue and the provision compared to the
proposal as described in the exam. (This point is analogous to income statement
classification differences that arise from the use of amortized cost interest for
fair valued items discussed in the course.) I prefer this alternative approach, but
it does not appear to be the one the FASB intends to choose.

The table below summarizes the amount and composition of income across the
three years under current GAAP, the proposal as described on the exam, and the
alternative proposal. Compared to the proposals, existing GAAP records too big
a loss at the beginning of year 1, when it ignores the partial reversal at the end
of the year. As a consequence, interest is too high and the loss too low in year 2
when the reversal reverses entirely and an additional impairment write-down is
recorded. In fact, total income recorded is positive despite expected and actual
cash flows dropping from 9 to 7.

total

Existing GAAP
interest revenue
+ gain
= net income

1.99
-4.98
-2.99

3.29
-2.81
0.48

0.64
0
0.64

5.92
-7.79
-1.87

Proposal
interest revenue
+ gain
= net income

2.49
-2.74
-0.25

1.74
-3.99
-2.25

0.91
-0.27
0.64

5.14
-7
-1.86

Alternative Proposal
interest revenue
+ gain
= net income

1.99
-2.24
-0.25

1.56
-3.82
-2.26

0.64
0
0.64

4.19
-6.06
-1.87

4) a) The proposal, applied without discretion in stable conditions where forecasts

are consistent with current conditions, should yield larger allowances for loan losses
than under current GAAP as applied in practice using loss emergence periods. This
is because expected losses should be larger than incurred, probable, and can be
reasonably estimated losses determined over a loss emergence period less than the
life of existing loans. Assuming the bank is not growing, provisions for loan losses
should be the same, however, because allowances that are higher by a constant
amount at the beginnings and ends of periods yield the same provisions for loan
losses.
When conditions are worsening, however, non-discretionary forecasts should reflect
conditions that are more adverse than those in the current period, and so allowance
for loan losses should be larger and increase on a timelier basis under the proposal
than under current GAAP. Hence, provisions for loan losses should be larger and
increase on a timelier basis under the proposal than under current GAAP.
b) The use of forecasts allows for more of managements superior information to be
incorporated into allowances and provisions for loan losses. However, it also allows
management more discretion and ability to smooth or otherwise manage provisions
for loan losses. It is difficult to know which effect would dominate in practice; likely
this would vary across banks depending on their financial condition and incentives.
5) a) Probably not. If the transferor retains a residual interest or provides recourse
then it would be deemed the legal owner of the SPE in a transaction structured
using only one SPE. ITSNOB retains a senior interest in the securitized mortgages;
this interest is neither equity nor recourse, although it could be risky if the
securitized assets are sufficiently risky so that the sold junior interests are
insufficient to absorb all risk. My only uncertainty, as a nonlawyer, about this
conclusion is that ITSNOB is obligated to repurchase defaulted loans for a fixed price
equal to their expected fair value at the time of the securitization. While this
6

obligation has zero initial value, it exposes ITSNOB to the risk of changes in the
value of the mortgaged property between the time of the securitization and the
time of default. I.e., if property values unexpectedly increase (decrease), this
obligation becomes an asset (liability). If this risk is deemed the primary one
involved in the securitization, then conceivably this obligation might be viewed as
equity or recourse under the law, requiring two SPEs to ensure legal isolation.
Absent high default and volatile property values, however, I think this possibly is
unlikely.
b) Aside from the possibility expressed above, this securitization does not have any
features that prevent sale accounting. In particular, the existence of the repurchase
obligation does not imply that ITSNOB retains control over the securitized assets as
defined in FAS 140/166, because default is out of ITSNOBs control and the
repurchase price is fixed. Of course, when mortgages default, ITSNOB must reverse
sale accounting for the defaulted mortgages.
c) Cash
22
Senior securities
MSRs
1
Repurchase obligation
expected fair value at
Mortgages
Gain on sale

80
0 (under assumption repurchase price is
time of securitization)
100
3

d) ITSNOB retains almost 80% of the value of the mortgages through its retained
senior interest and the risk of changes in the value of the property collateralizing
defaulted mortgages through its repurchase obligation. Recording the same gain
on sale as if the securitized assets were sold in their entirety does not capture
this value and risk retention.
e) Secured borrowing accounting captures the risk retention described above but
bloats ITSNOBs balance sheet insofar as it has sold the junior interest which
represents 22% of the value of in the securitized mortgages.