Accounting for Financial Instruments

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).

• Preface xi1 Introduction 11.1 Introduction 11.2 Scope of the book 41.3 Background 61.4 Concerns over the misuse of financial instruments 81.5 Complexity 101.6 Revenue recognition 111.7 Inappropriate reward incentives 111.8 Protection for shareholders 151.9 Measuring the ‘traders’ dilemma’ 162 Accounting Foundations 212.1 Introduction 212.2 IASB improvements 222.3 The framework 232.4 Fair value or cost 242.5 Artificial volatility 262.6 Cost model 282.7 Cherry-picking 282.8 Subjective valuations 292.9 Proactive vs. reactive 292.10 Goodwill 292.11 Market value accounting 302.12 IFRS and its contribution to banking crises 312.13 IFRS post-Enron 322.14 Conclusion 413 Corporate Governance 433.1 Introduction 433.2 Corporate governance 443.3 Small vs. large shareholdings 453.4 Traders’ dilemma 463.5 Moral hazard 473.6 Credit rating agencies I 483.7 Shareholder democracy 493.8 Structured products 503.9 Revenue recognition 533.10 Non-consolidation 543.11 Credit rating agencies II 573.12 Accounting standards and lobbying 593.13 Investment entities 603.14 Conclusion 61Appendix: Constant proportion debt obligations 624 Hedge Accounting 654.1 Introduction 654.2 Accounting for forward contracts 664.3 Accounting pre-IAS 39 674.4 Artificial volatility 684.5 Hedge accounting rules 694.6 Example: Forward rate agreement 744.7 Conclusion 765 Illustrative Examples: Hedge Accounting 775.1 Introduction 775.2 Illustration: Fair value hedge 785.3 Credit spreads 835.4 Cash flow interest rate swaps 915.5 Time value vs. change in interest rates 945.6 Long method fair value hedge 975.7 Foreign exchange hedge 100Appendix: Documentation 1146 Accounting for Structured Products (Market Risk) 1176.1 Introduction 1176.2 Risk adjusted return on capital 1186.3 Bifurcation rules 1206.4 The reward for risk 1216.5 Protection for shareholders 1216.6 Illustration: The structured products problem 1226.7 The accounting treatment under embedded derivative rules 1266.8 Past mistakes 1276.9 Conclusion 128 Appendix 6.1: Overview of embedded derivative rules in international accounting reporting standards 129Appendix 6.2: Introduction to derivatives 1297 Accounting for Credit Risk 1397.1 Introduction 1397.2 Loan approvals 1427.3 Credit spreads 1447.4 Accounting standards 1467.5 Credit rating agencies 1477.6 Credit derivatives 1487.7 Accounting for loans 1517.8 Changes in the accounting standards 1537.9 Accounting rules on credit derivatives and financial guarantees 1567.10 Structured credit products: an extra layer of complexity 1568 Accounting for Structured Products (Credit Risk) 1598.1 Introduction 1598.2 Securitisation overview 1608.3 Regulatory arbitrage 1628.4 Prepayment risk synthetic securitisations 1628.5 Accounting for credit risk 1648.6 Accountants, regulators and credit agencies 1658.7 Complexity 1688.8 Disclosure 1698.9 Credit Suisse fiasco 1698.10 Monoline insurance companies 1718.11 Accounting implications 1728.12 First to default 1738.13 SFAS 157 valuations 1748.14 Conclusion 1749 Off-Balance Sheet Accounting 1779.1 Introduction 1779.2 Off-balance sheet manipulation 1789.3 Case studies: off-balance sheet 1809.4 Accounting implications 18510 Reconciliation 19910.1 Introduction 19910.2 Middle office 20110.3 Initial and variation margin 20410.4 Example: Illustration of reconciliation 20810.5 Conclusion 21611 Moving Towards Mark-to-Market Accounting 21711.1 Introduction 21711.2 Liquidity and fair value 21711.3 Banking vs. trading book 21911.4 VaR 22311.5 Basel 2 23011.6 Accounting for VaR and IFRS 7 23511.7 Conclusion 24112 Accounting for Insurance 24312.1 Introduction 24312.2 Significance of insurance risk 24412.3 IFRS vs. embedded value reporting 24812.4 Finite insurance and unbundling 25012.5 Other aspects of IFRS 4 25212.6 Phase two embedded value 253Appendix: The collapse of AIG 25513 Conclusion 259Glossary 265Index 267