Accounting for Financial Instruments

Exam Answers and Grade Distribution

Summer 2015
Professor Ryan
Grade Distribution:
I graded the two classes, which had very similar distributions, I had miscalculated
and thus misreported the mean grade for the afternoon class earlier) together. The
overall distribution of numerical grades is
Mean
Min
25%
Median
75%
Max

68.5
44.8
59.2
69.9
76.6
93.3

I do not give out letter grades on exams, as your final grade will be based on a
weighted average of numerical grades. If I had to give out letter grades on this
exam, it would be as follows.
76+
69.83-74.33
60.5-68.83
50.87-59.87
44.83-48.15

A
AB+
B
B-

18 students
16 students
15 students
14 students
3 students

Brief Answers:
1)
a) i, ii, iv, v
b) ii
c) iii
d) i, iii
e) iii, v
f) iii, v
g) iv
h) v
i) iv
j) ii
2)
a) 0 (income statement already at fair value)
b) -27 (-15-12)
c) -15 (10-25)
d) -30 (-20-10)
e) 15 (20-5)

3)a)
HTM security (cost)
Cash

24.87=$10/1.1+$10/1.12+$10/1.13
24.87

Initial fair value = cost basis = 24.87

I assume that the impairment write-down is recorded immediately when the
economic impairment occurs at the beginning of year 1. If one instead assumes
that the decision whether to record any impairment write-down is delayed until the
end of the year, then no impairment write-down is recorded, because the economic
reversal has occurred by the end of the year.
Loss
7.51=24.87-(10/1.1+10/1.12)=24.87-17.36
HTM security (v.a.)
0.47=(10/1.08+10/1.082)-(10/1.1+10/1.12)=17.83-17.36
HTM security (cost)
7.51
A/OCI
0.47
Post-impairment fair value = 17.83 = 10/1.08+10/1.082 Post-impairment cost basis
= 17.36 = 10/1.1+10/1.12. Post-impairment valuation allowance and AOCI = 0.47 =
17.83 17.36.
Cash

10
Interest revenue
HTM security (cost)

1.74
8.26

(cost basis of 17.36 * 10%)

(HTM cost basis equals 9.09)

End of year 1 cost basis = 9.09 = 17.36 8.26 = 10/1.1

A/OCI

0.30=0.47-0.17
HTM security (v.a)
0.30 (HTM carrying value equals 9.26)

End of year 1 carrying value (i.e., expected fair value given the information at the
time of the impairment) = 9.26 = 10/1.08. Hence, end of year 1 valuation
allowance and AOCI = 0.17 = 9.26 9.09. Hence, accretion of valuation allowance
and AOCI = 0.30 = 0.47 0.17.
At end of year 1, reimpute effective interest rate to equate cost basis of 9.09 to new
expected cash flows, yielding 95.23%=irr(-9.09, 10, 10, 10). Because the security is
HTM, the increase in fair value to 24.02 =10/1.12+10/1.12 2+10/1.123 (above the
carrying value of 9.26 or expected) is unrecognized.
If instead the decision whether to record any impairment write-down is delayed until
the end of the year, then the journal entry is
Cash

10
Interest revenue
HTM security (cost)

2.49
8.51

(HTM cost basis of 24.87 * 10%)

(HTM cost basis equals 17.36)

End of year 1 cost basis = 17.36 = 24.87 8.51= 10/1.1+$10/1.1 2

There is no impairment write-down because the cash flows have more than fully
recovered by the end of year 1. Hence, there is no valuation allowance or AOCI.
At the end of year 1, reimpute effective interest rate to equate cost basis of 17.36
to new expected cash flows, yielding equal to %33.26=irr(-17.36, 10, 10, 10).
b) If the impairment write-down is recorded at the beginning of year 1, the journal
entries are:
Cash

10
Interest revenue
HTM security (cost)

8.66
1.34

(9.09*0.9523)
(HTM cost basis equals 7.75)

The end of year 2 cost basis = 7.75 = 9.09 1.34 = 10/1.9523 + 10/1.9523 2.
A/OCI

0.17
HTM security (v.a.)

0.17 (HTM carrying value equals cost basis of 7.75)

This accretion of the valuation allowance and AOCI entry zeros out both accounts.
If instead the decision whether to record any impairment write-down is delayed until
the end of year 1, then the journal entry are
Cash

10
Interest revenue
HTM security (cost)

5.77
4.23

(17.36*0.3326)
(HTM cost basis equals 13.13)

The end of year 2 cost basis = 13.13 = 17.36 4.23 = 10/1.3326 + 10/1.3326 2.
c) The GAAP accounting for this securities is severely limited in the following
respects.
In year 1
o The 7.51 impairment of the HTM security cost basis in year 1
overstates the 7.04 decline in the fair value of the security, yielding
the positive HTM security valuation allowance
o Interest revenue is based on a cost basis below fair value and an above
market interest rate
o The ending HTM security carrying value of 9.26 is far below the fair
value of 24.02.
o The accretion of the HTM valuation allowance is the opposite direction
of the increase in the fair value
In year 2
o Interest revenue is based on cost basis far below fair value and an far
above market interest rate of 95.23%
o The ending HTM security carrying value of 7.75 is far below the fair
value of 16.90
For accounting purposes, at the end of year 2 this security is has a cost basis of
7.75 and no valuation allowance.

4) a) At the end of year 0, TATs ALL should incorporate net loan charge-offs over
the following year 1. The current state is good, so if TAT does not anticipate the
10% probability that the state turns bad in year 1, its allowance should be $1 billion
loans * 0.25% loss rate in year 1 = $2.5 million. If TAT instead anticipates the 10%
probability that the state turns bad in year 1, its allowance should be $1 billion
loans * [(0.90 * 0.25% loss rate in year 1) + (0.10 *5% loss rate in year 1)] = $7.25
million. In the narrow confines of this problem, where the probability that the state
turns bad in year 1 is known, the latter/larger amount is entirely consistent with the
incurred and can be reasonably estimated conditions to accrue for loan losses under
the incurred loss model. In real world situations, the incurred and can be
reasonably estimated conditions generally would be much harder to meet. The 10%
probability that the state will turn bad does not meet the incurred loss models
probable requirement, however, so under a strict reading of FAS 5 TATs year 0 ALL
should be the former/lower amount of $2.5 million. On the other hand, bank
regulatory guidance does not apply FAS 5 in a strict fashion and instead simply
states that TATs year 0 ALL should capture expected loan charge-offs over a 1-year
horizon and thus be $7.25 million. Given that FAS 5 and bank regulatory guidance
basically conflict in this setting, I awarded full credit on this part if you calculated
either of these two amounts, recorded the journal entry properly, and gave a
sensible response to the qualitative question.
Journal entry:
Provision for loan losses
2.5 million or 7.25 million
Allowance for loan losses 2.5 million or 7.25 million
b) NADs year 0 ALL must incorporate expected loan charge-offs over the four-year
life of the loan. This requires predicting the probability that good and bad states
occur (which I gave you) as well as loan charge-offs and amortization of the nondefaulted loan balance over this four-year life (which I did not give you and which
makes this question time consuming, particularly absent access to a spreadsheet
program). NADs year 0 ALL (of approximately $22.5 million, as shown in the
spreadsheet for the extra credit question) is far in excess of TATs year 0 ALL for the
following reasons: (1) NADs ALL incorporates expected loan charge-offs in year 2-4
in addition to year 1; (2) the probability the state is bad increases from 10% year 1
to 18.75% in year 4 (toward but not quite to a steady state percentage of 20%); and
(3) if you decided that TAT should only record an ALL of $2.5 million rather than
$7.25 million in year 0, NADs ALL incorporates the probability that the state
becomes bad in year 1 with 10% probability.
c) Loan charge-offs in year 1 equal $1 billion * 0.05 bad state yearly loss rate = $50
million. This yields a journal entry of
ALL

50 million
Loans

50 million

Non-defaulted loans prior to loan amortization equal $950 million.

The year 1 loan amortization is 25% * $950 million = $237.5 million, which yields
end of year 1 loans of $712.5 million.

Loan charge-offs in year 2 if the state stays bad equal $712.5 million * 0.05 bad
state yearly loss rate = $35.625 million. Expected loan charge-offs incorporating
the 60% probability that the state remains bad in year 2 and the 40% probability
the state becomes good in year 2 = $712.5 million * [(0.6 * 0.05 bad state yearly
loss rate) + (0.4 * 0.025 good state yearly loss rate)] = $22.0875 million. The same
discussion as for part a applies as to which of these two amounts is correct for TATs
year 1 ALL, although in this case the strict FAS 5 approach yields a higher ALL than
the bank regulatory guidance approach.
If you applied the strict FAS 5 approach, TATs ALL must increase from $2.5 million
to $35.625 million, which given loan charge-offs of $50 million, requires a provision
for loan losses of $83.125 million. If you applied the bank regulatory guidance
approach, TATs ALL must increase from $7.25 million to $22.0875 million, which
given loan charge-offs of $50 million, requires a provision for loan losses of
$64.8375 million.
Provision for loan losses
83.125 million or 64.8375 million
Allowance for loan losses 83.125 million or 64.8375 million
d) NADs ALL must incorporate expected loan charge-offs over the remaining threeyear life of the loan. This again requires predicting the probability that good and
bad states occur, loan charge-offs, and amortization of the non-defaulted loan
balance over this remaining life. NADs end of year 1 ALL (of approximately $35.8
million, as shown in the spreadsheet for the extra credit question) is quite similar to
TATs end of year 1 ALL under the strict interpretation of FAS 5 approach because
the following two effects roughly offset: (1) NADs ALL incorporates expected loan
charge-offs in year 3-4 in addition to year 2; (2) TATs ALL does not anticipate the
40% chance that the state becomes good in year 2. NADs end of year 1 ALL is
greater than TATs end of year 1 ALL under the bank regulatory approach in which
the second effect does not apply.
The year 0 ALL of approximately $22.5 million expected loss model approach
anticipates only a little over a quarter of the year 1 loan charge-offs of $50 million
and the necessary end of year 1 ALL of $35.8 million due to the change in the state
to bad in year 1 due to the twenty times higher loss rate in the bad state than the
good state.
e) The expected loss approach may capture gradual, predictable changes in loss
rates over the life of existing loans. It is unlikely to capture sharp, dramatic
changes in loss rates such as occurred due to the financial crisis. This is particularly
true for the loan types that experience very low loan default in good times and
much higher loan default in bad times (e.g., commercial loans).
extra credit) See the attached spreadsheet for a simplified/approximate answer that
uses expected loan balances and expected loan charge-offs (rather than specific
state loan balances and loan charge-offs) that conveys the gist of this problem. The
precise answer can be calculated using a more extensive spreadsheet.

5) a) Sale, because Transferjedi is not required to return substantially the same

securities (US Treasuries are not substantially the same as Fannie Mae mortgagebacked securities) and no other condition described suggests the repurchase
agreement is not a sale.
b)
Cash
98
Forward
2
Securities

100

c) It does not. Transferjedi has the right to return either US Treasuries or Fannie Mae
MBS at the end of the term of the repurchase agreement. The fact that Transferjedi
chose ex post to return one of these types of securities does not change this fact.
d) This could if Transferjedis strong economic incentives to return substantially the
same securities yields a more than trivial benefit to Obiwanrepobi. Admittedly, It is
hard to see how returning highly liquid U.S. Treasury provides a more than trivial
benefit to Obiwanrepobi. Such a benefit might arise if the securities were illiquid or
otherwise hard to obtain, however.
e) This additional contemporaneous (and likely in contemplation) swap agreement
would change the required accounting for the repurchase agreement to secured
borrowing because the swap agreement implies that Obiwanrepobi can obtain
substantially the same securities from Transferjedi even if Transferjedi returns
Fannie Mae securities at the end of the term of the repurchase agreement.