ACCT 405 Saudi Electronic University Accounting of Financial Institutions Worksheet

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Financial Instruments
and Institutions
Accounting and
Disclosure Rules
Second Edition
STEPHEN G. RYAN
John Wiley & Sons, Inc.
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Financial Instruments
and Institutions
Accounting and
Disclosure Rules
Second Edition
STEPHEN G. RYAN
John Wiley & Sons, Inc.
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For John and Arlene, my parents,
and Lisa and Jacob, my life
This book is printed on acid-free paper.

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data
Ryan, Stephen G.
Financial instruments and institutions : accounting and disclosure rules /
Stephen G. Ryan. — 2nd ed.
p. cm.
Includes index.
ISBN 978-0-470-04037-9 (cloth)
1. Financial instruments —Accounting. 2. Financial institutions —
Accounting. I. Title.
HF5681.F54R93 2007
657′.76 — dc22
2006036780
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
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Contents
Preface
ix
Acknowledgments
xvii
CHAPTER 1
Financial Instruments and Institutions
1
Main Ingredients of the Analysis of Financial Instruments
Activities and Risks of Financial Institutions
Valuation of Financial Institutions in Practice
4
11
16
CHAPTER 2
Nature and Regulation of Depository Institutions
19
Activities of Depository Institutions
Bank Regulation
Bank Subtypes
Recent Trends
19
22
35
38
CHAPTER 3
Thrifts
45
Financial Statement Structure
Main Risk-Return Trade-Offs and Financial Analysis Issues
46
56
CHAPTER 4
Interest Rate Risk and Net Interest Earnings
63
Views of Interest Rate Risk
Interest Rate Risk Concepts
64
66
iii
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iv
Analysis of Net Interest Earnings
Rate-Volume Analysis
Repricing Gap Disclosures
CONTENTS
78
81
84
CHAPTER 5
Credit Risk and Losses
93
Economics of Credit Risk
Accounts for Loans and Loan Losses
Accounting and Disclosure Rules for Unimpaired Loans
Accounting and Disclosure Rules for Impaired Loans
Loan Portfolio Quality and Loan Loss Reserve Adequacy
Research on Banks’ Loan Loss Reserves
Appendix 5A: SunTrust Banks —After the Restatement
95
97
100
107
110
118
119
CHAPTER 6
Fair Value Accounting for Financial Instruments:
Concepts, Disclosures, and Investment Securities
131
Fair Value Accounting for Financial Instruments
Disclosures of the Fair Value of Financial Instruments
Investment Securities
Appendix 6A: Washington Federal’s Big Gap
133
141
149
158
CHAPTER 7
Mortgage Banks
161
Mortgage Banking Industry, Major Players, and Activities
Financial Statement Structure
Main Risk-Return Trade-Offs and Financial Analysis Issues
Accounting for Fees and Costs
162
167
174
186
CHAPTER 8
Securitizations
189
Why and What?
Securitization Structures
SFAS No. 140
192
196
204
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Contents
Financial Analysis Issues
Empirical Research on Securitizations
Servicing Rights and Prepayment-Sensitive Securities
Appendix 8A: Doral Financial’s Interesting
Interest-Only Strips
v
216
221
222
224
CHAPTER 9
Elements of Structured Finance Transactions
235
Special-Purpose/Variable-Interest Entities
Related Transactions
Hybrid Financial Instruments
Financial Guarantees
Recent SEC Decisions Regarding Structured Finance
Transactions
236
244
248
251
253
CHAPTER 10
Commercial Banks
255
Balance Sheet
Income Statement
Cash Flow Statement
257
261
265
CHAPTER 11
Derivatives and Hedging
269
Derivatives
Hedging
SFAS No. 133 (1998), as Amended
Framework for Assessing Financial Institutions’ Derivatives
and Hedging
272
282
285
308
CHAPTER 12
Market Risk Disclosures
311
Overview of FRR No. 48 (1997)
Tabular Format
Sensitivity Approach
312
315
322
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Value-at-Risk Approach
Comparison of Disclosure Approaches
Effect of SunTrust’s Derivatives and Hedging
on Its Market Risk
Research
Appendix 12A: Bank of America’s Derivatives,
Hedging, and Market Risk
CONTENTS
326
331
332
337
337
CHAPTER 13
Lessors and Lease Accounting
347
Competitive Advantages of Leasing
Lease Structures and Contractual Terms
Lessors’ Risks
Lease Accounting Methods
Analysis Issues Regarding Lease Accounting Methods
Special Lease Transactions
Lessors’ Financial Statements
Lease Disclosures
Possible Future Changes in Lease Accounting
350
352
355
357
366
369
374
379
387
CHAPTER 14
Insurers and Insurance Accounting
389
Products
Risk-Return Trade-Offs
Regulation
Primary Insurance Accounting Standards
Accounting Standards Governing Embedded
Derivatives and Other Life Insurance Policy Features
Financial Statements
Line of Business Disclosures
Other Insurance Accounting Systems
391
396
403
405
421
423
428
429
CHAPTER 15
Property-Casualty Insurers’ Loss Reserve Disclosures
435
Loss Reserve Footnote
438
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Loss Reserve Development Disclosures
Calculating Loss Reserves by Accident Year
Calculating Loss Reserve Revisions by Accident Year
Calculating Claim Payments by Accident Year and Tail
Constructing Accident Year Loss Reserve T Accounts
Property-Casualty Expense Ratios
vii
440
444
446
448
452
453
CHAPTER 16
Reinsurance Accounting and Disclosure
457
Accounting and Analysis Issues
Reinsurance Contracts
Accounting for Reinsurance Contracts
Reinsurance Disclosures and Analysis
Evolution of Financial Reporting for Reinsurance
459
462
472
487
493
Index
497
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Preface
T
his book provides a comprehensive guide to the analysis of financial
instruments and institutions using accounting information and disclosures that are publicly available in financial reports. It is primarily written
for users of financial reports who must confront the complex, voluminous,
and changing nature of financial reporting rules for financial instruments
and institutions. My primary goal is to provide these users with the tools
necessary to construct as coherent a story as possible about how financial
institutions and also nonfinancial firms generate or destroy value using
financial instruments. I show how financial reports provide clues to the construction of such a story through fair value accounting for financial instruments and accompanying estimation sensitivity and risk disclosures that
users can, with focused effort, piece together and interpret in a consistent
and conceptually sound fashion.
Most of the major accounting standards governing financial instruments
and transactions are covered, including those for loans, investment securities, securitizations, the constituent elements of structured finance transactions, derivatives and hedging, leasing, insurance, and reinsurance. Those
instruments and transactions for which the accounting is straightforward are
excluded. The exposition of accounting standards reflects my belief that
users of financial reports do not need to know all of the myriad details of
each standard but rather only the critical features that make or break the
representational faithfulness of financial reports. For example, in securitization accounting, these critical features pertain to the valuation and risk of
retained interests; excess value assigned to risky retained interests has led
to a sizable number of large losses by securitizers of risky assets, such as those
experienced by subprime mortgage banks during the hedge fund crisis in the
second half of 1998. This book hones in on these critical features.
My perspective is that fair value provides the simplest and most natural
measurement basis for financial instruments, especially for financial institutions that hold many instruments with correlated values that hedge or
accentuate risks at the portfolio level. However, I also emphasize that, aside
from securities and other instruments that are publicly traded in liquid
markets, fair value accounting for financial instruments inevitably involves
some degree of subjectivity (and thus possibly intentional bias) and inadvertent error (i.e., random noise) in estimation. I discuss how financial report
users can assess this subjectivity and error using required disclosures of
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PREFACE
estimation sensitivity, interest rate and other market risks, credit risk, and
insurance claims risk. Most of the major required estimation sensitivity and
risk disclosures are covered.
A distinctive aspect of this book is its integrated coverage of financial
reporting for financial instruments and institutions. This coverage reflects
my strong belief that financial reporting and analysis for financial instruments must reflect the economic context of the firms and transactions
involved. I examine six types of financial institutions, which were chosen
either because they reflect specific financial transactions in a clear fashion or
because they have distinctive accounting or disclosure requirements: thrifts,
mortgage banks, commercial banks, lessors, property-casualty insurers, and
life insurers. These financial institutions constitute specific understandable
contexts that are often unusually well described in financial reports because
of risk and other disclosures mandated by industry regulators. These institutions also tend to have more extensive ranges or lengthier histories of
specific financial transactions than nonfinancial firms. For these reasons,
financial institutions provide the best available settings to learn disciplined
analysis of financial instruments. Users of nonfinancial firms’ financial
reports will find learning such disciplined analysis useful in their settings.
WHY I WROTE THE BOOK
In teaching courses on financial instruments and institutions at the Stern
School of Business of New York University over the past 12 years, I have
found that the available treatments of the relevant financial reporting rules
have three weaknesses from the perspective of users of financial reports.
First, the available treatments usually target one of two audiences. Some are
written for preparers of financial statements or practicing accountants, who
naturally are concerned with how to account for specific complex transactions; these treatments tend to be poorly grounded in economic concepts and
overly detailed with respect to implementation issues. Alternatively, some
are written for the generalist student of financial analysis; these treatments
provide little of the context necessary to understand financial transactions
and institutions, discuss the relevant financial reporting rules inadequately
if at all, and apply analytical schemas that invariably have been developed
for nonfinancial transactions and firms. Either approach obscures the nature
and usefulness of the financial report information about financial instruments and institutions from the perspective of users of financial reports. In
contrast, while avoiding needless detail, I provide economically grounded
descriptions of financial transactions and institutions, thorough treatments
of the accounting standards and disclosure rules applying to financial instruments and financial institutions, and many cases drawn from the financial
reports of actual financial institutions.
Second, most of the recently propounded and likely future financial
reporting rules involve some form of fair value accounting for financial
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instruments. The available treatments do not provide sufficient discussion
of the nature, strengths, and weaknesses of fair value accounting for financial report users to be able to evaluate the information provided by these
rules. I provide a strong conceptual treatment of fair value accounting. I
supplement this with numerous cases drawn from actual financial institutions’ financial reports that illustrate when fair value accounting for financial instruments works well and when it is fragile. These cases span the
various types of financial institutions covered in the book, which allows me
to emphasize the common issues that apply across types of institutions.
These common issues arise because financial transactions inherently have
common features, but also because smart financial transaction designers
quickly import innovations developed in other settings. Moreover, the distinctions among various types of financial institutions continue to blur over
time, with the products they offer increasingly competing against each other.
For example, I discuss how the retention of residual risk raises similar financial reporting and analysis issues in securitizations, leasing, and reinsurance.
These features enable diligent readers to develop robust intuitions about fair
value accounting for financial instruments. They also imply that readers interested in a subset of the topics will benefit considerably from reading the
whole book.
Third, the available treatments give insufficient emphasis to the analysis of estimation sensitivity and risk disclosures. These disclosures are a critical complement to fair value accounting for financial instruments, since
they indicate the sensitivity of the fair value of the firm’s financial instruments to changes in risk factors and since assumptions about risk factors are
required to estimate the fair values of financial instruments. Moreover,
financial institutions are in large part and increasingly in the risk management business, and so risk disclosures are absolutely essential to the analysis
of these institutions.
ENRON, SARBANES-OXLEY, AND CHANGES IN
FINANCIAL REPORTING RULES FOR STRUCTURED
FINANCE TRANSACTIONS
The importance and limitations of financial reporting for structured finance
transactions was made apparent by the implosion of Enron, which engaged
in a diverse and complex set of those transactions, many of which were
accounted for properly but some significant examples of which were not.
Enron illustrates how these transactions, even if accounted for properly, can
place considerable stress on financial reporting, especially when they are used
to exploit existing accounting rules to obtain desired outcomes such as
off–balance sheet financing or income management. Enron along with other
accounting scandals such as WorldCom created the political pressure necessary to pass the landmark Sarbanes-Oxley Act of 2002, which has led swiftly
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to many significant changes in financial reporting rules, many of them pertaining to structured finance transactions.
For example, since the passage of Sarbanes-Oxley, the Financial Accounting Standards Board (FASB) has issued significant accounting standards on
derivatives and hedging, special-purpose/variable-interest entities, hybrid
financial instruments, financial asset servicing rights, financial guarantees,
and fair value measurements. The FASB’s agenda includes significant projects
on derivatives disclosures, transfers of financial instruments, liabilities and
equity, leases, insurance risk transfer, and the fair value option. The Securities and Exchange Commission (SEC) has issued comprehensive disclosure
requirements for off–balance sheet financing arrangements as well as a special
report that describes its approach and recommendations regarding accounting-motivated structured finance transactions. The SEC, Department of Justice, Office of the New York State Attorney General, and other regulators
have pursued their enforcement activities with unprecedented resources
and zeal.
This book provides many insights about how structured finance transactions should be accounted for and analyzed using the information provided
in financial reports. It describes the economic substance of and accounting
for some of the most important types of structured finance transactions,
including securitizations, (synthetic) leasing, and (finite) reinsurance as well
as the constituent elements of those transactions including special-purpose
entities, transactions related through netting agreements or by the intent of
the counterparties, hybrid financial instruments, and financial guarantees.
Structured finance transactions often partition the risk and value of underlying financial (and, in the case of leasing, nonfinancial) assets and liabilities nonproportionally; for example, securitizations frequently involve the
value of the securitized financial assets being disproportionately but not
fully transferred to asset-backed security purchasers while the risks of those
assets are disproportionately but not fully retained by issuers. When this is
the case, no single method of accounting for these transactions fully captures their nature, since accounting can describe either the value transfer or
the risk transfer but not both. The critical questions for financial report
users are how the accounting method chosen by the reporting firm does and
does not describe the specific transactions the firm engages in, and, given
the inevitable limitations of the accounting, how the estimation sensitivity
and risk disclosures provided by the firm can be analyzed to address the limitations of the accounting.
In the preface to the first edition of this book, published in the immediate wake of Enron, I expressed concern that Enron might provoke overreactions from accounting standards setters and regulators that would
have detrimental effects on financial reporting for financial instruments
and structured finance transactions. Thankfully, this has not been the case.
In particular, in most of its decisions the FASB has continued on a measured course toward broader fair value accounting for financial instruments.
Although fair values are judgmental for some financial instruments and this
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judgment can be abused, fair value accounting is absolutely necessary to
describe risky financial instruments and structured finance transactions,
especially at the level of portfolios of instruments, which financial institutions by their nature hold. While not all financial instruments currently
should be fair valued and errors in fair valuations will occur even for those
that should, a desirable property of fair value accounting is that it corrects
its mistakes over time, since financial instruments must be revalued each
period based on current market conditions. In this regard, many of Enron’s
problems simply would have taken longer to uncover if its accounting were
not based on fair value.
Moreover, in most of their decisions the FASB and SEC have recognized
that the proper way to deal with the stress placed on financial reporting
rules by structured finance transactions is not to jury-rig accounting standards in a futile attempt to dissuade abuse. Instead, they have worked diligently to develop conceptually sounder accounting standards, to require
enhanced disclosures about the nature and purposes of these transactions,
and to provide legal and regulatory (not accounting) disincentives to engage
in transactions with no business purpose that impair the transparency of
financial reports. For example, this approach is evident in the SEC’s disclosure rule on off–balance sheet financing arrangements and its special report
on structured finance transactions mentioned earlier.
Despite the progress made the FASB, SEC, and other accounting policymakers over the past five years, financial reporting rules for financial instruments and structured finance transactions remain highly limited in many key
respects and so will continue to evolve rapidly over the coming years. Fair
value accounting is required only for a small subset of financial instruments.
Virtually all of the major accounting standards for financial instruments
include bright-line, characteristic-based, or intent-based criteria that require
very different accounting for substantively similar instruments, providing
fertile ground for accounting-motivated structured finance transactions.
Disclosures of financial instruments, while voluminous, are disjointed and
often explained poorly or not at all by management. As a result of these limitations, users of financial reports must expend considerable effort and
make significant assumptions in order to draw conclusions about the reporting firm. This book’s conceptual approach will help financial report users
understand and cope with this evolution in financial reporting rules.
TOPICAL COVERAGE AND STRUCTURE OF THE BOOK
The structure of this book reflects my belief that it is important for users
of financial reports to recognize that the value and risk of financial instruments depends on the economic contexts in which they are embedded. I
use the six types of financial institutions mentioned earlier as the source of
context. The book is organized around these types of financial institutions,
starting with relatively simple institutions and proceeding to related but more
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PREFACE
complicated ones. I describe the activities and risks of each type of financial institution in an economically grounded yet intuitive fashion. Financial
reporting and analysis issues are discussed in the same chapter as or immediately subsequent to the chapter covering the most pertinent type of financial institution. This structure allows readers to progress naturally from
relatively simple financial institutions and associated financial reporting and
analysis issues to related but more complex institutions and issues. For readers interested in a specific topic, however, each chapter (or pair of related
chapters) is written to be as self-contained as possible.
Chapter 1 overviews the financial reporting and analysis of financial
instruments and institutions. Chapter 2 contains useful background material
on the structure and regulation of the two main types of depository institution: thrifts and commercial banks. Chapter 3 describes the activities, risks,
and financial reporting of thrifts, the simplest depository institution, which
primarily take deposits and hold residential mortgage-related assets. Most
of the material in this chapter also applies to commercial banks. Chapters
4 through 6 develop and illustrate the application of financial analyses based
on the accounting for and mandated disclosures of interest rate risk, credit
risk, and fair value of financial instruments, respectively. Chapter 7 describes
the activities, risks, and financial reporting of mortgage banks, which write
similar loans to thrifts, but which securitize or otherwise sell most of their
loans. Chapter 8 explains the financial reporting rules for financial asset securitizations and develops and illustrates the application of financial analyses of
prepayment risk and retained interests from securitizations. Chapter 9 discusses the accounting rules governing various important constituent elements
of structured finance transactions, including special-purpose/variable-interest
entities, transactions related through netting agreements or by the intent of
the counterparties, hybrid financial instruments, and financial guarantees.
Chapter 10 describes the financial reporting of commercial banks, which
do everything that thrifts and mortgage banks do but are more involved with
derivatives, hedging, and risk management activities. Chapter 11 explains
the financial reporting rules for derivatives and hedging and develops a
schema for the financial analysis of financial institutions’ derivatives and
hedging. Chapter 12 describes market risk disclosures and illustrates their
critical importance in applying that schema. Chapter 13 describes the activities, risks, and distinct financial reporting of lessors, which compete with
commercial banks for certain types of commercial lending. This chapter
also develops and applies financial analyses of lessors. Chapter 14 describes
activities, risks, and distinct financial reporting of property-casualty and life
insurers, which provide different sorts of risk management services from
commercial banks. This chapter also develops and applies financial analyses
of these insurers. Chapter 15 describes property-casualty insurers’ loss reserve
disclosures and develops and illustrates financial analyses using those disclosures. Chapter 16 describes the accounting and disclosures by ceding
insurers for reinsurance, focusing on retroactive and finite reinsurance.
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SIGNIFICANT CHANGES FROM THE FIRST EDITION
The most significant changes from the first edition are the inclusion of new
chapters on constituent elements of structured finance transactions (Chapter 9) and reinsurance (Chapter 16). Although these topics were covered
briefly in the first edition, events occurring since the publication of the first
edition made it clear that these topics demand fuller treatments. This is
especially apparent in the case of finite reinsurance transactions currently
receiving intense scrutiny from the SEC and other regulators. Both of these
chapters contain comprehensive yet accessible treatments of their topics that
are not available elsewhere.
All of the other chapters have been improved in their exposition and
updated for the many significant changes in financial reporting rules, regulation, and economic conditions that have occurred since the publication of
the first edition, only a portion of which have been mentioned. Although
the conceptual approach taken is the same as in the first edition, readers of
the first edition will find that the new edition serves as a decidedly superior reference guide.
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Acknowledgments
W
hen I began teaching a course on the analysis of financial institutions
at the Stern School of Business in 1995, I was fortunate to inherit the
materials and videotapes of the prior instructor, Gerald White, a gift that
has influenced this book in many ways. Tom Linsmeier provided me with
his materials on derivatives and hedging and wrote a valuable review of the
first edition of this book, and he continues to provide insightful answers to
obscure questions about the application of hedge accounting in practice.
I have been fortunate to have coauthors who have shared their understanding of financial institutions’ financial reporting with me. My mentor
Bill Beaver first involved me in research on banks’ loss reserving in 1985.
This led to a series of papers with Chi-Chun Liu and Jim Wahlen. Jim introduced me to Kathy Petroni, who taught me much of what I know about
property-casualty insurers in our project together. I have learned about
financial reporting in general and financial instruments in particular from
my many interactions with the members and staff of the Financial Accounting Standards Board and my colleagues on the American Accounting Association’s Financial Accounting Standards Committee and the Financial
Accounting Standards Advisory Council, especially Jim Leisenring, Dennis
Monson, Katherine Schipper, and Cathy Schrand. The book has also benefited from my interactions with many other accounting academics and practitioners, including Anne Beatty, Jeff Callen, Jack Ciesielski, Tom Frecka,
Dov Fried, Dan Gode, Lisa Koonce, Doron Nissim, Mohan Venkatachalam,
and Patricia Walters.
I am fortunate to have had hundreds of students at the Stern School with
whom I shared my ideas as they developed, who have provided suggestions
about or caught errors in my original draft chapters or in the first edition
of this book, and who have alerted me to recent developments. Particularly
notable contributions have been made by Andrew Henckler and Robert
Young. I also appreciate the financial support of the Stern School, Dean
Thomas Cooley, and Robert Stovall, who endowed my faculty fellowship.
I appreciate the capable editorial services of Sheck Cho, my executive
editor, at John Wiley & Sons. Sheck kept me moving on the second edition
of this book, which took longer than either he or I expected.
My parents believed strongly in the importance of education, and they
sacrificed considerably to provide their six children with good ones. More
important, they instilled in me the desire to learn a little more every day,
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ACKNOWLEDGMENTS
and the many improvements in the second edition of this book reflect the
gradual accumulation of knowledge over the five years since the publication
of the first edition.
Day in and day out, I come home from work to find my dear and tenacious wife, Lisa, helping our one and only son, Jacob, with his schoolwork,
which yields satisfactions and frustrations for both of them, while I get to
read to Jacob before bed, a pure pleasure for both of us. I wish for Jacob the
never-ending love of learning, in work and play, that my parents gave me,
and for Lisa the knowledge that she carries on, nobly, a family tradition.
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CHAPTER
1
Financial Instruments
and Institutions
F
inancial reporting for financial instruments and institutions is undergoing
a period of unprecedented change and salience for financial analysis. In
the past decade, the Financial Accounting Standards Board (FASB), the primary
accounting standards setter in the United States, has issued major standards
on derivatives and hedging, transfers of financial instruments including securitizations, servicing of financial assets, consolidation of special-purpose/
variable interest entities, hybrid financial instruments, financial guarantees,
and fair value measurements. These standards reflect the FASB’s attempts
to address the limitations of prior accounting and disclosure rules that
provided the settings for the huge losses recorded by firms that ineffectively
hedged using derivatives during the interest rate run-up in 1994 or that held
residual or subordinated interests from securitizations during the hedge fund
crisis of 1998. They also reflect its attempts to improve the transparency
of financial reporting for accounting-motivated structured finance transactions that provided much of the impetus for the Sarbanes-Oxley Act of
2002. During this period, the Securities and Exchange Commission (SEC)
developed extensive disclosure requirements for market risk and off–balance
sheet financing arrangements for much the same reasons.
This change will carry on for the foreseeable future, with the FASB’s agenda
including projects on the fair value option for financial instruments, transfers and servicing of financial instruments, liabilities and equity, leases, insurance risk transfer, and derivatives disclosures. All indications are that the FASB
will continue to proceed on a measured course toward fair value accounting for almost all financial instruments as well as enhanced dis

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