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Fair Value of Investments


Prepared for:        Prof. Shimin Chen
                     102 Financial Accounting

Prepared...
Executive Summary – An Introduction

With the adoption of IFRS (International Financial Reporting Standards), companies ar...
We acknowledge that there has thus far been no concrete implementation to align IFRS and US
GAAP, but indications point to...
The Problem

Building from the previous section, the problem arises when unobservable inputs need to be used
to derive fai...
tranches (“slicing”). Subsequently, the Investment Bank works with credit rating agencies
  to determine the credit risk o...
Firm                         Man Group plc                       The Blackstone Group                 Citigroup           ...
Valuation Difficulty

As part of our investigative efforts, we were able to interview a former auditor of KPMG.
To protect...
We believe that firm resolve and concrete action needs to be taken by the authorities and
governing bodies of accounting s...
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Fair Value of Investments

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Fair Value of Investments

  1. 1. Fair Value of Investments Prepared for: Prof. Shimin Chen 102 Financial Accounting Prepared by: Group 1, Section 1 (Term 1) 081153 081125 081112 081083 081032 081026 Submitted Date: November 14, 2008 This is to certify that this work is entirely and exclusively my/our own, except for those cited and noted. Team Number: Group 1 China Europe International Business School 1
  2. 2. Executive Summary – An Introduction With the adoption of IFRS (International Financial Reporting Standards), companies are required to measure some assets, liabilities, and equity at fair value. However, methods for calculating fair value has only been incorporated by the IASB (International Accounting Standards Board), the governing body of IFRS, on a piecemeal basis over many years, mainly in terms of what various particular situations called for over time1. Furthermore: “As a result, guidance on measuring fair value is dispersed across many IFRSs and it is not always consistent. Furthermore, the current guidance is incomplete, in that it provides neither a clear measurement objective nor a robust measurement framework. The Board believes that this adds unnecessary complexity to IFRSs and contributes to diversity in practice2.” The IASB itself is still in the process of addressing this issue, and a concrete plan is expected to be in place by 2010. The IASB’s objectives are3: a) “to establish a single source of guidance for all fair value measurements required or permitted by existing IFRSs to reduce complexity and improve consistency in their application; b) “to clarify the definition of fair value and related guidance to communicate the measurement objective more clearly; and c) “to enhance disclosures about fair value to enable users of financial statements to assess the extent to which fair value is used to measure assets and liabilities and to provide them with information about the inputs used to derive those fair values.” IFRS & US GAAP We delimit our scope to the fair valuation of investments. For US companies complying with US GAAP, guidance on the fair valuation of investments is provided under FAS 157 “Fair Value Measurements” (October 2006). For many companies in the rest of the world that comply with IFRS, the relevant provision is found in IAS 39 “Financial Instruments: Recognition and Measurement.” 1 http://www.iasb.org/Current+Projects/IASB+Projects/Fair+Value+Measurement/Fair+Value+Measurement.htm. Accessed October 9, 2008. 2 Ibid. 3 Ibid. 2
  3. 3. We acknowledge that there has thus far been no concrete implementation to align IFRS and US GAAP, but indications point toward the US adopting the former. As a matter of fact, the IASB and FASB (Financial Accounting Standards Board, USA) have already begun a convergence process to make their respective standards compatible, as pledged under the “Norwalk Agreement” which occurred as early as 2002 4 . Furthermore, the US SEC has charted a roadmap that allows foreign companies that list on US exchanges to report exclusively in IFRS by 20095. Key Tackling Points Tabulated in the following are key provisions in IAS 39 and FAS 157 most applicable to this research: Accounting Regulation IFRS (IASB) US GAAP (FASB) Guidance Principle/Rule IAS 39 FAS 157 Key Provisions  Financial Assets and Financial Liabilities  The fair value of assets and liabilities reflects (investments) shall be held in the balance sheet at current market observations7. fair value, i.e. market price (trading price between counterparties) plus transaction costs6. Fair Value Hierarchy  Market price  Level 1 – Observable market prices  Where a market price is unavailable, the  Level 2 – Observable inputs that are not valuation should be consistent with market generated from active markets but consistent with practices in valuing that security, and/or fair market expectations. value is based on the best information to value  Level 3 – Unobservable inputs that should be the security consistent with market expectations8. consistent with market expectations9. 4 http://www.journalofaccountancy.com/Issues/2007/Jun/IfrsComingToAmerica.htm. Accessed November 12, 2008. 5 Ibid. 6 IAS 39 Financial Instruments: Recognition and Measurement, IASB. file:///Users/Alex/Documents/AFF/CEIBS/102%20-%20Financial%20Accounting/Project/IASB%20-%20IAS%203 9.pdf. Accessed November 13, 2008. 7 Summary of Statement No. 157, Fair Value Measurements, FASB. http://www.fasb.org/st/summary/stsum157.shtml. Accessed November 13, 2008. 8 “Revised Fair Value Hierarchy,” Information for Observers, IASB, 25 May 2006, London. http://www.iasb.org/NR/rdonlyres/BB4CADFA-FC30-412F-B7B7-383E583AF256/0/ObNotes_FVM_0605ob08b.p df. 9 Ibid. 3
  4. 4. The Problem Building from the previous section, the problem arises when unobservable inputs need to be used to derive fair value consistent with market expectations. In effect, existing accounting policies and regulations allow companies to engage in subjective reasoning and internal valuation techniques – among others – yet still be compliant with fair value regulations. To test our position, we analyze financial institutions that actively invest in the financial markets. We attempt to find the difficulties in which current accounting rules allow companies to measure their investments at fair value. Financial Institutions – Active Investors in Financial Markets Specifically, we want to research the above issue in light of the growing significance of hedge funds (with around USD 1.7 trillion in assets under management as at 200810) vis-à-vis the financial crisis of 2008, triggered by falling home prices and mortgage defaults in the US, particularly in the subprime segment. CDO Anatomy Collateralized Debt Obligations (CDO) played a key role in the unraveling of the financial crisis. As a brief background, CDOs are a type of asset-backed security and structured credit product, constructed by pooling together fixed-income and credit assets, then dividing or “slicing” them into tranches tiered on the basis of credit rating. Normally, tranches are: Senior (AAA), Mezzanine (AA to BB), and Equity (unrated, i.e. the riskiest tranche)11. There are four primary roles in the construction of CDOs12:  The Asset Manager is responsible for pooling together the collateralized assets, e.g. mortgages, etc., in a process called “warehousing.” To acquire these collateralized assets, the Asset Manager is usually provided financing by an investment bank.  The Investment Bank acts as the underwriter of the CDO. The Investment Bank works with the asset manager in providing financing to acquire the assets to be collateralized, and sometimes, also works alongside the asset manager in determining which assets to pool together. The Investment Bank also tiers the CDO into its senior, junior, and equity 10 “Hedge Funds Lost $100 Billion on Investor Withdrawals;” Yamazaki, Tomoko; Bloomberg News; November 13, 2008. 11 http://en.wikipedia.org/wiki/Collateralized_debt_obligation. Accessed November 13, 2008. 12 Ibid. 4
  5. 5. tranches (“slicing”). Subsequently, the Investment Bank works with credit rating agencies to determine the credit risk of each tranche. Finally, the Investment Bank sells the CDOs to investors.  Credit Rating Agencies, such as S&P and Moody’s, conduct stress testing and sensitivity analyses on CDOs architectured by the investment banks. This allows them to apply ratings on the CDOs, which are a key consideration in CDO pricing13.  The Investors in CDOs are normally hedge funds and banks. CDOs are an attractive investment because they offer higher returns than more conventional fixed-income securities (e.g. corporate bonds) of the same credit rating. Real-World Observation CDOs are a key basis for our research as they are not priced by an open market, and are thereby difficult to price, often being recorded at par value14. Many investor-firms (banks, hedge funds) that suffered considerable writedowns and credit losses were active players in the CDO market. As there were rising delinquencies in the underlying assets of the CDOs (e.g. mortgage defaults), investors incurred large losses on the deterioration in value of the CDOs. What were once held at par value were recorded as losses and written-off. In the following, we tabulated key information that allows us to conduct side-by-side analysis on the firms we chose to analyze in this research, their respective accounting treatment of fair value, and corresponding credit-related losses. 13 “ ‘ Race to Bottom’ at Moody’s, S&P Secured Subprime’s Boom, Bust;” Smith, Elliot Blair; Bloomberg News; September 25, 2008. 14 Ibid. 5
  6. 6. Firm Man Group plc The Blackstone Group Citigroup Goldman Sachs Bear Stearns Bank of China Institution Type Hedge Fund Manager Private Equity, Financial Advisory Universal Bank Securities Firm, applied for Securities Firm, sold to JPMorgan Commercial Bank commercial bank status in 2008 in 1Q08 Hedge Fund Business Various Proprietary, Fund of Funds Alternative Investments Proprietary (Global Alpha) Bear Stearns Asset Management NA Auditor PwC Deloitte KPMG PwC Deloitte PwC Fiscal Year End 31 March 31 December 31 December 30 November 30 November 31 December Compliance IFRS US GAAP US GAAP US GAAP US GAAP IFRS Fair Value Provision IAS 39 FAS 157 FAS 157 FAS 157 FAS 157 IAS 39 Subprime/Mortgage/CDO None specifically disclosed. None specifically disclosed. As at 31DEC07, USD 29.3 billion As of NOV07, USD2.11 billion (of Securitized USD 113 billion of As at 31DEC07, USD4.99 billion Valuations However, PEMBA Credit Advisers, net exposure in CDOs. which USD 507 million are Level CDOs by 2006. Completed (2.13% of investment securities), of manager of Man Group plc’s credit 3), including USD 316 million in acquisition of Encore Credit which: 71% (AAA), 26% (AA), 1% portfolio, issued CDOs of EUR 300 CDOs backed by subprime Corporation in early-07 that would (A), of which all are ABS. Group to 558 million in 2008. PEMBA mortgages. generate USD 1 billion in subprime unloaded all US subprime related has structured 6 CDOs since 2002. loans per month. USD 43 billion CDOs by end-2007. of mortgages, mortgage- and asset-backed securities held in proprietary trading inventories as at 30NOV06. Writedowns and Unknown Unknown USD 55.1 billion USD 3.8 billion USD 3.2 billion. Two hedge USD 2 billion Credit-related Losses as funds suffered USD 1.5 billion in 15 at Aug. 12, 2008 losses during 2-3Q07. 16 52W Share price DOWN 69% DOWN 69% DOWN 71% DOWN 69% NA DOWN 59% Source: Respective company reports. 15 Banks' Subprime Losses Top $500 Billion on Writedowns (Update1), Yalman Onaran, Bloomberg News, August 12, 2008. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a8sW0n1Cs1tY. Accessed November 13, 2008. 16 Google Finance. http://finance.google.com/. 6
  7. 7. Valuation Difficulty As part of our investigative efforts, we were able to interview a former auditor of KPMG. To protect the person’s identity (henceforth referred to as “our Source”), we will not disclose the person’s name when citing our reference17. Our Source audited a Hong Kong subsidiary of Citigroup, which served as a legal entity vehicle for booking Citigroup investments. It contained mortgage-backed securities (MBS). For the MBS that were sold, their selling price was recorded as their fair value. For MBS that the subsidiary were still holding, their prices were quoted by Citigroup’s traders in London. KPMG recognized the difficulty in these valuations, and they were able to correspond with Citigroup’s CFO in London. The quotes provided by the traders were reiterated. As shown above, Citigroup’s total losses on subprime mortgages and credit-related securities are over USD 55 billion as at August 12, 2008. We also look deeper into Bear Stearns. Two of its hedge funds that had large exposure to subprime mortgages failed in 2-3Q08 and racked up around USD 1.5 billion in losses, as shown above. The valuations of around 60% of the hedge funds’ net worth were provided by the hedge fund manager and his team. In fact, Bear Stearns’ auditor, Deloitte & Touche, warned of such valuations in their 2006 report released in May 200718. Conclusion – A Call to Action With the advent of today’s financial crisis, financial market participants find it increasingly difficult to fairly value their portfolios. Information needed to make fair valuations have become scarce, leading participants to resort to alternative techniques such as internal valuation models, etc.19. The leading auditors are engaged in extensive discussions to resolve the issue, but nothing specific is yet in place: Ernst & Young20, PricewaterhouseCoopers21, KPMG22, and Deloitte & Touche23. 17 KPMG Auditor. Email correspondence, November 2008. 18 “Bear Stearn’s Bad Bet;” Goldstein, Matthew; Henry, David; BusinessWeek; October 11, 2007. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a8sW0n1Cs1tY. Accessed November 2008. 19 Fair Value Pricing: 2008 Survey Results. Deloitte. 20 Global Hedge Fund Survey 2007: Navigating New Complexities. Ernst & Young, in cooperate with Ipsos MORI. 7
  8. 8. We believe that firm resolve and concrete action needs to be taken by the authorities and governing bodies of accounting standards. With the convergence of accounting standards toward IFRS, the results of the IASB’s plan to enhance the fair value framework by 2010 are key in stabilizing the financial markets and restoring investor confidence. 21 Fair value measurements: Make your views count. PricewaterhouseCoopers, April 2007. 22 Defining Issues. KPMG, March 2008. 23 Ibid. 8

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