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b. The upfront payment is a liability of Country G, since under the contract it
Additional Problems
7A-1. While ceiling tests for all capital assets were not yet in place in the United States
in 1992, the SEC did enforce a ceiling test on the oil and gas reserves of
producers. Essentially, a write–down was required if the book value of reserves
exceeded their present value.
An article entitled “Natural–Gas Producers Bristle at ‘Snapshot’ Accounting”
appeared in The Wall Street Journal on April 17, 1992. It described the
annoyance of affected firms, some of whom were forced to make substantial
writedowns as a result of the ceiling test.
The SEC’s ceiling test required corporations to value their energy reserves at a
price that “is whatever the company is able to sell its gas or oil for on the last day
of the accounting period.” According to the article, the SEC states that this test is
necessary in order “‘to insure that investors receive disclosures based on
accounting that reflects recoverable value of assets.’” However, Bob Alexander,
president of Alexander Energy Co., feels that this is not a good rule because “‘the
ceiling calculation takes a snapshot of a price on one day.’” Mr. Alexander, along
with others, feels that this rule should be replaced by “a 12–month weighted
average price to eliminate seasonal fluctuations.”
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Not all companies were required to use the SEC ceiling test on their oil and gas
reserves. Firms that used successful efforts accounting for costs of oil and gas
exploration wrote off costs of unsuccessful wells, while firms using full cost
capitalized them into the cost of successful wells. The SEC test was only for
those companies that used full–cost accounting. Companies that use successful
efforts accounting for proved reserves were subject to the ceiling test under
SFAS 144.
If the book value of oil and gas reserves was higher than the ceiling calculation,
the company must write down the reserves to the ceiling. The article, for
example, states that Enserch Exploration had to take a $50 million write–down of
its reserves in 1991. These large write–downs often lead to a decrease in stock
price even though it is a non–cash adjustment. Analyst Catherine Montgomery
“believes the market sometimes reads too much into the write–downs,” adding “I
think that serious investors, institutions and analysts understand these write–
downs.…But the average investor out there has a knee–jerk response and stock
prices may be affected.”
Required
a. Explain why firms using the full–cost method of accounting for reserves are
more likely than successful–effort firms to be affected by the ceiling test. The
article stated that full–cost firms “have to apply the ceiling test to their oil and gas
reserves every quarter; successful efforts users never do.” Do you agree that
successful-effort firms never have to apply a ceiling test? Explain.
b. Evaluate a claim made in the article that ceiling test write–downs can
adversely affect stock price. Do you agree with this claim? Explain.
c. The article pointed out that once ceiling test write–downs are made, assets
cannot be written up again if prices recover. Presumably, this accounts for the
concern expressed by oil company managers about “snapshot” accounting. Why
do ceiling tests under U.S. GAAP impose write–downs but not allow subsequent
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write–ups? As an informed investor in the oil and gas industry, would you support
regular adjustment of book values of oil and gas reserves to fair value? Explain.
7A-2 As mentioned in Theory in Practice vignette 7.5, JDS Uniphase Corporation
reported a preliminary loss of $50.558 billion for the year ended June 30, 2001. In
a July 26, 2001, news release accompanying its financial statements, JDS also
presented a “pro–forma” income statement that showed a profit for the year of
$67.4 million. The difference is summarized as follows ($ million):
Net loss, as reported $50,558.0
Add:
Write off of purchased goodwill $44,774.3
Write off of tangible and intangible assets from acquisitions 5,939.2
Losses on equity investments 1,453.3
Gain on sale of subsidiary (1,768.1)
Non–cash stock option compensation 385.6
Income tax (158.9)
50,625.4
Pro–forma net income $ 67.4
Required
a. The purchased goodwill arose primarily from business acquisitions paid
for in shares of JDS Uniphase. In The Globe and Mail, July 27, 2001, Fabrice
Taylor stated that in JDS’ case, “most of the goodwill on the books comes from
overvalued stock.” In a separate article, Showwei Chu quotes a senior
technology analyst as saying, “They paid what the companies were worth at the
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time.” While trading in the $4 range in 2001, JDS’ shares were trading between
$100 and $200 when most of the acquisitions were made.
i) Assume securities markets are fully efficient. Does the $44,774.3 writeoff
of purchased goodwill represent a real loss to JDS Uniphase and its
shareholders, given that no cash is involved? If so, state precisely the nature of
the loss and who ultimately bears it.
ii) Would your answer change if securities markets are subject to momentum
and bubble behaviour? Explain.
b. What additional information is added to the publicly available information
about JDS Uniphase as a result of the supplementary pro–forma income
disclosure?
c. Why did JDS Uniphase management present the pro–forma income
disclosure?
d. To the extent that investors accept pro–forma income as a measure of
management performance, how might this affect management’s propensity to
overpay for future acquisitions? Explain.
7A-3 A serious problem with fair–valuing complex financial instruments was revealed
by the 2007–2008 meltdown of markets for asset–backed securities (ABSs) and
related financial instruments.
The meltdown began in the U.S. mortgage market during 2007–2008. Many
mortgage loans had been made to poor credit risks, who were unable to meet
increased variable–rate mortgage payments due to rising interest rates or
expiration of low introductory “teaser” rates. Due to a moral hazard problem,
many of these mortgages had been granted with little or no investigation of
borrowers’ financial positions, and statements made by borrowers as to their
incomes, credit histories, etc. were frequently not verified.
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Mortgages issued by mortgage lenders were packaged into ABSs. Many of these
ABSs were in turn repackaged into collateralized debt obligations (CDOs). A
typical CDO consisted of a series of tranches of increasing credit quality, where
each tranche consisted of ABSs. Losses from mortgage defaults would be
charged initially to the lowest quality CDO tranche. If this tranche was exhausted,
losses were charged to the next lowest tranche, and so on. A claimed advantage
of this mortgage securitization was that credit risk was dispersed across many
different mortgages. Given low interest rates at the time and buoyant housing
markets, it was felt that few homeowners would default. As a result, the tranches,
particularly the higher–quality ones, were viewed as low risk, particularly since
they received high ratings from credit rating agencies. Also, credit default swaps,
which were essentially insurance policies hedging credit losses, further
bootstrapped credit quality.
Many of these CDOs were purchased by large investors such as banks, hedge
funds, and mutual funds, including funds in Europe and elsewhere. Other major
CDO purchasers included variable interest entities (VIEs), also called “conduits.”
These VIEs were often sponsored by banks, which would transfer their CDOs
and other ABSs to them. As described in Section 1.3, sponsors were able to
avoid consolidation of VIEs by means of expected loss notes.
To pay the sponsors for the CDOs they received, the VIEs issued asset–backed
commercial paper (ABCP), which is short–term commercial paper secured by
CDOs. While the interest rate paid by ABCP was low, it was higher than that of
government treasury bills, another common short–term investment. Thus, ABCP
was very popular as a vehicle whereby outside firms could temporarily invest
excess cash. Other major ABCP purchasers included money–market mutual
funds. The perception of ABCP’s safety was enhanced because they also
received top ratings from credit–rating agencies.
As the ABCP matured, VIEs rolled it over by issuing new ABCP. VIEs earned
profits from the spread between the interest earned on their CDOs and the lower
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interest they paid on their ABCP liabilities. In the absence of consolidation of their
VIEs, sponsoring institutions did not have to worry about the effect of this ABCP
borrowing on their own leverage ratios or required capital adequacy ratios. Thus,
VIEs create huge amounts of CDOs and asset–backed securities, financing them
with ABCP so as to reap the spread.
As evidence (e.g., increasing default rates) that the U.S. mortgage market was in
trouble grew in the months leading up to August 2007, concerns about the
security of CDOs also grew. Matters came to a head when two hedge funds
operated by Bear Stearns Co. in New York declared bankruptcy because of CDO
losses. Shortly afterwards, on August 9, BNP Paribas, France’s biggest bank,
halted redemptions of three of its mutual funds because it was unable to
determine the fair value of the CDOs they contained. Several German funds
followed suit.
While CDOs and CDSs were, in theory, effective in dispersing risk, subsequent
events revealed serious problems in application, which came back to haunt the
creators of these financial instruments. Models used by financial institutions to
control risk had not anticipated the effects of lack of transparency concerning the
quality of the mortgages underlying CDOs. Once concern about mortgage
defaults appeared, lack of transparency contributed to investors’ lack of
confidence in all CDOs, leading to a situation whereby no one was willing to hold
them (an extreme version of the lemons problem, Section 4.6.1). Thus, liquidity
pricing ensued, leading to market collapse. Instead of dispersing risk, it seems
that CDOs and CDSs had merely transferred it from credit risk to liquidity risk.
Furthermore, as VIEs collapsed, their sponsors had to take the VIE’s assets back
onto their own balance sheets, creating huge writedowns.
Normally, asset writedowns would not be needed to the extent they were hedged
by CDSs. However, amounts of outstanding CDSs, and CDO losses, were so
large that they threatened the ability of the CDS issuers to meet their obligations
(counterparty risk). Then, impairment tests kicked in and the banks had to write
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their CDOs down to fair value. This fair value was difficult to determine since the
CDO market had collapsed. Well–working market values were not available,
meaning that CDOs had to be valued as level 3 assets. The low reliability of such
valuations further contributed to erosion of investor confidence, so that CDO
values fell even further. Indeed, fair value accounting itself came under severe
criticism by managers of many financial institutions affected by the meltdowns,
and by politicians, who claimed that it made matters worse.
Since ABCP was secured by CDOs, concerns about the security of ABCP also
grew. Eventually no one would buy ABCP either. As a result, conduits were
unable to roll over maturing ACBP, which spread the liquidity crisis to the short–
term credit market. VIE sponsors were typically required by contract to repay the
ABCP holders if the VIE could not. Many sponsors had to sell other assets to
obtain the needed cash to pay off ABCP holders, also transferring downward
pressure to stock markets.
Central banks responded to these events by lowering interest rates and making it
easier for banks and others to borrow funds. However, it quickly became
apparent that the world financial system suffered from serious structural
problems which would take some time to fully understand and fix. As part of the
fix, governments worked to inject much needed capital into banks, by organizing
takeovers and mergers, by buying banks’ impaired assets, and by direct equity
investments. In this manner, it was hoped to build up confidence so that banks
would resume lending. Other confidence building measures included increasing
government insurance of deposits and money– market funds.
Required
a. What was the moral hazard problem underlying the issue of mortgages?
b. Why was BNP Paribas unable to determine the fair value of its CDOs?
c. Why did CDSs not prevent the collapse of public confidence in CDOs?
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d. Why did the ABCP market collapse?
e. What did standard setters do in response to the criticisms of fair value
accounting for financial assets?
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Suggested Solution to Additional Problem
7A-1. a. Since firms that use successful efforts accounting write off costs of
unsuccessful wells, while firms using full cost capitalize them into the cost of
successful wells, the book value of oil and gas properties will be higher under full
cost, other things equal. The higher is book value relative to a given physical
quantity of reserves, the more likely it is that book value will hit the ceiling. Thus,
while it is less likely that a successful efforts firm would have to apply the ceiling
test than a full cost firm, the term “never” seems too strong.
b. Under efficient securities market theory, ceiling test write–downs would
only affect stock price if the write–down provided new information to the market.
This seems quite possible, due to the inside nature of management’s estimates
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7A-2 a. i) Yes, the writeoff represents a real loss. If securities markets are efficient,
JDS’ shares fully reflected their value in the $100–$200 range relative to publicly
available information at the time. The share prices of companies bought by JDS
also fully reflected their value. Then, the decline in value of acquired companies
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c. Reasons why CDS did not prevent CDO market collapse:
• Partial coverage. CDOs, which are costly, may have covered only a
portion of credit losses.
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