Accounting for an Operating Lease B. Accounting by the lessor:

1. Lease receipts recorded as rental revenue when accrued/received

2. Property remains on books of lessor

3. Depreciation expense recorded periodically on the property

Accounting for a Capital Lease A. Accounting by the lessee:

1. Property recorded as purchased – asset shown on balance sheet

2. Liability recorded equal to discounted present value of the lease payments

Accounting for a Capital Lease A. Accounting by the lessee:

3. Periodic lease payments recorded as payments on a level-payment loan, including interest

4. Depreciation expense recorded periodically on the property

Accounting for a Capital Lease A. Accounting by the lessor:

1. Treatment not necessarily parallel with lessee’s accounting treatment

2. Lease must first be characterized:

Sale-type lease Direct-financing lease Leveraged lease

Accounting for a Capital Lease A. Accounting by the lessor:

3. Transaction treated as a sale of the asset with long-term, level-payment financing

4. Periodic lease receipts treated as payments on the loan plus interest

Leases: Additional Disclosures A. Notes to the financial statements

disclose both capital and operating leases

B. Lessee discloses commitments on operating leases

Securitization & Debt Extinguishment I. Securitization, Debt Extinguishment

and Special Purpose Entities (SPE’s):

A. Introduction: Enron made this a hot topic

B. The SPE transaction summarized

C. The problems

D. The FASB response: FAS 190

Securitization & Debt Extinguishment A. Enron made this a hot topic:

1. Creative accounting: new techniques developed in each generation

2. How to detect – and adjust for – creative accounting

3. Drawing the line between creative accounting and financial fraud

Securitization & Debt Extinguishment B. The SPE transaction summarized:

1. Transfer owned debt or other financial assets

2. Transfer may be with or without associated liabilities.

3. Transfer is to a newly-created or existing special purpose entity (SPE) or variable Interest entity (VIE)

Securitization & Debt Extinguishment B. The transaction summarized:

4. Accounting treatment: sale, with associated extinguishment of the transferred assets and liabilities

5. Also possible: recognition of gain on transfer of assets to the SPE or VIE

Securitization & Debt Extinguishment C. The problems:

1. The transaction offers many opportunities for altering the appearance of the financial statements

2. Transferor may retain an interest in the transferred assets – or in the SPE or VIE – or a continued contingent liability on the transferred debt

Securitization & Debt Extinguishment C. The problems:

3. Basic question: when should the transfer be recognized, and when not?

4. When should the equity method or

consolidated accounting be applied to the SPE or VIE?

Securitization & Debt Extinguishment D. The FASB response – FAS 140

(93 double-column pages):

1. Part of a larger FASB project on financial instruments

Securitization & Debt Extinguishment D. The FASB response – FAS 140:

2. requirements for recognizing the transfer:

(i) Transferred assets are “isolated,” beyond the reach of the transferor and its creditors.

(ii) Transferee (or SPE) has the right – essentially unconditionally – to pledge or exchange the assets.

(iii) Transferor does not maintain effective control, by agreement or by ability to cause return of specific assets.

Securitization & Debt Extinguishment

E. Latest developments: FASB Interpretation 46(R) – Consolidation of Variable Interest Entities (2003):

1. Requires consolidated accounting for certain “variable interest entities” 2. Consolidation is required when any condition is present:

(i) Total equity investment at risk is not sufficient to finance its activities without additional subordinated financial support; or

(ii) As a group, the holders of the equity investment at risk lack the characteristics of a controlling financial interest

(iii) The voting rights of some investors are not proportional to their

obligation to absorb losses.

Impairment of Long-Lived Assets A. The pre-1995 rules

B. The genesis of the new rules

C. The new rules (FAS 144)

D. The moral of the story

Impairment of Long-Lived Assets A. The original rules (before 1995 and FAS

121):

1. Long-lived assets reflected at cost less depreciation/amortization

2. When useful life or utility declined, depreciation schedule was changed

3. Write-down of fixed assets was extremely rare

Impairment of Long-Lived Assets B. The genesis of the new rules:

1. Major business and bank failures following the real-estate boom of the 1980’s

2. Non-performing real estate (and other leased assets), secured by non-recourse debt

3. Little or no disclosure of impairment of assets or associated debt

Impairment of Long-Lived Assets C. The new rules

(FAS 144, replacing FAS 121):

1. Impairment defined: carrying value of asset exceeds its fair value

2. Recognition required when carrying amount is not recoverable and exceeds asset fair value

Impairment of Long-Lived Assets C. The new rules

3. The test: does the sum of the undiscounted cash flows expected from the asset exceed its carrying value?

4. When is testing for impairment appropriate: significant decrease in market value, operating or cash flow losses, adverse legal changes, etc.

Impairment of Long-Lived Assets C. The new rules

5. New cost basis: fair value

6. Discounted present value of cash flows is often best available technique for revaluation

7. After write-down, no subsequent upward revaluation is permitted

Impairment of Long-Lived Assets D. The moral of the story:

1. Accounting is still a work in progress

2. Major accounting reform usually follows financial disasters

The New Accounting for Investments in Debt and Equity Securities A. The original rules

B. The genesis of the new rules

C. The new rules – FAS 115

D. What is revolutionary in the new rules

F. What comes next

Investments in Securities A. The original rules, prior to 1993:

1. Debt generally held at amortized cost

2. Equity securities valued at aggregate: lower of cost or market, with write-up permitted back to original cost, but no higher

Investments in Securities B. The genesis of the new rules:

1. The same circumstances as impairment of long-lived assets

2. But the FASB opened Pandora’s infamous box – and couldn’t resist looking inside

3. What they found was – for accounting – revolutionary

Accounting for Investments C. The new rules – FAS 115:

1. The three methods of accounting for investments:

(i) Current investments – FAS 115

(ii) The equity method

(iii) Consolidated financial statements

Accounting for Investments C. The new rules – FAS 115:

2. The three categories of current investment, determined largely by intent:

(i) Held to maturity (debt only)

(ii) Available for sale

(iii) Trading securities

Accounting for Investments C. The new rules – FAS 115:

3. Held to maturity to be valued at amortized cost, subject to impairment test

4. Available for sale and trading securities subject to new rules:

(i) Carried on the balance sheet at fair value

(ii) Gains and losses reflected on the financial statements

Accounting for Investments C. The new rules – FAS 115:

4. Available for sale and trading securities subject to new rules:

(iii) For trading securities, gains and losses are recognized directly in the income statement

(iv) For available for sale securities, gains and losses are included in a separate category of “comprehensive income”

Accounting for Investments D. What is revolutionary:

1. Application of fair value and mark-to-market:

There was precedent, but only for downward revaluation, e.g. inventory

No clear guidance as to how to pick market values in a volatile exchange market

Accounting for Investments D. What is revolutionary:

2. New category of income for certain gains and losses

3. Intent-based characterization of assets

and accounting for them

Accounting for Investments E. What comes next:

1. Fair valuation of derivatives – FAS 133, 138

2. Problems of volatility: FASB chose the most volatile assets to subject to mark-to- market rule

3. Will other assets – and liabilities – ultimately be subject to similar rules?

Business Combinations and Intangible Assets I. Background: Old Accounting and the

Purchase vs Pooling-of-Interests Distinction

II. The New Rules on Business Combinations – FAS 141 (draft replacement)

III. Goodwill and Other Intangibles – FAS 142

Business Combinations – Old Accounting

I. Purchase vs Pooling-of-Interests Distinction:

A. Accounting Principles Board Opinion No. 16:

1. The effects of pooling of interests:

Carry-over of old asset basis

Combination of retained earnings and earnings history

Avoidance of creation of goodwill on acquisition

Business Combinations – Old Accounting

I. Purchase vs Pooling-of-Interests Distinction:

A. Accounting Principles Board Opinion No. 16:

2. The desirability of pooling-of-interests:

Avoiding significant additional charges against net income

Goodwill as an ephemeral and undesirable asset

Business Combinations – Old Accounting B. The effects of purchase accounting:

1. Assets valued at allocated purchase price

2. Step-up in values of tangible assets

3. Recording of acquired intangible assets

4. Increased financial statement values not necessarily matched by tax deductibility

Business Combinations – Old Accounting C. Substantive effects of the accounting

distinction:

1. Transactions structured to maximize the likelihood of pooling treatment

2. Pooling treatment became a “deal breaking” issue

3. International differences in accounting

New Rules on Business Combinations II. New Rules on Business

Combinations – FAS 141 (draft replacement 2005):

A. Rules apply to business combinations irrespective of form

B. Acquisition accounting is mandatory

C. New rules are comparable to International Accounting Standards

New Rules on Business Combinations

A. Rules apply to business combinations irrespective of form:

1. The combining entities may be of any form

2. The business combination may take any form

New Rules on Business Combinations

B. Acquisition accounting is mandatory:

1. Acquiring entity applies acquisition accounting to acquired entity

2. Assets recorded at aggregate cost, equal to fair value of the consideration transferred

3. Aggregate cost is allocated among acquired assets and liabilities, including tangible assets and intangibles other than goodwill

New Rules on Business Combinations

B. Acquisition accounting is mandatory:

4. Basic rules of cost allocation:

All acquired assets and liabilities – except goodwill – are to be measured and recognized at fair value.

Fair value measurement and recognition also applies to acquired contingent assets and liabilities.

New Rules on Business Combinations

B. Acquisition accounting is mandatory:

5. Goodwill is recorded:

Aggregate cost of acquired assets and liabilities, less

Aggregate amount assigned to other assets and liabilities

C. These rules are comparable to International Accounting Standards

Goodwill and Other Intangibles III. Goodwill and Other Intangibles -- FAS

142 (2001):

A. The old rules

B. The new rules

C. Amortization of non-goodwill intangibles

D. Amortization of goodwill

E. What happened – why were these unusual rules adopted?

Goodwill and Other Intangibles A. The old rules:

1. Intangibles with determinable useful life amortized ratably over useful life

2. Intangibles with indefinite useful life – including goodwill – amortized over a period not to exceed 40 years

3. Intangible amortization included in determining net income from operations

Goodwill and Other Intangibles B. The new rules:

1. Intangibles – other than goodwill – are recognized: if they (a) arise from contractual or other legal rights or (b) are separable

2. Intangibles are valued initially at cost, or at fair value in an aggregate acquisition

Goodwill and Other Intangibles C. Amortization of non-goodwill

intangibles:

1. Amortization over useful life, normally straight-line

2. Useful life may be indefinite – resulting in non-amortization – but there is a high presumption against indefinite life

3. Intangibles must be reviewed for impairment

Goodwill and Other Intangibles D. Non-amortization of goodwill:

1. Presumption of non-amortization of goodwill

2. Write-off – in whole or in part – based only on impairment of “reporting unit”

3. Any impairment loss reduces net income from operations, unless loss is based on discontinued operations

Goodwill and Other Intangibles E. What happened – why were these

unusual rules adopted?

1. Compare International Accounting Standards: mandatory amortization of goodwill, generally over a maximum 20 year period

2. American industry strongly opposed mandatory purchase accounting, because of the corresponding mandate to amortize goodwill

Goodwill and Other Intangibles E. What happened – why were these

unusual rules adopted?

3. Eventually, industry got its way: mandatory purchase but no mandatory goodwill charge

4. The effect: goodwill write-off may be indefinitely

deferred, until impairment 5. But the piper must be paid: look at goodwill –

and other intangible – impairment write-offs in the last several years

Post-Enron: Sarbanes-Oxley and Principles-Based Accounting I. The Problems of Accounting and

Their Origins

II. The Sarbanes-Oxley Act of 2002

III. Principles-Based Accounting

The Problems of Accounting A. Enron, Global Crossing,

WorldCom, etc.:

1. All of these cases involved accounting frauds and audit failures

2. In each case, high-level executives and partner-level professionals were implicated

The Problems of Accounting 3. In these and other cases, the

wrongdoing included:

Violation of statutes on disclosure and activities

Breach of clear fiduciary duties by officers and others

Violation of ethical standards by professionals

Issuance of financial statements not in compliance with GAAP

The Problems of Accounting 4. These cases – individually and

collectively – break the world record for fraud, in both absolute and relative amounts

5. These cases occurred in the most open, regulated and structured financial market in world history

The Problems of Accounting B. How and why – some speculations:

1. Increasing – and mistaken – belief that markets regulate themselves

2. Pressure for reporting continued – and

impossible – levels of income growth 3. Concentration, growth and excess profit-

orientation in professional practice

The Problems of Accounting B. How and why – some speculations:

4. Lack of education (!!) on the

fundamentals of business performance 5. Irrationality in the financial markets: are

the proponents of market efficiency too optimistic?

The Problems of Accounting C. Do we blame accounting or the

accountants?

1. If accounting/auditing was systematically defective, new principles and structures are necessary

2. If the fault lay with individual accountants, new

enforcement and review mechanisms are called for

3. Recent developments address – in varying

ways – both accounting and accountants

Key Concepts of Corporate Finance: Cash Flow, Risk, Return I. The importance of contemporary financial

theory. II. The core concept: valuation by cash-flow

analysis. III. The problem of determining the discount

rate. IV. Market efficiency.

I. The Importance of Contemporary Financial Theory A. How the "invisible hand" of Adam

Smith governs the markets. B. A key insight: totally free -- i.e.,

unregulated -- market is unworkable. C. A tool to help our clients evaluate

investment and other decision.

II. The Core Concept -- Valuation by Cash-Flow Analysis

A. The difference between finance and accounting.

B. How cash flow differs from net income. C. The cash flow diagram: timing, amounts

and risks of future cash flows. D. How are future cash flows predicted?

III. The Problem of Determining the Discount Rate A. The historical data establish a clear

relationship between risk and return in the capital markets

B. The Capital Asset Pricing Model (CAPM) assumes that there is a straight- line (linear) relationship between the relative riskiness of an investment and the expected return of that investment.

The Capital Asset Pricing Model (CAPM)

1. The market risky return rate, or rm

2. The risk-free return rate, or rrf

3. A standardized measure of risk, or β (beta)

4. The formula: re = rrf + β (rm - rrf).

CAPM Formula

re = rrf + β (rm - rrf)

The Capital Asset Pricing Model (CAPM)

The CAPM remains the most widely used method for determining risk-based discount rates.

In the past decade, there has been increasing application of multi-factor formulas for determining return rate: the Arbitrage Pricing Theories (APT).

These methodologies represent the state of the art in determining valuation under conditions of uncertainty.

IV. Market Efficiency

A. The basic argument of market efficiency: the financial market rapidly adjusts for ("impounds") information that is relevant to the price of stock. Some important assumptions:

Effective information dissemination. Informed investors. Rational, profit-maximizing conduct.

Market Efficiency B. The three major arguments – or “forms” –

of market efficiency:

“Weak Form” – The market rapidly reflects all past price movements.

“Semi-Strong Form” – The market rapidly reflects all publicly-available information.

“Strong-Form” – The market rapidly reflects all

information.

Market Efficiency C. An important limitation on the EMH

concerns how rapidly the market moves. What do we mean by “efficient”?

D. Market efficiency affects significantly the

nature of the required and desirable regulation of capital markets.

Empirical evidence on the three "forms" of the EMH

1. Weak Form: Strong support, except for short-term (< 15 minute) movements. Profit making based on patterns and “chaos.”

2. Semi-Strong Form: Many strong empirical studies – e.g., accounting methods – but new thinking on behavioral economics raises questions.

3. Strong Form: Strong contrary empirical evidence; regulation of insider trading.

VII. Options and Other Derivative Financial Instruments A. Options and other derivative financial

instruments differ in substance from the underlying assets on which they are written.

B. The two basic building blocks of financial derivates are the call (a right to purchase an asset at a price -- the strike price -- at a future date), and the put (a right to sell an asset at a price -- the strike price -- at a future date).

VII. Options and Other Derivative Financial Instruments

C. Derivatives are risk-shifting arrangements, in which one party "buys" risk, and the other "sells" risk.

D. Option pricing models have proved highly accurate in practice. They include the famous Black-Scholes Option Pricing Model and the Binomial Option Pricing Models.

VIII. Important Implications of Options and Option Theory A. The importance of including the value of

“embedded” put and call options in the valuation of a project.

B. The concept of stock in a leveraged firm as a form of call option.

C. Implications on corporate governance: stockholders and directors as risk-seekers.

What went wrong: Bad theory, or something else? A. Serious doubts about the effectiveness of

market efficiency, particularly valuational. 1. Do investors act rationally? 2. Is all information adequately considered? 3. Is important information missing or false?

B. Underestimating the importance of

regulation. 1. Can managers be trusted to act for investors? 2. What are the effects of high incentive compensation? 3. Does accounting give us relevant and accurate data?

What went wrong: Bad theory, or something else?

C. Implications for the future.

1. Greater regulation? What kind, and at what cost? 2. Greater enforcement. 3. Major changes in financial disclosure. 4. Substantive corporate regulation: transactions, self-

interest, compensation.