Teaching long term debt

I sometimes find it difficult to find real world articles that make long term debt more interesting. Usually, there is discussion about the features and then pricing. However, I don't think students get a good feeling for covenants, standing and default issues. There is an article in the WSJ today (not free to link) that is really interesting and discusses a number of interesting real world bond issues:

For months, bond investors have lamented the swing by companies to shareholder-friendly practices such as stock dividends, which often lead to credit-rating downgrades and take money away from such bond-friendly pursuits as debt repayment.

At the same time, the syndicated-loan market -- debt that carries recovery claims senior to bonds -- has exploded. In some cases, that means reduced recovery prospects for bondholders because holders of bank debt have the first claim on collateral.

Bondholders are forced now to become more vigilant, keeping one eye trained on the bank debt on the top of a company's capital structure and the other on stockholders, who are growing increasingly insistent on moves that benefit shareholders.

A number of interesting issues are brought up in the article, and issues that would create a lot of intereting classroom discussion.

Will the FASB kill pension plans?

There is an article in the Seattle Post Intelligencer today discussing how the FASB's intention to require full recognition of pension assets and liabilities will lead to companies killing their pension plans.

But some experts say new regulations requiring companies to more accurately calculate and show the cost of their retirement promises could speed up the move by employers away from guaranteed pensions and other benefits.

"Changing accounting rules can cause companies to change their behavior," said David Zion, an accounting analyst with Credit Suisse First Boston.

Everyone really should read this entire article. Once again we seem to be going back to the economic consequences argument. I always like to discuss these types of issues with my students to get their opinions on disclosure and measurement issues.

Maybe its not accounting that is doing this but rather short- sighted managers who do not see their employees as partners. I wonder how many of the firms who will end their general pension plans (open to all employees) will maintain their pension plans for high level executives?

For another take on this debate read Slate's article by Daniel Gross: The Cram Down Decade

FASB - IAS convergence

An Accountancy Age article reports the recent fair value proposal by the FASB:

The FASB today moved a step further along its IFRS convergence journey with a proposal that would allow companies the option of reporting financial assets and liabilities at fair value.

The article goes on to provide this information:

The FASB added that the change would simplify accounting and reduce earnings volatility caused by differences in current accounting rules.

If implemented, the new standard will allow financial assets and liabilities to be measured at fair value on a contract-by-contract basis. Companies will have to display these values separately from those measured under different attributes on the balance sheet.

I wonder how having an accounting fully based on market value principles would lead to reduced earnings volatility? It would seem to me that mark to market accounting would only lead to more volatility as the changes in interest rates, market values etc. would create a lot of variability.

The new restatement issue

There is an interesting article in the Wall Street Journal today (subscription required) about the number of restatements occuring due to firms' misunderstanding of the requirements necessary to qualify a transaction for hnedging treatment:

Hedge accounting is complex, but the goal is easy to understand: When a company uses derivatives to hedge exposure to risks like changes in interest rates and fluctuations in foreign currencies, it wants those derivatives to qualify for hedge-accounting treatment under accounting rules because any changes in the derivatives' value can be excluded from current earnings. The value changes are "smoothed" into earnings over time. Without that special accounting status, the derivatives' ups and downs would make earnings unpredictable, which companies and shareholders dislike.

To qualify for hedge accounting, however, companies have to meet a strict set of criteria. And dozens have discovered lately that either they haven't fully complied or have cut corners they shouldn't have. Some have found their hedges don't do the job they're supposed to in offsetting the changes caused by the risk they're hedging. Others don't have sufficient documentation for their hedges.A

A number of companies are filing non-reliance 8-Ks because they have used the short cut method without ever having checked for hedge effectiveness in the firstplace. Here is the 8-K from Great Southern Bancorp. Remember one of the keys to applying the shortcut method is the that the features of the hedge match precisely the features of the instrument being hedged (i.e. there is no value at initiation):

On January 18, 2006, management and the Audit Committee of the Board of Directors of the Company determined that the Company's financial statements as of and for the quarters ended March 31, 2005, June 30, 2005 and September 30, 2005, and as of and for the years ended December 31, 2004, 2003, 2002 and 2001, should no longer be relied upon as a result of the accounting treatment applied by the Company in connection with certain interest rate swaps associated with brokered CDs.

Since mid-2000, the Company has entered into interest rate swap agreements to hedge the interest rate risk inherent in certain of its brokered certificates of deposit (CDs). From the inception of the hedging program, the Company has applied a method of fair value hedge accounting under Statement of Financial Accounting Standards ("SFAS") 133 to account for the CD swap transactions that allowed the Company to assume the effectiveness of such transactions (the so-called "short-cut" method). The Company has recently concluded, in conjunction with BKD, LLP, its independent registered public accounting firm at all relevant times, that the CD swap transactions did not qualify for this method in prior periods because the method to pay the related CD broker placement fee was determined, in retrospect, to have caused the swap to not have a fair value of zero at inception (which is required under SFAS 133 to qualify for the "short-cut" method). Although the impact of applying the alternative "long-haul" method of documentation using SFAS 133 and the results under the "short-cut" method are believed to result in no significant difference in the hedge effectiveness of the majority of these swaps, and management believes these interest rate swaps have been effective as economic hedges, hedge accounting under SFAS 133 is not allowed for the affected periods because the proper hedge documentation was not in place at the inception of the hedge.

The Company is charged a fee in connection with its acquisition of brokered CDs. This fee is not paid separately by the Company to the CD broker, but rather is built in as part of the overall rate on the interest rate swap. In connection with the restatement, the Company has determined that this broker fee should be accounted for separately as a prepaid fee at the origination of the brokered CD and amortized into interest expense over the maturity period of the brokered CD. If the Company calls the brokered CD (at par) prior to maturity, the remaining unamortized broker fee is expensed at that time. The remaining unamortized prepaid broker fees related to these brokered CDs at December 31, 2005, were $6.5 million.

International standards gain another partner

It appears that South Korea will adopt International Financial Reporting Standards starting in the second half of 2006.
"The preparatory body will hold monthly meeting starting next month to check the issues at hand," said Kim Yong-hwan, a director at the commission. "The commission formed the body to fit our accounting principles to international standards without giving any shock to local companies."

The pressure on the US, Japan and Australia will continue.

Hello

Hello, I am back from hiatus and will be back to blogging tomorrow.