CASE: An Oversight in Accounting for the Fair Value Option
Requirements
1. Prepare journal entries for the Senior Debt Facility Fixed Rate - Series A bond issued on January 1, 2005 with a stated coupon rate of 3.75% (payable annually) when the market rate was 3.97%. This bond matures in 20 years on December 31, 2025. As part of your response, prepare an amortization schedule for the bond.
2. On January 1, 2008, Larkin Bank elected the FVO for the Senior Debt Facility Fixed Rate - Series A bond (regular adopter) when the bond's fair value is $10.302 billion.
a. Prepare the journal entries necessary to implement the FVO on Senior Debt Facility Fixed Rate - Series A bond (assume any difference between the unpaid principal balance and fair value is due to Larkin Bank's own creditworthiness and ignore tax affects if any).
b. Determine the effect of this election on the bank's regulatory capital.
3. Assume Senior Debt Facility Fixed Rate - Series A was redeemed on December 31, 2019 when its fair value was $12.662 billion.
a. Prepare the journal entries to properly record the debt valuation adjustment and corresponding unrealized gain/loss for 2019 (ignore tax affects if any).
b. Prepare the journal entries to properly record the early redemption of this bond after the annual coupon has been paid and all fair value amounts have been updated through a debt valuation adjustment account (3a above). Assume this is the only instrument redeemed in 2019 and ignore tax affects if any. Any adjustments to unrealized gains/losses and debt valuation adjustment accounts should be made based on the remaining instruments in the portfolio.
c. What is the effect of this redemption on Larkin Bank's Tier 1 capital ratio (assume a dollar for dollar impact of the redemption on any effect on regulatory capital and ignore tax affects if any)?
d. Assume Larkin Bank improperly accounted for the regulatory capital impact of the realized gain/loss in (3c above) above as if it were an unrealized gain/loss. How might this improper treatment impact your answer in 3c?
e. It is possible that the improper treatment in 3d resulting in an accounting error was motivated by an effort to manage regulatory capital (Tier 1 capital). Do you believe management would intentionally misreport realized losses related to debt accounted for under the FVO? Why or why not?
4. Why might the banking industry motivate the accounting standard setters to continue to move toward a more fair value oriented accounting framework?
5. Provide insight on why the FASB made the FVO irrevocable.
6. With shareholders and lenders (i.e. investors in bonds issued by a bank) in mind, what are potential explanations for the FVO requiring the seemingly counterintuitive accounting treatment for fluctuations in fair values of financial liabilities.
7. Why might bank regulators prevent Larkin Bank from pursuing a stock repurchase program? A detailed answer will articulate the use of Tier 1 capital in assessing Larkin Bank's financial stability.
Attachment:- case.pdf