Luis E. Cabrera, CPA
American Institute of Certified Public Accountants
Cash is both the beginning and the end of the operating cycle (cash–inventory–sales–receivables–cash) in the typical business enterprise, and almost all transactions affect cash either directly or indirectly. Cash transactions are probably the most frequently recurring type entered into by a business because (except for barter transactions) every sale leads to a cash receipt and every expense to a cash disbursement. It is recognized as the most liquid of the assets, and thus has prominence for users who are focusing on issues of liquidity.
Cash derives its primary importance from its dual role as a medium of exchange and a unit of measure. As a medium of exchange, it has a part in the majority of transactions entered into by an enterprise. Assets are acquired and realized, and liabilities are incurred and liquidated, in terms of cash. Thus, cash is generally the most active asset possessed by a company. As a unit of measure, it sets the terms on which all properties and claims against the enterprise are stated in its financial statements. Price-change reporting, which addresses disclosures for fluctuations in value as general and specific price levels rise and fall, is discussed in Chapter 17.
The major challenge in accounting for cash is maintaining adequate control over the great variety and quantity of cash transactions. Cash receipts may come from such diverse sources as cash sales, cash on delivery (C.O.D.) transactions, collections on accounts and notes receivable, loans, security issues, income from investments, and sales of such properties as retired assets, scrap, and investments. Disbursements may be made for a variety of expense items, for cash purchases and in payment of various liabilities, for dividends and for taxes. Thus, the variety of cash transactions in itself presents inherent problems.
The quantity of cash transactions constitutes another source of difficulty. To handle expeditiously the volume of cash transactions calls for appropriate equipment, careful organization and segregation of duties, planning of procedures, and design of appropriate forms. Information as to available cash balances is of daily interest to the management of every business, and this information must be accurate and prompt if it is to be useful.
Companies sometimes misrepresent their cash balance to improve the appearance of their financial liquidity. This practice is sometimes called window dressing. Smith and Skousen describe this practice as follows:
Certain practices designed to present a more favorable financial condition than is actually the case may be encountered. For example, cash records may be held open for a few days after the close of a fiscal period and cash received from customers during this period reported as receipts of the preceding period. An improved cash position is thus reported. If this balance is then used as a basis for drawing predated checks in payment of accounts payable, the ratio of current assets to current liabilities is improved. The current ratio may also be improved by writing checks in payment of obligations and entering these on the books even though checks are not to be mailed until the following period.[264]
The presentation of cash in the balance sheet is largely an issue of appropriate classification and description. Because of its importance in evaluating an entity's financial condition, cash must be stated as accurately as possible. This calls for careful analysis of each component of cash so that no items will improperly be included in, or excluded from, current assets. In this connection, ARB No. 43, "Restatement and Revision of Accounting Research Bulletins" (Ch. 3, pars. 4–6), states, in part:
For accounting purposes, the term current assets is used to designate cash and other assets or resources commonly identified as those which are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business. Thus the term comprehends in general such resources as (a) cash available for current operations and items which are the equivalent of cash....
This concept of the nature of current assets contemplates the exclusion from that classification of such resources as: (a) cash and claims to cash which are restricted as to withdrawal or use for other than current operations, are designated for expenditure in the acquisition or construction of noncurrent assets, or are segregated for the liquidation of long-term debts....
As the one asset that is liquid, that is, expendable with no intermediary transactions or conversions, cash assumes the position of prime importance in the balance sheet and is generally presented as the first item among the assets of the enterprise. Four examples of presentation are:
Cash and cash equivalents
Cash
Cash and equivalents
Cash includes certificates of deposit or time deposits
Generally, the form shown in example 1 above is widely used, but the important point is that cash subject to withdrawal restrictions should not be combined with cash of immediate availability. In this regard, O'Reilly, et al state in Montgomery's Auditing: "The cash caption on the balance sheet should include cash on hand and balances with financial institutions that are immediately available for any purpose and cash equivalents."
Statement of Financial Accounting Standards (SFAS) No. 95, "Statement of Cash Flows" (par. 8), states that cash equivalents are short-term highly liquid investments that are both:
Readily convertible to known amounts of cash
So near their maturity that they present insignificant risk of changes in value because of changes in interest rates
Paragraph 8 also states that "generally only investments with original maturities of three months or less qualify under that definition." Original maturity is further defined as maturity to the entity holding the investment. The Statement clarifies that the maturity date must be three months from the date of its acquisition by the entity. Thus, a Treasury note purchased three years ago and held does not become a cash equivalent when its remaining maturity is three months. Cash equivalents include Treasury bills, commercial paper, and money market funds.
Cash exists both in physical and book entry forms: physical in the form of coin and paper currency as well as other negotiable instruments of various kinds, and book entry in various forms such as commercial bank deposits and savings deposits. In addition to coin and paper currency, other kinds of physical cash instruments that are commonly reported as cash for financial accounting purposes include certificates of deposit, bank checks, demand bills of exchange (in some cases), travelers' checks, post office or other money orders, bank drafts, cashiers' checks, and letters of credit.
All these forms of cash involve credit and depend for their ready acceptance on the integrity and liquidity of some person or institution other than those offering or accepting them as cash. This is true even for coin and paper currency which is, ultimately, dependent on the credit of the government issuing it. Given this integrity and liquidity, the book entry forms and other physical instruments are properly viewed as cash because of their immediate convertibility into cash in its currency form at the will of the holder. Convertibility in the case of savings accounts, certificates of deposit, and other time deposits may be something less than immediate depending on stipulated conditions imposed by the depository, but the assurance of such convertibility makes these items a generally accepted form of cash. However, only investments with original maturities of three months or less qualify for presentation as cash equivalents, as described above.
Cash restricted as to use by agreement, such as amounts deposited in escrow or for a specified purpose subject to release only at the order of a person other than the depositor, should not be classified in the balance sheet as cash and, unless deposited to meet an existing current liability, should presumably be excluded from current assets. Cash is sometimes received from customers in advance payment for work being performed under contract or under similar circumstances. Such cash is properly designated as cash in the balance sheet, but may be properly classified as a current asset only if the resulting customer's deposit is classified as a current liability. Cash restricted as to withdrawal because of inability of the depository to meet demands for withdrawal (such as deposits in banks in receivership) is not a current asset and should not be designated in the balance sheet as cash without an appropriate qualifying caption.
In regard to cash awaiting use for construction or other capital purposes or held for the payment of long-term debt, O'Reilly, et al. state:
Cash sometimes includes balances with trustees, such as sinking funds or other amounts not immediately available, for example, those restricted to uses other than current operations, designated for acquisition or construction of noncurrent assets, or segregated for the liquidation of long-term debt. Restrictions are considered effective if the company clearly intends to observe them, even though the funds are not actually set aside in special bank accounts. The facts pertaining to those balances should be adequately disclosed, and the amounts should be properly classified as current or noncurrent.[265]
Overdrafts may be of two kinds: (1) an actual bank overdraft, resulting from payment by the bank of checks in an amount exceeding the balance available to cover such checks; (2) a book overdraft, arising from issuance of checks in an amount in excess of the balance in the account on which drawn, although such checks have not cleared through the bank in an amount sufficient to exhaust the account.
Actual bank overdrafts represent the total of checks honored by the bank without sufficient funds in the account to cover them; such an overdraft is the bank's way of temporarily loaning funds to its customer. Accordingly, bank overdrafts (other than those that arise in connection with a "zero-balance" or similar arrangement with a bank) represent short-term loans and should be classified as liabilities if the right of offset does not exist.
Book overdrafts representing outstanding checks in excess of funds on deposit should generally be classified as liabilities and cash reinstated at the balance sheet date. Such credit book balances should not be viewed as offsets to other cash accounts except where the legal right of setoff exists within the same bank due to the existence of other positive balances in that bank.
FASB Interpretation (FIN) No. 39, "Offsetting of Amounts Related to Certain Contracts," provides guidance on whether the right of offset has been met. Where right of setoff does not exist, the credit balance can be viewed as a reinstatement of the liabilities that were cleared in the bookkeeping process. When outstanding checks in excess of funds on deposit are reclassified, it is preferable that they be separately classified; if they are included in accounts payable, the amounts so included should be disclosed, if material. Reclassifying as a liability all outstanding checks (including those covered by funds on deposit in the bank account concerned) is generally not considered acceptable.
Cash in foreign countries may properly be included in the balance sheet as cash if stated at its equivalent in U.S. currency at the prevailing rate of exchange and if no exchange restrictions exist to prevent the transfer of such monies to the domicile of the owner. Depending on circumstances and the extent to which such cash balances may be subject to exchange control or other restrictions, the amount of cash so included should be considered for disclosure, either by being stated separately, parenthetically, or otherwise. The question of exchange restrictions (or economic conditions) preventing transfer of cash across national boundaries is of prime importance, and cash in foreign countries should be classified as a current asset only if appropriate review establishes that no significant restrictions or conditions exist with respect to the amounts involved. If restrictions exist but ultimate transfer seems probable, the cash may be included in the balance sheet in a noncurrent classification.
Difficulty in stating foreign cash balances at their equivalent in U.S. currency occurs when more than one rate of exchange exists. In this situation, the use of an exchange rate related to earnings received from the foreign subsidiary for the purpose of translating foreign currency accounts is recommended. SFAS No. 52, "Foreign Currency Translation," (pars. 26–28) provides guidance on the selection of exchange rates.
It is not uncommon for banks to require that a current or prospective borrower maintain a compensating balance on deposit with the bank. Frequently, the required compensating balance is based on the average outstanding loan balance. A compensating deposit balance may also be required to assure future credit availability (including maintenance of an unused line of credit). The compensating balance requirement may be (1) written into a loan or line of credit agreement, (2) the subject of a supplementary written agreement, or (3) based on an oral understanding. In some instances, a fee is paid on an unused line of credit (or commitment) to ensure credit availability.
The Securities and Exchange Commission (SEC) originally defined compensating balances in ASR No. 148 as follows:
A compensating balance is defined as that portion of any demand deposit (or any time deposit or certificate of deposit) maintained by a corporation (or by any other person on behalf of the corporation) which constitutes support for existing borrowing arrangements of the corporation (or any other person) with a lending institution. Such arrangements would include both outstanding borrowings and the assurance of future credit availability.
For SEC registrants, requirements for the disclosure of restrictions on the withdrawal or use of cash and cash items, such as compensating balance arrangements, are set forth in Rule 5-02.1 of Regulation S-X as follows:
CASH AND CASH ITEMS.
Separate disclosure shall be made of the cash and cash items which are restricted as to withdrawal or usage. The provisions of any restrictions shall be described in a note to the financial statements. Restrictions may include legally restricted deposits held as compensating balances against short-term borrowing arrangements, contracts entered into with others, or company statements of intention with regard to particular deposits; however, time deposits and short-term certificates of deposit are not generally included in legally restricted deposits. In cases where compensating balance arrangements exist but are not agreements which legally restrict the use of cash amounts shown on the balance sheet, describe in the notes to the financial statements these arrangements and the amount involved, if determinable, for the most recent audited balance sheet required and for any subsequent unaudited balance sheet required in the notes to the financial statements. Compensating balances that are maintained under an agreement to assure future credit availability shall be disclosed in the notes to the financial statements along with the amount and terms of such agreement.
Guidelines and interpretations for disclosure are in FRR No. 203 and Staff Accounting Bulletin (SAB) Topic 6H. These provide useful information in evaluating the need for segregation and disclosure of compensating balance arrangements, including determination of the amount to be disclosed. Cash float and other factors should be considered.
Although no other authoritative literature requires compensating balance disclosures in the financial statements of non-SEC registrants, disclosure of material compensating balances will usually be necessary for fair presentation of the financial statements in accordance with generally accepted accounting principles (GAAP). Consequently, the disclosure of material compensating balance arrangements in financial statements of non-SEC reporting companies, whether maintained under a written agreement or under an informal agreement confirmed by the bank, is usually considered necessary as an "informative disclosure" under the third standard of reporting. It should be noted that compensating balances may also relate to an agreement or an understanding relative to future credit availability (including unused lines of credit). Compensating balances related to future credit availability should be disclosed as well as those related to outstanding borrowings.
In circumstances where compensating balances relative to outstanding loans and future credit availability are not legally restricted as to withdrawal, note disclosure is appropriate.
Cash that is not subject to withdrawal should be classified as a noncurrent asset to the extent such cash relates to the noncurrent portion of the debt that causes its restriction. To the extent legally restricted cash relates to short-term borrowings, it may be included with unrestricted amounts on one line in financial statements of non-SEC reporting companies provided the caption is appropriate and there is disclosure of the restricted amounts in the notes, for example, "Cash and restricted cash (Note 3)." Rule 5-02.1 of Regulation S-X requires SEC-reporting companies to disclose separately funds legally restricted as to withdrawal, but FRR No. 203.02.b is more specific in its requirement to segregate all legally restricted cash in the balance sheet.
No single example is appropriate for the disclosure of all compensating balance arrangements and future credit availability (including unused lines of credit) because the terms of loan agreements vary greatly. However, the following hypothetical examples illustrate methods of disclosing the details of compensating balance agreements and future credit availability.
The following is an example of disclosure where withdrawal of the compensating balance was legally restricted at the date of the balance sheet.
CASH ITEMS DISCLOSED ON BALANCE SHEET
SEC-Reporting Companies
Current assets
Cash
$3,500,000
Restricted cash compensating balances (Note X)
6,500,000
Non-SEC Reporting Companies
Current assets
Cash and restricted cash (Note X)
$9,500,000
Note X. Compensating Balances
A maximum of $100,000,000 is available to the company under a revolving credit agreement. Under the terms of the agreement, the company is required to maintain on deposit with the bank a compensating balance, restricted as to use, of 10 percent of the outstanding loan balance. At December 31, 20XX, $6,000,000 of the cash balance shown in the balance sheet was so restricted after adjusting for differences of "float" between the balance shown by the books of the company and the records of the bank.
For SEC-reporting companies, the following disclosure should be added to the above note:
This "float" amount consisted of $3,000,000 of unpresented checks less $500,000 of deposits of delayed availability at the agreed-upon schedule of 1.5 days' deposits.
The following is an example of disclosure for both SEC and non-SEC reporting companies where withdrawal of the compensating balance was not legally restricted at the date of the balance sheet.
Current assets
Cash (Note X)
$10,000,000
Note X. Compensating Balances
Under an informal agreement with a lending bank, the company maintains on deposit with the bank a compensating balance of 5 percent of an unused line of credit and 10 percent of the outstanding loan balance. At December 31, 20XX approximately $5,800,000 of the cash balance shown in the balance sheet represented a compensating balance.
Rules 5-02.19 and 22 of Regulation S-X require that the amount and terms (including commitment fees and the conditions under which commitments may be withdrawn) of unused lines of credit or unused commitments for financing arrangements be disclosed. The term unused lines of credit is used for short-term financing arrangements; the term unused commitments refers to long-term financing arrangements. The requirements of Regulation S-X are as follows:
5.02.19 ACCOUNTS AND NOTES PAYABLE. (b) The amount and terms (including commitment fees and the conditions under which lines may be withdrawn) of unused lines of credit for short-term financing shall be disclosed, if significant, in the notes to the financial statements. The weighted average interest rate on short term borrowings outstanding as of the date of each balance sheet presented shall be furnished in a note. The amount of these lines of credit which support a commercial paper borrowing arrangement or similar arrangements shall be separately identified.
5.02.22. BONDS, MORTGAGES, AND OTHER LONG TERM DEBT, INCLUDING CAPITALIZED LEASES. (b) The amount and terms (including commitment fees and the conditions under which commitments may be withdrawn) of unused commitments for long-term financing arrangements that would be disclosed under this rule if used shall be disclosed in the notes to the financial statements if significant.
Many future credit arrangements are informal. Even formal arrangements may be withdrawn by lending institutions on very short notice, usually resulting from an adverse change in the financial position of a company. Therefore, limitations relating to the subsequent use of such lines of credit make it particularly difficult to provide informative and adequate disclosure so that the reader does not get a more favorable picture than is warranted. Because of the uncertainty of the duration of some lines of credit, disclosure of these types of lines of credit in financial statements requires the exercise of individual judgment based on the facts of the particular situation, and disclosures should include the limitations and conditions of subsequent use. Unused lines of credit or commitments that may be withdrawn at the mere option of the lender need not be disclosed but, if disclosed, the nature of the arrangement should be disclosed as well.
Disclosure of lines of credit and other borrowing arrangements is generally not considered to be essential information in financial statements of non-SEC reporting companies. In certain cases, however, such as when unused lines of credit support outstanding commercial paper, this type of information may be significant in evaluating financial position. Where this is so, disclosure of future credit availability under written or informal agreements would be necessary for a fair presentation, provided the unused credit may not be withdrawn solely at the option of the would-be lender. A fee paid on an unused line of credit or commitment would provide evidence of a binding agreement, as would maintenance of a compensating balance for this purpose.
A commitment fee has an effect on the cost of borrowing that is similar to that of a compensating balance. If a fee is paid to a lending bank for an unused line of credit or commitment, such fee should be disclosed if significant (Rule 502.19b of Regulation S-X).
The following is an example of disclosure of binding bank credit arrangements. Information of this nature may be combined with note disclosure of indebtedness.
Note X. Unused Lines of Credit
Bank lines of credit under which notes payable of $105,000,000 were outstanding at December 31, 20XX, aggregated $152,500,000. The use of these lines generally is restricted to the extent that the Company is required periodically to liquidate its indebtedness to individual banks for 30 to 60 days each year. Borrowings under such agreements are at interest rates ranging from 1/4 -to 1/2 of 1% above the prime rate, plus a commitment fee of 1/4 to 1/2 of 1% on the unused available credit. Commitments by the banks generally expire one year from the date of the agreement and are generally renewed.
For SEC-reporting companies the following disclosure should be added to the above note:
Total commitment fees paid on the unused lines of credit amounted to $175,000 for 20XX, $195,000 for 20XX, and $180,000 for 20XX.
Disclosures related to cash balances should include the existence of uninsured cash balances that represent a significant concentration of credit risk. American Institute of Certified Public Accountants (AICPA) Technical Practice Aid No. 2110.06, "Disclosure of Cash Balances in Excess of Federally Insured Amounts," provides the following guidance:
Inquiry. Should the existence of cash on deposit with banks in excess of Federal Deposit Insurance Corporation (FDIC)-insured limits be disclosed in the financial statements? Reply. The existence of uninsured cash balances should be disclosed if the uninsured balances represent a significant concentration of credit risk. Credit risk is defined in FASB Statement No. 105, "Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk," Paragraph 7 (AC F25.107), as "the possibility that a loss may occur from the failure of another party to perform according to the terms of the contract." As a result, bank statement balances in excess of FDIC-insured amounts represent credit risk.
An example of disclosure for this circumstance might be:
The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such account. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents.
SFAS No. 107, "Disclosure about Fair Value of Financial Instruments," requires disclosure of fair values of all financial instruments. The disclosure should include the method and significant assumptions used to estimate fair value. Due to the short-term maturity of cash and cash equivalents, this requirement is often met by the following sample disclosure:
Cash and Cash Equivalents. The carrying amount approximates fair value because of the short-term maturity of those instruments.
With some transfers of financial assets, the transferor has some continuing involvement with the transferred assets or with the transferee. Over the past few decades, these arrangements have grown in volume, variety, and complexity. Those transfers raise the issues of whether transferred financial assets should be considered to be sold and a related gain or loss recorded or whether the assets should be considered to be collateral for borrowings and the transfer not recognized. An entity may sell financial assets and receive in exchange cash or other assets that are unrelated to the assets sold so that the transferor has no continuing involvement with the assets sold. Alternatively, an entity may borrow money and pledge financial assets as collateral, or engage in any of a variety of transactions that transfer financial assets to another entity with the transferor having some continuing involvement with the assets transferred. Examples of continuing involvement include recourse or guarantee obligations, servicing, agreements to repurchase or redeem, and put or call options on the assets transferred. Many transactions disaggregate financial assets into separate components by creating undivided interests in pools of financial assets that frequently reflect multiple participations (often referred to as tranches) in a single pool. The components created may later be recombined to restore the original assets or may be combined with other financial assets to create still different assets. An entity also may enter into transactions that change the characteristics of an asset that the entity continues to hold. An entity may sell part of an asset, or an undivided interest in the asset, and retain part of the asset. In some cases, it has not been clear what the accounting should be. An entity may settle a liability by transferring assets to a creditor and obtaining an unconditional release from the obligation. Alternatively, an entity may arrange for others to settle or set aside assets to settle a liability later. To address these issues, the Financial Accounting Standards Board (FASB) issued guidance as described below.
The FASB issued its SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," in September 2000 to replace its Statement No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities."[266] Though it replaces Statement No. 125 in its entirety, Statement No. 140 carries forward most of the provisions of Statement No. 125. Like Statement No. 125, the Statement No. 140 employs a "financial-components approach" that focuses on control and recognizes that financial assets and liabilities can be divided into several components. Under that approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished.
Statement No. 140 distinguishes transfers of financial assets that are sales from transfers that are secured borrowings, and addresses servicing assets and liabilities, financial assets subject to prepayment and secured borrowing and collateral, and extinguishments of liabilities. It also provides implementation guidance for assessing isolation of transferred assets, conditions that constrain a transferee, conditions for an entity to be a qualifying special purpose entity (SPE), accounting for transfers of partial interests, measurement of retained interests, servicing of financial assets, securitizations, transfers of sales-type and direct financing lease receivables, securities lending transactions, repurchase agreements including "dollar rolls," "wash sales," loan syndications and participations, risk participations in banker's acceptances, factoring arrangements, transfers of receivables with recourse, and extinguishments of liabilities. Statement 140 also provides guidance about whether a transferor has retained effective control over assets transferred to qualifying SPE through removal-of-accounts provisions, liquidation provisions, or other arrangements.
Statement No. 125 was effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after December 31, 1996, and on or before March 31, 2001, except for certain provisions. Statement 127 deferred until December 31, 1997, the effective date (a) of paragraph 15 of Statement 125 and (b) for repurchase agreement, dollar-roll, securities lending, and similar transactions, of paragraphs 9–12 and 237(b) of Statement 125. Statement No. 140 is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001 and is effective for recognition and reclassification of collateral and for disclosures relating to securitization transactions and collateral for fiscal years ending after December 15, 2000. Disclosures about securitization and collateral accepted need not be reported for periods ending on or before December 15, 2000, for which financial statements are presented for comparative purposes. Statement No. 140 is to be applied prospectively with certain exceptions. Other than those exceptions, earlier or retroactive application of its accounting provisions is not permitted.
The following is a brief overview about securitizations. Securitizations are also discussed in Chapter 31. As discussed in paragraph 73–76 of Statement No. 140:
financial assets such as mortgage loans, automobile loans, trade receivables, credit card receivables, and other revolving charge accounts are commonly transferred in securitizations. Securitizations of mortgage loans may include pools of single-family residential mortgages or other types of real estate mortgage loans, for example, multifamily residential mortgages and commercial property mortgages. Securitizations of loans secured by chattel mortgages on automotive vehicles as well as other equipment (including direct financing or sales-types leases) are also common. Both financial and nonfinancial assets can be securitized; life insurance policy loans, patent and copyright royalties, and even taxi medallions have also been securitized. But securitizations of nonfinancial assets are outside the scope of Statement No. 140.
An originator of a typical securitization (the transferor) transfers a portfolio of financial assets to an SPE, commonly a trust. In "pass-through" and "pay-through" securitizations, receivables are transferred to the SPE at the inception of the securitization, and no further transfers are made; all cash collections are paid to the holders of beneficial interests in the SPE. In "revolving-period" securitizations, receivables are transferred at the inception and also periodically (daily or monthly) thereafter for a defined period (commonly three to eight years), referred to as the revolving period. During the revolving period, the SPE uses most of the cash collections to buy additional receivables from the transferor on prearranged terms.
Beneficial interests in the SPE are sold to investors, and the proceeds are used to pay the transferor for the assets transferred. The beneficial interests may comprise either a single class having equity characteristics or multiple classes of interests, some having debt characteristics and others having equity characteristics. The cash collected from the portfolio is distributed to the investors and others as specified by the legal documents that established the SPE.
Pass-through, pay-through, and revolving-period securitizations that meet the criteria in paragraph 9 of Statement No. 140 for transfers in which the transferor surrenders control over the financial assets and thus qualify for sale accounting. All financial assets obtained or retained and liabilities incurred by the originator of a securitization that qualifies as a sale are recognized and measured as provided in Section 18-4(c)(ii) that includes the implicit forward contract to sell new receivables during a revolving period, which may become valuable or onerous to the transferor as interest rates or other market conditions change.
Revolving-period securitizations and isolation of transferred assets in securitizations are discussed in paragraphs 77–84 of the statement.
A qualifying SPE, also referred to as a QSPE, is not consolidated in the financial statements of a transferor or its affiliates. A qualifying SPE is a trust or other legal vehicle that meets all the conditions described in paragraph 35 of Statement No. 140.
Transfers of all or a portion of a financial asset, for example, a loan, are accounted for as either sales or secured borrowings with a pledge of collateral, depending on the circumstances. Transfers of financial assets should be accounted for as a sale if the transferor surrenders control over those financial assets. Control is considered to have been surrendered if and only if all the following three conditions are met. Paragraph 9 of Statement 140 states that:
"The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership." Paragraphs 27–28 provide implementing guidance. The nature and extent of evidence required to support an assertion that has been accomplished depend on the facts and circumstances. All available evidence that supports or questions the assertion is considered. Judgment is required as to:
Whether the contract or circumstances permit the transferor to revoke the transfer
The kind of bankruptcy or other receivership into which the transferor or SPE might be placed
Whether a transfer of financial assets would likely be deemed a true sale at law
Whether the transferor is affiliated with the transferee
Other factors under pertinent law
Derecognition requires evidence providing reasonable assurance that the transferred assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor or any consolidated affiliate of the transferor that is not a special-purpose corporation or other entity designed to make remote the possibility that it would enter bankruptcy or other receivership.
"Each transferee (or, if the transferee is a qualifying SPE, each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor." Paragraphs 29–35 provide implementing guidance.
"The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call." (As discussed in the Glossary, a cleanup call is "an option held by the servicer or its affiliate, which may be the transferor, to buy the remaining transferred financial assets or the remaining beneficial interests not held by the transferor, its affiliates, or its agents in a qualifying SPE—or in a series of beneficial interests in transferred assets within a qualifying SPE, if the amount of outstanding assets or beneficial interests falls to a level at which the cost of servicing the assets or beneficial interests becomes burdensome in relation to the benefits of servicing.") Paragraphs 47–54 provide implementing guidance.
As stated in paragraph 10 of Statement No. 140, on completion of any transfer of financial assets, the transferor should:
"Continue to carry in its statement of financial position any retained interest in the transferred assets, including, if applicable, servicing assets, beneficial interests in assets transferred to a qualifying SPE in a securitization and retained undivided interests." Paragraph 58–59, 61–67, and 73–84 of Statement No. 140 provides implementing guidance.
"Allocate the previous carrying amount between the assets sold, if any, and the retained interests, if any, based on their relative fair values at the date of transfer."
Once a transfer of financial assets that meets the aforementioned conditions is completed, the transfer is accounted for as a sale only to the extent that consideration other than beneficial interests (i.e., rights to receive all or a portion of specified cash flows) in the transferred assets is received in exchange. As stated in paragraphs 11 and 12, the transferor shall:
"Derecognize all assets sold.
Recognize all assets obtained and liabilities incurred in consideration as proceeds of the sale, including cash; put or call options held or written, such as guarantee or recourse obligations; forward commitments, such as commitments to deliver additional receivables during the revolving periods of some securitizations; swaps, such as provisions that convert interest rates from fixed to variable; and servicing liabilities, if applicable." Paragraph 56, 57, and 61–67 of Statement No. 140 provides implementing guidance.
"Initially measure at fair value assets obtained and liabilities incurred in a sale or, if it is not practicable to estimate the fair value of an asset or a liability, apply alternative measures." Paragraph 71–72 of Statement No. 140 provides implementing guidance.
"Recognize in earnings any gain or loss on the sale."
The transferee shall recognize all assets obtained and any liabilities incurred and initially measures them at fair value (in aggregate, presumptively the price paid). If a transfer of financial assets in exchange for cash or other considerations (other than beneficial interests in the transferred assets) does not meet the criteria for a sale, the transferor and the transferee account for the transfer as a secured borrowing with pledge of collateral," as discussed below.
As discussed in paragraph 15 of Statement 140, "a debtor may grant a security interest in certain assets to a lender (the secured party) to serve as collateral for its obligation under a borrowing, with or without recourse to other assets of the debtor. An obligor under other kinds of current or potential obligations, for example, interest rate swaps, also may grant a security interest in certain assets to a secured party. If collateral is transferred to the secured party, the custodial arrangement is commonly called a pledge. Secured parties sometimes are permitted to sell or repledge (or otherwise transfer) collateral held under a pledge. The same relationships occur, under different names, in transfers documented as sales that are accounted for as secured borrowings. The accounting for noncash collateral by the debtor (or obligor) and the secured party depends on whether the secured party has the right to sell or repledge the collateral and on whether the debtor has defaulted.
If the secured party (transferee) has the right by contract or custom to sell or repledge the collateral, the debtor (transferor) reclassifies the asset and reports it in its statement of financial position separately (e.g., as security pledged to creditors) from other assets not so encumbered.
The sale of collateral is a transfer subject to the provisions of this Statement.
If the debtor defaults under the terms of secured contract and is no longer entitled to redeem the pledged asset, it derecognizes the pledged asset, and the secured party recognizes the collateral as its asset initially measured at fair value or, if it has already sold the collateral, derecognizes its obligation to return the collateral.
Except as provided in item c above, the debtor continues to carry the collateral as its asset, and the secured party does not recognize the pledged asset."
As discussed in paragraph 14: "Interest-only strips, retained interests in securitizations, loans, other receivables, or other financial assets that can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment, except for instruments that are within the scope of Statement 133, shall be subsequently measured like investments in debt securities classified as available-for-sale or trading under Statement 115, as amended."
Paragraph 13 of Statement 140 discusses servicing assets and liabilities as follows:
Each time an entity undertakes an obligation to service financial assets it recognizes either a servicing asset or a servicing liability for the servicing contract, unless it transfers the assets to a qualifying SPE in a guaranteed mortgage securitization, retains all of the resulting securities, and classifies them as debt securities held to maturity in conformity with FASB Statement No. 115. If the servicing asset or liability was purchased or assumed rather than undertaken in a sale or securitization of the financial assets being serviced, it shall measured initially at its fair value, presumptively the price paid. A servicing asset or liability shall be amortized in proportion to and over the period of estimated net servicing income (if servicing revenues exceed servicing costs) or net servicing loss (if servicing costs exceed servicing revenues). A servicing asset or liability shall be assessed for impairment or increased obligation based on its fair value. Paragraph 61–64 of Statement No. 140 provides implementing guidance.
Servicing of mortgage loans, credit card receivables, or other financial assets commonly includes collecting principal, interest, and escrow payments from borrowers; paying taxes and insurance from escrowed funds; monitoring delinquencies; executing foreclosure if necessary; temporarily investing funds pending distribution; remitting fees to guarantors, trustees, and others providing services; and accounting for and remitting principal and interest payments to the holders of the interests in the financial assets. While servicing is inherent in all financial assets, it becomes a distinct asset or liability only when contractually separated from the underlying assets by sale or securitization of the assets with servicing retained or separate purchase or assumption of the servicing. Servicing is most common in the financial institution and mortgage banking industries. Accordingly, this topic is also addressed in Chapter 31.
As discussed in paragraphs 96–100 of Statement 140:
Government securities dealers, banks, other financial institutions, and corporate investors commonly use repurchase agreements to obtain or use short-term funds. Under those agreements, the transferor ("repo-party") transfers a security to a transferee ("repo-counterparty" or "reverse party") in exchange for cash and concurrently agrees to reacquire the security at a future date for an amount equal to the cash exchanged plus a stipulated "interest" factor.
Other securities or letters of credit sometimes are exchanged. Those transactions are accounted for in the same manner as securities lending transactions.
Repurchase agreements can be put into effect in a variety of ways. Some are similar to securities lending transactions in that the transferee has the right to sell or repledge the securities to a third party during the term of the agreement. In others, the transferee does not have the right to sell or repledge the securities during the term of the agreement. For example, in a tri-party repurchase agreement, the transferor transfers securities to an independent third-party custodian that holds them during the term of the agreement. Also, many repurchase agreements are for short terms, often overnight, or have indefinite terms that allow either party to terminate the arrangement on short notice. However, other repurchase agreements are for longer terms, sometimes until the maturity of the transferred asset. Some repurchase agreements call for repurchase of securities that need not be identical to the securities transferred.
If the criteria in paragraph 9 are met, the transferor accounts for a repurchase agreement as a sale of financial assets and a forward repurchase commitment, and the transferee accounts for the agreement as a purchase of financial assets and a forward resale commitment. Other transfers accompanied by an agreement to repurchase the transferred assets that are accounted for as sales include transfers with agreements to repurchase at maturity and transfers with repurchase agreements in which the transferee has not obtained collateral sufficient to fund substantially all the cost of buying replacement assets.
Furthermore, "wash sales" previously not recognized if the same financial asset was bought soon before or after the sale are accounted for as sales. Unless there is a concurrent contract to repurchase or redeem the transferred financial assets from the transferee, the transferor does not maintain effective control over the transferred assets.
As with securities lending transactions, under many agreements to repurchase transferred assets before their maturity the transferor maintains effective control over the assets. Repurchase agreements that do not meet all the criteria in paragraph 9 are treated as secured borrowings. Fixed-coupon and dollar-roll repurchase agreements, and other contracts under which the securities to be repurchased need not be the same as the securities sold, qualify as borrowings if the return of substantially the same securities as those concurrently transferred is assured. Therefore, those transactions are accounted for as secured borrowings by both parties to the transfer.
If a transferor has transferred securities to an independent third-party custodian, or to a transferee, under conditions that preclude the transferee from selling or repledging the assets during the term of the repurchase agreement (as in most tri-party repurchase agreements), the transferor has not surrendered control over those assets.
Loan syndications, loan participations, and banker's acceptances are most common in the financial institution industry and are also addressed in Chapter 31.
As discussed in paragraphs 102–103 of Statement 140:
Borrowers often borrow amounts greater than any one lender is willing to lend. Therefore, groups of lenders commonly jointly fund the loans. That may be accomplished by a syndication under which several lenders share in lending to a single borrower, but each lender loans a specific amount to the borrower and has the right to repayment from the borrower.
A loan syndication is not a transfer of financial assets. Each lender in the syndication accounts for the amounts it is owed by the borrower. Repayments by the borrower may be made to a lead lender that then distributes the collections to the lenders of the syndicate. In those circumstances, the lead lender is simply functioning as a servicer and, therefore, does not recognize the aggregate loan as an asset.
As discussed in paragraphs 104–106 of Statement 140:
Groups of banks or other entities also may jointly fund large borrowings through loan participations in which a single lender makes a large loan to a borrower and subsequently transfers undivided interests in the loan to other entities.
Transfers by the originating lender may take the legal form of either assignments or participations. The transfers are usually nonrecourse, and the transferor ("originating lender") continues to service the loan. The transferee ("participating entity") may or may not have the right to sell or transfer its participation during the term of the loan, depending on the terms of the participation agreement.
If the loan participation agreement gives the transferee the right to pledge or exchange those participations and the other criteria in paragraph 9 are met, the transfers to the transferee are accounted for by the transferor as sales of financial assets. A transferor's right of first refusal on a bona fide offer from a third party, a requirement to obtain the transferor's permission that shall not be unreasonably withheld, or a prohibition on sale to the transferor's competitor if other potential willing buyers exist is a limitation on the transferee's rights but presumptively does not constrain a transferee from exercising its right to pledge or exchange. However, if the loan participation agreement constrains the transferees from pledging or exchanging their participations, the transferor presumptively receives a more than trivial benefit, has not relinquished control over the loan, and accounts for the transfers as secured borrowings.
As discussed in paragraphs 107–110 of Statement 140:
Banker's acceptances provide a way for a bank to finance a customer's purchase of goods from a vendor for periods usually not exceeding six months. Under an agreement among the bank, the customer, and the vendor, the bank agrees to pay the customer's liability to the vendor on presentation of specified documents that provide evidence of delivery and acceptance of the purchased goods. The principal document is a draft or bill of exchange drawn by the customer that the bank stamps to signify its "acceptance" of the liability to make payment on the draft on its due date.
Once the bank accepts a draft, the customer is liable to repay the bank at the time the draft matures. The bank recognizes a receivable from the customer and a liability for the acceptance it has issued to the vendor. The accepted draft becomes a negotiable financial instrument. The vendor typically sells the accepted draft at a discount either to the accepting bank or in the marketplace.
A risk participation is a contract between the accepting bank and a participating bank in which the participating bank agrees, in exchange for a fee, to reimburse the accepting bank in the event that the accepting bank's customer fails to honor its liability to the accepting bank in connection with the banker's acceptance. The participating bank becomes a guarantor of the credit of the accepting bank's customer.
An accepting bank that obtains a risk participation does not derecognize the liability for the banker's acceptance, because the accepting bank is still primarily liable to the holder of the banker's acceptance even though it benefits from a guarantee of reimbursement by a participating bank. The accepting bank does not derecognize the receivable from the customer because it has not transferred the receivable: It controls the benefits inherent in the receivable, and it is still entitled to receive payment from the customer. However, the accepting bank records the guarantee purchased, and the participating bank records a liability for the guarantee issued.
As discussed in paragraph 112 of Statement 140: "Factoring arrangements are a means of discounting accounts receivable on a nonrecourse, notification basis. Accounts receivable are sold outright, usually to a transferee (the factor) that assumes the full risk of collection, without recourse to the transferor in the event of a loss. Debtors are directed to send payments to the transferee. Factoring arrangements that meet the criteria in paragraph 9 of SFAS 140 are accounted for as sales of financial assets because the transferor surrenders control over the receivables to the factor."
As discussed in paragraphs 113 of Statement 140:
In a transfer of receivables with recourse, the transferor provides the transferee with full or limited recourse. The transferor is obligated under the recourse provision to make payments to the transferee or to repurchase receivables sold under certain circumstances, typically for defaults up to a specified percentage. The effect of a recourse provision on the application of the criteria in paragraph 9 may vary by jurisdiction. In some jurisdictions, transfers with full recourse may not place transferred assets beyond the reach of the transferor and its creditors, but transfers with limited recourse may. A transfer of receivables with recourse is accounted for as a sale, with the proceeds of the sale reduced by the fair value of the recourse obligation, if the criteria in paragraph 9 are met. Otherwise, a transfer of receivables with recourse is accounted for as a secured borrowing.
As discussed in paragraphs 114 of Statement 140:
If a creditor releases a debtor from primary obligation on the condition that a third party assumes the obligation and that the original debtor becomes secondarily liable, the release extinguishes the original debtor's liability. However, in those circumstances, regardless of whether explicit consideration was paid for the guarantee, the original debtor becomes a guarantor. As such, it recognizes a guarantee obligation in the same manner as would a guarantor that had never been primarily liable to the creditor, with due regard for the likelihood that the third party will carry out its obligations. The guarantee obligation is initially measured at fair value, and that amount reduces or increases the loss recognized on extinguishment.
FASB Statement No. 140 (par. 17) requires a reporting entity to disclose certain matters relating to collateral, certain debt extinguishments, assets designated for satisfying scheduled payments, description on assets and liabilities for which it not practicable to estimate fair values, servicing assets and liabilities, securitized assets and retained interests. Additional issues and disclosure requirements that are more prevalent for financial institutions—for example, servicing assets and liabilities—are discussed in Chapter 31. Issues and disclosure requirements related to extinguishments of liabilities are discussed in Chapter 25.
Although not the primary focus of their business, manufacturers, wholesalers, retailers, and service companies may nevertheless originate loans in connection with their revenue-generating activities. FASB Statement 114, "Accounting by Creditors for Impairment of a Loan," which applies to all creditors and defines a loan, in paragraph 4, as:
a contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset in the creditor's statement of financial position. Examples include but are not limited to accounts receivable (with terms exceeding one year) and notes receivable.
However, there are certain requirements, as discussed below, for any type of credit arrangement, including trade receivables. In contrast, one of the most significant activities for financial institutions is the origination and acquisition of loans in order to generate interest revenue. Chapter 31 discusses matters of interest to financial institutions and entities involved in lending and deposit taking activities.
Upon origination or acquisition, loans are generally recorded at their present value. Par. 8a of Statement of Position(SOP) 01-6, "Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others," states that:
Loans and trade receivables that management has the intent and ability to hold for the foreseeable future or until maturity or payoff should be reported in the balance sheet at outstanding principal adjusted for any chargeoffs, the allowance for loan losses (or the allowance for doubtful accounts), any deferred fees or costs on originated loans, and any unamortized premiums or discounts on purchased loans.
Generally, interest income on loans is accrued at the contractual rate, and premiums and discounts are amortized using the interest method in accordance with FASB Statement 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases." In addition, loans are generally presented in the statement of financial position at amortized cost. Accounting Principles Board (APB) Opinion No. 21, "Interest on Receivables and Payables" discusses the appropriate accounting when the face amount of a note does not reasonably represent the present value1 of the consideration given or received in the exchange. APB 21 (par. 3) excludes from its scope "receivables and payables arising from transactions with customers or suppliers in the normal course of business which are due in customary trade terms not exceeding approximately one year" and "transactions between parent and subsidiary companies and between subsidiaries of a common parent."
Noninterest bearing loans, loans with unrealistic interest rates, and loans obtained in exchange for property, goods, or services with fair values materially different from the principal amount of the loan lead to the recognition of premiums and discounts. APB Opinion No. 21 (par. 16) requires discounts and premiums to be reported "as a direct deduction from or addition to the face amount of the [loan]." Appendix A of APB Opinion No. 21 provides illustrations of the appropriate balance sheet presentation.
Nonrefundable fees and costs associated with an entity's lending activities are discussed in FASB Statement No. 91, Such considerations are most prevalent for financial institutions and the accounting for these fees and costs is discussed in Chapter 31.
Some acquired loans may have experienced a decline in credit quality. SOP 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" addresses the accounting and reporting for those loans. Loans that have been acquired should be evaluated to determine whether the provisions of SOP 03-3 should be applied.
Statement of Financial Accounting Concepts No. 6, "Elements of Financial Statements," defines assets as "probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events" (par. 25). FASB Statement No. 5, "Accounting for Contingencies" and FASB Statement No. 114 address the accounting by creditors for impairment of certain loans. The Statements indicate that a loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement." It applies to all creditors. While both statements address loan impairment, Statement No. 5 generally addresses smaller balance homogenous loans while Statement No. 114 addresses all loans except those specifically excluded (par. 6):
"Large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment...."
Loans that are measured at fair value or at the lower of cost or fair value, for example, in accordance with [SFAS] No. 65, "Accounting for Certain Mortgage Banking Activities," or other specialized industry practice.
Leases as defined in [SFAS] No. 13, "Accounting for Leases."
Debt Securities as defined in [SFAS] No. 115, "Accounting for Certain Investments in Debt and Equity Securities."
SFAS No. 114 does not specify how a creditor should identify loans that are to be evaluated for impairment. However, in practice, a number of different mechanisms are employed to identify loans for impairment evaluation. These mechanisms include but are not limited to past due reports, reports from regulatory examiners, reviews of incomplete loan files of financial institutions, identification of those borrowers facing financial difficulties or operating in industries facing such difficulties, and loss statistics pertaining to certain categories of loans.
The measurement of impairment should take into account both contractual interest payments and contractual principal payments consistent with the original payment terms of the loan agreement. For loans within the scope of Statement No. 114, the creditor should measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate. A loan's effective interest rate is defined as "the rate of return implicit in the loan (i.e., the contractual interest rate adjusted for any net deferred loan fees or costs, premium, or discount existing at the origination or acquisition of the loan)" (par. 14).
The Statement provides that as a practical expedient, creditors may alternatively measure impairment based on a loan's observable market price or the fair value of the collateral if the loan is collateral dependent. If the latter approach is used, the measurement of impairment should take into account estimated costs to sell the collateral, on a discounted basis. Furthermore, when a creditor determines that foreclosure is probable, impairment must be measured based on the fair value of the collateral.
In any event, a valuation allowance should be established if the recorded investment in the loan (including accrued interest, net deferred loan fees or costs, and unamortized discount or premium) exceeds the impaired measure. The recognition of such an allowance is accompanied by a corresponding charge to bad debt expense.
Once a loan has been impaired, some entities, particularly financial institutions, suspend the accrual of interest because such accruals do not in those circumstances reflect economic reality.
The recognition of interest income on impaired loans was initially addressed by SFAS No. 114 (pars. 17–19). Subsequent to its issuance, however, a number of commentators requested an extension of the effective date of the Statement due to the difficulty of applying the new guidelines. As a result, the FASB issued SFAS No. 118 to "allow a creditor to use existing methods for recognizing interest income on impaired loans" (par. 3). Statement 118 eliminated the original income recognition provisions of paragraphs 17–19 of SFAS No. 114. However, SFAS No. 114 (par. 17), as amended, recognizes that accounting methods for the recognition of interest income include using "a cost-recovery method, a cash-basis method, or some combination of those methods."
Occasionally, a loan may be restructured to meet a borrower's changing circumstances and a new loan is recognized. However, if "the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider" (par. 2), the transaction should be accounted for in accordance with SFAS No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings." The following types of restructuring arrangements are discussed in SFAS No. 15:
Transfers of assets of the debtor or an equity interest in the debtor to fully or partially satisfy the debt
Modification of debt terms, including reduction of one or more of the following: (1) interest rates with or without extension of maturity date(s), (2) face or maturity amounts, and (3) accrued interest
Creditors that receive assets or an equity interest in the debtor in full satisfaction of the loan should account for the restructuring at the fair value of the assets or equity interest received or the fair value of the loan, whichever is more clearly determinable. In the case of a partial satisfaction of the loan, the fair value of the loan may not be used (par. 28, fn. 16).
SFAS No. 114 amended SFAS No. 15 to require that a creditor account for a troubled debt restructuring involving a modification of terms in accordance with SFAS No. 114. However, the effective interest rate to be used in these situations is the original contractual rate and not the rate specified in the restructuring agreement. Furthermore, creditors must disclose "the amount of commitments, if any, to lend additional funds to debtors owing receivables whose terms have been modified in troubled debt restructurings" (SFAS No. 15, par. 40b).
Loans restructured through a modification of terms before the effective date of SFAS No. 114 may continue to be accounted for and disclosed in accordance with SFAS No. 15 as long as the loan, as restructured, is not impaired. Any subsequent impairment will require the application of SFAS No. 114.
An entity may sometimes receive a note from the sale of capital stock or as a contribution to paid-in capital. The Emerging Issues Task Force (EITF), in EITF 85-1, "Classifying Notes Received for Capital Stock," addressed the issue of whether an entity should report the note receivable as a reduction of shareholders' equity or as an asset. The EITF "reached a consensus that reporting the note as an asset is generally not appropriate, except in very limited circumstances when there is substantial evidence of ability and intent to pay within a reasonably short period of time." One situation where such a note receivable may be reported as an asset is the payment of the note prior to issuance of the financial statements.
There are a number of standards which require disclosures related to loans as follows:
APB Opinion 22, Disclosure of Accounting Policies, paragraphs 8 and 12
SOP 01-6, Accounting by Certain Entities (Including Entities With Trade Receivables) That Lend to or Finance the Activities of Others, paragraph 13–17
APB Opinion No. 12, Omnibus Opinion—1967, paragraphs 2 and 3
FASB Statement No. 5, Accounting for Contingencies, paragraphs 9–11
SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties, paragraphs 13 and 14
FSP-SOP 94-6-1, Terms of Loan Products That May Give Rise to a Concentration of Credit Risk
FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan, as amended by FASB Statement No. 118, Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosures, paragraph 20A
SOP 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer, paragraph 14–16
FASB Statement No. 107, Disclosures about the Fair Value of Financial Instruments
An entity may invest in debt securities (e.g., bonds) to generate interest revenue and/or to realize gains from their sale at increased market prices. SFAS No. 115 is the primary standard applicable to investments in debt securities. The FASB has also issued a special report entitled, "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities," which contains a series of questions and answers (herein referred to by question number as FASB Q&A) useful in understanding and implementing the Statement. Paragraph 137 of SFAS No. 115 defines, in part, debt securities as those securities that represent "a creditor relationship with an enterprise." These securities include:
"U.S. Treasury securities, U.S. government agency securities, municipal securities, corporate bonds, convertible debt, commercial paper, all securitized debt instruments, such as collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs), and interest-only and principal-only strips.
A CMO (or other instrument) that is issued in equity form but is required to be accounted for as a nonequity instrument regardless of how that instrument is classified (i.e., whether equity or debt) in the issuer's statement of financial position.
Preferred stock that by its terms either must be redeemed by the issuing enterprise or is redeemable at the option of the investor.
Structured notes that are in the form of debt securities."
Except as mentioned below, SFAS No. 115 "applies to all debt securities, including securities that have been grouped with loans in the statement of financial position" (EITF Topic No. D-39, "Questions Related to the Implementation of FASB Statement No. 115"). These include (1) a bank's originated and securitized mortgage loans that continue to be reported as loans in the Call Report, (2) bank investments in unrated industrial development bonds classified as loans in the Call Report, and (3) "Brady Bonds." In addition, FASB Technical Bulletin No. 94-1, "Application of Statement 115 to Debt Securities Restructured in a Troubled Debt Restructuring," indicates that "Statement 115 applies to all loans that meet the definition of a security in that Statement. Thus, any loan that was restructured in a troubled debt restructuring involving a modification of terms, including those restructured before the effective date of Statement 114, would be subject to the provisions of Statement 115 if the debt instrument meets the definition of a security" (par. 3).
Excluded from the definition of debt securities are unsecuritized loans, options on debt securities, accounts receivable, option contracts, financial futures contracts, forward contracts, and lease contracts. In addition, since SFAS No. 115 generally requires that investments in debt securities be presented at fair value, enterprises that already use similar measurement guidelines in accounting for these investments—for example, brokers and dealers in securities, defined benefit pension plans, and investment companies—need not apply the requirements of the Statement. In this regard, SFAS No. 115 (par. 4) states, the "Statement does not apply to enterprises whose specialized accounting practices include accounting for substantially all investments in debt and equity securities at market value or fair value, with changes in value recognized in earnings (income) or in the change in net assets."
Not-for-profit organizations are also excluded from the Statement's provisions. However, the Statement applies "to cooperatives and mutual enterprises, including credit unions and mutual insurance companies" (par. 4).
As previously discussed in Section 18-3(e), certain financial assets subject to prepayment are measured like investment in debt securities. Those assets include interest-only strips, retained interests in securitizations, loans, other receivables, or other financial assets that can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment, except for instruments that are within the scope of Statement 133.
EITF 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets," provides interest income recognition and measurement guidance for interests retained in a securitization transaction accounted for as a sale. The scope of EITF 99-20 includes retained beneficial interests in securitization transactions that are accounted for as sales under Statement 140 and certain purchased beneficial interests in securitized financial assets. The scope includes beneficial interests that (par. 5):
Are either debt securities under Statement 115 or required to be accounted for like debt securities under Statement 115 pursuant to paragraph 14 of Statement 140.
Involve securitized financial assets that have contractual cash flows (for example, loans, receivables, debt securities, and guaranteed lease residuals, among other items). Thus, the consensus in this Issue does not apply to securitized financial assets that do not involve contractual cash flows (e.g., common stock equity securities, among other items). The Task Force observed that the guidance in Issue No. 96-12, "Recognition of Interest Income and Balance Sheet Classification of Structured Notes," may be applied to those beneficial interests involving securitized financial assets that do not involve contractual cash flows.
Do not result in consolidation of the entity issuing the beneficial interest by the holder of the beneficial interests.
Upon acquisition, debt securities are classified into one of three categories: (1) held-to-maturity, (2) available-for-sale, or (3) trading. Generally, these securities are initially recorded at cost with appropriate identification of premium or discounts. EITF Issue No. 94-8, "Accounting for Conversion of a Loan into a Debt Security in a Debt Restructuring," states that "the initial cost basis of a debt security of the original debtor received as part of a debt restructuring should be the security's fair value at the date of the restructuring."
An entity that has the positive intent and ability to hold a debt security to maturity should classify such security as a held-to-maturity security. Otherwise, the security should be classified as trading or available-for-sale. A positive intent and ability to hold a security to maturity does not exist if management's intent to hold the security to maturity is uncertain, if the intent is "to hold the security for only an indefinite period" (par. 9), or if there is a "mere absence of an intent to sell" (par. 59). FASB Q&A No. 18 states that "given the unique opportunities for profit embedded in a convertible security, it generally would be contradictory to assert the positive intent and ability to hold a convertible debt security to maturity and forego the opportunity to exercise the conversion feature." In determining positive intent and ability, the following additional guidance is available:
SFAS No. 115 (par. 9) states that "a debt security should not, for example, be classified as held-to-maturity if the enterprise anticipates that the security would be available to be sold in response to ... needs for liquidity (e.g., due to the withdrawal of deposits, increased demands for loans, surrender of insurance policies, or payment of insurance claims)," or changes in (1) "market interest rates and related changes in the security's prepayment risk," (2) "the availability of and the yield on alternative investments," (3) "funding sources and terms," or (4) "foreign currency risk."
SFAS No. 115 (par. 7), as amended, provides that "a security may not be classified as held-to-maturity if that security can contractually be prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment." SFAS No. 140 (par. 14) also requires that "interest-only strips, loans, other receivables, or retained interests in securitizations that can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment shall be subsequently measured like investments in debt securities classified as available-for-sale or trading under Statement 115."
Debt securities classified as trading securities are those that are "bought and held principally for the purpose of selling them in the near term (thus held for only a short period of time)" (par. 12a). These include mortgage-backed securities held for sale in conjunction with mortgage banking activities.
Gains and losses realized upon the sale of debt securities are included in earnings. As previously discussed in Section 18.3, sale accounting is only appropriate for transfers of financial assets in which the transferor surrenders control over those financial assets pursuant to the provisions of SFAS No. 140, paragraph 9. Otherwise, the transferor should account for the transfer as a secured borrowing with pledge of collateral pursuant to SFAS No. 140, paragraph 15.
Generally, interest income is recognized at the contractual rate and premiums and discounts are amortized using the interest method. As discussed above, certain beneficial interests should follow the guidance in EITF 99-20. In addition, the retrospective interest method should be used for recognizing income on structured note securities that are classified as available-for-sale or held-to-maturity and that meet one or more of the conditions set forth in EITF Issue No. 96-12, "Recognition of Interest Income and Balance Sheet Classification of Structured Notes." Structured notes are debt instruments whose cash flows are linked to the movement in one or more indexes, interest rates, foreign exchange rates, commodities prices, prepayment rates, or other market variables.
The amount at which a debt security is presented in the statement of financial position depends on its classification as discussed below. This will require a determination of fair value—"the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. If a quoted market price is available for an instrument, the fair value to be used in applying [the] Statement is the product of the number of trading units of the instrument times its market price" (par. 137). If a quoted market price is not available for a debt security, pricing techniques such as "discounted cash flow analysis, matrix pricing, option-adjusted spread models, and fundamental analysis" (par. 111) can be used to obtain an estimate of fair value.
The appropriateness of a security's classification must be reassessed at each reporting date. In making this assessment, prior sales and transfers should be considered. Transfers to another category are discussed below.
Debt securities classified as held-to-maturity are carried at amortized cost. Like loans, premiums and discounts pertaining to these securities are generally amortized using the interest method in accordance with FASB Statement 91.
In assessing the appropriateness of the held-to-maturity designation at each reporting date, SFAS No. 115 (par. 8) provides that transfers or sales due to the following changes in circumstances do not refute the held-to-maturity classification of other debt securities:
Evidence of a significant deterioration in the issuer's creditworthiness.
A change in tax law that eliminates or reduces the tax-exempt status of interest on the debt security (but not a change in tax law that revises the marginal tax rates applicable to interest income).
A major business combination or major disposition (such as sale of a segment) that necessitates the sale or transfer of held-to-maturity securities to maintain the enterprise's existing interest rate risk position or credit risk policy.
A change in statutory or regulatory requirements significantly modifying either what constitutes a permissible investment or the maximum level of investments in certain kinds of securities, thereby causing an enterprise to dispose of a held-to-maturity security.
A significant increase by the regulator in the industry's capital requirements that causes the enterprise to downsize by selling held-to-maturity securities.
A significant increase in the risk weights of debt securities used for regulatory risk-based capital purposes.
It is not appropriate to apply these exceptions to situations that are similar, but not the same as, those listed above. However, the Statement indicates that "in addition to the foregoing changes in circumstances, other events that are isolated, nonrecurring, and unusual for the reporting enterprise that could not have been reasonably anticipated may cause the enterprise to sell or transfer a held-to-maturity security without necessarily calling into question its intent to hold other debt securities to maturity" (par. 8).
The FASB Q&A No. 29 indicates that "the sale of a held-to-maturity security in response to a tender offer will call into question an investor's intent to hold other debt securities to maturity in the future." In addition, FASB Q&A No. 24 notes that "sales of held-to-maturity securities to fund an acquisition (or a disposition, for example, if deposit liabilities are being assumed by the other party) are inconsistent with [SFAS No. 115] paragraph 8."
Debt securities classified as trading securities are carried at fair value. The resulting unrealized gain or loss is reflected in earnings.
Debt securities classified as available-for-sale are, like debt securities classified as trading, carried at fair value. The resulting unrealized gain or loss is reflected as a separate component of equity, net of related deferred income taxes (or in other comprehensive income). These unrealized gains and losses should include the entire change in the fair value of foreign currency-denominated available-for-sale debt securities, and not just the portion attributable to changes in exchange rates.
The FASB staff has announced that "when an entity has decided to sell an available-for-sale security whose fair value is less than its cost and the entity does not expect the fair value of the security to recover prior to the expected time of sale, a write-down for other-than-temporary impairment should be recognized in earnings in the period in which the decision to sell is made" (EITF Topic No. D-44, which was superseded with the issuance of FSP FAS 115-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments").
Changes in the classification of investments in debt securities are accounted for at fair value. The following table summarizes the proper accounting for transfers:
Transfer From | Transfer To | Accounting Principles |
|---|---|---|
Trading | Available-for-Sale | Previously recognized unrealized gains and losses are not reversed. |
Held-to-Maturity | Previously recognized unrealized gains and losses are not reversed. | |
Available-for-Sale | Trading | Unrealized gains and losses, including those already reflected in equity (or accumulated other Comprehensive income; see Section 18.5(c), are recognized in earnings. |
Held-to-Maturity | Unrealized gains and losses at the date of transfer remain in equity (or accumulated other Comprehensive income; see Section 18.5(c) but are amortized over the remaining life of the security Using the interest method. Premiums and discounts created by the transfer at fair value are also amortized using the interest method. | |
Held-to-Maturity | Trading | Unrealized gains and losses are recognized in earnings. |
Available-for-Sale | Unrealized gains and losses are reflected in equity, net of related deferred income taxes |
Temporary declines in the fair value of securities below amortized cost are not recognized since it is generally held that such declines will ultimately reverse. However, the evaluation of whether or not an impairment is considered other-than-temporary has been a long standing practice issue. In order to provide some guidance on evaluating other than temporary impairment, the FASB issued FSP FAS 115-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," in November 2005. While the FSP clarifies the accounting in a few areas, it largely refers to existing accounting literature and incorporates the existing guidance from the SEC. The FSP refers to a basic three-step model:
Step 1: Determine whether an investment is impaired (i.e., fair value is less than cost). Generally, cost equals amortized cost less any previous write-downs.
Step 2: Determine whether the impairment is other-than-temporary. Other-than-temporary does not necessarily mean permanent and an investment does not have to be deemed permanently impaired in order to require a write-down.
Step 3: If the impairment is deemed to be other-than-temporary, recognize an impairment loss equal to the difference between the carrying amount and its fair value, measured as of the balance sheet date. Further, the fair value becomes the new cost basis of the investment and should not be adjusted for subsequent recoveries in fair value.
FSP FAS-115-1 refers to Paragraph 16 of Statement 115 for determining whether an impairment is other than temporary:
For individual securities classified as either available-for-sale or held-to-maturity, an enterprise shall determine whether a decline in fair value below the amortized cost basis is other than temporary. (If a security has been the hedged item in a fair value hedge, the security's "amortized cost basis" shall reflect the effect of the adjustments of its carrying amount made pursuant to paragraph 22(b) of Statement 133.) For example, if it is probable that the investor will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment shall be considered to have occurred. [Footnote 4] If the decline in fair value is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value as a new cost basis and the amount of the write-down shall be included in earnings (that is, accounted for as a realized loss). The new cost basis shall not be changed for subsequent recoveries in fair value. Subsequent increases in the fair value of available-for-sale securities shall be included in other comprehensive income pursuant to paragraph 13; subsequent decreases in fair value, if not an other-than-temporary impairment, also shall be included in other comprehensive income.
Footnote 4: A decline in the value of a security that is other than temporary is also discussed in FSP FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," AICPA Statement on Auditing Standards No. 92, "Auditing Derivative Instruments, Hedging Activities, and Investments in Securities," and in SEC Staff Accounting Bulletin No. 59, "Accounting for Noncurrent Marketable Equity Securities."
As referenced in Statement 115, AICPA Statement on Auditing Standards No. 92, "Auditing Derivative Instruments, Hedging Activities, and Investments in Securities," paragraph 47, provides the following guidance:
Impairment Losses. Regardless of the valuation method used, generally accepted accounting principles might require recognizing in earnings an impairment loss for a decline in fair value that is other than temporary. Determinations of whether losses are other than temporary often involve estimating the outcome of future events. Accordingly, judgment is required in determining whether factors exist that indicate that an impairment loss has been incurred at the end of the reporting period. These judgments are based on subjective as well as objective factors, including knowledge and experience about past and current events and assumptions about future events. The following are examples of such factors.
Fair value is significantly below cost and —
— The decline is attributable to adverse conditions specifically related to the security or to specific conditions in an industry or in a geographic area.
— The decline has existed for an extended period of time.
— Management does not possess both the intent and the ability to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value.
The security has been downgraded by a rating agency.
The financial condition of the issuer has deteriorated.
Dividends have been reduced or eliminated, or scheduled interest payments have not been made.
The entity recorded losses from the security subsequent to the end of the reporting period.
As referenced in Statement 115, SEC SAB 59 (as amended by SAB 103, "Update of Codification of Staff Accounting Bulletins") provides the following guidance as Topic 5: "Miscellaneous Accounting, Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities":
M. Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities (SAB NO. 59)
Facts: Paragraph 16 of Statement 115 specifies that "[f]or individual securities classified as either available-for-sale or held-to-maturity, an enterprise shall determine whether a decline in fair value below the amortized cost basis is other than temporary... If the decline in fair value is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value as a new cost basis and the amount of the write-down shall be included in earnings (that is, accounted for as a realized loss)."
Statement 115 does not define the phrase "other than temporary." In applying this guidance to its own situation, Company A has interpreted "other than temporary" to mean permanent impairment. Therefore, because Company A's management has not been able to determine that its investment in Company B is permanently impaired, no realized loss has been recognized even though the market price of B's shares is currently less than one-third of A's average acquisition price.
Question: Does the staff believe that the phrase "other than temporary" should be interpreted to mean "permanent"?
Interpretive Response: No. The staff believes that the FASB consciously chose the phrase "other than temporary" because it did not intend that the test be "permanent impairment," as has been used elsewhere in accounting practice. [Footnote 12]
Footnote 12: Footnote 4 to Statement 115 refers to this SAB for a discussion of considerations applicable to a determination as to whether a decline in market value below cost, at a particular point in time, is other than temporary. FASB's implementation guide "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities," SAS 92, "Auditing Derivative Instruments, Hedging Activities, and Investments in Securities," AICPA Audit Guide, "Auditing Derivative Instruments, Hedging Activities, and Investments in Securities," and EITF Topic D-44 also address issues related to the determination of whether a decline in fair value of a investment security is other than temporary.
The value of investments in marketable securities classified as either available-for-sale or held-to-maturity may decline for various reasons. The market price may be affected by general market conditions which reflect prospects for the economy as a whole or by specific information pertaining to an industry or an individual company. Such declines require further investigation by management. Acting upon the premise that a write-down may be required, management should consider all available evidence to evaluate the realizable value of its investment.
There are numerous factors to be considered in such an evaluation and their relative significance will vary from case to case. The staff believes that the following are only a few examples of the factors which, individually or in combination, indicate that a decline is other than temporary and that a write-down of the carrying value is required:
The length of the time and the extent to which the market value has been less than cost;
The financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology that may impair the earnings potential of the investment or the discontinuance of a segment of the business that may affect the future earnings potential; or
The intent and ability of the holder to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.
Unless evidence exists to support a realizable value equal to or greater than the carrying value of the investment, a write-down to fair value accounted for as a realized loss should be recorded. In accordance with the guidance of paragraph 16 of Statement 115, such loss should be recognized in the determination of net income of the period in which it occurs and the written down value of the investment in the company becomes the new cost basis of the investment."
In addition to retaining the disclosure requirements of the superseded EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, and referring to existing GAAP and SEC guidance, the FSP also clarifies the following:
If the impairment is considered other-than-temporary, then the impairment should be measured as the difference between fair value and cost basis at the balance sheet date. (paragraph 15 of the FSP)
For post-impairment income recognition, income must be recognized on expected, not contractual, cash flows. (paragraph 16 of the FSP)
If the decision is made to sell an investment in a loss position, the loss should be recorded in the period the decision is made rather than when the actual sale occurs, incorporating existing guidance in EITF Topic D-44, "Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value." (paragraph 14 of the FSP)
The guidance in the final FSP is effective for reporting periods beginning after December 15, 2005. Earlier application is permitted. However, the existing disclosures, previously required under EITF 03-1, remain in place for December 31, 2005 year-ends.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income." The transition section of the Statement provides, among other things, that the Statement is effective for fiscal years beginning after December 15, 1997. Earlier application is permitted and reclassification of financial statements for earlier periods provided for comparative purposes is required. The previous discussion on available-for-sale debt securities parenthetically refers to other comprehensive income to facilitate the transition to the new requirements. Readers should be alert to the following major changes resulting from the adoption of Statement No. 130.
Subsequent to the adoption of SFAS No. 130, unrealized gains and losses previously reported net of applicable deferred income taxes in a separate component of shareholders' equity under SFAS No. 115 will have to be reported in other comprehensive income. In addition, the unrealized gain or loss at the date of transfer into the available-for-sale category from the held-to-maturity category will also have to be reported in other comprehensive income.
The new requirements will require reclassification adjustments "to avoid double counting in comprehensive income items that are displayed as part of net income for a period that also had been displayed as part of other comprehensive income in that period or earlier periods" (par. 18). SFAS No. 130 (Appendix C) provides illustrations of the calculation of reclassification adjustments for Statement 115 available-for-sale securities. The reporting and display of comprehensive income and its components in a full set of general-purpose financial statements is discussed further in Chapter 10.
Equity securities are often purchased to generate dividend income, to realize gains from their sale to other parties, and/or to achieve control over another enterprise. Except as discussed below, SFAS No. 115, as amended, is the primary standard applicable to investments in equity securities that have readily determinable fair values. As mentioned earlier, the FASB has also issued a special report entitled, "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities," which contains a series of questions and answers useful in understanding and implementing the Statement.
SFAS No. 115 (par. 137) defines an equity security as "any security representing an ownership interest in an enterprise (e.g., common, preferred, or other capital stock) or the right to acquire (e.g., warrants, rights, and call options) or dispose of (e.g., put options) an ownership interest in an enterprise at fixed or determinable prices." This definition excludes "convertible debt or preferred stock that by its terms either must be redeemed by the issuing enterprise or is redeemable at the option of the investor." FASB Q&A No. 3 indicates that this "definition does not include written equity options because they represent obligations of the writer, not investments. Is also does not include cash-settled options on equity securities or options on equity-based indexes, because those instruments do not represent ownership interests in an enterprise. Options on debt securities are not within the scope of the Statement." In addition, the Statement does not apply to:
"Enterprises whose specialized accounting practices include accounting for substantially all investments in debt and equity securities at market value or fair value, with changes in value recognized in earnings (income) or in the change in net assets" (par. 4).
Not-for-profit organizations. However, the Statement applies "to cooperatives and mutual enterprises, including credit unions and mutual insurance companies" (par. 4).
"Investments in equity securities accounted for under the equity method nor to investments in consolidated subsidiaries" (par. 4). Consolidation and the equity method of accounting are discussed in Chapter 11 of this Handbook.
Equity securities that do not have readily determinable fair values (e.g., restricted stock).
FASB Q&A No. 4 notes that "APB Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock," describes the cost method and the equity method of accounting for investments in common stock and specifies the criteria for determining when to use the equity method. Equity securities that do not have readily determinable fair values that are not required to be accounted for by the equity method are typically carried at cost, as described in paragraph 6 of Opinion 18, adjusted for other-than-temporary impairment."
Upon acquisition, equity securities are generally recorded at cost, presumably fair value at acquisition, and classified into one of two categories: (1) available-for-sale or (2) trading. The FASB Q&A No. 38 provides that the initial basis under Statement 115 of a marketable equity security that should no longer be accounted for under the equity method would be the previous carrying amount of the investment. The Q&A notes that "paragraph 19(1) of APB Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock," states that the earnings or losses that relate to the stock retained should remain as a part of the carrying amount of the investment and that the investment account should not be adjusted retroactively."
Gains and losses realized on the sale of equity securities are included in earnings and dividend income is recognized upon declaration. As previously discussed in the section 18.3, sale accounting is only appropriate for transfers of financial assets in which the transferor surrenders control over those financial assets pursuant to the provisions of SFAS No. 140, paragraph 9. Otherwise, the transferor should account for the transfer as a secured borrowing with pledge of collateral pursuant to SFAS No. 140, paragraph 15.
Equity securities are carried at fair value. As with debt securities, the accounting for the resulting unrealized gain or loss depends on the equity security's classification. Changes in the fair value of equity securities classified as trading are reflected in earnings while changes in the fair value of equity securities classified as available-for-sale are reflected in a separate component of shareholder's equity (or other comprehensive income), net of the related deferred income tax effects.
Declines in fair value that are deemed to be "other-than-temporary" should be accounted for as realized losses, resulting in a new cost basis for the security. Impairment is discussed above in Section 18.5(d). For equity securities with readily determinable market values, the impairment guidance in paragraph 16 of Statement 115 (see above) should be followed. For investments in equity securities that carried on the cost method, FSP-FAS 115-1 refers to Paragraph 6 of APB 18 for determining whether an impairment is other than temporary:
a. THE COST METHOD. An investor records an investment in the stock of an investee at cost, and recognizes as income dividends received that are distributed from net accumulated earnings of the investee since the date of acquisition by the investor. The net accumulated earnings of an investee subsequent to the date of investment are recognized by the investor only to the extent distributed by the investee as dividends. Dividends received in excess of earnings subsequent to the date of investment are considered a return of investment and are recorded as reductions of cost of the investment. A series of operating losses of an investee or other factors may indicate that a decrease in value of the investment has occurred which is other than temporary and should accordingly be recognized. [Footnote 3a]
Footnote 3a: FSP FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," discusses the methodology for determining impairment and evaluating whether the impairment is other than temporary.
Paragraph 10 of FSP FAS-115-1 discusses the impairment considerations for cost-method investments for which the fair value is not readily determinable.
The transfer of equity securities between categories is accounted for in the same manner as the transfer of debt securities discussed above. Of course, transfers to or from the held-to-maturity category do not apply.
As discussed in Section, in June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income." The transition section of the Statement provides, among other things, that the Statement is effective for fiscal years beginning after December 15, 1997. Earlier application is permitted and reclassification of financial statements for earlier periods provided for comparative purposes is required. The previous discussion on available-for-sale equity securities parenthetically refers to other comprehensive income to facilitate the transition to the new requirements. Readers should be alert to the major changes resulting from the adoption of Statement 130. The reporting and display of comprehensive income and its components in a full set of general-purpose financial statements is discussed further in Chapter 10.
American Institute of CPAs. "Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others" Statement of Position 01-6, AICPA, New York.
——— "Accounting for Certain Purchased Loans and Debt Securities Acquired in a Transfer" Statement of Position 03-3, AICPA, New York.
——— "Disclosure of Certain Significant Risks and Uncertainties" Statement of Position 94-6 AICPA.
Bort, Richard, Corporate Cash Management Handbook. Warren, Gorham & Lamont, Boston, 1989
Committee on Accounting Procedure, "Restatement and Revision of Accounting Research Bulletins," Accounting Research Bulletin No. 43. AICPA, New York, 1953.
Financial Accounting Standards Board. "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities." Special Report FASB, Norwalk, CT, 1995.
——— "Accounting for Changes That Result in a Transferor Regaining Control of Financial Assets Sold" EITF Issue No. 02-9. FASB, Norwalk, CT,
——— "Accounting for Contingencies" Statement of Financial Accounting Standards No. 5. FASB, Stamford, CT, 1975.
——— "Accounting for Conversion of a Loan into a Debt Security in a Debt Restructuring," EITF Issue No. 94-8. FASB, Norwalk, CT, 1997
——— "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases," Statement of Financial Accounting Standards No. 91, FASB, Norwalk, CT.
——— "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," Statement of Financial Accounting Standards No. 140, FASB, Norwalk, CT, 2000.
——— "Accounting by Debtors and Creditors for Troubled Debt Restructurings," Statement of Financial Accounting Standards No. 15. FASB, Stamford, CT, 1977.
——— "Accounting by Creditors for Impairment of a Loan," Statement of Financial Accounting Standards No. 114. FASB, Norwalk, CT, 1993.
——— "Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosures," Statement of Financial Accounting Standards No. 118. FASB, Norwalk, CT, 1994.
——— "Accounting for Certain Investment in Debt and Equity Securities," Statement of Financial Accounting Standards No. 115. FASB, Norwalk, CT, 1993.
——— "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities," Statement of Financial Accounting Standards No. 140. FASB, Norwalk, CT, 2001.
——— "Balance Sheet Treatment of a Sale of Mortgage Servicing Rights with a Subservicing Agreement." EITF Issue 90-21 FASB, Norwalk, CT.
——— "Classifying Notes Receivable for Capital Stock," EITF Issue 85-1, FASB, Norwalk, CT.
——— "Consolidation of All Majority-Owned Subsidiaries," Statement of Financial Accounting Standards No. 94. FASB, Stamford, CT, 1987.
——— "Determination of What Risks and Rewards, If Any, Can Be Retained and Whether Any Unresolved Contingencies May Exist in a Sale of Mortgage Loan Servicing Rights" EITF Issue 95-5, FASB, Norwalk, CT.
——— "Financial Reporting and Changing Prices," Statement of Financial Accounting Standards No. 89. FASB, Stamford, CT, 1986.
——— "Foreign Currency Translation," Statement of Financial Accounting Standards No. 52. FASB, Stamford, CT, 1981.
——— "Questions and Answers Related to Servicing Activities in a qualifying Special-Purpose Entity under FASB Statement No. 140." Topic D-99. FASB, Norwalk, CT.
——— "Questions Related to the Implementation of FASB Statement No. 115," EITF Topic No. D-39. FASB, Norwalk, CT.
——— "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets," EITF Issue No. 99-20, FASB, Norwalk, CT.
——— "Reporting Comprehensive Income," Statement of Financial Accounting Standards No. 130. FASB, Norwalk, CT, 1997.
——— "Terms of Loan Products That May Give Rise to a Concentration of Credit Risk" FASB Staff Position-SOP 94-6-1.
——— "The Applicability of FASB Statement No. 115 to Desecuritizations of Financial Assets," EITF Topic No. D-51. FASB, Norwalk, CT.
——— "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" EITF Issue 03-1. FASB, Norwalk, CT.
Keiso, Donald E., Weygandt, Jerry D., and Warfield, Terry D. Intermediate Accounting, Twelfth Edition., John Wiley & Sons, New York, 2006.
Meigs, Walter B., Larsen, E. John, and Meigs, Robert F., Principles of Auditing, Ninth Edition. Irwin, Homewood, IL, 1988.
O'Reilly, Vincent M., Mc Donnell, Patrick J., Winograd, Barry N., Gerson, James, S. and Jaenicke, Henry R., Montgomery's Auditing, Twelfth Edition. John Wiley & Sons, New York, 1998.
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[264] 1Jay M. Smith, Jr. and K. Fred Skonsen, Intermediate Accounting, Tenth Edition. (South-Western Publishing Co., Cincinnati, Ohio, 1990).
[265] 2Vincent M. O'Reilly et al, Montgomery's Auditing, Twelfth Edition. (John Wiley & Sons, New York, 1998) Section 17.17.
[266] 3On August 11, 2005, the FASB issued three exposure drafts to amend Statement 140: (1) "Accounting for Transfers of Financial Assets", (2) "Accounting for Servicing of Financial Assets" and (3) "Accounting for Certain Hybrid Financial Instruments". In February 2006, the FASB issued Statement No. 155, "Accounting for Certain Hybrid Financial Instruments", to resolves issues addressed in Statement 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets." The FASB expects to issue a final standard for servicing assets in the first quarter of 2006 and for transfers of financial assets in the second quarter of 2006. Readers should be alert to final issuances.