30.3 Mortgage Banking Activities

(a) Overview

Mortgage banking activities primarily include the origination or purchase, sale, and subsequent long-term servicing of mortgage loans. Mortgage loans are originated or purchased from a variety of sources including applications received directly from borrowers (retail originations) and loans acquired from mortgage brokers or other mortgage lenders (wholesale or correspondent purchases). These loans are then generally sold through the secondary mortgage market to permanent investors or retained by the lender in its own loan portfolio. Typically, loans are sold to permanent investors through conduits, although mortgage loans can also be sold through whole loan sales directly to investors or through public or private securitizations completed by the mortgage banker. Secondary market conduits include government-sponsored entities such as Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA), and Federal Home Loan Mortgage Corp (FHLMC), and other private companies involved in the acquisition and securitization of mortgage loans. Loan servicing includes the collection, recording, and remittance to investors of monthly mortgage payments, the maintenance of records relating to the loans, and the management of escrows for taxes and insurance. In return for performing these servicing activities, mortgage servicers earn a fee, which is usually a percentage of the loan's unpaid principal balance. Profits are earned from loan servicing activities if the mortgage banker's cost of performing the servicing of the loans is less than the fee received. The major risks associated with mortgage banking are interest rate risk associated with the loans in the pipeline and warehouse, credit risk associated with loans held for sale or held in portfolio, operational risk associated with performing servicing functions improperly, and prepayment risk associated with mortgage servicing rights.

(b) Accounting Guidance

The principal accounting guidance for the mortgage banking industry is found in SFAS No. 65, SFAS No. 91, and SFAS No. 140. SFAS No. 140 supersedes SFAS No. 125. SFAS No. 140 is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001, and is to be applied prospectively. Earlier or retroactive application is not permitted. The EITF also has addressed several issues related to the accounting for mortgage banking activities. The EITF represents the source of authoritative standards of accounting and reporting, other than those issued by the SEC, to be applied by nongovernmental entities.

An EITF Update summarizes issues discussed at meetings held by the EITF, including an overview of both consensuses and consensuses for exposure. Because consensuses and consensuses for exposure are subject to ratification by the FASB, and because some details of the conclusions reached at an EITF meeting are determined during the process of developing the meeting minutes, the contents of the EITF Update are preliminary.

(c) Mortgage Loans Held for Sale

Mortgage loans held for sale represent a mortgage banker's inventory of loans that have been originated or purchased and are awaiting sale to permanent investors. SFAS No. 65 requires that mortgage loans held for sale be reported at the lower of their cost or market value, determined as of the balance sheet date determined on an individual loan or aggregate basis. The excess of cost over market value is required to be accounted for as a valuation allowance with changes in the valuation allowance included in net income of the period in which the change occurs. SFAS No. 91 requires that loan origination fees and direct loan origination costs be deferred until the related loan is sold. Therefore, any net deferred fees or costs should be included in the cost basis of the loan and considered in determining the required valuation allowance at any balance sheet date. Capitalized costs of acquiring the rights to service mortgage loans associated with the purchase or origination of these assets should be excluded from the cost of the mortgage loans for the purposes of determining lower of cost or market. Likewise, the fair value of the servicing rights associated with the loans included in a mortgage banker's loans held for sale classification should be excluded from the determination of lower of cost or market.

The market value of mortgage loans held for sale is determined by type of loan. At a minimum, separate determinations of market value for residential and commercial mortgage loans shall be made. Either the aggregate or individual loan basis may be used in determining the lower of cost or market value for each type of loan under SFAS No. 65. The market value for loans subject to investor purchase commitments is based on those commitment prices. The market value for uncommitted loans held on a speculative basis is based on the market in which the mortgage banker normally operates.

At any balance sheet date, a mortgage banker will also have outstanding rate commitments, which represent commitments made to loan applicants to fund a loan at a locked-in interest rate provided that loan application eventually closes. These rate commitments make up a mortgage banker's pipeline. SFAS No. 65 does not specifically address a mortgage banker's pipeline as being subject to a lower of cost or market determination. However, the pipeline should be evaluated for the impact of any adverse commitments. This may be done in conjunction with the lower of cost or market analysis on loans held for sale. The analysis of the pipeline typically would be done only on those commitments expected to become loans (i.e., close) and not on those loans expected to fall out (i.e., not close). The existence of losses inherent in the pipeline after adjustment for fallout often can be determined by comparing commitment prices to investor delivery prices for similar loans. If any losses are determined to exist in the mortgage banker's pipeline, the loss should be accrued pursuant to SFAS No. 5.

(d) Mortgage Loans Held for Investment

Mortgage loans can be originated or purchased by a mortgage banker with the intention of holding the loan to maturity, or the loans can be transferred into a mortgage banker's loans held for investment category from a loans held for sale category after it is determined that the loan is unsalable or the mortgage banker decides to retain the loan for investment purposes. SFAS No. 65 requires that mortgage loans held for investment be reported at cost. For mortgage loans transferred into mortgage loans held for investment from loans held for sale, their initial cost basis must be determined as the lower of the loan's cost or market value on the date of the transfer. A mortgage loan must not be classified as held for investment unless the mortgage banker has both the intent and the ability to hold the loan for the foreseeable future or until maturity.

If the ultimate recovery of the carrying amount of a mortgage loan held as a long-term investment is doubtful, and the impairment is considered to be other than temporary, the carrying amount of the loan must be reduced to its expected collectable amount, which then becomes its new cost basis. The amount of the reduction is recorded as a loss. A recovery from the new cost basis is reported as a gain only at the sale, maturity, or disposition of the loan.

As noted, SFAS No. 91 requires that loan origination fees and direct loan origination costs be deferred. For mortgage loans held for investment, any net deferred fees or costs should be included in the cost basis of the loan and amortized into interest income on a level yield method. Under level-yield method, unamortized premiums and discounts are taken into income so as to recognize accounting income less coupon interest plus amortized premium or discount at a constant yield over the life of an investment. It calculates income for each period by multiplying the beginning of period carrying value by the internal rate of return of the investment. The carrying value is then increased by income and reduced by cash flow to get the next period's carrying value.

(e) Sales of Mortgage Loans and Securities

Mortgage bankers typically sell the majority of the loans they originate or purchase to third-party investors in order to remove these loans from their balance sheets and provide funds for the continued origination and purchase of future loans. The sale of mortgage loans results in a gain or loss that should be recognized when the mortgage banker has surrendered control over the assets to a purchaser in a manner such that the transfer of the loans can be accounted for as a sale. SFAS No. 140, which provides guidance concerning the transfers and servicing of financial assets and extinguishments of liabilities, states that a transfer of financial assets in which the transferor surrenders control over those financial assets must be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets have been received in exchange.

The control over financial assets is deemed to have been surrendered under SFAS No. 140 to the extent that all of the next three conditions have been met:

The sale of mortgage loans can occur primarily through one of three methods. Loans can be sold (1) through whole loan or bulk transactions to third-party investors where individual loans or groups of loans are transferred; (2) through government-sponsored MBS programs of investors such as FNMA, FHLMC, or GNMA; and (3) through private securitizations where the originator or loan purchaser will securitize and sell directly to third-party investors interests in an underlying pool of mortgage loans.

The most common type of sale utilized by mortgage bankers is the sale of MBSs through programs sponsored by FNMA, FHLMC, and GNMA. These sales are relatively straightforward and generally do not have the complex kinds of terms that could call into question sale treatment for the transfer under SFAS No. 140. Whole loan sales are also generally straightforward and do not present complex SFAS No. 140 sales issues; however, in instances where MBSs or whole loans are sold through private securitizations or on a recourse basis, surrender of control issues under SFAS No. 140 may be encountered.

Depending on the type of structure utilized in a private mortgage loan securitization, including those with terms where significant interests in securitized pools are retained, those with significant continued involvement of the seller in the securitized pool, and those with unusual legal structures, the attainment of sale accounting under SFAS No. 140 may also not be straightforward and may be difficult to assess. Careful consideration should be given to the requirements of SFAS No. 140 to ensure that a sale of the mortgage loans has occurred before a gain or loss on the transaction can be realized.

(i) Gain or Loss on Sale of Mortgage Loans

Upon completion of a transfer of mortgage loans that satisfies the conditions of SFAS No. 140 to qualify as a sale, the mortgage banker allocates the previous cost basis of the loans, including all deferred SFAS No. 91 costs and fees, between interests sold (i.e., the underlying loans) and interests retained (i.e., the loans' servicing rights, or other retained portions of a securitization such as residual spreads, subordinate bonds, and interest-only or principal-only strips) based on the relative fair value of those components on the date of the sale. The allocated basis assigned to interests in the mortgage loans that are sold should then be derecognized, and a gain or loss calculated as the difference between this allocated basis and proceeds received on the sale, net of any assets or liabilities created in the transaction that should be recorded. Newly created assets and liabilities from the sale should be recorded initially at their fair value and accounted for in accordance with current GAAP for similar assets and liabilities. Interests retained in the sale of mortgage loans are recorded initially at their allocated cost basis and subsequently accounted for in accordance with current GAAP for similar assets and liabilities.

(ii) Financial Assets Subject to Prepayment

Interest-only strips, loans, and other receivables and retained interests from sales or securitizations of mortgage loans that can be contractually prepaid or otherwise settled in a way such that the holder would not recover substantially all of its recorded investment are subsequently measured like investments in debt securities and classified as available-for-sale or trading assets under SFAS No. 115.

(f) Mortgage Servicing Rights

A mortgage banking entity may purchase mortgage servicing rights separately, or it may acquire mortgage servicing rights by purchasing or originating mortgage loans and selling or securitizing those mortgage loans with the servicing rights retained. When a mortgage banker purchases or originates mortgage loans, the cost of acquiring those loans includes the cost of the related servicing rights. These servicing rights become separate and distinct assets only when their respective mortgage loans are sold with the servicing rights retained.

SFAS No. 140 provides the primary accounting guidance for mortgage servicing rights and requires that servicing assets and other retained interests in the mortgage loans sold be measured by allocating the previous carrying amount of the mortgage loans (as previously discussed) between the mortgage loans sold and the servicing rights retained, based on their relative fair values at the date of the sale. FASB statement No. or SFAS No. 125 amends and extends to all servicing assets and liabilities the accounting standards for mortgage servicing rights now in FASB Statement No. 65, and supersedes FASB Statement No. 122, Accounting for Mortgage Servicing Rights.

Previously, net mortgage servicing rights were recognized as assets, and the amount recognized as net mortgage servicing rights was based on the fair value of certain expected cash inflows, net of expected cash outflows. The expected cash inflows (future servicing revenues) includes a normal servicing fee, expected late charges, and other ancillary revenues. The expected cash outflow (future servicing costs) includes various costs of performing the servicing.

SFAS No. 140 also requires that servicing assets and liabilities be subsequently (1) amortized in proportion to and over the period of estimated net servicing income or loss and (2) assessed for asset impairment or increased obligation based on their fair values.

SFAS No. 140 requires that a mortgage banking enterprise assess its capitalized mortgage servicing rights for impairment based on the fair value of those rights. A mortgage banking enterprise should stratify its mortgage servicing rights based on one or more of the predominant risk characteristics of the underlying loans. Impairment should be recognized through a valuation allowance for each impaired stratum. Each stratum should be recorded at the lower of cost or market value.

(i) Initial Capitalization of Mortgage Servicing Rights

Under SFAS No. 140, each time an entity undertakes an obligation to service mortgage loans, the entity must recognize either a servicing asset or a servicing liability for that servicing contract, unless it retains the underlying mortgage loans as an investment on its balance sheet. If a servicing asset was purchased or assumed rather than undertaken in a sale or securitization of the mortgage loans being serviced, the servicing asset is measured initially at its fair value, presumptively the price paid for the right to service the underlying loans.

Under SFAS No. 140, servicing rights retained in a sale of mortgage loans are initially recorded on the balance sheet at their allocated portion of the total cost of the mortgage loans purchased or originated. The allocation of the total cost basis of the mortgage loans is based on the relative fair values of the mortgage loans and their respective servicing rights.

(ii) Amortization of Mortgage Servicing Rights

SFAS No. 140 requires that amounts capitalized as servicing assets (net of any recorded valuation allowances) be amortized in proportion to, and over the period of, estimated net servicing income. For this purpose, estimates of future servicing revenue include expected late charges and other ancillary revenue, including float. Estimates of expected future servicing costs include direct costs associated with performing the servicing function and appropriate allocations of other costs. Estimated future servicing costs may be determined on an incremental cost basis.

(iii) Impairment of Mortgage Servicing Rights

For the purpose of evaluating and measuring impairment of servicing assets, SFAS No. 140 requires that servicing assets be stratified based on one or more of the predominant risk characteristics of the underlying loans. Those characteristics may include loan type, size, note rate, date of origination, term, and geographic location. Historically, note or interest rate has been the predominant prepayment risk characteristic considered by most mortgage bankers because, in declining interest rate environments, loans have tended to prepay more rapidly with corresponding impairment to the servicing asset.

Impairment is recognized through a valuation allowance for an individual stratum. The amount of impairment recognized is the amount by which the carrying value of the servicing assets in a stratum exceeds their fair value. The fair value of servicing assets that have not been recognized through a sale or securitization must not be used in the evaluation of impairment.

Subsequent to the initial measurement of impairment, the mortgage banking enterprise must adjust the valuation allowance to reflect changes in the measurement of impairment. Fair value in excess of the amount capitalized as servicing assets (net of amortization), however, must not be recognized. SFAS No. 140 does not address when a mortgage banking enterprise should record a direct write-down of servicing assets.

(iv) Fair Value of Mortgage Servicing Rights

A nonpublic entity must make a policy decision of whether to measure all of its liabilities incurred under share-based payment arrangements at fair value or to measure all such liabilities at intrinsic value. Regardless of the method selected, a nonpublic entity must remeasure its liabilities under share-based payment arrangements at each reporting date until the date of settlement. The fair value–based method is preferable for purposes of justifying a change in accounting principle under FASB Statement No. 154, Accounting Changes and Error Corrections. Assumptions used to estimate the fair value of equity and liability equipments granted to employees should be determined in a consistent manner from period to period.

The subprime scandals of 2008 can be attributed to many factors, including the improper application of fair value estimates by the real estate appraising industry. The conflicting interest between real estate appraisal firms and real estate brokerage firms provided incentives and opportunities for the appraisals to provide fair value estimates above and beyond reasonable and realistic fair value to get financing needs to close the deal. Banks had all the incentives and opportunities to get the highest fair value estimates to provide subprime loans to customers and then sell the mortgages to mortgage buyers such as Freddie Mac and Fannie Mae, quasi-government corporations established to buy up mortgages from banks. The other factor is banks' securitization vehicles of variable interest entities or SPEs. The appropriate tone set at the top by management regarding corporate culture within which financial reports are produced is vital to the integrity of financial reporting process. When the tone set at the top is lax, fraudulent financial reporting is more likely to occur and not be prevented.

SFAS No. 140 defines the fair value of an asset or a liability as the amount at which that asset or liability could be bought or sold in a current transaction between willing parties (i.e., other than in a forced or liquidation sale). Quoted market prices in active markets are the best evidence of fair value and under SFAS No. 140 are to be used as the basis for the measurement, if available. The FASB and the International Accounting Standards Board both agree pm fair value as an exit price. Both standard setters are trying to converge their accounting standards by 2012. Fair value, or mark to market, accounting has been controversial and blamed for helping exacerbate the financial crisis.

Standard setters have shown some flexibility in allowing financial institutions more discretion in valuing assets such as MBSs in recent years. If a quoted market price is available, the fair value is the product of the number of trading units' times that market price. If quoted market prices are not available, the estimate of fair value is based on the best information available in the circumstances. The estimate of fair value must consider prices for similar assets or liabilities and the results of valuation techniques to the extent available in the circumstances. Examples of valuation techniques include the present value of estimated expected future cash flows using a discount rate commensurate with the risks involved, option-pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis. Valuation techniques for measuring financial assets and liabilities and servicing assets and liabilities must be consistent with the objective of measuring fair value. Those techniques should incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses, including assumptions about interest rates, default, prepayment, and volatility. In measuring financial liabilities and servicing liabilities at fair value by discounting estimated future cash flows, an objective is to use discount rates at which those liabilities could be settled in an arm's-length transaction.

Estimates of expected future cash flows, if used to estimate fair value, should be the best estimate based on reasonable and supportable assumptions and projections. All available evidence must be considered in developing estimates of expected future cash flows. The weight given to the evidence should be commensurate with the extent to which the evidence can be verified objectively. If a range is estimated for either the amount or the timing of possible cash flows, the likelihood of possible outcomes must be considered in determining the best estimate of future cash flows.

If it is not practicable to estimate the fair values of assets, the transferor records those assets at zero. If it is not practicable to estimate the fair values of liabilities, the transferor recognizes no gain on the transaction and records those liabilities at the greater of:

• The excess, if any, of (1) the fair values of assets obtained less the fair values of other liabilities incurred, over (2) the sum of the carrying values of the assets transferred
• The amount that would be recognized in accordance with SFAS No. 5, as interpreted by FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss

SFAS No. 157, Fair Value Measurements, categorizes the source of information used in fair value measurements into three levels: (1) Level 1, where there are observable inputs from quoted prices in active markets; (2) Level 2, where there are indirectly observable inputs from quoted prices of comparable items in active markets, identical items in inactive markets, or other market-related information; and (3) Level 3, where there are unobservable, firm-generated inputs in determining fair value.

(v) Sales of Mortgage Servicing Rights

EITF No. 95-5 provides the primary accounting guidance for sales of mortgage servicing rights. It determines 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. The consensus reached in EITF No. 95-5 states that a sale of mortgage servicing rights should be recognized at the date title passes if substantially all risks and rewards of ownership have irrevocably passed to the buyer and any protection provisions retained by the seller are minor and can be reasonably estimated. If a sale is recognized and minor protection provisions exist, a liability should be accrued for the estimated obligation associated with those provisions. The seller retains only minor protection provisions if (1) the obligation associated with those provisions is estimated to be no more than 10 percent of the sales price and (2) the risk of prepayment is retained by the seller for no more than 120 days. The consensus additionally noted that a temporary subservicing agreement in which the seller would subservice the loans for a short period of time after the sale would not necessarily preclude recognizing a sale at the closing date.

(vi) Retained Interests

In certain asset sale or securitizations transactions, the mortgage banker may retain an interest in the transferred assets. Examples of retained interests include servicing assets, interest-only strips, and retained (or residual) interests in securitizations. Historically, excess servicing resulted from the sale of loans where the contractual service fee (the difference between the mortgage rate and the pass-through rate to the investor in the loans, after deducting any guarantee fees) was greater than a normal servicing fee rate. This excess servicing asset was then capitalized separately and subsequently accounted for distinctly from the normal servicing asset recorded. Under SFAS No. 140, the accounting distinction for excess servicing fees was eliminated. In general, under agency servicing contracts, past excess servicing fees represent contractually specified servicing fees as defined under SFAS No. 140 and are combined with servicing rights as a servicing asset. The combined servicing asset will then be subject to the stratified impairment test that was described in Subsection 30.3(f)(iii).

Generally, a servicing fee in excess of a contractually stated servicing fee would only be encountered in an instance where an entity securitizes and sells mortgage loans and creates an interest-only strip above and beyond the compensation allocated to the loan's servicer in the pooling and servicing agreements. If it is determined that an entity's excess servicing fees exceed contractually specified amounts, those amounts would be required to be classified as interest-only strips under SFAS No. 140.

Interest-only strips are rights to future interest income from the serviced assets that exceed contractually specified servicing fees. Interest-only strips are not servicing assets, they are financial assets. These assets should be recorded originally at allocated cost and recorded subsequently as an available-for-sale or trading asset in accordance with SFAS No. 115.

Retained or residual interests in securitizations represents the mortgage banker's right to receive cash flows from the mortgage assets that are not required to:

Such retained interests must be evaluated for impairment pursuant to EITF No. 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets.

(g) Taxation

Mortgage banks are subject to federal income taxes and certain state and local taxes. The British government now requires all U.K. banks to sign tax avoidance code to ensure that they pay their share of tax at a time of tight budgetary process and public spending. The taxation of mortgage banks is extremely complex; therefore, a discussion in depth is beyond the scope of this Handbook. However, certain significant factors of mortgage banking taxation are discussed next.

(i) Mortgage Servicing Rights

The tax treatment of servicing rights changed substantially in 1991 for both mortgage loan originators and subsequent purchasers of mortgage loans. Under Revenue Rule 91-46, a lender selling mortgages while retaining the right to service the loans for an amount in excess of reasonable compensation is deemed to have two types of income resulting from a servicing contract: normal (i.e., reasonable) and excess servicing compensation.

Generally, taxable income for normal servicing is recognized as received (i.e., as asset is not created at the time of loan sale as it is for book purposes); thus, a book-to-tax difference will exist upon sale of the underlying loan to a third party. Income deemed received for excess servicing is included in income on a yield-to-maturity basis.

The Treasury has provided safe harbor amounts offering guidance to what is deemed normal or reasonable compensation. Normal compensation is for the performance of general mortgage services, including a contract requiring the servicer to collect the periodic mortgage payments from the mortgagors and remit these payments to mortgage owners.

The safe harbors establish that compensation for the performance of all services under the mortgage servicing contracts should generally be between 25 and 44 basis points, annually, determined more specifically on the type of residential loans. Guidance as to reasonable compensation on commercial mortgages has not been provided; it is the taxpayer's responsibility to establish and support what is reasonable compensation for the services it performs.

Excess servicing is those funds received in excess of reasonable compensation, thus the term excess servicing rights. Excess servicing rights have been determined to represent a stripped coupon, while the underlying mortgage that was sold represents a stripped bond. The fair value of the stripped coupon (i.e., servicing right) is determined based on the relevant facts and circumstances.

The mortgage servicing business is fueled by volume; thus, it is common for a mortgage bank to be an originator of mortgage loans, a purchaser of mortgage loans, and a purchaser of servicing. If both the loan and the servicing right are purchased, and the loan is subsequently sold with servicing retained, tax treatment generally will follow the same treatment as if the seller originated the mortgage loan.

This treatment is significantly different from the purchase of mortgage servicing rights only. Purchased mortgage servicing rights are amortized over 15 years when acquired in connection with a trade or business or over 108 months when a servicing portfolio is acquired separately. Certain restrictions prevent the recognition of loss in value of a servicing portfolio unless the entire portfolio or individually identified loans within a pool of serviced loans are disposed of; thus, taxpayers may have difficulty realizing the loss in value of a servicing portfolio that has significant prepayments until all the underlying mortgages have been paid down.

(ii) Mark to Market

Contrary to normal realization-based tax accounting principles, IRC Section 475 requires dealers in securities to recognize gain or loss through marking-to-market their securities holdings, unless such securities are validly identified by the taxpayer as excepted from the provisions.

As used in this context, the terms dealer and securities have very broad application. Virtually all financial institutions are considered dealers in securities for mark-to-market purposes though regulations provide exceptions for certain institutions not engaging in more than de minimus dealer activities. Securities required to be marked (unless validly identified as excepted) include notes, bonds, and other evidences of indebtedness; stock; notional principal contracts; or any evidence of an interest in or a derivative of such security (other than Section 1256(a) contracts); and any clearly identified hedge of such security.

Securities that may be identified as exempted from the mark-to-market provisions are:

• Securities held for investment, and property identified as such for tax purposes.
• Notes and other evidences of indebtedness (and obligations to acquire such) that are acquired or originated by the taxpayer in the ordinary course of a trade or business that are not held for sale.
• Hedges of positions or liabilities that are not securities in the hands of the taxpayer, and hedges of positions or liabilities that are exempt from mark to market under the two foregoing provisions. This does not apply for hedges held as a dealer.

To be exempted from mark to market, the security must be identified by the taxpayer on a contemporaneous basis (generally, day of acquisition) as meeting one of the exceptions.

Whether a security is required to be marked to market for financial accounting purposes is not dispositive for purposes of determining whether such security is treated as held for investment or not held for sale.

Some financial institutions identify all or a significant portion of their loans to customers as exempted from the mark-to-market provisions because they intend to hold those loans to maturity. A possible exception are mortgages that are originated for sale (pipeline or warehoused loans), which do not meet the exception criteria and must be marked to market.

30.4 Investment Companies

(a) Background

An investment company (referred to as a fund or a mutual fund) generally pools investors' funds to provide them with professional investment management and diversification of ownership in the securities markets. Typically, an investment company sells its capital shares to the public and invests the net proceeds in stock, bonds, government obligations, or other securities, intended to meet the fund's stated investment objectives. A brief history of investment companies is included in paragraphs 1.07 and 1.08 of the AICPA Audit and Accounting Guide, Audits of Investment Companies. One of the more notable distinctions between investment companies and companies in other industries is the extremely high degree of compliance to which registered investment companies must adhere. The Audit and Accounting Guide summarizes applicable practices and delivers how-to advice for handling almost every type of financial statement. It describes relevant matters, conditions, and procedures unique to the investment industry, and illustrates treatments of financial statements and reports to caution auditors and accountants about unusual problems. As a financial statement preparer or auditor, it is essential to understand the unique operational, regulatory, accounting, reporting, and auditing aspects of investment companies. AICPA publications provide background on the industry as well as interpretive guidance for both new and existing rules.

(i) Securities and Exchange Commission Statutes

The SEC is responsible for the administration and enforcement of these statutes governing investment companies:

• Securities Act of 1933. Governs the content of prospectuses and addresses the public offering and distribution of securities (including debt securities and the capital shares of investment companies).
• Securities Exchange Act of 1934. Regulates the trading of securities in secondary markets after the initial public offering and distribution of the securities under the 1933 Act. Periodic SEC financial reporting requirements pursuant to Section 13 or Section 15(d) of the 1934 Act are satisfied by the semiannual filing of Form N-SAR pursuant to Section 30 of the 1940 Act.
• Investment Advisers Act of 1940. Requires persons who are paid to render investment advice to individuals or institutions, including investment companies, to register with the SEC and regulates their conduct and contracts.
• Investment Company Act of 1940. Regulates registered investment companies and provides extensive rules and regulations that govern record keeping, reporting, fiduciary duties, and other responsibilities of an investment company's management.

(ii) Types of Investment Companies

Three common methods of classification are by securities law definition, by investment objectives, and by form of organization.

Classification by Securities Law Definition

Securities law divides investment companies into three types: management companies, face amount certificate companies, and unit investment trusts. The most common classification is the management company. The term mutual fund refers to an open-end management company as described under Section 5 of the 1940 Act. Such a fund stands ready to redeem its shares at net asset value whenever requested to do so and usually continuously offers its shares for sale, although it is not required to do so. A closed-end management company does not stand ready to redeem its shares when requested (although it may occasionally make tender offers for its shares) and generally does not issue additional shares, except perhaps in connection with a dividend reinvestment program. Its outstanding shares are usually traded on an exchange, often at a premium or discount from the fund's underlying net asset value. In addition to open-end and closed-end management companies, there are also management companies that offer the ability for shareholders to redeem their shares periodically on specified dates or intervals.

Other management investment companies include small business investment companies (SBICs) and business development companies (BDCs). Management companies, at their own election, are further divided into diversified companies and nondiversified companies. A fund that elects to be a diversified company must meet the 75 percent test required under Section 5(b)(1) of the 1940 Act. Nondiversified companies are management companies that have elected to be nondiversified and do not have to meet the requirements of Section 5(b)(1).

The 1940 Act also provides for face amount certificate companies, which are rather rare, and unit investment trusts. Unit investment trusts normally are established under a trust indenture by a sponsoring organization that acquires a portfolio (often tax-exempt or taxable bonds that are generally held to maturity) and then sells undivided interests in the trust. Units of the trust may be offered continuously, such as for a trust purchasing treasury securities, but normally do not make any additional portfolio acquisitions. Units remain outstanding until they are tendered for redemption or the trust is terminated.

Separate accounts of an insurance company that underlie variable annuity and variable life insurance products are also subject to the requirements of the 1940 Act. They may be established as management companies or as unit investment trusts. Variable annuities and variable life products are considered to be both securities subject to the 1933 Act and insurance products subject to regulation by state insurance departments.

Classification by Investment Objectives

Investment companies can also be classified by their investment objectives or types of investments—for example, growth funds, income funds, tax-exempt funds, global funds, money market funds, and equity funds.

Classification by Form of Organization

Investment companies can also be classified by their form of organization. Funds may be organized as corporations or trusts (and, to a lesser extent, as partnerships).

Incorporation offers the advantages of detailed state statutory and interpretative judicial decisions governing operations and limited liability of shareholders, and, in normal cases, it requires no exemptions to comply with the 1940 Act.

The business trust, or Massachusetts trust, is an unincorporated business association established by a declaration or deed of trust and governed largely by the law of trusts. In general, a business trust has the advantages of unlimited authorized shares, no annual meeting requirement, and long duration. However, Massachusetts trusts have a potential disadvantage in that there is unlimited liability to the business trust shareholders in the event of litigation or other negative factors. Generally, however, the trust undertakes to indemnify the shareholders against loss.

(b) Fund Operations

When a new fund is established, it enters into a contract with an investment adviser (often the sponsoring organization) to manage the fund and, within the terms of the fund's stated investment objectives, to determine what securities should be purchased, sold, or exchanged. The investment adviser places orders for the purchase or sale of portfolio securities for the fund with brokers or dealers selected by it. The officers of the fund, who generally are also officers of the investment adviser or fund administrator, give instructions to the custodian of the fund holdings as to delivery of securities and payments of cash for the account of the fund. The investment adviser normally furnishes, at its own expense, all necessary advisory services, facilities, and personnel in connection with these responsibilities. The investment adviser may also act as administrator; administrative duties include preparation of regulatory filings and managing relationships with other service providers. The investment adviser and administrator are usually paid for these services through a fee based on the value of net assets.

The distributor or underwriter for an investment company markets the shares of the fund—either directly to the public (no-load funds) or through a sales force. The sales force may be compensated for their services through a direct sales commission included in (deducted from) the price at which the fund's shares are offered (redeemed), through a distribution fee (also referred to as a 12b-1 plan fee) paid by the fund as part of its recurring expenses, or in both ways. Rule 12b-1 under the 1940 Act permits an investment company to pay for distribution expenses, which otherwise are paid for by the distributor and not the fund.

A fund has officers and directors (and in some cases, trustees) but generally has no employees, the services it requires being provided under contract by others. Primary servicing organizations are summarized below.

(i) Fund Accounting Agent

The fund accounting agent maintains the fund's general ledger and portfolio accounting records and computes the net asset value per share, usually on a daily basis. In some instances, this service is provided by the investment adviser or an affiliate of the adviser, or a nonaffiliated entity may perform this service. The fund accounting agent, or in some cases a separate administrative agent, may also be responsible for preparation of the fund's financial statements, tax returns, semiannual and annual filings with the SEC on Form N-SAR, and the annual registration statement filing.

(ii) Custodian

The custodian maintains custody of the fund's assets, collects income, pays expenses, and settles investment transactions. The 1940 Act provides for three alternatives in selecting a custodian. The most commonly used is a commercial bank or trust company that meets the requirements of Sections 17 and 26 of the 1940 Act. The second alternative is a member firm of a national securities exchange; the third alternative is for the fund to act as its own custodian and utilize the safekeeping facilities of a bank or trust company. Section 17(f) and Rules 17f-1 and 17f-2 of the 1940 Act provide for specific audit procedures to be performed by the fund's independent accountant when either alternative two or three is used.

(iii) Transfer Agent

The fund's transfer agent maintains the shareholder records and processes the sales and redemptions of the fund's capital shares. The transfer agent processes the capital share transactions at a price per share equal to the net asset value per share of the fund next determined by the fund accounting agent (forward pricing). In certain instances, shareholder servicing—the direct contact with shareholders, usually by telephone—is combined with the transfer agent processing.

(c) Accounting

The SEC has set forth in Financial Reporting Policies, Section 404.03, Accounting, Valuation, and Disclosure of Investment Securities, its views on accounting for securities by registered investment companies.

Because for federal income tax purposes the fund is a conduit for the shareholders, the operations of an investment company are normally influenced by federal income tax to the shareholder. Accordingly, conformity between book and tax accounting is usually maintained whenever practicable under GAAP. In general, investment companies carry securities, which are their most significant asset, at current value, not at historical cost. In such a mark-to-market environment, the deviation between book and tax accounting has no effect on net asset value.

Uniquely, most mutual funds close their books daily and calculate a net asset value per share, which forms the pricing basis for shareholders who are purchasing or redeeming fund shares. SEC Rules 2a-4 and 22c-1 set forth certain accounting requirements, including a 1 cent per share pricing criterion. Because of this daily closing of the books, mutual funds and their agents must maintain well-controlled and current accounting systems to provide proper records for their highly compliance-oriented industry.

The SEC has promulgated extensive rules under each of the statutes that it administers, including these:

• Article 6 of Regulation S-X (Article 3-18 and Article 12-12). Sets forth requirements as to the form and content of, and requirements for, financial statements filed with the SEC, including what financial statements must be presented and for what periods.
• Financial reporting policies. Section 404 relates specifically to registered investment companies.

(d) Financial Reporting

(i) New Registrants

Any company registered under the 1940 Act that has not previously had an effective registration statement under the 1933 Act must include, in its initial registration statement, financial statements and financial highlights of a date within 90 days prior to the date of filing. For a company that did not have any prior operations, this would be limited to a seed capital statement of assets and liabilities and related notes.

Section 14 of the 1940 Act requires that an investment company have a net worth of at least $100,000. Accordingly, a new investment company is usually incorporated by its sponsor with seed capital of that amount.

(ii) General Reporting Requirements

The SEC reporting requirements are outlined in Section 30 of the 1940 Act and the related rules and regulations thereunder, which supersede any requirements under Section 13 or Section 15(d) of the 1934 Act to which an investment company would otherwise be subject. A registered management investment company is deemed by the SEC to have satisfied its requirement under the 1934 Act to file an annual report by the filing of semiannual reports on Form N-SAR.

The SEC requires that every registered management company send to its shareholders, at least semiannually, a report containing financial statements and financial highlights. Only the financial statements and financial highlights in the annual report are required to be audited.

Some funds prepare quarterly reports to shareholders, although they are not required to do so. They generally include a portfolio listing, and in relatively few cases, they include full financial statements. Closed-end funds listed on an exchange have certain quarterly reporting requirements under their listing agreements with the exchange.

(iii) Financial Statements

Article 6 of Regulation S-X deals specifically with investment companies and requires these statements:

• A statement of assets and liabilities (supported by a separate listing of portfolio securities) or a statement of net assets, which includes a detailed list of portfolio securities at the reporting date
• A statement of operations for the year
• A statement of changes in net assets for the latest two years

SFAS No. 95 provides that a statement of cash flows should be included with financial statements prepared in accordance with GAAP. This Statement requires that a statement of cash flows classify cash receipts and payments according to whether they stem from operating, investing, or financing activities and provides definitions of each category. It requires that information about investing and financing activities not resulting in cash receipts or payments in the period be provided separately. A business enterprise that provides a set of financial statements that reports both financial position and results of operations must also provide a statement of cash flows for each period for which results of operations are provided. The information provided in a statement of cash flows, if used with related disclosures and information in the other financial statements, should help investors, creditors, and others to assess:

• The enterprise's ability to generate positive future net cash flows
• The enterprise's ability to meet its obligations, its ability to pay dividends, and its needs for external financing
• The reasons for differences between net income and associated cash receipts and payments
• The effects on an enterprise's financial position of both its cash and noncash investing and financing transactions during the period

Financial statements that show only cash receipts and payments during a short period, such as a year, cannot adequately indicate whether an enterprise's performance is successful. Important uses of information about an entity's financial position include helping users to assess factors such as the entity's liquidity, financial flexibility, profitability, and risk.

SFAS No. 102 exempts investment companies from providing a statement of cash flows, provided certain conditions are met. A statement of changes in net assets should be given even if the statement of cash flows is presented because a statement of changes in net assets shows the changes in shareholders' equity required by GAAP and by Article 6 of Regulation S-X.

(e) Taxation

Investment companies are subject to federal income taxes and certain state and local taxes. However, investment companies registered under the 1940 Act may qualify for special federal income tax treatment as regulated investment companies (RICs) under the IRC and may deduct dividends paid to shareholders. If a fund fails to qualify as an RIC, it will be taxed as a regular corporation, and the deduction for dividends paid by the fund is disallowed. Subchapter M (Sections 851–855) of the IRC applies to RICs. Chapter 6 of the Audit Guide discusses the tax considerations related to RICs.

To qualify as an RIC, the fund must:

• Be a domestic entity registered under the 1940 Act
• Derive 90 percent of its total income from dividends, interest, and gross gains on sales of securities
• Have 50 percent of its assets composed of cash, U.S. government securities, securities of other funds, and other issues, as defined
• Have not more than 25 percent of the value of its total assets invested in the securities (other than U.S. government securities or the securities of other regulated investment companies) of any one issuer or of two or more issuers controlled by the fund that are determined to be engaged in the same or similar trades or businesses

In order for an RIC to use its distributions to offset taxable income, it must distribute at least 90 percent of its net investment company taxable income and net tax-exempt interest income to its shareholders. Also, to avoid a 4 percent nondeductible excise tax, a fund must distribute, by December 31 of each year, 98 percent of its ordinary income measured on a calendar year basis and 98 percent of its net capital gains measured on a fiscal year basis ending October 31. Actual payment of the distribution must be before February 1 of the following year.

(f) Filings

SEC registration forms applicable to investment companies include:

• Form N-8A. The notification of registration under the 1940 Act.
• Form N-1A. The registration statement of open-end management investment companies under the 1940 and the 1933 Acts. (It is not to be used by SBICs, BDCs, or insurance company separate accounts.) The form describes in detail the company's objectives, policies, management, investment restrictions, and similar matters. The form consists of the prospectus, the statement of additional information, and a third section of other information, including detailed information on the SEC required yield calculations. Post-effective amendments on Form N-1A, including updated audited financial statements, must be filed and become effective under the 1933 and 1940 Acts within 16 months after the end of the period covered by the previous audited financial statements if the fund is to continue offering its shares.
• Form N-SAR. A reporting form used for semiannual and annual reports by all registered investment companies that have filed a registration statement that has become effective pursuant to the 1933 Act, with the exception of face amount certificate companies and BDCs. BDCs file periodic reports pursuant to Section 13 of the 1934 Act. Management investment companies file the form semiannually; unit investment trusts are only required to file annually. There is no requirement that the form or any of the items be audited. The annual report filed by a management investment company must be accompanied by a report on the company's system of internal accounting controls from its independent accountant. The requirement for an accountant's report on internal accounting controls does not apply to SBICs or to management investment companies not required by either the 1940 Act or any other federal or state law or rule or regulation thereunder to have an audit of their financial statements.
• Form N-2. A registration statement for closed-end funds comparable to Form N-1A for open-end funds. Under Rule 8b-16 of the 1940 Act, if certain criteria are met in the annual report of a closed-end fund, the fund may not need to annually update its Form N-2 filing with the SEC.
• Forms N-1, N-3, N-4, and N-6. The registration statements for various types of insurance-related products, including variable annuities and variable life insurance.
• Form N-5. The registration statement for SBICs, which are also licensed under the Small Business Investment Act of 1958, is used to register the SBIC under both the 1933 Act and the 1940 Act.
• Form N-14. The statement for registration of securities issued by investment companies in business combination transactions under the 1933 Act. It contains information about the companies involved in the transaction, including historical and pro forma financial statements.

(g) Investment Partnerships—Special Considerations

Investment partnerships may be described generally as limited partnerships organized under state law to trade and/or invest in securities. They are sometimes also referred to as hedge funds, which has become a generic industry term for an investment partnership (or another nonpublic investment company), although this may be a misnomer depending on the partnership's investment strategy. Investment partnerships, if certain conditions are met, are generally not required to register under the 1940 Act and are also generally not subject to the IRC rules and regulations that apply to RICs.

An investment partnership is governed by its partnership agreement. This is the basis for legal, structural, operational, and accounting guidelines. The majority of the capital in an investment partnership is owned by its limited partners. The general partner usually has a minimal investment in the partnership, if any at all. Limited partners may be a variety of entities, including private and public pension plans, foreign investors, insurance companies, bank holding companies, and individuals. There are legal, regulatory, and accounting and tax considerations associated with each of these types of investors. For example, investment in an investment partnership by pension plans may subject the investment partnership to the rules and regulations of the Employee Retirement Income Security Act of 1974 (ERISA) (generally, investment partnerships will not be subject to ERISA if less than 25 percent of the partnership's capital is derived from pension or other employee benefit plan assets); foreign investors may be subject to foreign withholding taxes; and the number of partners in an investment partnership may subject the investment partnership to registration under the 1940 Act (generally, an investment partnership must have fewer than 100 partners [or must have partners who are all qualified purchasers] to avoid registration under the 1940 Act).

The limited partners are generally liable for the repayment and discharge of all debts and obligations of the investment partnership, but only to the extent of their respective interest in the partnership. They usually have no part in the management of the partnership and have no authority to act on behalf of the partnership in connection with any matter. The general partner can be an individual, a corporation, or other entity. The general partner usually has little or no investment in the investment partnership (often 1 percent of total contributed capital) and is responsible for the day-to-day administration of the investment partnership. The general partner, however, usually has unlimited liability for the repayment and discharge of all debts and obligations of the partnership irrespective of its interest in the partnership. The general partner may also be the investment adviser or an affiliate of the adviser.

Although investment partnerships are generally not investment companies as defined in federal securities laws, they do meet the definition of investment companies as contained in the Audit Guide. Accordingly, the Audit Guide is generally applicable to investment partnerships. There are, however, certain disclosure requirements in the Audit Guide to which most partnerships historically have taken exception and have not followed. The AICPA clarified the appropriate disclosure for partnerships in its issuance of SOP No. 95-2, Financial Reporting for Nonpublic Investment Partnerships, as amended by SOP No. 01-1, Amendment to Scope of Statement of Position 95-2, which is applicable for fiscal years beginning after December 15, 1994.

A partnership is classified as a pass-through entity for tax purposes, meaning that the partners, not the partnership, are taxed on the income, expenses, gains, and losses incurred by the partnership. The partners recognize the tax effects of the partnership's operations regardless of whether any distribution is made to such partners. This differs from a corporation, which incurs an entity level tax on its earnings and whose owners (stockholders) incur a second level of tax when the corporation's profits are distributed to them.

(h) Offshore Funds—Special Considerations

Offshore funds may be described generally as investment funds set up to permit international investments with minimum tax burden on the fund shareholders. This is achieved by setting up the funds in countries with favorable tax laws and in countries with nonburdensome administrative regulations. Popular offshore locations include Bermuda, the Cayman Islands, and the Netherlands Antilles.

An offshore fund's shares are offered to investors (generally non-U.S.) residing outside the country in which the fund is domiciled. Assuming the offshore fund is not publicly sold in the United States and does not have more than 100 U.S. shareholders (or only qualified purchasers), the offshore fund will not be subject to SEC registration or reporting requirements. Similar to hedge funds, because of the lack of regulatory restrictions, offshore funds often have higher risk investment strategies than U.S. regulated funds.

A major U.S. tax advantage to non-U.S. shareholders of investing in U.S. securities through an offshore fund as opposed to a U.S. domiciled fund is the avoidance of certain U.S. withholding taxes. By investing through the offshore fund, the shareholder avoids withholding taxes on most U.S.-sourced interest income and short-term capital gains, which would be subject to withholding taxes if the amounts were paid to the non-U.S. shareholder through a U.S. domiciled fund. Offshore funds also avoid the U.S. IRC distribution requirements imposed on U.S. funds. This allows for the potential roll-up of income in the fund (i.e., the deferral of income recognition for the shareholder for tax purposes, depending on the tax residence of the shareholder).

Under new 1996 tax legislation, a fund's U.S. administrative and other activities, which were previously required to be performed offshore to comply with IRC Reg. Sec. 1.864–2(c)2 (the Ten Commandments), generally will not create tax nexus for U.S. federal income tax purposes. However, depending on the laws of the particular jurisdiction in which its U.S. activities are conducted, those same U.S. activities may under some circumstances create tax nexus in certain state or local jurisdictions. Careful consideration should be given to the potential state and local tax consequences of onshore activities before any activities that were previously recommended to be conducted outside the United States are brought onshore.

Fund managers and advisers should consider several nontax factors before bringing certain functions onshore. These include:

• Whether the performance of more operations onshore will make it more likely that the fund, manager, and/or advisers can be subject to the jurisdiction of U.S. courts and/or applicable U.S., state, or local laws and regulations
• The regulatory requirements of the fund's domicile (e.g., Luxembourg, Dublin, and Bermuda require administration and certain other functions to be performed locally)
• The investor's desire for confidentiality
• The potential applicability of federal, state, and local tax or other filing requirements
• The potential effect on prospectus disclosure

30.5 Sources and Suggested References

Accounting Principles Board. Opinion 30, Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. New York: AICPA, 1973.

Accounting Standards Codification 360, Property, Plant, and Equipment, Overall, Scope and Scope Exceptions. Available at http://asc.fasb.org/link&sourceid=SL2163854-110220&objid=6390208

American Institute of Certified Public Accountants. Accounting Standards Division, Statement of Position 78-9, Accounting for Investments in Real Estate Ventures. New York: Author, 1978.

_____. AICPA Practice Bulletin No. 1, Purpose and Scope of AcSEC Practice Bulletins and Procedures for Their Issuance (1987), New York: Author, 1987.

_____. AICPA Practice Bulletin No. 4, Accounting for Foreign Debt/Equity Swaps. New York: Author, 1988.

_____. AICPA Practice Bulletin No. 5, Income Recognition on Loans to Financially Troubled Countries. New York: Author, 1998.

_____. AICPA Practice Bulletin No. 6, Amortization of Discounts on Certain Acquired Loans. New York: Author, 1989.

_____. Audit and Accounting Guide, Banks and Savings Institutions. New York: Author, 1997.

_____. Audits of Investment Companies. New York: Author, 2001.

_____. Statement of Position 92-3, Accounting for Foreclosed Assets. New York: Author, 1992.

_____. Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties. New York: Author, 1994.

_____. Statement of Position 95-2, Financial Reporting for Nonpublic Investment Partnerships. New York: Author, 1995.

_____. Statement of Position 97-1, Accounting by Participating Mortgage Loan Borrowers. New York: Author, 1997.

_____. Statement of Position 01-1, Amendment to Scope of Statement of Position 95-2, Financial Reporting for Nonpublic Investment Partnerships. New York: Author, 2001.

Ashcraft, A. B., and T. Schuermann. Understanding the Securitization of Subprime Mortgage Credit. New York: Federal Reserve Bank of New York, Staff Reports, 2008.

Bank for International Settlements (BIS) Basel Committee on Bank Supervision. Principles for Sound Liquidity Risk Management and Supervision, 2008. www.bis.org/publ/bcbs.htm

Bank for International Settlements (BIS) Basel Committee on Banking Supervision. Microfinance Activities and the Core Principles for Effective Banking Supervision—Consultative Document, August 2010. www.bis.org/publ/bcbs.htm

Bank for International Settlements (BIS) Basel Committee on Banking Supervision, Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring, 2011. www.bis.org/publ/bcbs188.htm

Bank for International Settlements (BIS) Basel Committee on Banking Supervision: Principles for Enhancing Corporate Governance, October 2010. http://www.bis.org/publ/bcbs176.htm

Cammarano, N., and J. J. Klink Jr. Real Estate Accounting and Reporting: A Guide for Developers, Investors, and Lenders, 3rd ed. New York: John Wiley & Sons, 1995.

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. 111-203, 2010.

Financial Accounting Standards Board. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 84-7, Termination of Interest Rate Swaps. Norwalk, CT: Author, 1984.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 84-14, Deferred Interest Rate Setting. Norwalk, CT: Author, 1984.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 84-36, Interest Rate Swap Transactions. Norwalk, CT: Author, 1984.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 85-6, Futures Implementation Question. Norwalk, CT: Author, 1985.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 86-25, Offsetting Foreign Currency Swaps. Norwalk, CT: Author, 1986.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 86-28, Accounting Implications of Indexed Debt Instruments. Norwalk, CT: Author, 1986.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 87-1, Deferral Accounting for Cash Securities That Are Used to Hedge Rate or Price Risk. Norwalk, CT: Author, 1987.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 87-26, Hedging of Foreign Currency Exposure with a Tandem Currency. Norwalk, CT: Author, 1987.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 88-8, Mortgage Swaps. Norwalk, CT: Author, 1988.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 88-11, Allocation of Recorded Investment When a Loan or Part of a Loan Is Sold. Norwalk, CT: Author, 1995.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 90-17, Hedging Foreign Currency Risk with Purchased Options. Norwalk, CT: Author, 1990.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 91-1, Hedging Intercompany Foreign Currency Risks. Norwalk, CT: Author, 1991.

_____, EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 91-4, Hedging Foreign Currency Risk with Complex Options and Similar Transactions. Norwalk, CT: Author, 1991.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 93-10, Accounting for Dual Currency Bonds. Norwalk, CT: Author, 1993.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 94-7, Accounting for Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock. Norwalk, CT: Author, 1994.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 94-8, Accounting for Conversion of a Loan into a Debt Security in a Debt Restructuring. Norwalk, CT: Author, 1994.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 94-9, Determining a Normal Servicing Fee Rate for the Sale of an SBA Loan. Norwalk, CT: Author, 1994.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 95-2, Determination of What Constitutes a Firm Commitment for Foreign Currency Transactions Not Involving a Third Party. Norwalk, CT: Author, 1995.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 95-5, 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. Norwalk, CT: Author, 1995.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 95-11, Accounting for Derivative Instruments Containing Both a Written Option-Based Component and a Forward-Based Component. Norwalk, CT: Author, 1995.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 96-1, Sale of Put Options on Issuer's Stock that Require or Permit Cash Settlement. Norwalk, CT: Author, 1996.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 96-2, Impairment Recognition When a Nonmonetary Asset Is Exchanged or Is Distributed to Owners and Is Accounted the Asset's Recorded Amount. Norwalk, CT: Author, 1996.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 96-10, Impact of Certain Transactions on the Held-to-Maturity Classification under FASB Statement No. 115. Norwalk, CT: Author, 1996.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 96-11, Accounting for Forward Contracts and Purchased Options to Acquire Securities Covered by FASB Statement No. 115. Norwalk, CT: Author, 1996.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 96-12, Recognition of Interest Income and Balance Sheet Classification of Structured Notes. Norwalk, CT: Author, 1996.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 96-13, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock. Norwalk, CT: Author, 1996.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 96-14, Accounting for the Costs Associated with Modifying Computer Software for the Year 2000. Norwalk, CT: Author, 1996.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 96-15, Accounting for the Effects of Changes in Foreign Currency Exchange Rates on Foreign-Currency-Denominated Available-for-Sale Debt Securities. Norwalk, CT: Author, 1996.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 96-19, Debtor's Accounting for a Substantive Modification and Exchange of Debt Instruments. Norwalk, CT: Author, 1996.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 96-20, Impact of FASB Statement No. 125 on Consolidation of Special-Purpose Entities. Norwalk, CT: Author, 1996.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 96-22, Applicability of the Disclosure Required by FASB Statement No. 114 When a Loan Is Restructured in a Troubled Debt Restructuring into Two (or More) Loans. Norwalk, CT: Author, 1996.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 96-23, The Effect of Financial Instruments Indexed to, and Settled in, a Company's Own Stock of Pooling-of-Interests Accounting for a Subsequent Business Combination. Norwalk, CT: Author, 1996.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 97-3, Accounting for Fees and Costs Associated with Loan Syndications and Loan Participations after the Issuance of FASB Statement No. 125. Norwalk, CT: Author, 1997.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 97-7, Accounting for Hedges of Foreign Currency Risk Inherent in an Available-for-Sale Marketable Equity Security. Norwalk, CT: Author, 1997.

_____. EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, EITF Issue No. 97-9, Effect on Pooling-of-Interests Accounting of Certain Contingently Exercisable Options or Other Equity Instruments. Norwalk, CT: Author, 1997.

_____. Interpretation No. 9, Applying APB Opinions No. 16 and 17 When a Savings and Loan Association or a Similar Institution Is Acquired in a Business Combination Accounted for by the Purchase Method. Norwalk, CT: Author, 1976.

_____. Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts. Norwalk, CT: Author, 1992.

_____. Interpretation No. 41, Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements—An Interpretation of APB Opinion No. 10 and a Modification of FASB Interpretation No. 39. Norwalk, CT: Author, 1994.

_____. Statement of Financial Accounting Standards No. 5, Accounting for Contingencies. Stamford, CT: Author, 1975.

_____. Statement of Financial Accounting Standards No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings. Stamford, CT: Author, 1977.

_____. Statement of Financial Accounting Standards No. 34, Capitalization of Interest Cost. Stamford, CT: Author, 1979.

_____. Statement of Financial Accounting Standards No. 52, Foreign Currency Translation. Stamford, CT: Author, 1981.

_____. Statement of Financial Accounting Standards No. 58, Capitalization of Interest Cost in Financial Statements That Include Investments Accounted for by the Equity Method. Stamford, CT: Author, 1982.

_____. Statement of Financial Accounting Standards No. 65, Accounting for Certain Mortgage Banking Activities. Stamford, CT: Author, 1982.

_____. Statement of Financial Accounting Standards No. 66, Accounting for Sales of Real Estate. Stamford, CT: Author, 1982.

_____. Statement of Financial Accounting Standards No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects. Stamford, CT: Author, 1982.

_____. Statement of Financial Accounting Standards No. 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions (an Amendment of APB Opinion No. 17, an Interpretation of APB Opinions No. 16 and 17, and an Amendment of FASB Interpretation No. 9). Norwalk, CT: Author, 1983.

_____. Statement of Financial Accounting Standards No. 77, Reporting by Transferors for Transfers of Receivables with Recourse. Stamford, CT: Author, 1983.

_____. Statement of Financial Accounting Standards No. 80, Accounting for Futures. Stamford, CT: Author, 1984.

_____. Statement of Financial Accounting Standards No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (an Amendment of FASB Statements No. 13, 60, and 65 and a Rescission of FASB Statement No. 17). Stamford, CT: Author, 1986.

_____. Statement of Financial Accounting Standards No. 95, Statement of Cash Flow. Norwalk, CT: Author, 1987.

_____. Statement of Financial Accounting Standards No. 102, Statement of Cash Flows—Exception of Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale (an amendment of FASB Statement No. 95). Norwalk, CT: Author, 1989.

_____. Statement of Financial Accounting Standards No. 104, Statement of Cash Flows—Net Reporting of Certain Cash Receipts and Cash Payments and Classification of Cash Flows from Hedging Transactions (an Amendment of FASB Statement No. 95). Norwalk, CT: Author, 1989.

_____. Statement of Financial Accounting Standards No. 105, Disclosure of Information about Financial Instruments Off-Balance Sheet Risk and Financial Instruments with Concentrations of Credit Risk. Norwalk, CT: Author, 1990.

_____. Statement of Financial Accounting Standards No. 107, Disclosures About Fair Value of Financial Instruments. Norwalk, CT: Author, 1991.

_____. Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan (an Amendment of FASB Statements 5 and 15). Norwalk, CT: Author, 1993.

_____. Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities. Norwalk, CT: Author, 1993.

_____. Statement of Financial Accounting Standards No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures (an Amendment of FASB Statement 114). Norwalk, CT: Author, 1994.

_____. Statement of Financial Accounting Standards No. 119, Disclosures about Derivative Financial Instruments and Fair Value of Financial Instruments. Norwalk, CT: Author, 1994.

_____. Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. Norwalk, CT: Author, 1995.

_____. Statement of Financial Accounting Standards No. 122, Accounting for Mortgage Servicing Rights. Norwalk, CT: Author, 1995.

_____. Statement of Financial Accounting Standards No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Norwalk, CT: Author, 1996.

_____. Statement of Financial Accounting Standards No. 126, Exemption from Certain Required Disclosures about Financial Instruments for Certain Nonpublic Entities (an Amendment of FASB Statement No. 107). Norwalk, CT: Author, 1996.

_____. Statement of Financial Accounting Standards No. 127, Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125 (an Amendment of FASB Statement No. 125). Norwalk, CT: Author, 1996.

_____. Statement of Financial Accounting Standards No. 123R, Share-Based Payment. Norwalk, CT: Author, 2004.

_____. Statement of Financial Accounting Standards No. 157, Fair Value Measurements. Norwalk, CT: Author, 2006.

_____. Statement of Financial Accounting Standards No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases. Norwalk, CT: Author, December 1986.

_____. Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan. Norwalk, CT: Author, May 1993

_____. Statement of Financial Accounting Standards No.115, Accounting for Certain Investments in Debt and Equity Securities. Norwalk, CT: Author, May 1993

_____. Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities. Norwalk, CT: Author, June 1998

_____. Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Norwalk, CT: Author, September 2000.

_____ Statement of Financial Accounting Standards No. 157 was codified into FASB Accounting Standard Codification Topic 820, Fair Value Measurements and Disclosures, in 2009.

_____. Technical Bulletin 85-2, Accounting for Collateralized Mortgage Obligations. Norwalk, CT: Author, 1985.

_____. Technical Bulletin 94-1, Application of Statement 115 to Debt Securities Restructured in a Troubled Debt Restructuring. Norwalk, CT: Author, 1994.

International Federation of Accountants (IFAC). 2010. Accountancy Summit on Corporate Governance Reform Beyond the Global Financial Crisis (October 18, 2010) New York. Available at http://www.ifac.org/news-events/2010-10/accountancy-summit-corporate-governance-reform-looks-beyond-global-financial-cri

Rezaee, Z. Corporate Governance Post-Sarbanes-Oxley: Regulations, Requirements, and Integrated Processes, Inc. Hoboken, NJ: John Wiley & Sons, 2007.

Sarbanes-Oxley Act of 2002, July 30, 2002. www.sarbanesoxleysimplified.com/sarbox/compact/htmlact/sec407.html

Securities and Exchange Commission. Federal Reporting Release No. 23, The Significance of Oral Guarantees to the Financial Reporting Process. Washington, DC: Author, 1985.

_____. Federal Reporting Release No. 28, Accounting for Loan by Registrants Engaged in Lending Activities. Stamford, CT: Author, 1986.

_____. Federal Reporting Release No. 36, Management's Discussion and Analysis of Financial Condition and Results of Operations; Certain Investment Company Disclosures. Stamford, CT: Author, 1989.

_____. Federal Reporting Release No. 48, Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information About Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments. Stamford, CT: Author, 1997.

_____. Federal Reporting Release No. 72. Interpretation:Commission Guidance regarding Management's Discussion and Analysis of Financial Condition and Results of Operations, Releases Nos. 33-8350, 34-48960, December 29, 2003. Available at www.sec.gov/rules/interp/33-8350.htm

_____ Financial Reporting Policies, Section 401, Banks and Holding Companies, Financial Reporting Release No. 1, Section 404.03, Accounting, Valuation, and Disclosure of Investment Securities, Accounting Series Release No. 118, Accounting for Investment Securities by Registered Investment Companies. Boston: Warren, Gorham & Lamont, 1995.

_____. Regulation S-X, Article 9, Bank Holding Companies. SEC 2004. www.spee.org/images/PDFs/ReferencesResources/Full%20text%20SEC%20Reg%20regsx2.pdf

_____. Securities Act Guide 3, Statistical Disclosure by Bank Holding Companies. SEC. www.sec.gov/about/forms/industryguides.pdf

_____. Staff Accounting Bulletin No. 50, Financial Statement Requirements in Filings Involving the Formation of a One-Bank Holding Company. Washington, DC: Author, 1983.

_____. Staff Accounting Bulletin No. 56, Reporting of an Allocated Transfer Risk Reserve in Filings under the Federal Securities Laws. Washington, DC: Author, 1984.

_____, Staff Accounting Bulletin No. 59, Accounting for Noncurrent Marketable Equity Securities. Washington, DC: Author, 1985.

_____. Staff Accounting Bulletin No. 60, Financial Guarantees. Washington, DC: Author, 1985.

_____. Staff Accounting Bulletin No. 61, Allowance Adjustments. Washington, DC: Author, 1986.

_____. Staff Accounting Bulletin No. 69, Application of Article 9 and Guide 3 to Non-Bank Holding Companies. Washington, DC: Author, 1987.

_____. Staff Accounting Bulletin Nos. 71 and 71A, Financial Statements of Properties Securing Mortgage Loans. Washington, DC: Author, 1987. Also see www.occ.gov/topics/bank-operations/accounting/index-accounting.html.

_____. Staff Accounting Bulletin No. 75, Accounting and Disclosures by Bank Holding Companies for a “Mexican Debt Exchange” Transaction. Washington, DC: Author, 1988.

_____. Staff Accounting Bulletin No. 82, Certain Transfers of Nonperforming Assets and Disclosures of the Impact of Assistance from Federal Financial Institution Regulatory Agencies. Washington, DC: Author, 1989.

_____. Staff Accounting Bulletin No. 89, Financial Statements of Acquired Financial Institutions. Washington, DC: Author, 1989.

Walter, J. R. Loan Loss Reserve, American Banker issues, Economic Review, July/August 1991.

Bank and Savings Institutions' Regulatory Guidance

Selected guidance prepared by the federal bank and savings institutions regulatory agencies is contained in the following documents:

• Bank Holding Company Supervision Manual, Federal Reserve System
• Comptroller's Handbook for Compliance, OCC
• Comptroller's Handbook for Fiduciary Activities, OCC
• Comptroller's Handbook for National Bank Examiners, OCC
• Comptroller's Manual for National Banks, OCC
• Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

• FDIC Trust Examination Manual
• Federal Banking Law Reporter, Commerce Clearing House, Inc.
• Manual of Examination Policies, FDIC Division of Supervision
• Commercial Bank Examination Manual, Federal Reserve System
• Instructions—Consolidated Reporting of Condition and Income, FFIEC
• OCC Bank Accounting Advisory Series, 3rd ed. (June 1994). Also see www.occ.gov/topics/bank-operations/accounting/index-accounting.html
• Thrift Activities Regulatory Handbook, OTS