Surrender of Control

A transfer of financial assets (or a component of a financial asset) is recognized as a sale if the transferor surrenders control over those assets in exchange for consideration. However, control is not surrendered to the extent that the consideration received is a beneficial interest in these very same transferred assets. For example, a transferor's exchange of one form of beneficial interests in a trust for an equivalent, but different, form in the same transferred financial assets cannot be accounted for as a sale. If the trust initially issued the beneficial interests, the exchange is not even considered to be a transfer under ASC 860.

The criteria for identifying surrender of control are described in ASC 860-10-40-5:

1. Isolation of transferred financial assets. The financial assets transferred are beyond the reach of the transferor and its affiliates, its creditors, potential bankruptcy trustees, or other receivers. This is achieved only if the transferred financial assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor or any of its consolidated affiliates included in the financial statements being presented. For multiple-step transfers, an entity that is designed to make remote the possibility that it would enter bankruptcy or other receivership (the “bankruptcy-remote entity”) is not considered a consolidated affiliate for purposes of performing the isolation analysis. Notwithstanding the isolation analysis, each entity involved in the transfer is subject to the applicable GAAP guidance on whether it must be consolidated.

   NOTE: The former distinction made between qualifying special purpose entities (QSPEs) and variable interest entities (VIEs) has been eliminated and former QSPEs are now subject to consolidation, as are all VIEs, if defined criteria are met.

2. Pledge or exchange rights. Each transferee (or—if the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities, and if it is constrained from pledging or exchanging the assets it receives—each third-party holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both (1) constrains the transferee (or third-party holder of its beneficial interests) from taking advantage of its right to pledge or exchange, and (2) provides more than a trivial benefit to the transferor.
3. Effective control. The transferor or its consolidated affiliates included in the financial statements being presented, or its agents, does not maintain effective control over the transferred financial assets or the third-party beneficial interests related to those transferred assets. A transferor maintains effective control if (1) an agreement both entitles and obligates the transferor to repurchase or redeem the financial assets before their maturity, (2) the transferor has the ability to unilaterally cause the holder to return specific financial assets and that ability conveys more than trivial benefit, or (3) an agreement permits the transferee to require the transferor to repurchase the transferred financial assets at a price that is so favorable to the transferee that it is probable that the transferee will require this to occur. If the transferor can cause the holder to return assets only through a cleanup call, that ability does not indicate effective control.

A repurchase to maturity transaction is accounted for as a secured borrowing. (ASC 860-10-40-5A)

All available evidence is assessed to determine if transferred assets would be beyond the reach of the powers of a bankruptcy trustee (or equivalent). It is irrelevant to this determination that the possibility of bankruptcy is remote at the date of the transfer. Instead, the transferor must endeavor to isolate the assets in the event of bankruptcy, however unlikely that eventuality may be. In many cases, transferors use two transfers to isolate the transferred assets. First, it transfers the assets to a wholly owned corporation that is designed in a way that prevents the transferor or its creditors from reclaiming the assets (or makes the possibility that they can reclaim them remote). Next, the wholly owned corporation transfers the assets to a trust. The trust is prevented from undertaking any business other than management of the assets and from incurring any liabilities. (Thus, there are no creditors to force bankruptcy of the trust.)

A determination that the transferred assets are beyond the reach of a bankruptcy trustee may require a legal opinion regarding the application of the laws of the relevant jurisdiction. Such legal opinions commonly address whether a “true sale” has occurred, and in practice different attorneys may reach different conclusions regarding a given transaction.

Prior to 2010, a common practice was to transfer financial assets to a related entity (a securitization trust, typically) that would qualify as a QSPE, which under then-extant GAAP would always be excluded from consolidation by the sponsoring entity. The concept of QSPE has been entirely eliminated; such transferee entities must be evaluated for possible consolidation by the sponsoring entity under other existing GAAP requirements.

The existence of setoff rights does not impede the finding of a “true sale.” In practice, while setoff rights may exist for the transferor and transferee, if either the obligor under the transferred financial asset (e.g., debtor under transferred receivable) or the transferor entity enters bankruptcy, the transferee might have only an unsecured claim, notwithstanding the nominal right of setoff.

Assets transferred by a bank or other financial institution that is subject to possible receivership by the FDIC can be considered isolated from the transferor even if the FDIC or another creditor can require their return, provided that the return can only occur in receivership, after a default, and in exchange for a payment of, at a minimum, principal and interest earned at the contractual yield to the date the investors are paid. (That rule does not apply to situations in which the transferor can require return of the assets in exchange for payment of principal and interest earned at the contractual yield to the date the investors are paid. In those cases the assets are not isolated from the transferor.)

A transferee has control of transferred assets if there is the unconstrained right to both pledge and exchange the assets. In actual practice it may be more difficult to discern whether the transferee has control if it can pledge the transferred assets but cannot sell them. The key to a determination of control by a transferee with the right to pledge or exchange the assets rests on whether the transferee obtains all or most of the cash inflows that are the primary economic benefits of the pledged or exchanged assets. Generally, the right of first refusal, prohibition of a sale to competitors, and the requirement to obtain transferor permission that won't be unreasonably withheld (judgment is necessary in this case) to sell or pledge won't preclude accounting as a sale. Agreements that constrain the transferee from pledge or exchange are to be accounted for as secured borrowings.

Maintaining Effective Control

If the transferor maintains effective control, the transfer is accounted for as a secured borrowing and not as a sale.

FASB substantially limits sale accounting, by stipulating that sale accounting can be applied only if transfers are of entire financial assets, a group of financial assets—or of a portion of those assets only if the transferor and transferee proportionately share in all the rights, risks, and benefits of the entire asset. Thus, it is difficult to employ sale accounting (and thus to recognize gains on such sales) when transferring less than an entire financial asset (or group of assets).

The concept of a participating interest is used to denote a portion of a financial asset that is transferred meeting criteria for sale accounting. If a given financial asset is divided into components prior to transfer, the transfer can be accounted for as a sale only if the components meet the criteria for being participating interests (see criteria, below). It is not appropriate to apply surrender of control criteria unless the component (or entire asset or group of assets) being transferred meets the definition of participating interests. If the definition of participating interest is satisfied, and if control is surrendered, only then will sale accounting be validly applied.

The transferor must not be able to unilaterally take back the transferred assets. Therefore, a call option, a forward purchase contract, or a removal of accounts provision will in most cases defeat the determination that a sale has taken place. The transferor cannot take back the transferred assets even through the liquidation of the VIE or other transferee.

A transferor maintains effective control over the transferred assets, and thus cannot account for the transfer as a sale, if a repurchase or redemption agreement meets all of the following conditions:

1. The financial assets covered by the agreement are the same or substantially the same as the transferred assets. In order to meet this condition, the assets transferred and those to be repurchased or redeemed must meet all of the following conditions:
   1. The same primary obligor or, in the case of government-guaranteed instruments, the same guarantor and terms of the guarantee. (If the asset is debt guaranteed by a sovereign government, central bank, government-sponsored enterprise, or agency thereof, the guarantor and the terms of the guarantee must be the same.)
   2. Identical form and type providing the same risks and rights
   3. The same maturity, or, in the case of mortgage-backed pass-through or pay-through securities, have similar remaining weighted-average maturities that provide approximately the same market yield
   4. Similar assets as collateral
   5. The same aggregate unpaid principal amount or principal amounts that are within accepted “good delivery” standards for the type of security being transferred.
2. The redemption or repurchase agreement is executed concurrently with the transfer of the assets and requires repurchase or redemption prior to maturity at a fixed or determinable price.
3. The agreement is entered into simultaneously with, or in contemplation of, the transfer.

ASC 860-20-55 addresses situations where the original transferee subsequently transfers the financial assets back to the original transferor as collateral for a borrowing arrangement under a repurchase arrangement. The issue is whether this violates the surrender of control criterion of ASC 860, obviating the ability of the original transferor to record the transfer as a sale. It establishes criteria under which the secured borrowing could be evaluated separately from the initial transfer for purposes of determining proper accounting.

Under the provisions of ASC 860, the transferor and transferee are to separately account for a transfer of a financial asset and a related repurchase financing arrangement only if the two transactions have a valid and distinct business or economic purpose for being entered into separately, and the repurchase financing does not result in the transferor regaining control over the financial asset. The valid business purpose criterion excludes obtaining favorable accounting treatment. To qualify for separate accounting treatment, the initial transfer of a financial asset and the repurchase financing entered into, either contemporaneously with or in contemplation of each other, must meet all of the following conditions at inception of the transaction:

1. The initial transfer and the repurchase financing are not contractually contingent on each other, so that the pricing and performance of either the transfer or the repurchase financing will not be dependent on the terms and execution of the other.
2. The repurchase financing provides the initial transferor with recourse to the transferee upon default, which must leave the transferor exposed to the credit risk of the transferee or its affiliates, and not only exposed to the market risk of the transferred financial asset.
3. The transferee's agreement to repurchase the previously transferred financial asset is at a fixed price (generally related to the agreed interest rate on the amount financed) and not at fair value.
4. The financial asset is readily obtainable in the marketplace, and the transfer and repurchase financing are executed at market rates, and not circumvented by embedding off-market terms in a separate transaction contemplated at the time of the initial transfer or the repurchase financing.
5. The maturity date of the repurchase financing is earlier than that of the financial asset.

If the transaction satisfies each of the above-noted conditions, the initial transfer should be evaluated to determine whether, without consideration of the repurchase financing, it meets the requirements for sale accounting under ASC 860. Also, the transferor and transferee should analyze the repurchase financing as a repurchase agreement, with both parties using the same criteria.

On the other hand, if the transactions do not meet all of these conditions, the initial transfer and repurchase financing should be evaluated as a linked transaction to determine whether it meets the requirements in ASC 860 for sale accounting. If the linked transaction does not qualify for sale accounting, the linked transactions should be accounted for based on the economic substance of the combined transactions. Typically, these will represent a forward contract, to be accounted for in accordance with ASC 815.

Components of Financial Assets

As securitization activity increased over recent years, it became clear that more guidance was needed, particularly since a number of such arrangements appeared to feature implicit transferor guarantees or other arrangements that raised doubts about the extent to which control had really been relinquished, even as sales (and gains) were being reported by the sponsoring entity. Transferors often kept custody of the securitized assets, further adding to the difficulty in objectively assessing the transfer of control necessary to justify applying “gain on sale” accounting.

Partially in response to this specific concern, ASC 860-10-05 establishes the definition of a participating interest to describe when it would be appropriate to evaluate a transferred portion of a financial asset for sale accounting treatment. FASB decided that, for sales of partial interests in financial assets, it was only appropriate to apply the sale accounting conditions if the transferor and transferee proportionately share in all of the rights, risks, and benefits of the entire financial asset.

A transfer can only be treated as a sale if the transferor has surrendered control over the financial asset. If a portion, rather than the entire asset, is transferred, the transferor retains a participating interest, the character of which will determine whether sale treatment is warranted. If an entity transfers part of a financial asset and retains another portion of that asset, gain can be recognized on the portion sold only, and then only if all components qualify as participating interests; gain can be recognized, in such situations, only on the components transferred, assuming control is relinquished. However, if the entire asset (or group) is transferred in circumstances where sale accounting is warranted, and then, after first relinquishing control, the transferor obtains a beneficial interest in the transferred asset, the gain recognized on the transfer will be based on the entire transfer.

FASB has provided specific guidance on the definition of a portion of a financial asset that would be eligible for sale accounting. According to ASC 860-10-40-60, participating interest must have all of the following characteristics:

1. From the date of the transfer, the participating interest represents a proportionate (pro rata) ownership interest in an entire financial asset. The percentage of ownership interests held by the transferor in the entire financial asset may vary over time, while the entire financial asset remains outstanding, as long as the resulting portions held by the transferor (including any participating interest retained by the transferor, its consolidated affiliates, or its agents) and the transferee(s) meet the other characteristics of a participating interest.

   For example, if the transferor's interest in an entire financial asset changes because it subsequently sells another interest in the entire financial asset (a piecemeal transfer of its interests to others), the interests held initially and subsequently by the transferor will meet the definition of a participating interest.

2. From the date of the transfer, all cash flows received from the entire financial asset are divided proportionately among the participating interest holders according to their respective shares of ownership. Cash flows that are allocated as compensation for services performed (e.g., for loan servicing), if any, may not be included in that determination provided those cash flows are not subordinate to the proportionate cash flows of the participating interest and are not significantly above an amount that would fairly compensate a substitute service provider, should one be required, which includes any profit that would be demanded by a market participant.

   Also, any cash flows received by the transferor as proceeds of the transfer of the participating interest are to be excluded from the determination of proportionate cash flows, provided that the transfer does not result in the transferor receiving an ownership interest in the financial asset that permits it to receive disproportionate cash flows.

3. The rights of each participating interest holder (including the transferor, in its role as a participating interest holder) have the same priority of cash flow, and no participating interest holder's interest is subordinated to the interest of another participating interest holder. Priority is not subject to change in the event of bankruptcy or other receivership of the transferor, the original debtor, or any other participating interest holder. Participating interest holders can have no recourse to the transferor (or its consolidated affiliates or its agents) or to each other, other than for the standard representations and warranties, ongoing contractual obligations to service the entire financial asset and administer the transfer contract, and contractual obligations to share in any setoff benefits received by any participating interest holder. Thus, no participating interest holder can be entitled to receive cash before any other participating interest holder under its contractual rights as a participating interest holder.

   Note however, that if a participating interest holder also is the servicer of the entire financial asset, and receives cash in its role as servicer, that arrangement would not violate the requirement that all participating interest holders share the same priority.

4. No party has the right to pledge or exchange the entire financial asset unless all participating interest holders agree to pledge or exchange the entire financial asset.

If all the foregoing conditions are satisfied, the transfer of a portion of the entire financial asset would be accounted for as a sale, if control is relinquished. If one or more of the foregoing conditions are not met, however, the transfer would be accounted for as a lending transaction. Specifically, regarding surrender of control, the transfer is to be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange, and if all of the following conditions are met:

1. The transferred financial assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in the event of bankruptcy or other receivership. The assets are effectively isolated only if the transferred financial assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor or any of its consolidated affiliates. For multiple-step transfer structures, if an entity is designed to make remote the possibility that it would enter bankruptcy or other receivership (thus being a “bankruptcy-remote entity”), it is not considered a consolidated affiliate for the isolation analysis. (However, each entity involved in the transfer is subject to the applicable guidance on whether it must be consolidated, which is a separate determination to be made.)
2. Each transferee has the right to pledge or exchange the assets (or beneficial interests) it received, and there is no condition that both (1) constrains the transferee from taking advantage of its right to pledge or exchange, and (2) provides more than a trivial benefit to the transferor. If the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities and it is constrained from pledging or exchanging the assets it receives, each third-party holder of its beneficial interests must have the right to pledge or exchange those interests.
3. The transferor, its consolidated affiliates, and its agents, if any, do not maintain effective control over the transferred financial assets or third-party beneficial interests related to those transferred assets. A transferor's effective control over transferred assets is exemplified by (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity, (2) an agreement that provides the transferor with both the unilateral ability to cause the holder to return specific financial assets and a more-than-trivial benefit attributable to that ability, other than through a “cleanup call” (to eliminate a small outstanding balance that would be more administratively costly to maintain than it would be worthwhile to do), and (3) an agreement that permits the transferee to require the transferor to repurchase the transferred financial assets at a price that is so favorable to the transferee that it is probable that the transferee will require the transferor to repurchase them.

Accounting for Transfers

When a transfer of a participating interest that satisfies the conditions above (i.e., surrender of control over a participating interest in a financial asset) has been completed, the transferor (seller) is to:

1. Allocate the previous carrying amount of the entire financial asset between the participating interests sold and the participating interest that continues to be held by the transferor, on the basis of relative fair values as of the date of the transfer;
2. Derecognize the participating interest(s) sold;
3. Recognize and initially measure at fair value servicing assets, servicing liabilities, and any other assets obtained and liabilities incurred in the sale;
4. Recognize in earnings any gain or loss on the sale; and
5. Report any participating interest or interests that continue to be held by the transferor as the difference between the previous carrying amount of the entire financial asset and the amount derecognized (i.e., the initial amount is allocated book value).

Any participating interest(s) obtained, other assets obtained, and any liabilities incurred are to be recognized and initially measured at fair value.

If, instead of a participating interest, the entire financial asset or group of financial assets is transferred, in a manner that complies with the requirements (as set forth above) for sale accounting, then the transferor (seller) is required to:

1. Derecognize all transferred financial assets;
2. Recognize and initially measure at fair value servicing assets, servicing liabilities, and any other assets obtained (including a transferor's beneficial interest in the transferred financial assets) and liabilities incurred in the sale; and
3. Recognize in earnings any gain or loss on the sale.

The transferee furthermore is to recognize all assets obtained and any liabilities incurred and initially measure them at fair value (which, in the aggregate, presumptively equals the price paid).

If the transfer is accounted for as a secured borrowing, there is no adjustment to carrying value and no gain recognition.

Measuring Assets and Liabilities after Completion of a Transfer

ASC 860 addresses initial recognition and measurement. For example:

1. Interest-only strips, other beneficial interests, 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 derivative instruments that are within the scope of ASC 815) are to be subsequently measured like investments in debt securities classified as available-for-sale or trading under ASC 320, and thus at fair value. They cannot be reported at amortized cost, since they cannot be classified as held-to-maturity.
2. Equity securities that have readily determinable fair values are subsequently measured in accordance with ASC 320, at fair value (either available-for-sale or trading).
3. Debt securities are subsequently measured in accordance with ASC 320, ASC 948 (mortgage-backed securities), or ASC 325-40 (purchased and retained beneficial interests in securitized financial assets).
4. Derivative financial instruments are subsequently measured in accordance with ASC 815.

ASC 860-30-35-2 provides subsequent measurement guidance for pledged assets required to be reclassified that are accounted for as secured borrowings. For those assets, the transferor should follow the same measurement principles as before the transfer.

If it was initially impracticable to measure the fair value of an asset or liability but it later becomes practicable, the transferor does not remeasure the asset or liability (or the gain or loss) under ASC 860 unless it is a servicing asset or liability. (ASC 860-50-35, Transfers and Servicing—Servicing Assets and Liabilities, has revised accounting for servicing assets and liabilities; this is discussed in detail later in this chapter.) However, adjustment of the carrying value may be required by other standards, such as ASC 320.

The provisions of ASC 860 apply to a wide range of transfers of financial instruments. Some of those are discussed in the following paragraphs.

Transfers of Receivables with Recourse

Classic factoring involves the outright sale of receivables and, notwithstanding the existence of a “holdback” intended to deal with returns and allowances, are accounted for as sales. However, some entities have such a poor history of uncollectible accounts that factors are only willing to purchase their accounts if a substantial fee is collected to compensate for the risk. If the company believes that the receivables are of a better quality than the factor has assessed them, a way to avoid excessive factoring fees is to sell these receivables with recourse. This variation of factoring is, in substance, an assignment of receivables with notification to the affected customers (whereas traditional assignment does not include notification of debtors).

Structure of transfer. In a transfer of receivables with recourse, the transferor is obligated to make payments to the transferee or to repurchase receivables sold upon the occurrence of an uncertain future event. Typically, recourse provisions compensate the transferee for uncollectible accounts (sometimes amounts over a defined threshold), but they can also be written to compensate the transferee for such uncertain future events as prepayments of receivables subject to discounts or that are interest bearing, merchandise returns, or other events that change the anticipated cash flows from the receivables.

The effect of a recourse provision on the application of ASC 860's surrender of control provisions may vary by jurisdiction and by the level of recourse provided. For example, in some jurisdictions, full recourse will not place the receivables beyond the reach of the transferor and its creditors, while a limited recourse provision may have this result. Thus, some transfers of receivables with recourse will meet the criteria of ASC 860 and be accounted for as sales; other transfers will fail the criteria and be accounted for as secured borrowings. The remaining discussion in this section relates to scenarios where the arrangement qualifies for sales treatment.

Applicability of ASC 815 or ASC 460. For the recourse provision to be exempt from derivatives accounting, it must meet all three of the following criteria:

1. Restricted payment. The contract provides for payments to be made solely to reimburse the guaranteed party (the factor) for failure of the debtor to satisfy its obligations to make required payments, when due at prespecified payment dates or at dates that are earlier due to acceleration caused by a default. For the purposes of meeting this criterion, the debtor's obligation cannot be due under a contract that is accounted for as a derivative.
2. Past due limitation. Payment under the recourse provision is made only if the debtor's obligation under item 1 is past due.
3. Risk of nonpayment. At the date of inception of the factoring arrangement and subsequently throughout the term of the arrangement, the factor will be exposed to the risk of nonpayment through direct or indirect ownership of the guaranteed receivable.

If the recourse provision fails any of the three above criteria, it is considered a derivative and is accounted for by the transferor under the provisions of ASC 815.

Another accounting issue to consider is whether the recourse provision is considered a guarantee under ASC 460. ASC 460 provides that a contract that contingently requires the guarantor to make payments to the guaranteed party (in this case the factor) based on the nonoccurrence of a scheduled payment under a contract is considered a guarantee. The determination that the recourse obligation is a guarantee does not affect the measurement of that obligation because the measurement rules of ASC 460 are identical with the measurement rules for a recourse obligation that is not considered a guarantee. However, it is important to determine the applicability of that interpretation because ASC 460 requires additional disclosures not demanded by ASC 860.

Computing gain or loss. In computing the gain or loss to be recognized at the date of a transfer of receivables that meets the criteria of ASC 860, the borrower (transferor) must take into account the anticipated chargebacks from the transferee. This action requires an estimate by the transferor, based on its past experience. Adjustments are to be made at the time of sale to record the recourse obligation for the estimated effects of any bad debts, prepayments by customers (where the receivables are interest-bearing or where cash discounts are available), and any defects in the eligibility of the transferred receivables. In computing this recourse obligation, the transferor is to consider all probable credit losses over the life of the transferred receivables. The recourse obligation is to be measured at its fair value on the date of sale.

A present value method is acceptable for estimating fair value if the timings of the future cash flows are reasonably estimable. In applying a present value method, the estimated future cash flows are to be discounted using a discount rate at which the liability could be settled in an arm's-length transaction (i.e., a risk-adjusted rate versus a risk-free rate). Subsequent accruals to adjust the discounted amount are to be discounted at the interest rate inherent in determining the initial recourse obligation. ASC 860 expresses a preference for the use of the CON 7 probability-weighted expected cash flow model over the more traditional discounting of the single point estimate of the most probable or most likely cash flows. This model is discussed and illustrated in Chapter 1.

The accounts receivable net of the allowance for uncollectible accounts (a valuation allowance) is removed from the transferor's accounting records, as it has been sold. Previously accrued bad debts expense is not reversed, however, as the transferor still expects to incur that expense through the recourse provision of the factoring agreement. (Alternatively, the bad debts expense could have been reversed and the new charge to loss on sale will have to be increased by $10,000.) The loss on sale of receivables is the sum of the interest charged by the factor ($3,945), the factor's fee ($6,000), the expected chargeback for cash discounts to be taken ($1,600), and the difference between the holdback receivable at face value and at carrying value ($500). The factor's holdback receivable is a retained interest in the receivables transferred, and it is measured by allocating the original carrying amount ($190,000) between the assets sold ($190,000) and the assets retained ($10,000).

If, subsequent to the sale of the receivables, the actual experience relative to the recourse terms differs from the provision made at the time of the sale, a change in an accounting estimate results. It is accounted for prospectively, as are all changes in accounting estimates, and therefore will be reflected as an additional gain or loss in the subsequent period. These changes are not to be deemed corrections of errors or other retroactive adjustments.

If the above facts apply, but the transfer does not qualify as a sale, the borrower's entry will be:

In a secured borrowing, the accounts receivable continue to be recognized by the borrower. Both the accounts receivable and the factor borrowings payable must be cross-referenced on the face of the statement of financial position or in the notes to the financial statements. The accounting for the collateral under ASC 860 depends upon the terms of the collateral agreement. Accounting for collateral is discussed later in this chapter.

Retained Interests

Interests in transferred assets that are not a part of the proceeds of a sale are considered retained interests that are still under the control of the transferor. Retained interests include participating interests for which control has not been given up by the transferor, servicing assets and liabilities, and beneficial interests in assets transferred in a securitization in a transaction that can be accounted for as a sale. In general, the more extensive an interest that the transferor of assets retains, the less likely the transaction will be classified as a sale and the more likely the transaction will be classified as a secured borrowing. The primary reason for this result is that in a true sale, the transferor no longer bears the risks or reaps the rewards associated with the transferred assets. If a determination cannot be made between classification as proceeds of a sale or as retained interests, the asset is classified as proceeds and measured at fair value.

In practice, retained interests are usually comprised of one or both of two items: the spread between the average yield on the assets securitized and the cost of the debt issued by the securitization trust, and any overcollateralization provided. Regarding the spread in yields, it is often the case that trusts can issue debt securities at a lower cost than could the transferring entity, for reasons that may include the lower risk attaching to trust instruments, which are isolated from the transferor's overall credit risk. Indeed, this is one of the major attractions of employing a securitization structure. Typically the excess of the yields on the assets placed into securitization over the costs of servicing the debt issued by the securitization trust, less credit losses and other costs incurred, revert to the transferor at the termination of the securitization. Since this event may be many years in the future, the current value of this residual interest, to the transferor, must be measured on a present value (i.e., discounted) basis, which then accretes over the term to final maturity.

Overcollateralization is the other principal residual interest held by transferors. To enhance the creditworthiness of the securities issued by the trust, it is commonly found that placing a surfeit of collateral (i.e., the underlying mortgage or other loans) into the trust (say, $100 of loans receivable for each $90 of debt to be issued by the trust) will result in a significantly reduced net interest cost incurred by the trust, and hence a greater yield spread that will ultimately revert to the transferor. Additionally, an overcollateralization structure will garner a better rating for the trust securities, making them more readily marketable (in addition to having lower coupon rates), thus insuring the ability to fully fund the trust. Alternatives to the use of an overcollateralization structure include the purchase of credit insurance and arranging for a standby letter of credit. Only overcollateralization results in a residual interest being retained by the transferor, however.

Retained interests are measured by allocating the carrying value of the transferred assets before the transfer between the assets sold (if any) and the assets retained based on their relative fair values on the date of transfer. ASC 860-50-35 specifies that the carrying value allocated is to be exclusive of any amounts included in an allowance for loan losses. Any gain recognized upon a partial sale of a loan is not to exceed the gain that would be recognized if the entire loan were sold. If the transferor retains a servicing contract, a portion of the carrying value is allocable to either a servicing asset retained or a servicing liability undertaken since ASC 860 requires all entities servicing financial assets for others to recognize either a servicing asset or servicing liability for each servicing contract.

Relative fair value determinations are to incorporate assumptions regarding interest rates, defaults, and prepayments that marketplace participants would make, as well as the expected timing of cash flows. This allocation must be applied to all transfers that have retained interests, regardless of whether or not they qualify as sales. It should be noted that this fair value allocation may result in a relative change in financial reporting basis unless the fair values are proportionate to their carrying values. Thus, the gain or loss from any sale component could also be affected.

The retained interests continue to be the transferor's assets, since control of these assets has not been transferred. Thus, the retained interest is considered continuing control over a previously owned asset (although the form may have changed). It is not to be remeasured at fair value, nor is a gain or loss recognized on it.

In some transfers of receivables, the transferor provides credit enhancement (similar to a recourse provision) by retaining a beneficial interest that absorbs the credit risk. If there is no liability beyond the transferor's retained subordinated interests, the retained interest is initially measured at allocated carrying value based on relative fair value, and no recourse liability is necessary. The retained interest would be subsequently measured like other retained interests held in the same form.

Cash reserve accounts and subordinated beneficial interests created as credit enhancements are retained interests and are accounted for as such even if the seller collects the proceeds and deposits a portion in the cash reserve account. (New asset credit enhancements such as financial guarantees and credit derivatives are measured at the fair value of the amount to benefit the transferor.) ASC 860-10-35 provides guidance on estimating fair values and should be used in the case of credit enhancements.

One possible method of estimating fair value of a credit enhancement is the cash-out method. Using that method, cash flows are discounted from the date the credit enhancement asset becomes available to the transferor (i.e., when the cash in the credit enhancement account is expected to be paid out to the transferor). The present value can be computed using an expected present value technique with a risk-free rate or a “best estimate” technique with an appropriate discount rate. Among other transferor assumptions, time period of restrictions, reinvestment income, and potential losses due to uncertainties must be included. ASC 860 does not provide guidance concerning subsequent measurement of credit enhancements.

ASC 860-20-55-18 states that:

The right to receive the accrued interest receivable, if and when collected, is transferred to the securitization trust. Generally, if a securitization transaction meets the criteria for sale treatment and the accrued interest receivable is subordinated either because the asset has been isolated from the transferor (see paragraph 860-10-50-5) or because of the operation of the cash flow distribution (or waterfall) through the securitization trust, the total accrued interest receivable should be considered to be one of the components of the sale transaction. Therefore, under the circumstances described, the accrued interest receivable asset should be accounted for as a transferor's interest. It is inappropriate to report the accrued interest receivable related to securitized and sold receivables as loans receivable or other terminology implying that it has not been subordinated to the senior interest in the securitization.

Servicing

When loans (mortgages and other) are sold to securitization trusts, the debtors are not informed that ownership has been transferred, and they will continue to make monthly (or other) payments to the original creditor. Often the transferor retains servicing, which involves collections of loan principal and interest, payment of expenses, and forwarding of net proceeds to the trustee or other transferee, to be further distributed, depending on the terms of the so-called “waterfall” provisions, to the various classes of investors in trust-issued securities. For example, if the cash flows have been assigned to different tranches of securities (having claims to early period cash flows, later period cash flows, principal payments only, interest payments only, etc.), the cash flows will be first used to satisfy certain securities holders, then others, in accordance with the prescribed cash-flow sequence set forth in the trust indenture.

Transferors will most commonly retain the right and obligation to perform this servicing, and will be paid a certain fee to do so, often a small percentage (say, one-quarter of 1%) of the principal amount of loans being serviced. In some cases third parties will buy the right to service loans, or, in other situations, the transferor will retain servicing and purchase rights to service yet other loans. If the fee for providing servicing exceeds the expected cost of doing so, the right to service will be a valuable asset, which will trade for a positive price. In other circumstances, a party (generally the transferor) will have to perform servicing for a fee that will not cover expected costs, in which case a servicing liability exists.

The nature of servicing. Servicing of financial assets can include such activities as:

1. Collecting payments (principal, interest, and escrows)
2. Paying taxes and insurance from escrows
3. Monitoring delinquencies
4. Foreclosing
5. Investing funds temporarily prior to their distribution
6. Remitting fees to guarantors, trustees, and service providers
7. Accounting for and remitting distributions to holders of beneficial interests.

Although inherent in holding most financial assets, servicing is a distinct asset or liability only when separated contractually from the underlying financial asset. Servicers' obligations are contractually specified. Servicing is subject to significant risks due to the effects of change in interest rates and debtors' propensity for prepayment of the related obligations. As the likelihood of prepayment (known as prepayment speed) increases, the value of the servicing asset decreases, and vice versa.

Adequate compensation for servicing is determined by the marketplace. The concept of adequate compensation is judged by requirements that would be imposed by a new or outside servicer. It includes profit demanded by the marketplace and does not vary with the specific servicing costs of the servicer. Thus, it would not be acceptable to use a given servicer's cost plus a profit margin to estimate the fair value of a servicing asset or liability to be recognized by that particular servicer.

Other changes in economic conditions may also impact the value of servicing arrangements. Some entities having servicing contracts will attempt to hedge these risks by holding financial assets, the value of which will move in the opposite direction of the servicing contracts.

Typically, the benefits are more than adequate compensation for the servicing and the servicing contract results in an asset. The benefits to be reaped by the servicer include:

1. Fees
2. Late charges
3. Float
4. Other income.

If the above benefits are not expected to provide adequate compensation, the contract results in a liability. With regard to the sale of assets, a servicing liability would reduce the net proceeds and would affect the gain or loss calculation.

Accounting for servicing. Servicing assets are recognized at fair value if arising out of the transfer of the entire financial asset or group of financial assets, or a participating interest in financial assets, or if associated with purchased servicing rights unrelated to the assets transferred. If financial assets are transferred to an unconsolidated affiliate in a sale transaction, and the transferor retains servicing and obtains debt securities (from the securitization process) that are properly classified as held-to-maturity, the servicing rights may be reported either as a separate asset or combined with the debt instruments held.

Once a servicing asset is recognized, the asset must be expensed over the expected period over which serving income will be realized. Similarly, if a loss on servicing is anticipated, the liability must be taken into income over the appropriate time horizon. One of two acceptable methods can be employed:

1. Amortization method: Amortize servicing assets or servicing liabilities 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), and assess servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date; or
2. Fair value measurement method: Measure servicing assets or servicing liabilities at fair value at each reporting date and report changes in fair value of servicing assets and servicing liabilities in earnings in the period in which the changes occur.

The method chosen can vary by class of servicing, so a given entity may be using both amortization and fair value methods simultaneously. However, all servicing in a given class must be accounted for consistently, and cannot be changed after being elected. For purposes of this requirement, a class of servicing assets and servicing liabilities is identified based on (1) the availability of market inputs used in determining the fair value of servicing assets or servicing liabilities, (2) an entity's method for managing the risks of its servicing assets or servicing liabilities, or (3) both.

A reporting entity that elects to subsequently measure a class of separately recognized servicing assets and servicing liabilities at fair value should apply that election prospectively to all new and existing separately recognized servicing assets and servicing liabilities within those classes that a servicer elects to subsequently measure at fair value. This election cannot be applied on a contract-by-contract basis.

ASC 860-50-35 requires that servicing assets or liabilities must be given recognition whenever the entity undertakes a commitment to provide servicing of financial assets, such as loans. This may arise when the entity transfers assets in a “true sale” situation (i.e., when gain or loss on the transfer is recognized, in contrast to transfers that are only secured borrowings). Additionally, it can arise from independent acquisitions or assumptions of servicing rights or obligations unrelated to financial assets of the reporting entity or its consolidated affiliates.

ASC 860-50-35 provides reporting entities with recognized servicing rights with an optional onetime reclassification of available-for-sale securities to trading securities, without calling into question the treatment of other available-for-sale securities under ASC 320, provided that the available-for-sale securities are identified as offsetting the entity's exposure to changes in fair value of servicing assets or servicing liabilities that a servicer elects to subsequently measure at fair value. Note that this election is not available relative to servicing assets or liabilities that will be accounted for by the amortization method. Any gains and losses associated with the reclassified securities that are included in accumulated other comprehensive income at the time of the reclassification should be reported as a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year that an entity adopts ASC 860-50-35. The carrying amount of reclassified securities and the effect of that reclassification on the cumulative-effect adjustment should be separately disclosed.

The purpose of reclassifying financial assets to trading is to have the changes in fair values reported in current earnings, rather than in other comprehensive income. Including fair value changes in current income will tend to offset, albeit not perfectly, the income effects of changes in the servicing assets and liabilities being accounted for at fair value. There is no need to test for hedging effectiveness, in contrast to hedge accounting under ASC 815, although ASC 860-50-35 does require that these assets be identified as being useful in this regard.

Finally, ASC 860-50-35 requires that servicing assets and liabilities that are being accounted for at fair value must be segregated from those being accounted for by the amortization method. This can be accomplished by using separate financial statement captions, or by footnote disclosures.

ASC 860 imposes standards for both initial measurement and subsequent measurement of servicing assets and liabilities. Specifically, servicing assets or servicing liabilities from each contract are to be accounted for separately as follows:

1. Assets are to be reported separately from liabilities. They are not to be netted, since there is no right of offset.
2. Initially measure retained servicing assets and liabilities at fair values at date of sale or securitization.
3. Initially measure at fair value all purchased servicing assets, assumed servicing liabilities, and servicing liabilities undertaken in a sale or securitization.
4. Account separately for interest-only strips (future interest income from serviced assets that exceeds servicing fees).
5. Either amortize servicing assets and liabilities in proportion to and over the period of estimated net servicing income (the excess of servicing revenues over servicing costs), or adjust to fair value at each reporting date. However, if amortization is employed, impairment of servicing assets and increased obligation of servicing obligations must be accounted for, as described in the following point.
6. Evaluate and measure impairment of servicing assets as follows:
   1. Stratify recognized servicing assets based on predominant risk (asset size, type, interest rate, term, location, date of organization, etc.).
   2. Recognize impairment through a valuation allowance for individual stratum in the amount of the excess of carrying value over fair value.
   3. Adjust the valuation allowances to reflect subsequently needed changes. Excess fair value for a stratum is not recognized.
7. If amortization of servicing liabilities is employed, it is done in proportion to and over the period of net servicing loss (excess of servicing costs over servicing revenues). In cases where subsequent changes have increased the fair value of the servicing liability above the carrying value, an increased liability and a loss are recognized.
8. If servicing assets and liabilities are reported at fair value, changes in value are to be included in periodic earnings as they occur.

The fair value of a servicing asset or liability at date of transfer is best measured by quoted market prices for similar servicing responsibilities. There is the potential for significantly different estimates of fair value when a quoted market price is not available. The transferor is to analyze all available information to obtain the best estimate of the fair value of the servicing contract. These include:

1. The amount that would result in a current transaction between willing parties other than in a forced or liquidation sale
2. The legitimacy of the offer
3. The third party's specific knowledge about relevant factors
4. The experience of the broker with similar contracts
5. The price of other parties that have demonstrated an interest
6. The right to benefit from cash flows of potential future transactions (late charges, ancillary revenue, etc.)
7. The nature of the assets being serviced.

In cases where there are few servicing contracts purchased or sold, present value methods may be used for estimating the fair value of servicing. Disclosure is required of the methods and significant assumptions followed to determine the estimate of fair value (unless not practicable) of recognized servicing assets and liabilities.

The foregoing example presumes that the recourse obligation does not obviate the ability to apply sale accounting for the asset transferred. While this is possible under specific circumstances, it is less likely to be acceptable under the revised ASC 860 provisions than it would have been under preamendement GAAP.

Impairment testing. In remeasuring servicing assets for impairment, this is to be based on the fair value of the contracts and not on the gain or loss from carrying out the terms of the contracts. ASC 860-50-35 requires that entities separately evaluate and measure impairment of designated strata of servicing assets. Stratification requires that judgment be used when selecting the most important characteristic. ASC 860 does not require that either the most predominant risk characteristic or more than one predominant risk characteristic be used to stratify the servicing assets for purposes of evaluating and measuring impairment. Different stratification criteria may be used for ASC 860 impairment testing and for ASC 815 grouping of similar assets to be designated as a hedged portfolio in a fair value hedge. The stratum selected is to be used consistently; a change is to be accounted for as a change in estimate under ASC 250. The change and reasons for the change are to be included in the disclosures made in accordance with ASC 860-50-50.

A servicing liability accounted for by the amortization method, on the other hand, is to be remeasured for increases in fair value, which would be recognized as a loss. Similar to the accounting for changes in a valuation allowance for an impaired asset, increases in the servicing obligation may be recovered, but the obligation cannot be adjusted to less than the amortized measurement of its initially recognized amounts.

Subcontracted servicing. Subcontracting the servicing to another entity is not accounted for under ASC 860 because it does not involve a transfer. It is to be accounted for under other existing guidance (noting that executory contracts generally do not receive financial statement recognition under GAAP).

In the unusual case that servicing assets are assumed without a cash payment, the facts and circumstances will determine how the transaction is recorded. For example, the servicing asset may represent consideration for goods or services provided by the transferee to the transferor of the servicing. The servicing assets also might be received in full or partial satisfaction of a receivable from the transferor of the servicing. Another possibility is that the transferor (the party providing servicing) is in substance making a capital contribution to the transferee (the party receiving the servicing) in exchange for an increased ownership interest. Additionally, the possibility that there is an overstatement of the value of the servicing by the transferee must be carefully considered.

The amount to be paid to a replacement servicer under the terms of the servicing contract is not relevant to the determination of adequate compensation. This amount could, however, be relevant for determining the contractually specified servicing fees.

Rights to serviced asset income. Rights to future income from serviced assets that exceed contractually specified servicing fees are accounted for as a servicing asset, an interest-only strip, or both, depending on whether the servicer would continue to receive the value of the right to future income if a replacement servicer started servicing the assets. Generally, the value of the right to receive future cash flows from ancillary sources such as late fees is included with the servicing asset if retention of the right depends on servicing being performed satisfactorily.

An interest-only strip does not depend on satisfactory performance of servicing, and any portion that would continue to be received if servicing were shifted to a replacement servicer would be accounted for separately as a financial asset. ASC 860-50-35 specifies that interest-only strips or other interests that continue to be held by the transferor in securitizations, loans, other receivables, or other financial assets that can be prepaid or otherwise settled in such a way that the entity might not recover its investment are to be subsequently remeasured as an investment in debt securities classified as available-for-sale or trading under ASC 320.

Transferred servicing rights. Some organizations transfer servicing rights on loans to third parties. ASC 942 provides criteria to be considered when evaluating whether the transfer qualifies as a sale, the first three of which are cited by reference to ASC 860-50-40.

1. Has title passed?
2. Have substantially all risks and rewards of ownership been irrevocably passed to the buyer?
3. Are any protection provisions retained by the seller considered minor and are they reasonably estimable?
4. Has the seller received written approval from the investor (if required)?
5. Is the buyer a currently approved seller/servicer and not at risk of losing approved status?
6. If the sale is seller-financed:
   1. Has the buyer made a nonrefundable deposit large enough to demonstrate a commitment to pay the remaining sales price?
   2. Does the note receivable from the buyer provide full recourse to the buyer?
7. Is the seller adequately compensated in accordance with a subservicing agreement for any short-duration, temporary servicing provided?

If the servicing rights sold are on loans that are retained, the carrying amount is allocated between servicing rights and loans retained using the relative fair value method prescribed by ASC 860.

Changes Resulting in Transferor Regaining Control of Financial Assets Sold

If a transferor is required to re-recognize financial assets in which it holds a beneficial interest because the transferor's contingent right (for example, a removal of accounts provision, known as ROAP, or other contingent call option on the transferred financial assets) becomes exercisable, no gain or loss is recognized. The transferor continues to account for its beneficial interest in those assets apart from the re-recognized assets. That is, the beneficial interest is not combined with and accounted for with the re-recognized assets. A gain or loss may be recognized upon the exercise of a ROAP or similar contingent right with respect to the “repurchased” portion of the transferred assets that were sold if the ROAP or similar contingent right held by the transferor is not accounted for as a derivative under ASC 815 and is not at-the-money. The exercise would result in a recombination of the beneficial interest with the repurchased assets.

If a transferor is required to re-recognize financial assets because the SPE becomes non-qualifying, no gain or loss is recognized with respect to the “repurchase” by the transferor of the financial assets originally sold that remain outstanding in the SPE (or the portion thereof, if the transferor retained a partial interest in those assets). The fair value of the re-recognized assets will equal the fair value of the liability assumed by the transferor, because the transferor is contractually required to pass on all of the cash flows from the re-recognized assets to the SPE for distribution in accordance with the contractual documents governing the SPE. The transferor continues to account for its beneficial interest in those assets, if any, apart from the re-recognized assets.

Under no circumstances is a valuation allowance initially recorded for assets (loans) that are re-recognized at their fair value.

The accounting for the servicing asset related to the previously sold financial assets does not change because the transferor, as servicer, is still contractually required to collect the asset's cash flows for the benefit of the SPE and otherwise service the assets. The transferor continues to recognize the servicing asset and assess it for impairment as required by ASC 860-20-55.

Sales-Type and Direct Financing Lease Receivables

Lessors' lease receivables are composed of two components: minimum lease payments and residual values. Minimum lease payments are requirements for lessees to pay cash, and thus are financial assets subject to ASC 860 if transferred. Residual values are the rights to the leased equipment at the end of the lease. If the residual value is guaranteed at the inception of the lease, the right is a financial asset subject to ASC 860 if transferred. If the residual value is not guaranteed (or if it is guaranteed after the inception of the lease), transfers of that residual value are not subject to ASC 860. When entities sell lease receivables, the gross investment of the lease is allocated between minimum lease payments, residual values guaranteed at inception, and residual values not guaranteed at inception. If the reporting entity retains servicing rights, it also records a servicing asset or liability if appropriate. ASC 860 does not apply to sales of operating lease payments.

Securitizations

Entities that generate a large number of similar receivables, such as mortgages, credit card receivables, or car loans, sometimes securitize those receivables. Securitization is the transformation of the receivables into securities that are sold to other investors. For example, mortgages can be converted into mortgage-backed securities, which entitle the investors to receive specific cash flows generated by the mortgages. With an established market, issuance of the securities can cost less than using the receivables as collateral for a borrowing. Transfers in securitization transactions must be evaluated for sale accounting treatment by the criteria in ASC 860, and must be evaluated for consolidation by the usual GAAP criteria applicable to variable interest entities, set forth at ASC 810. If consolidation of the securitization entity is necessitated by the circumstances, gain cannot be recognized on the transfer.

Note that securitizations may still be treated as transfers warranting sale treatment, and thus gain recognition if justified by the facts, but the new, stricter, criteria will make this more difficult to achieve.

Securitizations may involve a single transfer to a special-purpose entity, or multiple transfers, which are designed to provide greater assurance that the transferred assets have been isolated, thus providing not only greater bankruptcy protection, but also stronger support for sale accounting treatment of the transfer. ASC 860 provides a detailed description of the conditions that would warrant this treatment.

In a typical securitization, the transferor (also called issuer or sponsor) forms a securitization mechanism (a separate corporation or a trust) to buy the assets and to issue the securities. The securitization mechanism then generates beneficial interests in the assets or resulting cash flows that are sold to investors with the sales proceeds used to pay the transferor/sponsor for the transferred assets. The form of the securities chosen depends on such things as the nature of the assets, income tax considerations, and returns to be received. The securities issued by the securitization entity may consist of a single class of interests with the characteristics of equity or multiple classes of interests, some having debt characteristics and others equity characteristics.

For example, a transferor originates long-term loans and accumulates them on its statement of financial position (referred to as warehousing). When the group of loans reaches a sufficient size, the loans are sold to a securitization entity. During the accumulation phase, the transferor finances the cost of holding the loans with prearranged lines of credit, known as warehouse lines. Often the transferor hedges the price risk of the loans as they await sale. This is referred to as an on-statement-of-financial-position warehousing.

Alternatively, a transferor may use a properly structured off-statement-of-financial-position warehousing to securitize assets. In an off-statement-of-financial-position warehouse, the transferor creates a temporary securitization vehicle. A bank typically extends credit to the securitization vehicle in the form of a variable-funding note. Using the proceeds of the note, the vehicle acquires loans from the transferor as they are originated. The principal of the note increases, up to a ceiling, as the transferor transfers additional loans to the securitization vehicle. When the loans have reached the ceiling amount of the note, the bank puts the note back to the securitization vehicle, forcing the vehicle to sell the loans to a permanent securitization entity to raise the cash to pay the note.

Payments by the securitization mechanism are usually classified as pay-through, pass-through, or revolving-period. In a pay-through, cash flows from the assets pay off the debt securities. The assets are essentially collateral. In a pass-through, undivided interests are issued and the investors share in the net cash flows. In a revolving-period, undivided interests are issued, but until liquidation, the net cash flows are split between buying additional assets and paying off investors. During the reinvestment period, principal repayments are reinvested in additional receivables generated by the debtors whose receivables were securitized. Under ASC 860-10-05, any gain recognized by the transferor/sponsor on the sale of credit card or other receivables to a securitization entity is limited to amounts relating to receivables existing at the date of sale. This prevents the transferor/sponsor from recognizing additional gains on transfers that are anticipated to occur during the specified reinvestment period.

In computing gain or loss on the initial transfer, the transferor/sponsor recognizes costs estimated to be incurred for all future servicing activities, including the costs of servicing the receivables that the sponsor expects to sell to the vehicle during the reinvestment period. If the initial sale results in a gain, the costs associated with the receivables to be sold during the reinvestment period may be recorded as an asset and allocated to expense using a systematic and rational method over the initial and reinvestment periods.

Various financial components arise from securitizations. Examples include servicing contracts, interest-only strips, retained interests, recourse obligations, options, swaps, and forward contracts. All controlled assets and liabilities must be recognized under ASC 860. The following examples presume that sale criteria under amended ASC 860 are met, but it is important to bear in mind that this is a facts and circumstances determination that must be made in each situation.

Just as it is necessary to distinguish new assets, which are recorded at fair value, from retained interests, which are recorded at allocated carrying value, when accounting for a transfer to another enterprise, it is necessary to do so when accounting for a transfer to a securitization entity. In certain securitization transactions, more than one transferor contributes assets to a single securitization entity. A transferor treats the beneficial interests it receives in a securitization that commingles assets from more than one transferor as:

1. New assets, to the extent that the sources of the cash flows to be received by the transferor are assets transferred by another entity
2. Retained interests, to the extent that the sources of the cash flows are assets transferred by the transferor
3. New assets, to the extent that any derivatives, guarantees, or other contracts were entered into by the securitization entity to “transform” the transferred assets.

After a securitization, the beneficial interests held by the transferor either are in the form of securities that are accounted for under ASC 320 or are required to be accounted for as available-for-sale securities in accordance with ASC 860. Thus, the transferor must classify the beneficial interests into one of the ASC 320 categories. If beneficial interests held by the transferor after the transfer convey rights to the same cash flows as the transferor was entitled to receive from securities that it transferred to the securitization entity, the ASC 320 classification of the beneficial interests is the same as the securities held before the transfer. For example, if prior to the transfer the debt securities were accounted for as available-for-sale securities in accordance with ASC 320, the beneficial interests are to be classified as available-for-sale securities if the transferor receives the cash flows from those securities via its beneficial interest. In contrast, if the transferred assets were not ASC 320 securities prior to the transfer but the beneficial interests were issued in the form of debt securities or in the form of equity securities that have readily determinable fair values, then the transferor has the opportunity to decide the appropriate ASC 320 classification at the date of the transfer.

Revolving-period securitizations present some unique issues because they contain an implicit forward contract to sell new receivables during the revolving period. The forward contract may become valuable to the transferor or burdensome depending upon how interest rates and market conditions change. The value of the implicit forward contract arises from the difference between the rate promised to the holders of the beneficial interests and the market rate of return on similar investments. For example, if the agreed-upon rate to holders is 5% and the market rate is 7%, the forward contract's value to the transferor is 2% of the amount of the investment for each year remaining in the revolving period, after the initially transferred receivables are collected. When receivables are sold to a revolving-period securitization trust, gain or loss recognition is limited to receivables that exist and have been sold. Similarly, servicing assets or liabilities are limited to servicing receivables that exist and have already been transferred. As proceeds from collection of the receivables are used to purchase new receivables for the trusts, each additional transfer is treated as a separate sale, with its own gain or loss calculation. Those additional transfers also can result in recognition of additional servicing assets and liabilities.

ASC 860 does not address the accounting for desecuritization of securities into loans or other financial assets. ASC 320-10-25 addresses that issue. It states that the guidance in ASC 860 is to be extended by analogy to desecuritizations. Thus, the transfer of securities or beneficial interests in a securitized pool of financial assets in which the transferor receives in exchange only the financial assets underlying those securities or beneficial interests would not be accounted for as a sale.

Repurchase Agreements

Repurchase agreements are used to obtain short-term use of funds. Under the terms of a repurchase agreement the transferor transfers financial assets to a transferee in exchange for cash. Concurrently, the transferor agrees to reacquire the financial assets at a future date for an amount equal to the cash exchanged and an interest factor. Many repurchase agreements are for short terms, often overnight.

It is necessary to determine whether the repurchase agreement meets the requirements described in the section earlier in this chapter, “Surrender of control.” Usually the critical determination is whether the repurchase agreement gives the transferor effective control over the transferred assets. That determination is made by applying the criteria described in the section entitled, “Maintaining effective control.” In most cases, if the repurchase is required prior to the maturity of the security transferred and the cash transferred is sufficient to repurchase the assets if the transferee defaults, the transferor retains effective control and the agreement is accounted for as a secured borrowing. For example, 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 transferred is assured. However, if a transferor does not maintain control over the transferred assets and other criteria in ASC 860 are met, the transfer is accounted for as a sale and a forward commitment. ASC 860-20-55, discussed earlier in this chapter, addresses situations where a transferee transfers the assets back to the transferor in a repurchase financing arrangement, which (depending on meeting criteria specified) may or may not interfere with derecognition of the assets by the original transferor.

Securities Lending Transactions

Broker-dealers and other financial services companies initiate securities lending transactions when they need to obtain specific securities to cover a short sale or a customer's failure to deliver securities sold. The transferor/lender provides the securities to the transferee/borrower in exchange for “collateral,” usually in an amount greater than the fair value of the borrowed securities. This collateral is commonly cash but could alternatively be other securities or standby letters of credit.

When the collateral is cash, the transferor/lender invests the cash during the period that the security is loaned. The investment return on the cash collateral is larger than the fees paid by the lender under the agreement (the rebate). Because the cash collateral is usually valued daily and adjusted frequently for changes in the market value of the underlying securities, the transaction has very low credit risk.

In determining whether to account for a securities lending transaction as a sale or a secured borrowing, the same criteria used for other asset transfers are applied. Many securities lending transactions are accompanied by an agreement that entitles and obligates the transferor/lender to repurchase or redeem the transferred assets before their maturity. Thus, the transferor maintains effective control over the securities lent. If that is the case, the transaction is accounted for as a secured borrowing. The following is an example of a securities lending transaction accounted for as a secured borrowing:

Accounting for Collateral

Accounting for collateral depends both on whether the secured party has the right to sell or repledge the collateral and on whether the debtor has defaulted. Ordinarily, the transferor should carry the collateral as an asset and the transferee does not record the pledged asset.

The collateral provisions of ASC 860 apply to all transfers (repurchase agreements, dollar-roll, securities lending, etc.) of financial assets pledged as collateral and accounted for as a secured borrowing. The provisions do not apply to the accounting for cash in secured borrowing transactions.

If the secured party (transferee) has the right to sell or repledge the collateral, then the debtor (transferor) reclassifies the asset used as collateral and reports it in the statement of financial position separately from other assets not similarly encumbered. That is, the debtor (transferor) continues to hold the collateral assets as its own, and the secured party (transferee) does not recognize the collateral asset. If the secured party (transferee) sells the collateral, it recognizes the proceeds from the sale and the obligation to return the collateral to the debtor (transferor).

Although collateral is required to be reclassified and reported separately by the transferor if the transferee has the right to sell or repledge the collateral, that requirement does not change the transferor's measurement of the collateral. The same measurement principles are to be used as before the transfer and the collateral is not derecognized. The subsequent measurement of the transferee's obligation to return the collateral in securities borrowing and resale agreement transactions is not addressed by ASC 860.

If the transferor defaults and is not entitled to the return of the collateral, it is to be derecognized by the transferor. If not already recognized, the transferee records its asset at fair value.

Financial Assets Subject to Prepayment

ASC 860 requires interest-only strips, loans, other receivables, or retained interests in securitizations to be measured like investments in debt securities. If they can be contractually prepaid or settled in a way that potentially precludes recovery of substantially all of the recorded investment, they are classified as available-for-sale or trading under ASC 320 (i.e., they generally cannot be treated as held-to-maturity debt instruments). Only assets meeting all of the ASC 320 requirements and acquired late enough in life that, even if prepaid, the holder would recover substantially all of its recorded investment may be initially classified as held-to-maturity. The probability of prepayment or settlement is not relevant to the classification under ASC 320.

Although financial assets that do not meet the securities definition of ASC 320 must be measured in the same manner as investments under ASC 320, other provisions of that Statement (disclosures, etc.) are not required to be applied.