Convertible bonds settled for cash upon conversion and balance sheet treatment for certain sales of mortgage servicing rights.

ISSUE NO. 90-19

This EITF issue, Convertible Bonds with Issuer Option to Settle for Cash upon Conversion, discusses how the cash settlement of all or part of the convertible debt's conversion obligation affects the initial balance sheet treatment and subsequent accounting. The facts are these:

A company issues convertible debt that may be converted into a fixed number of common shares. (Often, the debt instruments are deeply discounted bonds.) Upon conversion, the issuer either is required or has the option to settle all or part of the obligation in cash. The EITF identified three types of discounted bonds.

1. Instrument A. Upon conversion, the issuer must pay cash to debt holders at the conversion value (the number of shares the holder is entitled to upon conversion x the stock price on the conversion date).

2. Instrument B. Upon conversion, the issuer may choose either cash or stock equivalent to the conversion value as compensation.

3. Instrument C. Upon conversion, the issuer must pay cash for the obligation's accreted value (the debt's carrying amount at conversion) and may satisfy the conversion spread (the excess conversion value over the accreted value) in either cash or stock.

Accounting issues. The issues are

1. Whether the issuer allocates any portion of the bond proceeds to equity in order to reflect the conversion feature.

2. How the issuer should account for the excess conversion value over the accreted value.

3. How each instrument should be treated in earnings-per-share computations. (Because this issue affects public companies only, the consensus is not discussed in this column. Refer to the EITF Abstracts for further information.) Consensuses. On issue 1, the EITF concluded bond proceeds should not be allocated between the debt and equity sections of the balance sheet. The EITF adopted the combined approach as discussed in Accounting Principles Board Opinion no. 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants.

Opinion no. 14 says no portion of the proceeds from conventional convertible debt should be allocated to equity due to the inseparability of the debt and the conversion option. It also says other types of convertible debt, not specifically discussed in the opinion, should be accounted for in accordance with their substance. The EITF concluded convertible debt partially or entirely redeemable in cash paralleled conventional convertible debt and should be accorded the same accounting treatment.

On issue 2, the EITF concluded instruments A and C should be accounted for similarly to indexed debt obligations, which provide for contingent interest payments in addition to a guaranteed minimum interest payment. The issuer adjusts the debt's carrying amount in each reporting period to reflect the current stock price, but not below the bond's accreted value. These adjustments are included currently in income, not spread over future periods. This decision conforms to conclusions reached in EITF Issue no. 86-28, Accounting Implications of Indexed Debt Instruments, when the contingent interest payment was inseparable from the indexed obligation.

Instrument B, however, should be accounted for as convertible debt. If the issuer pays cash upon exercise of the option, the debt should be considered extinguished at that time and the issuer should follow the accounting prescribed by paragraph 20 of APB Opinion no. 26, Early Extinguishment of Debt. That is, the difference of Debt. That is, the difference between the reacquisition price and the net carrying amount of the extinguished debt should be recognized in the income statement as an extraordinary item, if material.

ISSUE NO. 90-21

This issue, Balance Sheet Treatment of a Sale of Mortgage Servicing Rights with a Subserving Agreement, answers the question of whether the transaction should be accounted for as a sale with a deferred gain or as a financing. It supplements EITF Issue no. 87-34, Sale of Mortgage Servincing Rights with a Subservicing Agreement, which concluded income should not be recognized immediately on such sales.

In these transactions, an enterprise that services mortgage loans (transferor) agrees to transfer mortgage servicing rights to an unrelated entity (transferee) at a gain. The transferee decides not to perform the required servicing functions (standard loan administration activities such as collecting mortgage payments and escrow funds, forwarding payments and accounting reports to investors, paying taxes and insurance and maintaining mortgage loan records) and enters into a subservicing agreement with the transferor.

Accounting issue. Should transfers of mortgage servicing rights accompanied by a subservicing agreement with the transferor be accounted for as a sale with gain deferred or as a financing?

Consensus. The EITF concluded such transfers should be accounted for as a sale with gain deferred if substantially all the risks and rewards of owning the mortgage rights have been effectively transferred to the buyer. Therefore, sales treatment may be permitted if the seller performs purely administrative functions for the buyer under a subservicing agreement.

If, in substance, only a portion of the servicing revenues have been transferred to the buyer, the SEC staff believes the "substantially all risks and rewards" test has not been met. Therefore, the accounting for these transactions would be governed by EITF Issue no. 88-18, Sales of Future Revenues. Under this consensus, classification as debt or deferred income depends on facts and circumstances, although the existence of one or more specified conditions may trigger debt classification.

The EITF decided "substantially all the risks and rewards" have not been transferred if one or more of the factors below is present. Such transactions should be accounted for as a financing if the seller-subservicer

* Either directly or indirectly guarantees a yield to the buyer. For example, the seller-subservicer guarantees either prepayment speeds or maximum loan default ratios to the buyer.

* Must advance either some or all of the servicing fees on a nonrecoverable basis to the buyer before receiving the loan payment from the mortgagor.

* Indemnifies the buyer for damages beyond those caused by the buyer's own nonperformance under the subservicing agreement. For example, the seller-subservicer indemnifies the buyer if the servicing rights are terminated by the mortgage agency without cause. In substance, such indemnification agreements actually guarantee the buyer's investment.

* Absorbs losses on mortgage loan foreclosures not covered by the Federal Housing Administration, the Veterans Administration or other guarantors, if any, including absorption of foreclosure costs and management costs on foreclosed property.

* Retains title to the servicing rights.

The EITF also concluded if the factors below are present, there is a "rebuttable presumption" that financing treatment is appropriate. That is, these factors indicate a financing but are not conclusive due to variations in the facts and circumstances of each transaction. The presence of mitigating factors may justify the transfer of substantially all risks and rewards to the buyer and therefore support sales treatment.

* The seller-subservicer directly or indirectly provides financing or guarantees the buyer's financing. For example, nonrecourse financing would indicate that risks have not been transferred to the buyer.

* The terms of the subservicing agreement unduly limit the buyer's ability to exercise ownership control over the servicing rights or result in the seller's retaining some ownership risks and rewards. For example, if the buyer cannot cancel the subservicing agreement after a reasonable period, the buyer lacks certain rights of ownership. Conversely, if the seller cannot cancel the subservicing agreement within a reasonable period, the seller has not transferred substantially all the risks of ownership to the buyer.

* The buyer is a special-purpose entity without substantive capital at risk.

The factors enumerated above are not intended to be all-inclusive. The presence of other factors also may impair the transfer of substantially all risks and rewards, thus precluding sales treatment.