FASB 125 changes transfer accounting.

The Financial Accounting Standards Board has issued Statement no. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which changes and clarifies the differences between secured borrowings and sales. (Examples of transactions affected include securitizations, repurchase agreements, loan participations, sales of receivables with recourse, servicing of mortgages and other assets, pledges of collateral and defeasances.) The implementation issues are complex; the FASB included a 30-page implementation appendix, although the statement itself is less than half that.

Halsey Bullen, FASB project manager, said after reviewing "a lot of comments on the exposure draft that offered a lot of constructive criticism," (see also "FASB ED Changes Rules on Accounting for Transfers of Financial Assets," JofA, Jan.96, page 18) the FASB made some important changes in the final statement.

Criteria changed

"The key to this statement's financial-components approach is knowing whether you've surrendered control of an asset," said Bullen. He said the ED had listed four criteria for determining when a transferor had surrendered control. The final statement has three criteria; the first two are similar to what was in the ED and the third has some aspects of old numbers three and four:

1. The transferred assets have to have been isolated; the transfer must be beyond the reach of the transferor and its creditors, even in the event of bankruptcy. The implementation guide gives details.

2. Either the transferee has the right to pledge or exchange the transferred assets, or the transferee is a qualifying special purpose entity. The final statement expands the first condition to make it clear it's really whether the transferee retains the right free of conditions that may constrain it from taking advantage of that right. Some conditions are relatively minor; even when they are in place, the transferor can still presume it has given up control. The statement also clarifies what can qualify as a special purpose entity.

3. The transferor must not maintain effective control over the transferred assets through agreements to repurchase or redeem the transferred assets. The implementation appendix covers which types of agreements maintain effective control over the transferred assets.

Collateral clarified

Bullen said the FASB discussed the collateral issue at length. The final statement explains that in certain cases, after the transfer of collateral, it may be necessary for the debtor to reclassify the assets pledged and report them as being receivable from the other party. The party that takes custody may have to recognize that collateral as its asset, as well as its obligation to return it. This can occur if the secured party is permitted to sell or repledge the collateral and the debtor doesn't have the right or ability to redeem it on short notice. "Those are new concepts. Those engaged in collateral transfers--common in banks and Wall Street brokerage firms--will have to look at their current arrangements carefully."

Repo timing

Repurchase agreements (repos) are common for Treasury and mortgage securities. The ED said that a transfer of a security that the transferor agreed to buy back more than three months later was a sale. However, many respondents criticized the three-month period as arbitrary. The final statement eliminates the timing rule: The transfer is a secured borrowing as long as the transferor is entitled and able to get back substantially the same security.

"The statement is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after December 31, 1996," said Bullen. "So those with significant volume of financial transfers should be starting now to look at their transactions, figure out whether the statement affects them and initiate accounting system changes." Statement no. 125 is available from the FASB order department, 203-847-0700, ext. 555, for $11.50. The statement without its appendixes is in this month's Official Releases section.