Simultaneous common control mergers and "removal of accounts" provisions in credit card securitizations.

This month's column discusses two recent consensuses reached by the Financial Accounting Standards Board emerging issues task force (EITF) concerning accounting for simultaneous common control mergers and certain "removal of accounts" provisions in credit card securitizations.

EITF Abstracts, copyrighted by the FASB, is available in softcover andloose-leaf versions and may be obtained by contacting the FASB order department at 401 Merritt 7, P.O. Box 5116, Norwalk, Connecticut 06856-5116. Phone: [phone].

ISSUE NO. 90-13

This issue, Accounting for Simultaneous Common Control Mergers, addresses mergers designed to allow U.S. companies to better compete with foreign buyers when bidding on acquisitions. Simultaneous common control mergers are the brainchild of a Wall Street investment banker and Dow Chemical Company. Investment bankers and the corporate community saw these mergers as a way to avoid the charge to earnings from the amortization of goodwill under purchase accounting. They believed purchase accounting would not apply to such transactions because they are combinations of enterprises under common control, which normally are accounted for at historical cost in a manner that is similar to pooling.

The Securities and Exchange Commission asked the EITF to address the issue as an increasing number of companies planned this transaction. The result was EITF Issue no. 90-13. The decision received media attention (see Forbes, August 20, 1990).

The deals are structured as follows: An entity (Parent) obtains control of aanother entity (Target), either by ownership or otherwise. Almost simultaneously, as part of an integrated planned transaction, Target issues additional shares to Parent in exchange for Parent's interest in a subsidiary (Subsidiary). In substance, Parent is selling its subsidiary in partial consideration for acquiring Target.

Accounting issues. Several accounting issues were considered by the task force.

1. Should Parent account for Subsidiary's transfer to Target at fair value, as in a purchase accounting transaction, or at historical cost, as in a transfer between entities under common control?

2. If the transaction is to be accounted for at fair value

* Should Parent recognize a gain on the sale of Subsidiary?

* How should the assets and liabilities of Target and Subsidiary as well as minority interest be determined in Parent's consolidated financial statements?

* How should Target account for the transaction?

Arguments: On the first issue, those in favor of applying historical cost accounting cite AICPA Accounting Interpretation no. 39, "Transfers and Exchanges Between Companies under Common Control," of Accounting Principles Board Opinion no. 16, Business Combinations, for support. They believe Parent effectively controls both Target and Subsidiary at the time Subsidiary is transferred to Target. Under Interpretation no.39, combinations involving parties under common control do not result in a step-up in basis.

Others contend Interpretation no. 39 does not apply, because when both transactions (that is, obtaining control of Target and the merger of Subsidiary with Target) are being negotiated, Target and Subsidiary are not under common control. Therefore, the steps of the transaction cannot be separated and should be viewed as one transaction. As a result, they believe the transfer should be recorded by Parent as a purchase under APB Opinion no. 16.

Still others argue the applicability of Interpretation no. 39 should be determined based on the facts and circumstances of each transaction. For example, if the substance of the control relationship before the merger is an equity ownership interest, Interpretation no. 39 should apply. On the other hand, if the premerger control is merely a voting proxy, the interpretation would not apply. Rather, purchase accounting should be used.

On whether Parent should recognize a gain on the transaction (assuming issue 1 is decided in favor of purchase accounting treatment), proponents believe gain recognition should be allowed to the extent a partial sale to Target's shareholders has occurred.

Others argue no gain should be recognized based on (1) the related party nature of the transaction, (2) the form of the consideration received (that is, an interest in an entity in the same line of business) and (3) the fact that the earnings process has not been completed (that is, gain has not been realized in a transaction with an outside party).

On how the Parent should determine the amounts assigned to Target and Subsidiary assets and liabilities and the minority interest in Parent's consolidated statements, these three valuation methods for the combined Target--Subsidiary entity were proposed:

* Parent's basis in Target divided by Parent's interest in Target.

* A stepped-up basis in Target to the extent of ownership interest acquired while retaining Subsidiary's basis at historical cost.

* A stepped-up basis for both entities to the extent transferred.

On how to account for the transaction in Target's separate financial statements, three possible approaches were considered:

* Reverse acquisition of Target by Subsidiary. After the exchange, Target's original shareholders will have fewer shares in the combined entity than Parent.

* Revalue Target's financial statements only if pushdown accounting applies. To do otherwise, some say, would result in pushing down Parent's basis in Target in situations in which pushdown accounting may not be appropriate .

* View the merger as a purchase of Subsidiary by Target. Proponents of this theory adopted a "two transaction" approach that views Parent's acquisition of an equity interest in Target as a separate transaction from the subsequent exchange of stock for the subsidiary. Target would record its acquisition of Subsidiary at either the fair value of the shares its issues or the fair value of the subsidiary, whichever is more objectively determinable.

Consensuses. The task force concluded on the first issue that Interpretation no. 39 does not apply. Parent should account for Subsidiary's transfer to Target as a purchase of Target under Opinion no. 16. Because the transfer is negotiated together with Parent's obtaining control of Target, the two steps (obtaining control and the transfer) cannot be separated and should be treated as one transaction.

The task force concluded on the second issue that, in accordance with EITF Issue no. 86-29, Nonmonetary Transactions: Magnitude of Boot and the Expectations to the Use of Fair Value, Parent should account for the transaction as a partial sale of Subsidiary (to the minority shareholders of Target) and a partial acquisition of Target. Accordingly, Parent should recognize a gain or loss on the portion of Subsidiary sold.

The task force also reached a consensus that, to determine the values assigned to Target and Subsidiary assets and liabilities and the minority interest in Parent's consolidated financial statements, Parent should step up

* Target's assets and liabilities to the extent acquired by Parent.

* Subsidiary's assets and liabilities to the extent ownership interest in the Subsidiary was sold.

The partial step-up in Subsidiary's assets and liabilities is consistent with the consensus in which Parent recognizes a gain or loss to the extent Subsidiary is sold.

Concerning Target's separate financial statements, the EITF concluded the transaction should be accounted for as a reverse acquisition of Target by Subsidiary in accordance with paragraph 70 of Opinion no. 16. For this transaction, Target's separate financial statements would reflect its assets and liabilities at fair value to the extent acquired. However, Subsidiary's assets and liabilities should not be revalued. Task force members noted this treatment is consistent with the concept underlying reverse acquisition accounting (that is, Subsidiary has acquired an interest in Target) and reflects the lack of gain or loss recognition at the Target--Subsidiary level.

The exhibit at left illustrates the application of the consensuses reached on EITF Issue no 90-13.

ISSUE NO. 90-18

This issue, Effect of a "Removal of Accounts" Provision on the Accounting for a Credit Card Securitization, considers whether such provisions should affect the sales treatment often accorded these transactions.

Credit card securitizations (structured as sales transactions) were described in EITF Issue no. 88-22, Securitization of Credit Card Portfolios. A financial institution, such as a bank, forms a pool of receivables from credit card accounts in its portfolio and transfers the receivables to a trust. The bank then sells undivided participation interests in the trust or its receivables and retains the rest.

The investors receive interest based on multiplying a specified rate of interest by the outstanding participation balance of credit card receivables. Typically, the bank services the credit card accounts for the trust and may receive a higher rate of interest from those accounts than the other investors.

During a specified reinvestment period (usually 18 to 36 months), the trust purchases additional credit card receivables generated by selected accounts. The bank's and the investors' participation interests in the receivables in the trust increases or decreases depending on the aggregate outstanding principal balances of the selected accounts resulting from charge and payment activities. However, during the reinvestment period, the investors' dollar investment remains constant because principal payments allocated to the investors' interest are reinvested in additional credit card receivables. After the reinvestment period, a liquidation period occurs during which investors receive an allocated portion of principal payments relating to receivables in the trust.

Under EITF Issue no. 88-22, transfers of participating interests in credit card receivables to investors could be accounted for as sales if the conditions specified in paragraph 5 of FASB Statement no. 77, Reporting by Transferors for Transfers of Receivables with Recourse, are met.

Securitization agreements may contain certain "removal of accounts" provisions that give a transferor the right to periodically designate credit card accounts (and the related receivables) for removal from the pool of receivables securitized, assuming that certain conditions have been satisfied.

Why would the bank (the transferor) want a removal of accounts provision in the securitization process? Growth of the pool of receivables during the reinvestment period results in a growing seller's interest. (Because the absolute amount of the investors' interest must remain constant, the investors' interest in the total pool, relative to the seller's interest, fluctuates depending on the charge and payment activities of the pool.) If, through this process, the seller's interest becomes excessive relative to marketplace requirements, the seller can use the removed accounts to establish a new pool, 80% of which may be sold to new investors in a new securitization agreement.

Accounting issue. The question is whether credit card securitizations with certain removal-of-accounts provisions should be recognized as a financing or as a sale in accordance with Statement no. 77.

Arguments. Those who argue the transfer should be accounted for as a financing transaction believe the removal-of-accounts provision represents a transferor's call option, thereby precluding recognition of the transfer as a sale under paragraph 5a of Statement no. 77. Among other conditions, that paragraph requires the transferor to surrender control of the future economic benefits embodied in the receivables to qualify for sales treatment. Proponents of financing treatment conclude the seller has not relinquished control of the sold accounts because they can be removed and used for other purposes.

Those who favor sales treatment do not believe the removal-of-accounts provision represents a transferor's call option. In their view, the transferor funded the net increase in receivable balances, and such increased balances serve no legal or credit function with respect to the investor's interest.

In addition, they believe transferring participating interests in a pool of receivables causes individual accounts to lose their separate identities because of the homogeneous nature of those accounts. Further, credit card securitizations are structured, valued, priced and reported at the pool level, not at the individual account level.

Proponents of the sales method view removal of designated accounts as a reduction in the transferor's interest, with no corresponding impact on the investor's economic interest in the pool. They point to the fact that before and after the removal, the investors have a fixed dollar interest in the pool of receivables. They also say transfer requirements, which operate to protect the investor's interest, ensure investors do not suffer any material adverse effects from the removal. The conditions of transfer and the large number of accounts involved in securitization also guarantee the pool of receivables has the same economic attributes before and after the removal has occurred.

Consensus. The EITF decided a credit card securitization with a removal-of-accounts provision that otherwise meets conditions of paragraph 5 of FASB Statement no. 77 should be recognized as a sales transaction, provided

* Removal of such individual accounts is within the specified terms of the securitization and cannot reduce the amount the investor has invested in the pool.

* The seller's relative percentage interest in the pool does not fall below that specified by the contractual terms of the securitization.