Accounting for servicing assets: a reporting challenge for executives and financial statement users.
What Is a Servicing Asset?
According to the Accounting Standard Codification (ASC) topic 860-50, Servicing Assets and Liabilities, a servicing asset is "a contract to service financial assets under which the benefits of servicing are expected to more than adequately compensate the servicer for performing the servicing." By the same token, a servicing liability is defined similarly, only that the benefits of servicing are not expected to adequately compensate the servicer.
From the onset, the definitions of servicing asset and liability pose a challenge in dial they deviate from the fundamental accrual-basis accounting and the revenue recognition principle that underpin today's accounting system. Under accrual-basis accounting, assets are defined as economic benefits obtained as a result of past transactions or events, and revenues are recognized upon delivery of goods or rendering of services, in other words, when earned. In that sense, a servicing asset is unique because it is a contract to be performed; no economic benefits have been obtained yet. Depending on the course of future events, expected economic benefits may or may not be realized. As a result, the same contract can be an asset or a liability, or switch back and forth when expectations change. Anyone can easily see the challenge of evaluating future expectations and putting dollar amounts on them. This constitutes the core challenge for servicing asset valuation.
Having understood that servicing assets are contracts to be performed in the future, the natural follow-up question is how are servicing assets created and recognized. The servicing of financial assets--such as collecting principal and interest, escrowing payments from borrowers, monitoring delinquencies, and remitting funds to investors--is inherent in all financial assets. This inherent part of a financial asset becomes a distinct asset or liability only when an entity undertakes an obligation to service a financial asset by entering into a servicing contract. When ownership of financial assets coincides with the servicership, there is no complication of servicing asset recognition and valuation, as the owner cannot enter into a contract with himself for servicing. Servicing assets are created only upon the separation of the ownership of financial assets and the servicership of financial assets.
The two most popular ways to separate ownership of financial assets from servicership are 1) sales of financial assets with servicing retained and 2) securitization of financial assets through a qualifying special-purpose entity with servicing retained. Once created and separated, however, servicing assets are transferable. Thus, technically, a third way an entity can obtain servicing assets is simply through acquisition/purchasing.
In the fourth quarter of 2010, among the 206 public bank holding companies that carried servicing assets on their balance sheets, servicing assets totaled more than $70 billion, according to the Consolidated Financial Statements for Bank Holding Companies (PR Y-9C Report) that bank holding companies file with the Federal Reserve. Exhibit I gives the list of the top 10 services and their respective servicing asset holdings. Most servicing assets are for residential mortgage loans; the rest include servicing for credit card receivables and automobile loans.
EXHIBIT 1 Top 10 Servicers and Their Servicing Asset Holdings Mortgage Nonmortgage Total Servicing Servicing Assets Servicing Assets Assets Bank of America $15,177 $3,077 $18,254 Wells Fargo 15,886 186 16,072 JPMorgan Chase 13,649 897 14,546 Citigroup 4,554 2,748 7,302 Ally Financial 3,738 0 3,738 U.S. Bancorp 1,837 279 2,116 PNC Financial 1,700 1 1,701 Sun Trust Banks 1,439 6 1,445 MetLife 950 0 950 BB&T Corporation 942 0 942 Source: 2010 Q4 Y-9C Reports. Numbers are in millions.
Valuation of Servicing Assets
The accounting rule for servicing asset valuation looks straightforward: Servicing assets or liabilities should be measured at fair value upon initial recognition (ASC 860-50-30-1). However, after this seemingly clear, one-sentence rule, the accounting codes provide two pages to address the practicability of coming up with a fair value estimate. Basically, fair value of servicing asset is the net of 1) adequate compensation for performing the servicing and 2) the estimate of the benefits of servicing. Both need to be estimated before a fair value of servicing asset or liability can be determined. Once servicing assets or liabilities are created and carried on the balance sheet, a reporting entity shall subsequently measure each class of servicing assets using either the amortization method or the fair value method.
The rules are simple. But the bottom line is: How do you reach the fair value of economic benefits of a contract yet to be performed, given all the uncertainty in future events?
To illustrate possible uncertainties involved in valuing servicing, consider a typical servicing contract tor a 30-year residential mortgage loan. Periodical fee income is contracted and can be expected, but that's about the only item under control. Depending on the borrower's financial condition and the market interest rate, the mortgage can default, resulting in foreclosure-related expenses; be prepaid, resulting in the termination of the service; or continue for the next 30 years as contracted. These are uncertainties of the underlying financial asset totally beyond the servicer's control. On the servicer side, the costs of performing the service can change; what is considered "adequate compensation" may also change, depending on the servicer's cost of capital. Given all these uncertainties, financial executives, nevertheless, have to attach a price tag for the servicing asset or liability--it's easy to understand why it is listed among the top financial reporting challenges.
Financial Executives' Dilemma
No one can precisely anticipate future events, and it is understood that fair values, at best, are unbiased estimates of future economic benefits. But for financial executives, the stakes are high if their estimates are off the mark because servicing assets, like most other assets and liabilities, are recognized with income statement effects. The initial recognition/valuation and subsequent valuations of servicing assets have direct, dollar-for-dollar effects on reported accounting earnings. If financial executives' performance evaluations are tied to accounting earnings, then it is critical that the proper estimate of the value of servicing assets be obtained.
Upon the separation of ownership of a financial asset and its servicership, the servicing asset is created: the accounting standard made this clear, regardless of whether or not explicit consideration was exchanged (ASC 860-50-30-1). The value of this newly created asset is part of the gain on sale (or gain on securitization) of the financial asset; with no explicit consideration received, simply by entering into a contract, the reporting entity can increase the accounting earnings by the value of the servicing assets. To this end, a reporting entity has incentive to overstate servicing assets for current-period earnings.
To illustrate the income statement effects of servicing assets recognition, a numerical case is presented in Exhibit 2 that replicates the illustration given in ASC 806-50-55-22, with interpretive notes to help better understand this complicated transaction.
Illustration of the Income Statement Effect for Servicing Asset Recognition
Entity A originates $1,000 of loans that yield 10% interest income for their estimated lives of nine years. Entity A sells the $1,000 principal plus the right to receive interest income of 8% to another entity for $1,000. Entity A will continue to service the loans, and the contract stipulates that its compensation for performing the servicing is the right to receive half of the interest income not sold. The remaining half of the interest income not sold is considered an interest-only strip receivable that Entity A classifies as an available-for-sale security.
At the date of the transfer, the fair value of the loans is $1,100. The fair values of the servicing asset and the interest-only strip receivable are $40 and $60, respectively.
Entity A's accounting for the loan sale with servicing and interest-only strip receivable retained are calculated as follows.
Allocation of Carrying Amount Based on Relative Fair Values: Fair Value Percentage Allocated of Total Carrying Fair Value Amount Loans sold $1,040 94.55% $945.5 Interest-only $ 60 5.45% $ 54.5 strip receivable Total $1,100 100% $1,000
(Interpretive note: The carrying amount of the loans ($1,000) is allocated to loans sold and the interest-only strip receivable, which is another asset created in this transaction and not sold. A servicing asset is also created in this transaction but is measured at fair value and, therefore, not included in this allocation calculation.)
Gain-on-Sale Calculation: Net proceeds $1,040.00 Less: Carrying amount of loans sold $ 945.50 Gain on sale $ 94.50
(Interpretive note: in addition to the cash proceeds received in the transaction ($1,000), fair value of the servicing asset is recognized as part of the proceeds received, even though no explicit consideration is exchanged for the servicing asset. In this case, if the fair value of the servicing asset is estimated at $50 instead of $40, the gain on sale will be $104.50, instead of $94.50. There is a dollar-for-dollar effect on accounting earning.)
Journal Entries: Cash $ 1,000.00 Interest-only strip receivable $ 54.50 Servicing asset $ 40.00
Overstatement upon initial recognition, however, will catch up in subsequent periods. Because estimated net future benefits of servicing are recognized through earnings upon the creation of servicing assets, later on, when economic benefits are realized, they cannot be recognized again. Instead, they are netted against the carrying value of the servicing assets. That is, values of servicing assets are amortized over the life of the underlying financial assets. Overvaluation of servicing assets can lead to low or even negative servicing income in subsequent periods.
One less understood accounting item for the financial servicing industry is the "net servicing fee income" on banks' income statements. According to the Federal Reserve's instructions for banks' call reports (or the Y-9C Report for bank holding companies), net servicing fee income reports fee income net of the servicing asset's amortization expenses for servicing assets measured under the amortization method. For servicing assets measured at fair value, net servicing fee income includes changes in the fair value of the servicing assets. In the fourth quarter of 2010, 31 out of the 206 bank holding companies carrying servicing assets (15%) reported negative fee income in their Y-9C Report. Apparently, they overvalued their servicing assets in the first place and had to compensate for that in subsequent periods. When realization of servicing fees income fails to catch up with the amortization of servicing assets or the drop in fair value, a negative fee income has lo be reported. While financial executives have incentives to overvalue servicing assets at initial recognition, they have to consider whether it is to the detriment of future accounting earnings.
Statement Users' Challenges
For financial statement users, this unique accounting poses challenges in understanding a reporting entity's servicing practice. Below is a summary of the challenges from the perspective of both the balance sheet and the income statement.
On the balance sheet:
Anticipated economic benefits versus obtained economic benefits. Most noticeably, while other assets are economic benefits obtained as a result of past transactions or events, servicing assets, as contracts yet to be performed, have a much higher degree of uncertainty. Given ever-changing economic situations such as housing prices, interest and prepayment rates, and the mortgage borrower's financial condition, how much of the $70 billion combined servicing assets is realizable is questionable. Statement users should keep in mind that while total assets is the aggregate of all assets, there are different degrees of uncertainties involved in each of the assets. Servicing assets or liabilities surely are some of the most uncertain ones.
Disparate treatments to service self-owned versus others' financial assets. Servicing becomes a distinct asset or liability only when an entity undertakes an obligation to service a financial asset by entering into a servicing contract. For a mortgage originator to service its mortgage loans before sales or securitizations, no servicing assets are recognized. Once the mortgage loans are sold or securitized with the service retained, the servicing assets are created and recognized on the balance sheets. While recognized servicing assets, given the valuation issues discussed above, may or may not be fully realized, statement users have to keep in mind that there may be hidden economic benefits from servicing self-owned financial assets. However, those economic benefits are recognized only when realized. Yes, those recognized may not be realized, and those realizable may not be recognized. It depends on the ownership structure of the underlying financial assets.
A class-by-class option to subsequently measure at amortized cost versus fair value. Servicing assets are initially recognized at fair value. Once carried on the balance sheet, however, the importing entity has the option to subsequently measure servicing assets at either the amortized costs or at fair value. The options can be exercised on a class-by-class basis. For this purpose, classes of servicing assets are identified based on 1) the availability of market inputs used in determining the fair value, 2) the entity's method for managing the risks of its servicing asset, or 3) both. The accounting standard made it clear that it is the fair value availability and risk aspects that identify classes of servicing assets, not the asset type of tile underlying financial assets (ASC 860-50-35-6). In that sense, credit card receivables can be classified together with mortgage loan receivables, as long as they have similar risk aspects.
Financial statement users should keep in mind that the aggregate value of servicing assets carried on the balance sheet is a mix of apples and oranges, some at amortized cost, some at fair value. Different measurement bases have different sensitivities to changes of market condition and the impacts on accounting earnings.
On the income statement:
Interpretation of net servicing fee income. For the financial servicing industry, other than interest income, servicing fee income represents another important source of revenue. Given the unique servicing assets accounting method, however, the economic benefits had been recognized upon entering the servicing contract Financial statement users should pay attention to the net servicing fee income. It is realized fee income net of servicing assets amortization expenses or fair value fluctuations. It does not present the whole picture of realized revenues from servicing fees. If the initial recognition and valuation of servicing assets is an estimate of economic benefits in advance, then the net servicing fee income is the reality check of estimate errors afterward. If the estimates were perfect--that is, if the amount and timing on servicing fee collections perfectly match the amortization schedule--then net servicing fee income will be zero at all the subsequent periods. A negative net servicing fee income .simply indicates that servicing assets were overvalued initially.
However, a positive net servicing fee income does not necessary mean that servicing assets were undervalued initially. Notice that not all services are performed for third-party-owned financial assets. Fee incomes for servicing performed on self-owned financial assets are recognized upon realization. So this net servicing fee income is also a mix of apples and oranges--that is, a mix of the realized fee incomes from servicing self-owned financial assets and the estimate errors of servicing assets amortizations from servicing third-party-owned financial assets.
Exhibit 3 shows the relationship between net servicing fee income and the amount of servicing assets. For top servicers, net servicing fee income is presented as a percentage of total servicing assets. Given the competitive market, servicers basically charge a similar percentage premium as the servicing fee; however, servicing fee income as a percentage of servicing assets moves sporadically, ranging from more than 75% to -28%. Because net servicing fee income is a mixed bag, income statement reporting does not present the whole picture of realized revenues from servicing fees.
Financial executives' earnings management. The difficulties in estimating fair values of servicing assets challenge financial executives; on the flip side, this lack of verifiability provides a vehicle for earnings management. While no one can perfectly predict future events, and estimate errors are expected, financial statement users have no way of telling whether the estimate errors are inherent or intentionally introduced. The standard made it clear (ASC 860-50-25) that servicing assets can be recognized without explicit considerations exchanged. What is preventing financial executives from inflating accounting earnings upon initial recognition at future periods" expenses? In addition, future periods' fee incomes are mixed with revenues from servicing self-owned financial assets. In subsequent periods, there is no telling how much is the correction of an estimate error. But up front, gains on sales or on securitizations are recognized in accounting earnings. Financial statement users should always keep in mind the possibility of earnings management.
In Accounting 101 classes, future accountants and other business majors are told that accounting is the language of business. Just like any other language, the purpose is to communicate. The key to successful communication lies in the counterparties having a common understanding of the words they use in carrying out a conversation. In that sense, financial statements are the conversations between financial executives and financial statement users. FASB determined that servicing for financial assets has economic benefits. Even though the benefits only realize in the future, it has to be recognized up front when the servicing contract is executed. And the present value of the future economic benefits, in the form of fair value, has to be communicated to financial statement users.
The challenge faced by financial executives is how to predict future events and to attach a price tag on the servicing contract that the reporting entity just entered. Equipped with private information about the underlying assets that the entity is servicing, financial executives should calculate the best estimates to communicate to financial statement users.
Financial statement users face the challenge of understanding the unique accounting method. Contrary to the revenue recognition principle, which says that revenues can only be recognized when earned, servicing asset accounting recognizes economic benefits before realization. This article helps to explain the unique accounting and tries to bring financial statement users to the same page as financial executives. The key is for statement users to understand the estimated nature of servicing assets and the uncertainties involved.
Financial statement users, however, face an even bigger challenge, namely, trust. This unique accounting method facilitates private, unobservable, and unverifiable information. Fair value estimate is but one element. The options to measure under fair value or amortized cost, the discretion to define a class of servicing assets, the ownership structure of self-owned or third-party-owned financial assets--these are all detailed types of accounting information that only financial executives have access to. Given the complication of financial assets transfer and the information asymmetry, financial statement users have little choice but to trust the accounting information being conveyed to them.
Kang Cheng, PhD, CPA, is an associate professor at Morgan State University, Baltimore, Md.
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|Title Annotation:||financial reporting|
|Publication:||The CPA Journal|
|Date:||Oct 1, 2011|
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