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Accounting for the sale of receivables under EITF Issue NO. 88-11.

In increasing variety of loans and other receivables is being packaged for sale in transactions where the seller retains certain credit, interest rate, prepayment or other risks associated with the receivables sold. These sales bring into question whether sale recognition is appropriate and, if it is, how the seller should account for the retained risk. This article explores some of the difficulties of accounting for financial instruments and the development of fair value solutions.

EITF CONSENSUS

In mid-1988, the Financial Accounting Standards Board's emerging issues task force began to address allocating the cost basis of a loan between the interest-only (10) strip of the loan sold and the principal only (PO) portion retained. Allocation of the cost basis of a loan between the portion sold and the portion retained had usually been on a pro rata basis between the portion of principal sold and the portion retained. In the case of a sale of an 10 strip of a loan and retention of the PO strip, or sale of the PO and retention of the IO, pro rata allocation based on principal could not generally be applied.

In discussing the issue, the EITF determined

* There were other loan sale transactions that resulted in disproportionate sharing of the elements of the loan between the seller and the buyer.

* Pro rata cost allocation frequently produced anomalous accounting results for these transactions.

* Their deliberations should encompass transactions other than IO and PO sales where pro rata cost allocation may not apply.

The ETIF's final consensus on Issue no. 88-11 in June 1989 effected a major change in the accounting for certain loan sales.. The consensus illustrated the difficulty of fitting complex financial instrument transactions to the historical cost accounting model. Although the consensus improved the accounting for certain loan sales, the EITF was constrained by its inability to modify the statements of the FASB. The consensus can be considered only a temporary, partial solution to the accounting problems it tried to address.

BACKGROUND OF ETIF ISSUE NO. 88-11 What are some of those transactions for which pro rata cost allocation may be inappropriate? Sale of an IO strip and retention of the PO portion is an obvious example. Another example is sale of loans with recourse. Many such transactions involve sales of pools of mortgage loans.

The secondary market for mortgage loans has been one of the fastest-growing markets in the past two decades and many of these mortgages are securitized by the Federal National Mortgage Association (FNMA), the Government National Mortgage Association (GNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). Many sales transactions are structured so a percentage of a securitized pool of mortgage loans is sold and the remaining portion is retained by the seller, but the seller subordinates his interest in the retained portion to the portion sold, so credit losses on the total pool of mortgages are absorbed first by the holder of the retained portion. Other recourse arrangements have been fashioned involving sales of mortgage and other types of loans.

Under FASB Statement no. 77, Reporting by Transferors of Receivables with Recourse, recognition of the sale of receivables is permitted when the buyer has recourse to the seller for credit losses if those losses can be estimated at thE,, time of sale. In addition, the seller must also establish an allowance for losses for the recourse obligation. Provided the requirements of Statement no. 77 are met, a sale can be recognized when all or a portion of a pool of loans is sold, but a disproportionate sharing of related credit risk is created. If the marketplace perceives the recourse arrangement has enhanced the value of the portion of the loans sold by more than the seller's estimate of loss under the recourse obligation, the seller may be able to recognize gain, where gain would otherwise not exist, by selling with recourse.

CREATIVE LOAN PACKAGING

Assume, for example, a financial institution has a pool of loans on the books for $10 million and can sell them for that amount to a buyer who assumes the inherent credit risk. The financial institution chooses instead to sell a participating interest in $8 million of the loans, with recourse. The institution estimates its loss under the recourse obligation to be approximately $40,000 but can sell the participating interest for $8,160,000. The market assigns a greater value to the recourse arrangement than the seller is establishing as its obligation, and the financial institution can recognize up to $120,000 of gain.

In the above example, the financial institution is effectively manufacturing a gain by packaging the sale to result in a disproportionate sharing of credit risk between buyer and seller. Other features of the loan may also be shared disproportionately between buyer and seller to increase gain recognition. The seller may, for example, sell the $8 million participating interest in a pool of fixed rate loans and guarantee a variable yield on the loans, thereby retaining interest rate risk. If the guaranteed variable yield exceeds the fixed rate earned on the loans, the seller makes up the difference.

Statement no. 77 requires no adjustment at the time of sale to the sales price or the cost basis of the loans sold if such a variable rate guarantee exists. In this case, the seller may be able to increase the sales price to $8,320,000 by including such a guaranteed variable yield feature, yet Statement no. 77 does not require the seller to recognize the value of the obligation under the variable-rate guarantee. The seller, by issuing an interest rate swap to the buyer in the form of the guaranteed variable interest rate, has increased the value of the loans sold by an additional $160,000. The interest rate swap requires the seller to receive the fixed-rate interest on the loans sold and pay the buyer the guaranteed variable rate. Statement no. 77 does not require the seller to recognize the fair value of the interest rate swap issued at time of sale as an obligation ($160,000 in this example) and effectively allows recognition of gain by creative packaging of the loan sale.

Recognition of accounting gains through creative loan packaging reflects a problem in applicable accounting principles. In addressing this problem, the EITF did not have the authority to modify Statement no. 77, but it did have the authority to address cost allocation when a portion of a loan is sold and a portion retained, an issue that had not been addressed by the FASB. If disproportionate sharing of credit or interest rate risk occurred in a transaction involving sale of a portion of a loan, then the resolution of the issue of cost allocation could also apply to the issue of gains through creative packaging of the loan sale. Indeed, this is the effect of the EITF's decision in Issue no. 88-11.

THE CONSENSUS

In Issue no. 88-11, the EITF's consensus was: "An enterprise that sells the right to receive the interest payments, the principal payments, or a portion of either or both relating to a loan should allocate the recorded investment in that loan between the portion of the loan sold and the portion retained based on the relative fair values of those portions on the date that the loan was acquired, adjusted for payments and other activity from the date of acquisition to the date of sale." The EITF acknowledged that it may not be practicable to determine the fair values as of the date of the acquisition. In that case, the allocation should be based on the relative fair values of the portion sold and the portion retained on the date of sale.

In practice, the allocation is usually determined based on relative fair values as of the date of sale. The EITF also concluded the amount of any gain recognized when a portion of a loan is sold should not exceed the gain that would be recognized if the entire loan was sold. If a loan is sold with disproportionate sharing of credit risk or interest rate risk, the credit guarantee or the implicit interest rate swap should be considered attached to the portion of the loan retained for purposes of determining that portion's fair value. Such enhanced risk will depress the fair value of the portion retained.

A lower relative fair value on the portion retained will result in more cost allocated to the portion sold in the fair value cost allocation. This should eliminate gains from creative packaging of disproportionate sharing of credit risk or interest rate risk on loan sales involving the sale of the right to receive the interest payments, the principal payments or some of either or both.

The consensus reached under EITF Issue no. 88-11 has done much to eliminate gains on loan sales involving disproportionate risk-sharing. The consensus has broad application in an environment where an increasing variety of loans and receivables is packaged for sale in transactions involving complex sharing of credit, interest rate and prepayment risk. The consensus has, however, proved troublesome for companies that have grown to rely on the gains they have been able to recognize in the past.

The consensus illustrates the difficulty of making the historical cost accounting model fit transactions involving financial instruments. Under the consensus, market value information is required to effect the accounting. Gathering such information for certain loans will be difficult, for example, where secondary markets do not exist for the whole loan or the portion of the loan retained. Complaints about the difficulty and expense of gathering data and the subjectivity of the estimates are also likely. Yet, few would disagree the pro rata allocation approach is inappropriate for the transactions addressed by the EITF consensus and that the relative fair value cost allocation approach generates a preferable accounting result.

INCONSISTENCIES AND UNANSWERED QUESTIONS

Although the consensus resulted in a marked improvement in the accounting for certain loan sale transactions, it has to be considered only a temporary solution. The consensus creates inconsistencies in the accounting for transactions it covers relative to very similar transactions not covered and leaves certain questions unanswered. The resolutions to these inconsistencies and the answers to these questions await the deliberations of the FASB financial instruments project, established in 1986 to provide a consistent conceptual basis and broad standards for resolving current and future issues in reporting on financial instruments.

The consensus applies only to transactions involving the sale of the right to receive interest payments, principal payments or a portion of either or both. It does not apply to transactions involving the sale of whole loans, including sales of whole loans where servicing and a portion of the interest to cover normal servicing is retained by the seller. Sales of whole loans can also involve a recourse arrangement whereby the seller guarantees the purchaser against credit losses or an arrangement whereby the purchaser receives a variable rate of interest on loans that earn a fixed rate.

Under Statement no. 77, the seller is required to recognize as an allowance only estimated credit losses under the recourse arrangement, even if the purchaser pays a higher premium on the loans for the recourse arrangement than the seller provides as an allowance. Statement no. 77 also does not require recognition by the seller of the fair value of the interest rate swap issued to provide a variable rate to the buyer. On whole loan sales, gains from creative packaging providing disproportionate sharing of credit and interest rate risk are still permitted under the literature.

How should an entity account for the sale of whole loans with such disproportionate sharing of credit and interest rate risk? This is a question that will need to be answered by the financial instruments project; however, it would seem appropriate for the seller to establish as an obligation the fair value of the credit guarantee and/or the interest rate swap issued in the whole loan sale. Theoretically, the premium paid by the buyer should equal the obligation recognized by the seller.

It would also seem appropriate that the obligation related to the credit guarantee be accounted for by either marking it to market or by applying the accounting principles for recognition of premiums received on credit insurance contracts. The obligation related to the interest rate swap should be marked to market over the life of the swap, as would an interest rate swap issued that is not designated as a hedge established to reduce interest rate risk.

In applying the consensus, the effects of a recourse arrangement or an interest rate swap are to be considered in determining the fair value of the portion of the loan retained. The consensus does not address the subsequent accounting for the effect of the credit guarantee or the interest rate swap on the cost allocated to the portion retained. Assuming the effect would be either to create or increase a discount on the loan portion retained, a seller may choose to simply amortize the discount using the interest method.

Amortization of the effect as part of the cost basis of the retained portion of the loan would appear to be inappropriate under the circumstances. The recourse arrangement or the interest rate swap is not a part of the portion retained; it is related to the portion sold, more appropriately accounted for as an obligation separate from the portion retained. Once established as a separate obligation, it should be accounted for as described earlier.

FAIR VALUE

If the financial instruments project determines the credit guarantee, interest rate swap and other possible elements of disproportionate risk-sharing issued in a whole loan sale should be recognized as the seller's obligations at fair values, then accounting for similar obligations generated by sales of a portion of a loan should be based on fair value rather than relative fair value cost allocation. The accounting issues addressed by EITF Issue no. 88-11 illustrate the complexity of accounting for transactions involving financial instruments. The resolution of those accounting issues should illustrate the persistent trend toward fair value solutions to accounting issues involving financial instruments. n
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Author:Lewis, Christopher E.
Publication:Journal of Accountancy
Date:Jun 1, 1991
Words:2350
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