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Accounting for transfers and servicing of financial assets and extinguishment of liabilities.

Transfers of assets may take many forms. Accounting for transfers when the transferor has no continuing involvement with the transferred assets, or with the transferee, has not been controversial. On the other hand, transfers of financial assets frequently occur in which the transferor has some continuing involvement with either the assets or with the transferee. For example, sales that involve recourse, servicing, agreements to reacquire, options written or held, and pledges of collateral represent continuing involvement with the assets or the transferee. Such transfers of financial assets raise issues about the circumstances under which a transfer should be considered as a sale of all or a part of the assets or as a secured borrowing and about how transferrers and transferees should account for sales and secured borrowings.

Similarly, an entity may settle a liability by transferring assets to the creditor or obtaining an unconditional release. An entity may enter other arrangements designed to set aside assets dedicated to eventually settling a liability. Accounting for those arrangements has raised issues regarding when a liability should be considered extinguished.

The Financial Accounting Standards Board (FASB) addressed these matters in FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities. FASB 125 is part of the Board's effort to develop standards to aid in resolving financial accounting and reporting issues and other issues likely to arise in the future about various financial instruments and related transactions. This article reports on the provisions of FASB 125 and illustrates the accounting for transfers of financial assets and extinguishment of liabilities.

The Need for New Standards

Previous accounting standards generally required that a transferor account for financial assets transferred as an inseparable unit that had been either entirely sold or entirely retained. Those standards were difficult to apply and produced inconsistent and arbitrary results. Previous standards also did not accommodate recent innovations in the financial markets. Consequently, the Board decided approaches that viewed each financial asset as an indivisible unit do not provide an appropriate basis for developing consistent and operational standards for dealing with transfers and servicing of financial assets and extinguishment of liabilities.

To deal with these issues more adequately and consistently, the Board adopted a financial-components approach that focuses on control and recognizes that financial assets and liabilities can be divided into several components. In adopting this approach, the Board established two objectives of accounting for transfers of financial assets and extinguishment of liabilities.

One objective is for an entity to recognize only assets it controls and liabilities it has incurred, to de-recognize (remove) assets only when control has been surrendered, and to de-recognize liabilities only when they have been extinguished. Sales and other transfers often result in a disaggregation of financial assets and liabilities into components, which become separable assets and liabilities. An example is when an entity sells a portion of a financial asset it owns, and the portion retained becomes an asset separable from the portion sold and from the assets received in exchange.

A second objective is that recognition of financial assets and liabilities should not be affected by the sequence of transactions that result in their acquisition or incurrence unless the effect of those transactions is to maintain effective control over a transferred financial asset. For example, if a transferor sells financial assets it owns and at the same time writes a put option (such as a guarantee or a recourse obligation) on those assets, it should recognize the put obligation in the same manner as would another unrelated entity that writes an identical put option on assets it never owned. Similarly, a creditor may release a debtor on the condition that a third party assumes the obligation and that the original debtor becomes secondarily liable. In those circumstances, the original debtor becomes a guarantor and should recognize a guarantee obligation in the same manner as would a third-party guarantor who had never been primarily liable to that creditor, whether or not consideration was paid for that guarantee. Other agreements to repurchase or redeem transferred assets maintain effective control over those assets and should be accounted for differently than agreements to acquire assets never owned.

FASB 125 Establishes New Accounting Standards

A financial asset includes cash, evidence of ownership interest in an entity, or a contract that conveys to another a contractual right (a) to receive cash or another financial instrument from a first entity or (b) to exchange other financial instruments on potentially favorable terms with the first entity. Similarly, a financial liability includes a contract that imposes on one entity a contractual obligation (a) to deliver cash or another financial instrument to a second entity or (b) to exchange other financial instruments on potentially unfavorable terms with the first entity. Servicing a financial asset means to service financial assets under which the estimated future revenues from contractually specified servicing fees, late charges, and other ancillary revenues are expected to more than adequately compensate the servicer for performing the servicing. Similarly, servicing a liability means a contract to service financial assets under which the estimated future revenues from stated servicing fees, late charges, and other ancillary revenues are not expected to adequately compensate the servicer for performing the servicing.

A transfer of financial assets (all or a portion) in which the transferor surrenders control over those financial assets should be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. Beneficial interests are rights to receive specified cash inflows to an entity, including senior and subordinated shares of interest, principal, or other cash inflows to be "passed through" or "paid through," premiums to guarantors, and residual interests. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met:

a. The transferred assets have been isolated from the transferor (put presumably beyond the reach of the transferor and its creditors, even in a bankruptcy or other receivership)

b. Either (1) each transferee obtains the right - free of conditions that constrain it from taking advantage of that right - to pledge or exchange the transferred assets or (2) the transferee is a qualifying special-purpose entity(*) and the holders of beneficial interests in that entity have the rightfree of conditions that constrain them from taking advantage of that right to pledge or exchange those interests.

c. The transferror does not maintain effective control over the transferred assets through (1) an agreement that both entitles and obligates the transferror to repurchase or redeem them before maturity or (2) an agreement that entitles the transferor to repurchase or redeem transferred assets that are not readily obtainable.

Upon completion of a transfer of financial assets that qualifies as a sale, the transferor should:

a. De-recognize all assets sold.

b. Recognize all assets obtained and liabilities incurred in consideration as proceeds of the sale, including cash, put or call options held or written (for example, guarantee or recourse obligations), forward commitments (for example, commitments to deliver additional receivables during the revolving periods of some securitization), swaps (for example, provisions that convert interest rates from fixed to variable), and servicing liabilities, if applicable.

c. Initially measure at fair value assets obtained and liabilities incurred in a sale or, if it is not practicable to estimate the fair value of an asset or liability, apply alternative measures.

d. Recognize in earnings any gain or loss on the scale.

The transferee should recognize all assets obtained and any liabilities incurred and initially measure them at fair value. Consider the following example:

XYZ sells loans with a fair value of $125,000 and a carrying amount of 100,000. XYZ retains no servicing responsibilities, but obtains an option to purchase from the transferee the loans sold or similar loans and assumes a recourse obligation to repurchase delinquent loans. XYZ agrees to provide the transferee a return at a floating rate of interest even though the contractual terms of the loan are fixed rate in nature (effectively, an interest rate swap). Fair values and the net proceeds of sale are:
Fair Values:

Cash proceeds $125,000
Interest rate swap 500
Call option 750
Recourse obligation 1,000
Net proceeds:
Cash received $125,000
Plus: Call option 750
Interest rate swap 500
Less: Recourse provision (1,000)

Net proceeds $125,250


Assuming that this transfer qualifies as a sale, what gain or loss should XYZ recognize? The gain to be recognized by XYZ is computed as follows:

Net proceeds $125,250 Carrying amount of loan sold 100,000 Gain on sale $ 25,250

The entry to record the sale would be as follows:
Cash 125,250
Interest rate swap 500
Call option 750
Loans 100,000
Recourse obligations 1,000

Gain on sale $ 25,250


What If a Transfer Does Not Qualify as a Sale?

If a transfer of assets in exchange for cash or other consideration (other than beneficial interests in the transferred assets) does not qualify as a sale, the transferor and the transferee should account for the transfer as a secured borrowing with pledge of collateral.

A debtor may grant a security interest in certain assets to a lender (the secured party) to serve as collateral for its obligation under a borrowing, with or without recourse to other assets of the debtor. Under other kinds of current or potential obligations, for example, interest rate swaps, a debtor also may grant a security interest in certain assets to a secured party. If collateral is transferred to a second party, the custodial arrangement is commonly referred to as a pledge. Secured parties sometimes are permitted to sell or repledge (or otherwise transfer) collateral held under a pledge. The same relationship occurs, under different names, in transfers documented as sales that are accounted for as secured borrowings. The accounting for collateral by debtor and the secured party depends on whether the secured party has taken control over the collateral and on the rights and obligations that result from the collateral arrangement:

a. If (1) the secured party is permitted by contract or custom to sell or repledge the collateral and (2) the debtor does not have the right and ability to redeem the collateral on short notice, for example, by substituting other collateral or terminating the contract, then

i. The debtor should reclassify and report that asset in its statement of financial position separately (for example, as securities receivable from broker) from other assets not so encumbered.

ii. The secured party should recognize that collateral as its asset, initially measure it at fair value, and also recognize its obligation to return it.

b. If the secured party sells or repledges collateral on terms that do not give it the right and ability to repurchase or redeem the collateral from the transferee on short notice and thus may impair the debtor's right to redeem it, the secured party should recognize the proceeds from the sale or the asset repledged and its obligation to return the asset to the extent that it has not already recognized them. The sale or repledging of the asset is a transfer subject to the provisions of FASB 125.

c. If the debtor defaults under the terms of the secured contract and is no longer entitled to redeem the collateral, it should de-recognize the collateral, and the secured party should recognize the collateral as its asset to the extent it has not already recognized it and initially measure it at fair value.

d. Otherwise, the debtor should continue to carry the collateral as its asset, and the secured party should not recognize the pledged asset.

Each time an entity undertakes an obligation to service financial assets it should recognize either a servicing asset or a serving liability for that servicing contract, unless it secures the assets, retains all of the resulting securities, and classifies them as debt securities held-to-maturity in accordance with FASB 115, Accounting for Certain Investments in Debt and Equity Securities.

If the servicing asset or liability was purchased or assumed rather than undertaken in a sale or a securitization of the financial assets being serviced, it should be measured initially at its fair value, presumptively the price paid. A servicing asset or liability should be amortized in proportion to and over the period of estimated net servicing income (if servicing revenues exceed servicing costs) or net servicing loss (if servicing costs exceed servicing revenues). A servicing asset or liability should be assessed for impairment or increased obligation based on its fair value.

Interest-only strips, loans or other receivables, or retained interest in securities that can conceptually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment, should be subsequently measured like investments in debt securities classified as available-for-sale or trading securities under FASB 115.

Upon completion of any transfer of financial assets, the transferor should:

a. Continue to carry in its statement of financial position any retained interest in the transferred assets, including, if applicable, servicing assets, beneficial interest in assets transferred to a qualifying special-purpose entity in a securitization, and retained undivided interests.

b. Allocate the previous carrying amount between the assets sold, if any, and the retained interests, if any, based on their relative fair values at the date of transfer.

FASB 125 supersedes FASB 77, Reporting by Transferrers for Transfers of Receivables with Recourse.

Extinguishment of Liabilities

A debtor should de-recognize a liability if and only if it has been extinguished. A liability has been extinguished if either of the following conditions is met:

a. The debtor pays the creditor and is relieved of its obligation for the liability. Paying the creditor includes delivery of cash, other financial assets, goods, or services or reacquisition by the debtor of its outstanding debt securities whether the securities are canceled or held as so-called treasury bonds.

b. The debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor.

Consider the following example:

In 19x2, ABC issued $5,000,000 bonds at face value. During 19x5, ABC purchased $1,000,000 of the these bonds on the open market, paying $1,050,000. ABC is currently holding this debt as treasury bonds. Is ABC's debt considered extinguished?

According to FASB 125, debt is considered extinguished when either of (a) the debtor pays the creditor and is relieved of its obligation for the liability or (b) the debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor. Condition (a) is met whenever the debtor pays the creditor cash or other financial assets whether the securities are canceled or held as treasury bonds. Thus, ABC's debt is considered extinguished.

FASB 125 supersedes FASB Statement No. 76, Extinguishment of Debt. Under FASB 76, debt was considered extinguished if the debtor completed an in-substance defeasance. In-substance defeasance no longer is considered to constitute an extinguishment of debt. However, FASB 125 does not alter the accounting for defeasance transactions before the effective date of FASB 125. FASB 125 continues to require disclosure of debt defeased in accordance with FASB 76 before the effective date of FASB 125.

Disclosures

An entity should disclose the following information regarding transfers and servicing of financial assets and extinguishment of liabilities:

a. If the entity has entered into repurchase agreements or securities lending transactions, its policy for requiring collateral or other security.

b. If debt was considered to be extinguished by in-substance defeasance under FASB 76, Extinguishment of Debt, prior to the effective date of FASB 125, a general description of the transaction and the amount of debt that is considered extinguished at the end of the period so long as the debt remains outstanding.

c. If assets are set aside after the effective date of FASB 125 for satisfying scheduled payments of a specific obligation, a description of the nature of restrictions placed on those assets.

d. If it is not practicable to estimate the fair value of certain assets obtained or liabilities incurred in transfers of financial assets during the period, a description of those items and the reasons why it is not practicable to estimate their fair value.

e. For all servicing assets and servicing liabilities:

(1) The amounts of servicing assets and servicing liabilities recognized and amortized during the period.

(2) The fair value of recognized servicing assets and liabilities for which it is practicable to estimate that value and the method and significant assumptions used to estimate fair value

(3) The risk characteristics of the underlying financial assets used to stratify recognized servicing assets for purposes of measuring impairment

(4) The activity in any valuation allowance for impairment of recognized servicing assets - including beginning and ending balances, aggregate additions charged and reductions credited to operations, and aggregate direct write-downs charged against the allowances - for each period for which results of operations are presented.

When Is FAS 125 Effective?

FASB 125 is effective for transfers and servicing of financial assets and extinguishment of liabilities occurring after December 31, 1996 (except as noted below), and should be applied prospectively. Earlier or retroactive application is not permitted. For each servicing contract in existence before January 1, 1997, previously recognized servicing rights and "excess servicing" receivables that do not exceed contractually specified servicing fees should be combined, net of any previously recognized servicing obligations under that contract, as a servicing asset or liability. Previously recognized servicing receivables that exceed contractually specified servicing fees should be reclassified as interest-only strips receivable. Thereafter, the subsequent measurement provisions of FASB 125 should be applied to the servicing assets or liabilities for those servicing contracts and to the interest-only strips receivable.

FASB Statement No. 127 (FASB 127), Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125, was issued in December 1996. FASB 127 amends FASB 125 to delay the effective date for some transactions. The Board was made aware that the volume and variety of certain transactions and related changes to information systems and accounting processes that are necessary to comply with the requirements of FASB 125 would make it extremely difficult, if not impossible, for some enterprises to apply the transfer provisions of FASB 125 to those transactions as soon as January 1, 1997. As a result, this Statement defers for one year the effective date of FASB 125 for the provisions related to secured borrowings and collateral and for repurchase agreement, dollar-roll, securities lending, and similar transactions.

* A qualifying special-purpose entity must meet both of the following conditions:

a. It is a trust, corporation, or other legal vehicle whose activities are permanently limited by the legal documents establishing the special-purpose entity to:

(1) Holding title to transferred assets.

(2) Issuing beneficial interests.

(3) Collecting cash proceeds from assets held, reinvesting proceeds in financial instruments pending distribution to holders of beneficial interests, and otherwise servicing the assets held.

(4) Distributing the proceeds to the holders of its beneficial interests.

b. It has standing at law distinct from the transferor.

James H. Thompson is a Professor of Accounting at the Meinders School of Business in Oklahoma City, OK.
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Author:Thompson, James H.
Publication:The National Public Accountant
Date:Jan 1, 1999
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