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Determining what constitutes "all risks and rewards" and "no significant unresolved contingencies" in a sale of mortgage servicing rights; buyouts of compensatory stock options.

Statement on Auditing Standards no. 69, The Meaning of "Present Fairly in Conformity With Generally Accepted Accounting Principles" in the Independent Auditor's Report, identifies Financial Accounting Standards Board emerging issues task force (EITF) consensuses as sources of established generally accepted accounting principles.

This month's column lists new EITF consensuses adopted September 22, 1994 (see "NEW EITF CONSENSUSES ADOPTED SEPTEMBER 22, 1994"). in addition, the consensuses on the determination of what constitutes all risks and rewards and no significant unresolved contingencies in a sale of mortgage servicing rights under Issue no. 89-5 and accounting for the buyout of compensatory stock options are summarized. The summaries are presented in the order of importance from broad to narrow applicability.

EITF Abstracts, copyrighted by the FASB, is available in soft-cover and loose-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: (203) 847-0700.

ISSUE NO. 94-5

EITF Issue no. 94-5, Determination of What Constitutes All Risks and Rewards and No Significant Unresolved Contingencies in a Sale of Mortgage Loan Servicing Rights under Issue no. 89-5, clarifies the risks sellers may retain that would disqualify treatment of the transaction as a sale under EITF Issue no. 89-5, Sale of Mortgage Loan Servicing Rights (see JofA, Aug.89, page 24).

In Issue no. 89-5, a consensus was reached that says, "A sale of mortgage loan servicing rights should not be recognized before the closing of the sale; that is, when title and all risks and rewards have irrevocably passed to the buyer, and there are no significant unresolved contingencies."

Agreements to sell mortgage loan servicing rights may include provisions that require the seller to retain certain risks for a specified period of time, such as risk of prepayment, default or foreclosure for a short period of time after closing (for example, 90 days). Most of these agreements also include provisions for the seller's representation or warranty against eligibility defects.

The issue is whether including some or all of these provisions in a mortgage servicing sale contract precludes recognition of a sale under Issue no. 89-5 because "all risks" have not been irrevocably passed to the buyer and because "significant unresolved contingencies" are retained by the seller.

The EITF reached a consensus that the seller's retention of risk attributable to uncertainties caused by prepayment, credit and similar risks, such as defaults and foreclosure, would preclude recognition of the sale of the mortgage servicing rights until those uncertainties have been resolved. Further, a seller cannot eliminate these risks by recording a liability for its retained risk. The consensus applies to all mortgage servicing sales agreements, including those that contractually limit payment, credit or similar risks retained by the seller.

The task force also agreed that representation and warranty provisions, if not significant, do not preclude sales treatment because these are normal contract requirements that relate to the conformity with agreed-upon standards, rather than the risks and rewards of ownership, and typically assert that loans are properly underwritten and free of defects.

This consensus is consistent with the AICPA audit and accounting guide Audits of Savings Institutions, paragraph 8.21, which says, "...The buyer should be able to return the servicing right only if it does not meet agreed-upon standards, not because the loan defaulted or was prepaid subsequent to closing."

ISSUE NO. 94-6

EITF Issue no. 94-6, Accounting for the Buyout of Compensatory Stock Options, addresses employers' accounting for the repurchase (buyout) of outstanding options that have no intrinsic value and for which the employees' rights to exercise the options are not vested. (Options have no intrinsic value if their exercise price equals or exceeds the market price of the underlying stock. They are also referred to as at-the-money or out-of-the-money options.

When an employer grants options to employees under traditional plans, the

employees have the right to purchase a fixed number of shares of employer stock during a specified period of time at a stated price (exercise prcie), often at a discount from the stock's market price.

For traditional plans Accounting Principles Board Opinion no. 25, Accountign for Stock Issued to Employees, says on the date of the grant, if both the number of shares that an individual employee is entitled to recieve and the stated price (exercise price), if any, are known, the employer measures compensation cost as the difference between the state price and the quoted market price of the stock. This difference is amortized over the vesting period.

When an employer repurchases outstanding options from an employee, Opinion no. 25, paragraph 11(g), says, "Cash paid to an employee to settle an earlier award of stock or to settle a grant of option to the employee should measure compensation cost. If the cash payment differs from the earlier measure of the award of stock or grant of option, compensation cost should be adjusted."

Because compensation cost has been recognized previously for such options, questions have been raised as to whether, in applying paragraph 11(g), companies should reverse previously recognized compensation cost. In other words, does paragraph 11(g), limit the amount of total compensation cost related to the repurchased options to the cash settlement amount?

The issue is how to determine the amount of total compensation cost recognized for compensatory stock options that have no intrinsic value when they are repurchased by the issuing company.

The EITF reached a consensus that, for repurchased compensatory stock options that have no intrinsic value at the buyout date, total compensation cost recognized should be the sum of the compensation cost amortized to the buyout date and the cash paid to repurchase the outstanding options. Previously recorded compensation expense should not be reversed. The task force also agreed that any previously measured about unamortized compensation cost should not be included in the income for any period.


* EITF Issue no. 94-5 Accounting problem: Does the seller's retention of certain risks in an agreement to sell mortgage servicing rights, such as risk of prepayment, default or foreclosure, preclude recognition of the sale under Issue no. 89-5 because "all risks" have not been passed to the buyer? Consensus: Yes.

* EITF Issue no. 94-6 Accounting problem: When, prior to the expiration of the vesting period, a company repurchases outstanding options from employees and the option price equals or exceeds the market price of the stock (the option is either at-the-money or out-of-the-money), should the company's total compensation cost be the sum of the previously recognized compensation cost and the amount paid to repurchase the outstanding options? Consensus: Yes.

By LINDA C. DELAHANTY, CPA technical manager, and SUSAN L. MENELAIDES, CPA, director of the AICPA technical information division.
COPYRIGHT 1994 American Institute of CPA's
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Author:Menelaides, Susan L.
Publication:Journal of Accountancy
Date:Dec 1, 1994
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