Transfers and servicing of financial assets

Transcription

1 Second edition, March 2016 Transfers and servicing of financial assets 2013

2 This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PricewaterhouseCoopers LLP, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. The content of this publication is based on information available as of May 31, Accordingly, certain aspects of this publication may be superseded as new guidance or interpretations emerge. Financial statement preparers and other users of this publication are therefore cautioned to stay abreast of and carefully evaluate subsequent authoritative and interpretive guidance that is issued. This publication has been updated to reflect new and updated authoritative and interpretative guidance since the 2013 edition. See Appendix C for a Summary of significant changes. Portions of FASB Accounting Standards Codification, copyright by Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, are reproduced by permission.

3 PwC guide library Other titles in the PwC accounting and financial reporting guide series: Bankruptcies and liquidations (2014) Business combinations and noncontrolling interests, global edition (2014) Consolidation and equity method of accounting (2015) Derivative instruments and hedging activities (2013), Second edition Fair value measurements, global edition (2015) Financial statement presentation (2014), Second edition Financing transactions: debt, equity and the instruments in between (2014), Second edition Foreign currency (2014) IFRS and US GAAP: similarities and differences (2015) Income taxes (2013), Second edition Leases (2016) Revenue from contracts with customers, global edition (2014) Stock-based compensation (2013), Second edition Utilities and power companies (2013) Variable interest entities (2013), Second edition

4 Dear Clients and Friends: PricewaterhouseCoopers is pleased to offer this comprehensive exploration of a complex and still evolving area of accounting: the accounting for transfers/securitizations and related transactions. FASB ASC 860, Transfers and Servicing, remains the principal guidance in this area. The release of new or modified guidance by the FASB is more than likely to continue as the Board considers practice issues that emerge in this innovative area of finance, as well as it continues to work with international standard setters to achieve convergence. We intend to keep you up to date through further communications whenever necessary. Securitization activity slowed during the recent credit crisis. However, as the global economy continues to recover, companies may look once again to securitization transactions as a way to allocate risk and access the capital markets. Investors may again start looking to the securitization market as a source for attractive investments that meet their risk profile. As a result, the volume, variety, and complexity of these transactions will likely increase. For this reason, securitization transactions, which are inherently intricate, continue to attract heightened regulatory scrutiny. Tasked with bridging the gap between the guidance as written and the economics of these transactions, companies have struggled to comply with ASC 860 while continuing to execute their deals in ways that meet their business objectives. In practice, accounting for transfers of financial assets is difficult to apply and gives rise to divergent interpretations. In this Guide our purpose is to clarify a complex area of accounting by bringing together all of the guidance in one document, providing decision trees to help you navigate the rules, and offering clear and detailed examples. As well, we add our own perspective throughout, based on both analysis of the guidance and our experience in applying it. While this publication is intended to clarify the fundamental requirements of accounting for transfers of financial assets and to highlight key points that should be considered before transactions are undertaken, needless to say it cannot substitute for a thorough analysis of the facts and circumstances surrounding proposed transactions and relevant accounting literature. Nonetheless, we trust that you will find in these pages the information and insights you need to work with greater confidence and certainty when accounting for transfers of financial assets. PricewaterhouseCoopers LLP

5 Table of contents Chapter 1: Introduction and scope of Topic 860 Chapter overview revised March Does the guidance apply to transactions in which the transferee is a consolidated affiliate of the transferor? Which financial assets fall within the scope of ASC 860? Instruments, contracts, and agreements that are considered financial assets Instruments, contracts, and agreements that are not considered recognized financial assets Instruments, contracts, and agreements that may be financial assets when purchased What is considered a transfer of financial assets? Definition of a transfer Unit of account on transferred financial assets What types of transfers are scoped out of ASC 860? Chapter wrap-up What are some of the more common types of transfers? FASB s implementation guidance and PwC s questions and interpretive responses Consolidation of transferee by transferor Scope of ASC Transfer of financial assets Transfers scoped out of ASC Chapter 2: Control criteria for transfers of financial assets revised March Does the transfer involve an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset? Have the transferred financial assets been isolated beyond the reach of the transferor and its creditors? Transferred financial assets with no continuing involvement by the transferor Transfer of a financial asset or group of financial assets with continuing involvement by the transferor Involvement by consolidated affiliates of the transferor PwC i

6 Table of contents Legal support for determination of isolation Applicability of legal opinions received for previous, similar transactions Use of an external legal opinion Management s analysis of a legal opinion Consideration of legal isolation when multiple entities within the consolidated group have continuing involvement with the transferred financial assets How the two-step securitization structure meets the isolation requirement Special considerations for transferors subject to FDIC receivership Does the transferee have the right to pledge or exchange the financial assets it has received? Constraints on pledging or exchanging financial assets or beneficial interests More than a trivial benefit Has the transferor given up effective control of the transferred financial assets? Agreements to repurchase or redeem the transferred financial assets Ability to unilaterally cause the return of specific transferred financial assets Ability of transferee to require the transferor to repurchase at a favorable price Chapter wrap-up FASB s implementation guidance and PwC s questions and interpretive responses Transferred financial assets (entire, groups of, or participating interests therein) Isolation of transferred financial assets Transferee right to pledge or exchange the financial assets Transferor retaining effective control Chapter 3: Accounting for sales-type transfers Chapter overview How should a transferor account for a transfer of entire financial assets, group of entire financial assets, or participating interests in entire financial assets that qualify for sale accounting? Derecognition of transferred financial assets ii PwC

7 Table of contents Assets obtained and liabilities incurred (proceeds received in the transfer) Calculation of gain or loss on sale How should a transferor subsequently account for financial instruments obtained or created as part of a sale of financial assets? How should a transferor account for beneficial interests obtained in a transfer that qualifies as a sale? General accounting guidance for beneficial interests Accounting for certificated transferor s beneficial interests Recognition of interest income and impairment of beneficial interests with prepayment risk Subsequent accounting for accrued interest receivable How should a transferor account for the re-recognition of financial assets previously sold? How should a transferee account for transfers of financial assets? Chapter wrap-up FASB s implementation guidance and PwC s questions and interpretive responses Accounting for sales Subsequent accounting for assets obtained or liabilities incurred Subsequent accounting for beneficial interests Re-recognition of previously sold assets Chapter 4: Accounting for financing-type transfers revised March Chapter overview When should a transfer be accounted for as a secured borrowing? Financial assets that are the same or substantially the same Repurchase or redemption before maturity at a fixed or determinable price Timing of repurchase agreements execution What is the general accounting model for secured borrowings? When should collateral be recognized? Cash collateral Noncash collateral PwC iii

8 Table of contents 4.5 What is the appropriate accounting for a repurchase agreement? Accounting for repurchase agreements What is the appropriate accounting for a dollar roll? Accounting for dollar rolls What is the appropriate accounting for a securities lending transaction? Accounting for securities lending Chapter wrap-up PwC s questions and interpretive responses Chapter 5: Servicing of financial assets Chapter overview Overview When and how should the right to service an entire, a group of entire, or a participating interest in an entire financial asset be separately recognized and accounted for? Determining when servicing rights should be separately recognized Determining whether a servicing asset or a servicing liability should be recorded Initial measurement of separately recognized servicing rights Subsequent measurement of separately recognized servicing rights Classes of servicing assets and servicing liabilities Fair value measurement method Amortization method Distinguishing servicing assets from IO strips Hedging considerations What are the financial statement presentation and disclosure requirements for servicing rights under ASC 860? revised March How should the sale of servicing rights be accounted for? General guidance Sale of mortgage servicing rights with a subservicing agreement Sales of mortgage servicing rights for participation in an income stream iv PwC

9 Table of contents 5.5 Are there standards that servicers of financial assets are required to follow? Uniform single attestation program for mortgage bankers Regulation AB Other servicing standards Servicing reform Chapter wrap-up FASB s implementation guidance and PwC s questions and interpretive responses Recognition Chapter 6: Taxation Chapter overview How is a securitization transaction determined to be a sale or a secured borrowing for tax purposes? Securitization structures Tests to determine whether a transaction is a sale or a secured borrowing for tax purposes Substance over form: A question of debt versus equity Facts and circumstances test Sale considerations What tax entities should be used in a securitization? Real estate mortgage investment conduit (REMIC) The interests test The assets test The arrangements test American Jobs Creation Act of 2004 (2004 Act) Taxes imposed on the REMIC Transferring assets to a REMIC Taxation of regular and residual interest holders Financial asset securitization investment trust (FASIT) How are the holders of debt instruments in securitizations taxed? Cash and accrual methods of accounting Original issue discount (OID) Market discount Acquisition premium What are Taxable Mortgage Pools? PwC v

10 Table of contents 6.5 How are servicing assets and servicing liabilities treated for tax purposes? Chapter wrap-up Chapter 7: International considerations 7.1 How well do legal opinions prepared outside the U.S. meet the need for a legal opinion under ASC 860? How do IFRS and U.S. GAAP differ regarding derecognition of financial assets? Scope Application Consolidation before derecognition Defining the asset Is there a transfer? Have all the risks and rewards been substantially transferred? Accounting treatment based on risks and rewards and control analyses Has control over the financial assets been retained? Continuing involvement accounting Servicing assets and liabilities Summary of differences between U.S. GAAP and IFRS Developments Chapter 8: Effective date, transition, and disclosures See Chapter 22 of PwC s Financial statement presentation guide for information on effective date, transition, and disclosures. Appendices Appendix A Technical references and abbreviations... A-1 Appendix B Glossary of terms... B-1 Appendix C Summary of significant changes... C-1 vi PwC

11 Chapter 1: Introduction and scope of Topic 860 PwC 1

12 Introduction and scope of Topic 860 Chapter overview revised March 2016 The guidance in FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities (FAS 140), was originally issued in 2000 to establish the accounting and reporting model for transfers and servicing of financial assets. In 2006, the FASB amended the guidance specific to the accounting for certain hybrid financial instruments and the accounting around servicing rights by simplifying the accounting and moderating the volatility caused by asymmetrical accounting for servicing rights and the related hedging activities through the election of a fair value measurement method. In 2008, the FASB amended the guidance to address specific issues on accounting for a transfer of financial assets and a repurchase financing and by significantly extending the disclosure requirements for public entities. In 2009, the FASB codified FAS 140 into the FASB Accounting Standards Codification, Topic 860, Transfers and Servicing, and subsequently amended ASC 860 through the issuance of Accounting Standards Updates (ASU ) and (ASU ). The following were some of the key changes: Eliminated the QSPE exception from the consolidation guidance. Eliminated the guaranteed mortgage securitization exception when a transferor has not surrendered control over the transferred financial assets. Established a new participating interest concept for transfers of portions of financial assets. Clarified and amended the derecognition criteria for a transfer to be accounted for as a sale. Changed the amount to be recognized as gain/loss on sales in which beneficial interests are received by the transferor. Eliminated the requirement for the transferor to have the ability to perform when assessing effective control, and focused the assessment on the contractual terms. Added extensive new disclosures, which now apply to both public and non-public entities. In June 2014, the FASB released ASU , Repurchase-to-Maturity Transactions, Repurchase Financings and Disclosures, which amends the accounting for repurchase-to-maturity transactions and repurchase financings. The ASU mandates that the former be reported as financings, and eliminates the linked accounting model for repurchase financings. The ASU also requires transferors to disclose additional information about certain transactions reported as sales and collateralized borrowings. See TS 4.1 for additional information. This Guide provides an in-depth analysis of ASC 860, as amended by ASU and ASU , and our observations regarding some of its major provisions and likely business implications. Throughout the Guide, ASC 860 and the guidance refer to ASC 860, as amended. 1-2 PwC

13 Introduction and scope of Topic 860 Overview of ASC 860 Companies conduct financial asset transfers regularly with a variety of purposes in mind. These include the following: Enhance liquidity. Complete borrowing arrangements. Manage interest rate risk. Free up capital commitments. Reduce, diversify, or transfer customer credit risk. Provide alternative funding. Reduce cost of capital. Remove targeted financial assets from a line of business to reduce credit risk or facilitate divestiture. Diversify funding sources and improve profit margins. Facilitate asset/liability management. Improve return on assets and equity. Obtain the benefits that result from transforming the financial assets into new financial assets with new rights and obligations (e.g., securitization transactions). Have financial assets transferred under an agreement to be returned at a later date (e.g., repurchase agreements). When it comes to accounting for transfers of financial assets, there are several important questions that must be answered: (i) How exactly should one account for a particular transfer of financial assets? (ii) Has the transferor and all of its consolidated affiliates in the financial statements being presented sold the entire financial asset, group of entire financial assets or a portion of an entire financial asset it transferred? (iii) Should it therefore derecognize the transferred financial assets and recognize a gain or loss on the sale? (iv) What should the transferee record as its financial assets and liabilities, if anything? Or, (v) Was the transfer more akin to a borrowing arrangement where the transferor was substantively posting the financial assets as collateral on a loan? Historically, these issues have been difficult to address and require a careful analysis of the specific facts and circumstances of the transfer transaction. In 2000, the FASB introduced the effective control model with the aim of eliminating the inconsistencies that existed in previous literature about accounting for transfers of financial assets. ASC 860 establishes a single, comprehensive accounting PwC 1-3

14 Introduction and scope of Topic 860 and reporting Topic that provides guidelines for determining when financial assets should be derecognized by the transferor (i.e., when financial assets should be removed from the balance sheet and a resulting gain or loss recognized) and recognized by the transferee. The ASC 860 guidance attempts to provide consistent accounting guidance, not just for securitizations, but for all transfers of financial assets with or without continuing involvement by the transferor. The accounting framework provided by ASC 860 focuses on which party effectively controls the financial assets after a transfer. That determination must consider the transferor s continuing involvement in the transferred financial asset, including all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer, even if they were not entered into at the time of the transfer. Under this approach, an entity must recognize all financial assets it controls and liabilities it has incurred after a transfer of financial assets. The entity must also derecognize financial assets when control has been surrendered. The following flowchart summarizes the basic accounting framework that should be utilized in determining the proper accounting for transfers of financial assets. 1-4 PwC

15 Introduction and scope of Topic 860 Figure 1-1 Framework for accounting for transfers of financial assets* * For the purposes of this figure, the consolidation models in ASC 810 are not incorporated. In determining whether the transferee is a consolidated affiliate of the transferor, these models must be considered. Further, ASC 860 prescribes an approach to accounting for servicing of financial assets. This Guide also addresses the accounting for servicing of financial assets (refer to TS 5), tax (refer to TS 6), and international considerations (refer to TS 7). PwC 1-5

16 Introduction and scope of Topic 860 Key questions answered in this chapter Paragraphs in ASC Page in this publication Does the guidance apply to transactions in which the transferee is a consolidated affiliate of the transferor? Which financial assets fall within the scope of ASC 860? What is considered a transfer of financial assets? What types of transfers are scoped out of ASC 860? What are some of the more common type of transfers? 05-6 through ASC 860 only applies to transfers between a transferor and a transferee that is not a consolidated affiliate of the transferor in the financial statements being presented. In addition, it generally applies to transfers of recognized financial assets, whether in sales or financing-type transactions, and to the servicing of financial assets. The requirements of the guidance apply to transfers of an entire financial asset, a group of entire financial assets or transfers of a participating interest in an entire financial asset. ASC 860 also applies to whole loan sales, pledges of collateral, repurchase and reverse-repurchase agreements, dollar-rolls, and securities lending transactions. 1.1 Does the guidance apply to transactions in which the transferee is a consolidated affiliate of the transferor? The ASC 860 guidance only applies to entities acting as transferor and transferee, in a transfer of financial assets as further discussed in this Chapter, and whose assets and liabilities are not included in the consolidated financial statements being presented. That is, an entity transferring financial assets, must first determine whether the transferee is considered a consolidated affiliate. The objective of the guidance includes: 1-6 PwC

17 Introduction and scope of Topic 860 Excerpt from ASC Conditions for a Sale of Financial Assets The objective of the following paragraph and related implementation guidance is to determine whether a transferor and its consolidated affiliates included in the financial statements being presented have surrendered control over transferred financial assets or third-party beneficial interests. This determination: a. Shall first consider whether the transferee would be consolidated by the transferor (for implementation guidance, see paragraph D) b. Shall consider the transferor s continuing involvement in the transferred financial assets c. Requires the use of judgment that shall consider all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer, even if they were not entered into at the time of the transfer With respect to item (b), all continuing involvement by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents shall be considered continuing involvement by the transferor. In a transfer between two subsidiaries of a common parent, the transferor-subsidiary shall not consider parent involvements with the transferred financial assets in applying the following paragraph [ASC ]. As stated above, only transfers to entities that are not considered consolidated affiliates of the transferor will be subject to the derecognition criteria. However, as stated in the FASB s implementation guidance (ASC D), if the transferee is a consolidated affiliate of the transferor (its parent) the transferee shall recognize the transferred financial assets in its separate entity financial statements, unless the nature of the transfer is a secured borrowing with a pledge of collateral. In considering the nature of the parent to subsidiary transfer, it may be relevant to evaluate the criteria in ASC (b) transferability criterion and ASC (c) effective control criterion in determining whether the transfer should be treated as a borrowing. Also, all continuing involvement by the transferor, its consolidated affiliates and its agents must be considered in the evaluation as to whether the financial asset transferred meets the conditions for sale accounting. The requirement to consider whether the financial asset has been isolated from the transferor s consolidated affiliates was further clarified in the most recent amendments to the guidance. Prior to such amendments, the importance of considering the transferor s consolidated affiliates was not apparent to some because it was not previously specified in the legal isolation criterion (ASC (a)). Depending on an entity s previous interpretation of ASC 860, the clarification may require a transferor to update its legal opinions to consider the involvement of all PwC 1-7

18 Introduction and scope of Topic 860 consolidated affiliates with the transferred financial assets in all new transfers completed after the effective date of the amendments. Refer to TS for more details on the definition of a consolidated affiliate. Transfers between subsidiaries or sister companies should not be evaluated as exchanges between consolidated affiliates. 1.2 Which financial assets fall within the scope of ASC 860? Only recognized financial assets fall within the scope of ASC 860. The guidance defines a financial asset as: ASC Financial Asset Cash, evidence of an ownership interest in an entity, or a contract that conveys to one entity a right to do either of the following: a. Receive cash or another financial instrument from a second entity b. Exchange other financial instruments on potentially favorable terms with the second entity. A financial asset exists if and when two or more parties agree to payment terms and those payment terms are reduced to a contract. To be a financial asset, an asset must arise from a contractual agreement between two or more parties, not by an imposition of an obligation by one party on another. An entity should carefully consider the definition above when assessing whether a transaction is within the scope of ASC 860. While an item may be considered an asset, it may not be considered a financial asset within the scope of the guidance Instruments, contracts, and agreements that are considered financial assets Among the most common instruments that meet the definition of financial assets are government and corporate bonds, commercial loans, residential and commercial mortgages, installment loans, minimum lease payments under sales-type and direct finance leases, credit card receivables, and trade receivables. However, there are many types of instruments and contracts that exist in today s market for which the determination is less clear. Figure 1-2 contains a list of fairly common instruments, contracts, and agreements in today s business environment that are considered financial assets within the scope of ASC PwC

19 Introduction and scope of Topic 860 Figure 1-2 Examples of instruments, contracts, and agreements that are considered financial assets Description Beneficial interests in a securitization trust that holds nonfinancial assets (e.g., stranded utility costs, auto titling trust) Common stock representing an ownership interest in a controlled investee accounted for under the cost method Common stock or another form of ownership interest accounted for as an equity-method investment Installment loans, balloon notes, mortgages, commercial loans, and credit cards Forward contract on a financial instrument that must be (or may be) physically settled Legal settlements-contractual payment plan Analysis Beneficial interests are considered financial assets because they represent a contract that conveys to a second entity a contractual right to receive cash or another financial instrument from a first entity. Investments in controlled subsidiaries are not consolidated, but are accounted for as cost-method investments such as temporarily controlled investments. Such investments are considered financial assets because they represent an ownership interest. Equity-method investments are typically considered financial assets as they represent an ownership interest. However, ASC 860 specifically excludes any transfer of investment that is in substance a sale of real estate, as defined in ASC 360. Loans are typically considered financial assets because they represent a contract that conveys to a second entity a contractual right to receive cash or another financial instrument from a first entity. Forward contracts on financial instruments are typically considered financial assets because they convey to a second entity 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.* The analysis of legal settlements depends on facts and circumstances. It may be a financial asset if the rights to payments are enforceable by a government or a court of law and are reduced to a contractual payment plan. PwC 1-9

20 Introduction and scope of Topic 860 Description Repurchase agreements, dollar rolls, and securities lending arrangements Lease residual values that are guaranteed at lease inception Sales-type and direct-financing lease receivables Investment securities Analysis Repurchase agreements, dollar rolls, and securities lending arrangements are considered financial assets because they represent a contract that conveys to a second entity a contractual right to receive cash or another financial instrument from the first entity. ASC explicitly states that the residual value in a lease that is guaranteed at the inception of a lease is a financial asset. Sales-type and direct-financing lease receivables are considered financial assets because they represent a contract that conveys to a second entity a contractual right to receive cash or another financial instrument from the first entity. Investment securities are considered financial assets because they represent a contract that conveys to a second entity a contractual right to receive cash or another financial instrument from the first entity. * If a forward contract is in an asset position, ASC must be applied. However, when a forward contract is in a liability position, ASC is applicable Instruments, contracts, and agreements that are not considered recognized financial assets Both the form and the substance of a transaction need to be considered when evaluating transactions under ASC 860. For instance, a shareholder note receivable can be considered a financial asset. However, if the note receivable is not classified as an asset on the balance sheet (i.e., a shareholder note classified in equity), it is not considered a recognized financial asset within the scope of ASC 860. Figure 1-3 contains a list of common instruments, contracts, and agreements that are not considered recognized financial assets within the scope of ASC 860. The list also includes financial assets that are explicitly scoped out of ASC PwC

21 Introduction and scope of Topic 860 Figure 1-3 Examples of instruments, contracts, and agreements that are not considered recognized financial assets Description Common stock of a consolidated subsidiary Fees received on 12b-1 mutual funds Derivative assets that are not financial assets such as a physically settled commodity forward contract Insurance contracts Lease residual values that are guaranteed after lease inception and unguaranteed lease residuals Minimum lease payments to be received under an operating lease Analysis Ownership interest in a consolidated subsidiary is evidence of control of the entity s individual assets and liabilities. It is not evidence of an investment in a single financial asset or a group of financial assets. However, ASC 860 does apply to the transfer of an equity interest in a consolidated subsidiary by its parent if that consolidated subsidiary holds only financial assets. In other words, a wholly owned subsidiary that only holds financial assets should apply ASC 860. A fee received on 12b-1 mutual funds is not a financial asset of the party who is owed the fee (i.e., it is an unrecognized asset). The entity s right to receive 12b-1 fees is predicated on an obligation to perform a duty (i.e., asset management), whereas an entity s right (or contractual right) to receive cash flows from a financial asset is conveyed in a contract by a second entity. See ASC for further information. Transfers of assets that are derivative instruments subject to ASC 815, but are not financial assets, should be accounted for as specified in ASC 860. See ASC for further details. Under an insurance contract, a premium is received over time in return for protection. Those future revenue streams are not currently recognized as financial assets. See ASC for further information. ASC explicitly states that the residual value in a lease not guaranteed at the inception of a lease is not a financial asset. See ASC 840 for further information. Minimum lease payments to be received under an operating lease are unrecognized financial assets. See ASC 840 for further information. PwC 1-11

22 Introduction and scope of Topic 860 Description Legal settlements-no contractual payment plan Property taxes receivable Sale of future revenues Sales taxes receivable Servicing rights Shareholder note-classified in equity Securitized stranded utility costs Treasury stock Analysis The analysis of legal settlements depends on facts and circumstances. A financial asset does not exist if the rights to payments are not enforceable by a government or a court of law and have not been reduced to a contractual payment plan. A property taxes receivable is not considered a financial asset. The amount to be received is not contractual unless a legal settlement plan is established. In a sale of future revenues, future revenue streams are committed in return for a current payment. Those future revenue streams are not currently recognized financial assets. See ASC for further information. A sales taxes receivable is not considered a financial asset if the amount to be received is not contractual or certain until a sale occurs. Servicing rights represent a contract to receive future revenues related to the servicing of financial assets, whereas a financial asset represents a series of contractual cash flows that are not dependent on future services. The right to receive future revenues is not considered a financial asset. See ASC for further information. A shareholder note classified in equity is not a financial asset because it is recognized as a component of equity. Accordingly, transfers of shareholders notes classified as equity would fall within the exclusions in ASC Although the right to collect cash flows exists, securitized stranded utility costs are not considered financial assets as they do not result from a contract. Treasury stock is recognized as a contraequity account. Thus, it is not a financial asset PwC

23 Introduction and scope of Topic 860 Description Value-Added Tax (VAT) Analysis VAT is not considered a financial asset, because it does not arise as a direct result of a term governing the contract between two parties. In other words, the obligation is a result of taxes imposed by the government as a consequence of the contractual obligation, and not as a consequence of specific contractual terms of the agreement. To be a financial asset, the obligation must be created out of the specific terms of the contract. For example, in a trade accounts receivable, the obligation to pay is inherent in the original terms to purchase the goods Instruments, contracts, and agreements that may be financial assets when purchased Upon purchase, certain nonfinancial assets may become financial assets in the hands of the purchaser. For example, under ASC , if Company A sells to Company B the right to receive future revenue, an unrecognized financial asset that Company A has a substantial role in generating, Company B would recognize the right to receive the future revenue as a financial asset even if Company A accounts for the sale as a borrowing. As a result, the subsequent transfer of the purchased future revenues by Company B is a transfer of a financial asset that falls within the scope of ASC 860. Other examples include insurance contracts purchased in the secondary market (excluding surrender value) and the purchase of rights to receive 12b-1 fees. Sale and securitization of future revenues is beyond the scope of ASC 860, unless the future revenues are existing financial assets at the time of the transfer. If the financial assets are not yet born, no financial assets exist to be transferred. The transaction would be accounted for under the provisions of ASC Rule 12b-1 fees are not considered a financial asset for an entity that is entitled to receive the fee as a result of performing a service (e.g., asset management). However, they are considered a financial asset when transferred to a third party. In this case, the right to receive (or contractual right to receive) cash flows is conveyed in a contract by the first entity (see ASC ). Accordingly, purchased 12b-1 fees are considered a financial asset in the hands of the buyer of the rights to receive the fees. A transfer of a contract may consist of more than just a financial asset. For example, a lease contract may include a rental component, as well as the provision of equipment maintenance. If the rental relates to a capital lease, it may be a financial asset. However, the maintenance portion constitutes a future revenue stream. 1.3 What is considered a transfer of financial assets? Having defined recognized financial assets, we now turn to what meets the definition of a transfer and the units of account defined under the guidance. That is, in order to PwC 1-13

24 Introduction and scope of Topic 860 have transferred financial assets, the transaction structure needs to be that of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset Definition of a transfer A transfer is defined as: ASC Transfer: The conveyance of a noncash financial asset by and to someone other than the issuer of that financial asset. A transfer includes the following: a. Selling a receivable b. Putting a receivable into a securitization trust c. Posting a receivable as collateral A transfer excludes the following: a. The origination of a receivable b. Settlement of a receivable c. The restructuring of a receivable into a security in a troubled debt restructuring. Based on this definition, a transfer is the delivery of a noncash financial asset to a third party. The origination of a financial asset, the settlement of that financial asset for cash, or any restructuring of that financial asset is not a transfer. A transfer includes the sale of a financial asset, the placement of that financial asset in a trust, or the posting of that asset as collateral PwC

25 Introduction and scope of Topic 860 Types of transactions that are specifically identified as transfers within the scope of ASC 860 include the following: Typical sales-type transfers Transfers of entire or participating interests in receivables, or groups of entire receivables (e.g., trade receivables and consumer loans such as credit cards, mortgage, commercial and other loans, salestype and direct-financing lease receivables, and other financial assets) Securitizations (e.g., pay-through, pass-through, or revolving period) Transfers of participating interests in loans (e.g., loan participations) Wash sales Banker s acceptances Typical financing-type transfers Repurchase or reverse repurchase agreements (e.g., treasuries and overnights) Securities lending arrangements Secured borrowings Pledges of collateral Bond swaps Certain receivable factoring arrangements Transfers can take many different forms depending on the financial asset being transferred, the objective of the transfer, and the extent of the sponsor or transferor s continuing involvement (refer to TS for further information on what is meant by continuing involvement) Unit of account on transferred financial assets Transferred financial assets are defined as: ASC Transferred Financial Assets Any of the following: a. An entire financial asset b. A group of entire financial assets c. A participating interest in an entire financial asset. In order for a transaction to be subject to the derecognition criteria in ASC , the transaction or structure needs to meet the definition of transferred financial PwC 1-15

26 Introduction and scope of Topic 860 assets included above. A transfer of an entire financial asset or a group of entire financial assets occurs when full title and ownership of the underlying financial assets subject to the transaction is legally transferred to the transferee. A transfer of a participating interest in an entire financial asset results from a transaction in which something less than full title and ownership of the underlying financial assets subject to the transaction is legally transferred to the transferee and only if the specified criteria in ASC A are met. The above guidance requires that only entire financial assets, group of entire financial assets, or participating interests in entire financial assets be subjected to the three broad criteria in ASC That is, a transfer of a portion of a financial asset, when that portion does not meet the definition of a participating interest, would not qualify as a sale, even if it meets the conditions in ASC Prior to the most recent amendments, ASC 860 included the term undivided interest. Most interpreted this term to mean a portion of a financial asset, (i.e., a portion of the financial asset sold which generally holds a senior right to the cash flows received on the entire financial asset up to the par value of the financial asset sold) an interpretation that resulted in sales recognition for transactions involving the transfer of undivided interests when the portion sold represented the right to receive specified cash flows of an SPE. The FASB decided that the terms undivided interests and beneficial interests do not differ sufficiently to warrant different accounting, but recognized that those terms were being used differently in practice. Consequently, the Board decided to remove the undivided interest term and define a new term (participating interest) to describe the transfer of a portion of a financial asset. The Board also made some clarifications to the beneficial interest definition. A participating interest is an interest having the following characteristics: Excerpt from ASC A Meaning of the Term Participating Interest A participating interest has all of the following characteristics: a. From the date of the transfer, it represents a proportionate (pro rata) ownership interest in an entire financial asset. The percentage of ownership interests held by the transferor in the entire financial asset may vary over time, while the entire financial asset remains outstanding as long as the resulting portions held by the transferor (including any participating interest retained by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents) and the transferee(s) meet the other characteristics of a participating interest. For example, if the transferor s interest in an entire financial asset changes because it subsequently sells another interest in the entire financial asset, the interest held initially and subsequently by the transferor must meet the definition of a participating interest PwC

27 Introduction and scope of Topic 860 b. From the date of the transfer, all cash flows received from the entire financial asset are divided proportionately among the participating interest holders (including any interest retained by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents) in an amount equal to their share of ownership. An allocation of specified cash flows is not an allowed characteristic of a participating interest unless each cash flow is proportionately allocated to the participating interest holders. In determining proportionate cash flows: 1. Cash flows allocated as compensation for services performed, if any, shall not be included provided those cash flows meet both of the following conditions: i. They are not subordinate to the proportionate cash flows of the participating interest ii. They are not significantly above an amount that would fairly compensate a substitute service provider, should one be required, which includes the profit that would be demanded in the marketplace. 2. Any cash flows received by the transferor as proceeds of the transfer of the participating interest shall be excluded provided that the transfer does not result in the transferor receiving an ownership interest in the financial asset that permits it to receive disproportionate cash flows. c. The priority of cash flows has all of the following characteristics: 1. The rights of each participating interest holder (including the transferor in its role as a participating interest holder) have the same priority. 2. No participating interest holder s interest is subordinated to the interest of another participating interest holder. 3. The priority does not change in the event of bankruptcy or other receivership of the transferor, the original debtor, or any other participating interest holder. 4. Participating interest holders have no recourse to the transferor (or its consolidated affiliates included in the financial statements being presented or its agents) or to each other, other than any of the following: i. Standard representations and warranties ii. Ongoing contractual obligations to service the entire financial asset and administer the transfer contract iii. Contractual obligations to share in any set-off benefits received by any participating interest holder. PwC 1-17

28 Introduction and scope of Topic 860 That is, no participating interest holder is entitled to receive cash before any other participating interest holder under its contractual rights as a participating interest holder. For example, if a participating interest holder also is the servicer of the entire financial asset and receives cash in its role as servicer, that arrangement would not violate this requirement. d. No party has the right to pledge or exchange the entire financial asset unless all participating interest holders agree to pledge or exchange the entire financial asset. A set-off right is not an impediment to meeting the participating interest definition. For implementation guidance on the application of the term participating interest, see paragraph D. Many transactions considered participations from a commercial perspective may not be treated as sales under this definition. A participating interest in an entire financial asset cannot be the result of the division of an entire financial asset into components upon a transfer, unless all of the components meet the definition. Oftentimes, there are varying levels of subordination between the interests transferred and interests retained, which precludes sale accounting under this new definition. The participating interest concept and its use in place of the term undivided interest has a significant impact on companies that utilize commercial paper conduits to facilitate sales of their accounts receivable. Companies had typically established these structures by setting up a wholly owned bankruptcy-remote entity that sold senior undivided interests in its accounts receivable to a bank-sponsored commercial paper conduit, while retaining a subordinated financial interest in the transferred financial assets. Historically, companies have applied sale accounting for many of these transfers. Transfers of financial assets under these structures may not qualify as sales after the effective date of the amendments and would therefore need to be accounted for as secured borrowings. Transactions with commercial paper conduits need to be carefully scrutinized to ascertain the transfer is that of an entire financial asset vs. an interest or a portion of a financial asset. In cases where an interest or portion is transferred to the commercial paper conduit, the interests transferred and retained should be proportionate and comply with all the other criteria set forth in ASC A. If the transfer from BRE to conduit is purported to be that of an entire financial asset, but includes terms that might suggest the BRE retains a portion of the financial asset, a detailed analysis of the legal documents should be performed in order to understand the legal form of the financial asset transferred and what the financial asset conveys in determining whether transfer was in fact that of an entire financial asset. Transfers of portions of financial assets to revolving structures will often fail to meet the participating interest definition. Revolving structures occur when the assets in the structure are continually replaced with new assets using the cash flows generated. Bullet and turbo provisions often exist in these structures. Bullet provisions entail the reinvestment of cash flows in short term assets prior to liquidation, with the proceeds 1-18 PwC

29 Introduction and scope of Topic 860 from those investments used to pay certain interest holders. If the bullet provision enables certain interest holders to receive cash before other interest holders this criterion would not be met. Turbo provisions generally preclude this criterion being met because they require a specified amount of cash flows to be paid to one class of investor before other interest holders. It should also be noted that the participating interest definition results in sale accounting being precluded by a transferor of an interest-only strip in an entire financial asset it owns. However, an investor in an interest-only strip from an entire financial asset it does not own may still be eligible for sale accounting. The key distinction is that in the former the transferor is transferring a disproportionate interest in an entire financial asset since the holder of the purported interest-onlystrip will only be entitled to receive interest payments while the transferor retains the rights to the entire principal payments and the portion of the interest payments not transferred. In the latter example, however, the transfer is that of an entire financial asset, since the interest-only-strip represents the totality of the financial asset held by the transferor prior to the transfer. In applying the criteria in ASC A(b), the determination of what is significantly above adequate compensation requires judgment. This assessment should consider the compensation in relation to what is customary for such services, including a customary profit margin. Also noteworthy; fees received as compensation for services (e.g., servicing, origination, and arrangement fees) cannot be subordinated to the proportionate cash flows of the participating interest holders in order to exclude them from the analysis. In considering the rights of each participating interest holder as described in ASC A(c), the receipt of fees as compensation for services by a party that is also a participating interest holder is not included in this assessment of whether cash flows received by the participating interest holder are subordinated. Similarly, the guidance excludes cash flows to a third-party guarantor from the assessment of the rights of each participating interest holder. The assessment of whether the participating interest holders have recourse to the transferor is made based on their contractual rights as participating interest holders. Therefore, recourse to the transferor as a result of a third-party guarantee is not considered in this assessment. The following examples would result in the transfer not meeting the definition of a participating interest, (1) the transfer results in a participating interest holder having the different rights and/or priority in the entire individual financial asset, (2) a participating interest holder s interest is subordinated to another, (3) a participating interest holder is able to receive cash under its contractual rights as a participating interest holder before another participating interest holder, or (4) a participating interest holder has or provides recourse (other than standard representation and warranties, servicing or administration obligations, and contractual setoff arrangements) to another participating interest holders, (i.e., no participating interest holder can be entitled to receive cash before any other participating interest holder). The participating interest definition is form-based and could result in situations where the economics of the transaction are not reflected in the accounting. For example, if a reporting enterprise transfers almost all of the economics of a financial PwC 1-19

30 Introduction and scope of Topic 860 asset in a manner where all the interest holders do not share cash proportionately or do not have equal priority to the cash flows, the entity would still need to recognize the entire financial asset until such time as it has transferred all of its interest and can meet the derecognition criteria in ASC through Also, consideration as to whether the transfer of an individual financial asset meets the participating interest definition is an ongoing assessment. For example, in a transfer of a portion of a financial asset where the transferor has an obligation to reimburse the transferee for any premium the transferee paid if the financial asset is prepaid within 90 days of the transfer date, the reimbursement requirement would preclude the transfer from meeting the participating interest definition until that 90 day recourse period has elapsed. Overall, the changes set forth in the most recent amendments to the guidance related to transfers of portions of financial assets reduces the circumstances whereby a transfer of a portion of a financial asset can achieve sale accounting. If a transfer of a portion of an individual financial asset does not meet the definition of a participating interest, the transferor and transferee should account for the transfer as a secured borrowing. If a reporting entity transfers portions of an entire financial asset that individually do not meet the participating interest definition, the entity can derecognize the entire financial asset only after the entity transfers all of its interests in the entire financial asset and the conditions for sale accounting are met. Refer to TS and TS for more implementation guidance and illustrations. 1.4 What types of transfers are scoped out of ASC 860? Certain transfer transactions are explicitly outside the scope of the guidance. Excerpt from ASC The guidance in this Topic does not apply to the following transactions and activities: a. Except for transfers of servicing assets (see Subtopic ) and for the transfers noted in the following paragraph, transfers of nonfinancial assets b. Transfers of unrecognized financial assets, for example, minimum lease payments to be received under operating leases c. Transfers of custody of financial assets for safekeeping d. Contributions (for guidance on accounting for contributions, see Subtopic ) 1-20 PwC

31 Introduction and scope of Topic 860 e. Transfers of ownership interests that are in substance sales of real estate (For guidance related to transfers of investments that are in substance a sale of real estate, see Topics 845 and 976. For guidance related to sale-leaseback transactions involving real estate, including real estate with equipment, such as manufacturing facilities, power plants, and office buildings with furniture and fixtures, see Subtopic ) f. Investments by owners or distributions to owners of a business entity g. Employee benefits subject to the provisions of Topic 712 h. Leveraged leases subject to Topic 840 i. Money-over-money and wrap lease transactions involving nonrecourse debt subject to Topic 840. Excerpt from ASC Paragraph states that transfers of assets that are derivative instruments and subject to the requirements of Subtopic but that are not financial assets shall be accounted for by analogy to this Topic. Accordingly, the following transfers are not within the scope of ASC 860: Transfers of cash. Contributions of financial assets (already addressed by ASC 958). Transfers involving employee benefit trusts. Transfers involving leveraged leases. Transfers involving money-over-money and wrap-lease transactions involving non recourse debt. Transfers of nonfinancial assets (e.g., transfers of unguaranteed residual values of lease assets). Transfers of unrecognized financial assets (e.g., sales of future revenues). It should also be noted that even though transfers of servicing rights are included in the scope of ASC 860, the derecognition guidance for a transfer of servicing rights in ASC is different than the derecognition guidance in ASC , which applies to all other transfers subject to this guidance. This is due to the fact that servicing rights are not considered to be financial assets. PwC 1-21

32 Introduction and scope of Topic Chapter wrap-up ASC 860 generally applies to most transfers of recognized financial assets, whether in sales or financing type transactions, and to servicing of financial assets. Determining whether a specific transaction falls within the scope of ASC 860 is predicated on four questions: Was the transaction completed between a transferor and transferee that are considered to be consolidated affiliates? Does the transaction involve financial assets? Does the transaction meet the definition of a transfer? Does the transfer meet any of the scope exceptions? Separate questions must also be answered for the recognition; subsequent accounting and eventual transfer of servicing rights. Though answering these questions for actual transactions may appear simple, the task requires a thorough analysis of the facts and circumstances of the transactions in question. Certain transactions, such as a transfer of the right to receive future revenue, may at first seem to meet the scope of ASC 860. However, a careful analysis may demonstrate that this conclusion is not as clear as initially anticipated. Classification of such a transfer may be contingent on whether the right to receive future revenue is a recognized financial asset. That determination, in turn, is predicated on whether the entity receiving the future revenue is significantly involved in producing the revenue or whether the right to receive future revenue was purchased by a third party. The corresponding accounting and reporting requirements for transactions within the scope of ASC 860 is based on the notion of control for transfers of financial assets and the notion of risks and rewards for transfers of servicing rights. Transferred financial assets are considered sold if the transferor no longer controls the financial assets. If the transferor maintains control of the financial assets after the transfer, the transfer is a borrowing arrangement. This difficult determination of control is discussed further in Chapter 2 of this Guide (refer to TS 2). In addition, transferred servicing rights are considered sold if the transferor no longer is entitled to the risks and rewards of ownership. This determination of transferring title and risks and rewards is discussed further in Chapter 5 of this Guide (refer to TS 5). 1.6 What are some of the more common types of transfers? The following are some common transfer types seen in the marketplace. We have included a brief description of the typical structure, as well as some ASC 860 considerations for each structure. The actual assessment for these types of transfers is highly dependent on the specific facts and circumstances, thus the following perspectives should not be viewed as an alternative to applying the ASC 860 model. EXAMPLE Two-step securitization A two-step securitization structure is typically utilized in situations where the transferor or sponsor will maintain continuing involvement in the transferred financial assets. First, this structure involves a transfer of financial assets (e.g., residential mortgage loans) to an intermediate SPE (typically a wholly owned 1-22 PwC

33 Introduction and scope of Topic 860 subsidiary of the sponsor) designed as a BRE (i.e., is only permitted to engage in the business of acquiring, owning, and selling the transferred financial assets, has at least one independent director, and is restricted in various ways from entering into voluntary bankruptcy and other prohibited acts). In the second of the two steps, the BRE sells the financial assets to the issuer SPE, who issues securities (i.e., bond classes) to investors. This structure is intended to enhance the true sale and bankruptcy remote characteristics of the transaction. That is, the transaction is structured to ensure that the transfer of financial assets to the BRE is a true sale at law rather than a financing transaction. Following the introduction of ASC 860, use of the two-step securitization structure was essentially required in the U.S. to illustrate an isolation of financial assets and obtain a true sale in situations where the sponsor has continuing involvement in the transferred financial assets. Financing agreement Sponsor Obligor Recognized financial asset Transfer financial assets Cash* Cash* BRE Transfer financial assets Monthly payments Issuer (SPE) Servicer Cash Notes Monthly payments Trustee and custodian Underwriter Monthly payments Cash Notes Investors * In addition to cash, the BRE/Sponsor may also obtain a residual interest in the Issuer SPE. After the most recent amendments to ASC 810 related to consolidation of VIEs, the accounting conclusions for this type of structure is likely to change. Prior to the issuance of the revised guidance in ASC 810, many of these entities were designed as QSPEs, which were exempt from consolidation provided certain criteria were met. Under the revised guidance, this exception has been eliminated. As a result, it is expected that many transferors/sponsors of these entities will be required to consolidate them. This is generally due to their role as servicer which gives them the ability to undertake activities that most significantly influence the economic PwC 1-23

34 Introduction and scope of Topic 860 performance of the entity, coupled with them holding a residual interest in the entity (i.e., interests that expose the transferor to potentially significant benefits or losses). As discussed in our VE Guide (Guide to Accounting for Variable Interest Entities), there are also other considerations that could impact the conclusion as to who holds both the power and the benefits/losses. For example, if the servicer or special servicer can be kicked out based on the unilateral decision of a controlling class holder, or there are multiple servicers, or if related parties to the servicer or special servicer also hold interests in the issuer SPE, the analysis could be complicated and require a very detailed evaluation of the securitization structure. As a result, the balance sheet of the transferor/sponsor in these types of structures after the amendments to ASC 860 and ASC 810 may need to include both the assets and liabilities of the issuer trust, also resulting in the elimination of any beneficial interests, servicing assets and/or servicing liabilities, gain on sale, etc., that would have resulted if the transaction had met the requirements for sale accounting and the issuer trust was not a consolidated affiliate of the transferor. EXAMPLE revised March 2016 Multi-seller asset-backed commercial paper conduit (CP conduit) A CP conduit is a limited-purpose securitization entity sponsored and administered by a banking institution. To ensure that the conduit can repay its commercial paper obligations, the sponsor bank provides liquidity support and credit enhancement. CP conduits are commonly used by originators of trade receivables or loans (collectively referred to as receivables in this example) to monetize (finance) these assets on an ongoing basis. The two-step structure described in Example is typically used in these arrangements. Originators periodically transfer (legally sell) eligible receivables to a bankruptcy-remote entity (BRE), which in turn (i) transfers the receivables to a trust, that then issues interests to a CP conduit (and perhaps to other investors) or, more commonly, (ii) transfers the receivables (or an interest therein) directly to the CP conduit itself. The former arrangement is illustrated in the following diagram PwC

35 Introduction and scope of Topic 860 * CP conduit deals can be structured as the transfer of full title and ownership of the receivables or a transfer of an interest in the receivables to the conduit. If the latter, the issuer SPE retains an undivided interest in the receivables. Alternatively, the issuer SPE may issue a beneficial interest in the assets it owns (i.e., a debt instrument) to the CP conduit. Transactions with CP conduits sometimes involve the transfer an undivided ownership interest in an originator s underlying pool of receivables that entitles the conduit to receive a portion of the receivables subsequent cash flows (collections). Prior to ASU s amendments to ASC 860, an undivided interest was defined as a partial legal or beneficial ownership of a financial asset as a tenant in common with others. As owner of an undivided interest, the tenant s rights to the cash flows generated from the underlying entire financial assets can take various forms, and may be shared on a pro rata or non-pro rata basis with the legal owner of the related asset(s). A pro rata right would be, for example, the right to receive 50 percent of all cash flows collected on the asset(s). A non-pro rata right would be, for example, the right to receive (1) cash flows relating to all the interest, referred to as an interest-only strip, or (2) cash flows relating to the asset s principal, referred to as a principal-only strip. As a consequence of ASU s amendments, the term undivided interests no longer appears in ASC 860. Instead, a participating interest concept now exists. As a result, transferors/sponsors that engage in CP conduit securitization transactions must now evaluate whether interests transferred to a CP conduit meet ASC 860 s participating interest rules. Typically, the transferor provides overcollateralization to the CP conduit in these transactions. This condition is commonly achieved by the PwC 1-25

36 Introduction and scope of Topic 860 transferor retaining an interest in the underlying receivables that is subordinate to the interest transferred to the CP conduit. That interest is structured to absorb first any losses incurred on the receivables as well as the timing risk associated with the receivables ultimate collection. If the interest conveyed to the CP conduit represents an undivided interest in a pool of receivables that remain legally owned by the transferor, these structures will fail to meet the participating interest criteria described in TS If so, these transfers are required to be accounted for as secured borrowings. If an issuer SPE is involved, in addition to the BRE, the transferor/sponsor will need to evaluate the issuer SPE for potential consolidation based on applying the relevant guidance in ASC 810. If consolidated, the transfer of financial assets between the transferor/sponsor and the issuer SPE will be eliminated in consolidation. If so, from a consolidated standpoint, the ultimate transaction with the third-party investors will be reported as the issuance of debt, i.e., as a financing transaction. The transferor also may be required to evaluate the CP conduit for consolidation. However, the banking entity that sponsors the CP conduit is frequently its consolidator (primary beneficiary), stemming from the bank s involvement in the conduit s design, the credit enhancements and liquidity facilities provided by the bank, and the bank s role as the conduit s administrator. EXAMPLE revised March 2016 Factoring arrangement for trade receivables To enhance cash inflows, many companies transfer (sell) trade receivables to financial institutions under traditional factoring arrangements or, alternatively, enter into financing arrangements with bank-sponsored multi-seller commercial paper conduits. Under traditional factoring arrangements, a transferor sells trade receivables in their entirety (or portions thereof) at a discount to the financial institution. In certain instances, the transferor receives entirely cash consideration at the date of the exchange. In others, purchase price consideration consists of upfront cash and a deferred payment feature ( holdback ). The amount and timing of the holdback s realization is contingent on the subsequent performance (collections) of the underlying receivables. As discussed in TS 1.3.2, the first step in evaluating transfers of trade receivables is to evaluate whether the exchange is subject to the participating interest rules of ASC 860. The determination of whether the transfer involves the conveyance of a right to a portion of the cash flows of a trade receivable (and thus is subject to the participating interest requirements), or instead represents as sale of the trade receivable in its entirety, hinges largely on the legal form of the transaction. For simple factoring transactions, this determination can be made by evaluating a true-sale opinion obtained from attorneys, as well as the underlying transaction documents. By evaluating the true-sale opinion and the underlying transaction documents, it may be evident that a company has transferred legal title to the receivables to the financial institution. Regardless of whether a transferor receives entirely cash at the transfer date or, alternatively, receives cash equal to only a portion 1-26 PwC

37 Introduction and scope of Topic 860 of the sales price with a related holdback, as long as the legal opinion and transaction documents clearly support the assertion that the seller has transferred full title and interest in the receivables to the purchaser, the transfer will not be subject to the participating interest rules. With respect to transfers of trade receivables involving CP conduits, the assessment of whether the participating interest requirements apply should focus on understanding the legal form of the second step of the transaction, that is, the legal character of the transfer between the BRE and the CP conduit. This analysis should consider all relevant contractual provisions and terms governing the transaction. In certain structures, the underlying receivables purchase agreement ( RPA ) will specify that the BRE is legally transferring to the CP conduit, in the form of an undivided ownership interest, rights to certain cash flows from the underlying pool of trade receivables. In these cases, the BRE retains legal title to the underlying receivables. The transferred undivided ownership interest typically entitles the CP conduit to only a portion of the underlying receivables cash flows, and thus the exchange between BRE and CP conduit is subject to the participating interest rules. The specifics of the CP conduit s entitlement to the underlying receivables cash flows are prescribed in the priority of payments (or waterfall ) section of the RPA, which directs how cash collections on the underlying receivables are to be periodically disbursed to the various parties. In these structures, through the priority of payments arrangements, the transferor typically retains first-dollar exposure to credit losses on the receivables pool. If such subordination is present, these transfers fail the participating interest rules and thus are required to be accounted for as secured borrowings. In other instances, the exchange of consideration between the BRE and the CP conduit involves the legal sale of an entire trade receivable (or groups of entire trade receivables) by the BRE. In these cases, the sponsoring bank of the CP conduit (or, if multiple conduits are providing financing, one of the CP conduits sponsoring banks), in its capacity as agent for the CP conduit(s), typically acquires the receivables from the BRE. The agent bank legally owns the receivables for the benefit of the participating conduit(s), each of which in turn acquires an interest in the receivables pool corresponding to its financing commitment. In exchange for selling the receivables to the agent bank, the BRE receives cash from the CP conduit(s) 1 for a portion of the purchase price, and a beneficial interest (an obligation of the CP conduit(s)) for the remainder. This beneficial interest, which is typically subordinated to the CP conduit s investment in the receivables pool, is commonly referred to as the deferred purchase price, or DPP, in the industry. In practice, a legal opinion that analyzes the second step exchange between the BRE and the agent bank is rarely obtained. The use of a BRE, accompanied by would level true sale and substantive consolidation opinions that address the first step of the transfer, typically provide sufficient comfort to the parties that the transferred receivables have been legally isolated from the receivables originator. As a result, analyzing whether the second step of the transaction represents a transfer of the 1 The cash may be remitted directly to the BRE by the purchasing conduit(s), or may be routed through the agent bank to the BRE. PwC 1-27

38 Introduction and scope of Topic 860 entire trade receivable can be difficult. To determine whether the second-step of the transaction is or is not subject to the participating interest rules, the legal character of the exchange, as well as the commercial and economic substance of all relevant terms and provisions, should be evaluated. We believe that to reach a conclusion that the transfer between the BRE and CP conduit (or the conduit s agent bank, on its behalf) involves an entire receivable, the language in the underlying transaction document(s) (typically the RPA executed between the seller BRE, the originator (as servicer), the conduit(s) and backstop bank purchaser(s), and the agent bank) should support the following assertions: The transfer between the BRE and agent bank involves an entire financial asset (versus the conveyance of an interest in, or portion of, the financial asset). That is, language in the RPA clearly and unequivocally states that the BRE is selling, assigning, and transferring all of its rights, title, and interest in, to, and under the receivable(s) (or pool of receivables) to the agent bank (on behalf of the conduit purchaser(s)). The DPP is a contractual obligation of the conduit purchaser(s), payable to the BRE from collections received on the receivables in accordance with the priority of payments set forth in the RPA. (Note that receipt of any amounts under the DPP is entirely dependent upon the performance of the transferred receivables.) As a consequence of its purchase of the receivables from the BRE, the agent bank (on behalf of the conduit purchaser(s)) is the legal creditor with respect to the obligor of each underlying receivable. This relationship may be is evidenced through financing statements required to be filed under the Uniform Commercial Code or equivalent statutes in accordance with the RPA, and may be inferred from the RPA s enumeration of the rights/actions that the agent bank may exercise with respect to the receivables, including dealing directly with the receivables obligors and disposing of the receivables, particularly in the event of a servicer default. Assuming that the RPA (or equivalent agreements) provide assurance with respect to these attributes, it would be appropriate to conclude that the BRE has transferred full title to, and ownership of, the trade receivables to the agent bank (on behalf of the purchasing conduit(s)), and thus the participating interest rules would not apply to the exchange. EXAMPLE Revolving credit card structure A vast majority of credit card securitizations have been completed using two different vehicles: the stand-alone trust and the master trust. The stand-alone structure is a single pool of receivables sold to a trust and used as collateral for a single security. When the issuer intends to issue another security, it must designate a new pool of credit card accounts and sell the receivables in those accounts to a separate trust. This structure was first used in 1987 for the first credit card securitization and remained popular until 1991, when the master trust became the preferred vehicle. The master 1-28 PwC

39 Introduction and scope of Topic 860 trust structure allows the issuer to create various securities from the same pool of receivables. The master trust serves as a reservoir of receivables. On occasion, new receivables are added to the master trust so that more securities can be issued. * In addition to cash, the BRE/Sponsor may also obtain a seller s interest in the Master Trust. ** Credit Card securitizations can be structured as the transfer of full title and ownership of the receivables or a transfer of an interest in the receivables to investors. If the latter, the issuer SPE retains an undivided interest in the receivables. While transfers of credit card receivables are subject to ASC 860, many transferors/sponsors of credit card securitizations are expected to consolidate these entities under ASC 810. This is because in most fact patterns, the transferor/sponsor is the servicer to the entity and therefore makes the decisions that significantly impact the economic performance of the entity as well as holds interests that could expose the transferor to potentially significant benefits or losses. Also, as discussed in TS 1.3.2, to the extent the securitization structure is established so that what it transfers is an interest in the receivable instead of the entire receivable, the participating interest guidance in ASC A will need to be considered. This will include an evaluation of turbo and bullet provisions, which are likely to cause these interests transferred from failing to meet the participating interest rules and thus fail the conditions for sale accounting, even in circumstances in which the master trusts are not consolidated under ASC 810. PwC 1-29

40 Introduction and scope of Topic 860 EXAMPLE Collateralized Debt Obligation (CDO) structure A CDO is a type of securitization that consists of a pool of bonds or loans managed by collateral managers. The underlying investments held by the CDO structure can be wide ranging and can include commercial loans, corporate loans, interests in other securitizations and event other CDOs. CDOs typically fall into two broad categories: cashflow and market value. In cashflow CDOs, the ratings of the various tranches of offered securities are based primarily on the underlying pool s ability to generate sufficient interest and principal to fund the cost of issued securities. In market value CDOs, the ratings of the various tranches of the offered securities are primarily based on the market value of the underlying pool of bonds or loans. As we have seen in the different securitization examples above, this arrangement also has many of the same features: financial assets are purchased by an issuer trust and notes are issued to investors in the capital markets. The collateral manager (i.e., asset manager) is responsible for managing the portfolio composition to ensure that specific measures and concentrations of assets are consistent with transaction document requirements. As a result, the collateral manager determines which assets must be purchased or replaced in a transaction, either for credit or other reasons. Transfers to CDO structures are subject to the scope of ASC 860. Additionally, it is generally expected that the decisions made by the collateral manager are the decisions that most significantly impact the CDO s economic performance. As a result, a careful analysis under ASC 810 should be performed to determine whether the collateral manager (or a party holding a right to remove and replace the collateral manager) may be its primary beneficiary and be required to consolidate the CDO PwC

41 Introduction and scope of Topic 860 EXAMPLE Synthetic CDO structure In a synthetic CDO, no legal or economic transfer of financial assets occurs. Instead, the synthetic CDO structure gains exposure to credit risk by selling protection to others through a credit default swap (CDS). A CDS is a privately negotiated bilateral agreement in which one party, variously known as the protection buyer or risk shedder, pays a premium to another, generally referred to as the protection seller or risk taker, in order to secure protection against any losses that may be incurred through exposure to an investment as a result of an unforeseen development (or credit event ). A CDS can be entered into for each individual investment or credit name against which exposure is sought or referenced to a basket of credit names that may be actively managed. In other words, the synthetic CDO structure bears credit risk, just as it would if it physically owned a bond or loan. Using a synthetic CDO structure versus a typical CDO makes it easier to structure a portfolio of credit risk to meet the preferences of the transferor and investors. Synthetic CDO structures are also attractive for securitizing multi-jurisdictional portfolios or loans made in countries where the local legal framework does not allow for the true sale of assets or where the local tax system makes the transfer of the legal title of assets uneconomic. Exposure to the synthetic CDO market versus cash bonds provides investors with another benefit: It allows them to buy pure credit. This is because the synthetic structure separates the credit risk component from the other assets risks, such as interest rate and currency risk. 1.7 FASB s implementation guidance and PwC s questions and interpretive responses The information contained herein is generally based on the Implementation Guidance and Illustrations included in ASC We ve also included certain questions PwC 1-31

42 Introduction and scope of Topic 860 and interpretive responses intended to supplement discussions in this Chapter regarding the application of guidance to specific fact patterns Consolidation of transferee by transferor Excerpt from ASC D Paragraph states that the determination of whether a transferor and its consolidated affiliates included in the financial statements being presented have surrendered control over transferred financial assets shall first consider whether the transferee would be consolidated by the transferor. If all other provisions of this Topic are met with respect to a particular transfer, and the transferee would be consolidated by the transferor, then the transferred financial assets would not be treated as having been sold in the financial statements being presented. However, if the transferee is a consolidated subsidiary of the transferor (its parent), the transferee shall recognize the transferred financial assets in its separate entity financial statements, unless the nature of the transfer is a secured borrowing with a pledge of collateral (for example, a repurchase agreement that would not be accounted for as a sale under the provisions of paragraph ) Scope of ASC 860 Excerpt from ASC The guidance in this Topic applies to the following transactions and activities, among others: a. All loan participations b. Transfers of equity method investments, unless the transfer is of an investment that is in substance a sale of real estate, as defined in Subtopic c. Transfers of cost-method investments d. With respect to the guidance in paragraph only, transfers of financial assets in desecuritization transactions. Excerpt from ASC A payment of cash or a conveyance of noncash financial assets to the holder of a loan or other receivable in full or partial settlement of an obligation is not a transfer under this Subtopic. In addition, a loan syndication is not a transfer of financial assets. See paragraph for further guidance on a loan syndication. Excerpt from ASC The following implementation guidance addresses whether certain instruments are financial assets, the transfer of which is subject to the guidance in this Subtopic, specifically: 1-32 PwC

43 Introduction and scope of Topic 860 a. Minimum lease payments and guaranteed residual values under certain leases b. Securitized stranded costs c. Judgment from litigation d. Forward contract on a financial instrument e. Ownership interest in a consolidated subsidiary by its parent if the subsidiary holds nonfinancial assets f. Investment in a nonconsolidated investee. Excerpt from ASC Sales-type and direct financing receivables secured by leased equipment, referred to as gross investment in lease receivables, are made up of two components: minimum lease payments and residual values. Minimum lease payments are requirements for lessees to pay cash to lessors and meet the definition of a financial asset. Thus, transfers of minimum lease payments are subject to the requirements of this Subtopic. Residual values represent the lessor s estimate of the salvage value of the leased equipment at the end of the lease term and may be either guaranteed or unguaranteed. Residual values meet the definition of financial assets to the extent that they are guaranteed at the inception of the lease. Thus, transfers of residual values guaranteed at inception also are subject to the requirements of this Subtopic. Unguaranteed residual values do not meet the definition of financial assets, nor do residual values guaranteed after inception, and transfers of them are not subject to the requirements of this Subtopic. Excerpt from ASC Securitized Stranded Costs The deregulation of utility rates charged for electric power generation has caused electricity-producing entities (utilities) to identify some of their electric power generation operations as stranded costs. Before deregulation, utilities typically expected to be reimbursed for costs through regulation of rates charged to customers. After deregulation, some of these costs may no longer be recoverable through unregulated rates. Hence, such potentially unrecoverable costs often are referred to as stranded costs. However, some of those stranded costs may be recovered through a surcharge or tariff imposed on rate-regulated goods or services provided by another portion of the entity whose pricing remains regulated. Some entities have securitized their enforceable rights to impose that tariff (often referred to as securitized stranded costs), thereby obtaining cash from investors in exchange for the future cash flows to be realized from collecting surcharges imposed on customers of the rate-regulated goods or services. PwC 1-33

44 Introduction and scope of Topic 860 Excerpt from ASC Securitized stranded costs are not financial assets, and therefore transfers of securitized stranded costs are not within the scope of this Subtopic. Securitized stranded costs are not financial assets because they are imposed on ratepayers by a state government or its regulatory commission and, thus, while an enforceable right for the utility, they are not a contractual right to receive payments from another party. To elaborate, while a right to collect cash flows exists, it is not the result of a contract and, thus, not a financial asset. Excerpt from ASC However, beneficial interests in a securitization trust that holds nonfinancial assets such as securitized stranded costs or other similar imposed rights would be considered financial assets by the third-party investors, unless that third party must consolidate the trust. The Variable Interest Entities Subsections of Subtopic should be applied, together with other guidance on consolidation policy, as appropriate, to determine whether such a special-purpose entity should be consolidated by a third-party investor. Excerpt from ASC Judgment from Litigation A judgment from litigation is generally not a financial asset. However, the determination depends on the facts and circumstances. A contingent receivable that ultimately may require the payment of cash but does not as yet arise from a contract (such as a contingent receivable for a tort judgment) is not a financial asset. However, when that judgment becomes enforceable by a government or a court of law and is thereby contractually reduced to a fixed payment schedule, the judgment would be a financial asset. Excerpt from ASC A judgment from litigation is a financial asset if it is transferred to an unrelated third party and would be within the scope of this Subtopic only if that judgment is enforceable by a government or a court of law and has been contractually reduced to a fixed payment schedule. Excerpt from ASC Forward Contract on a Financial Instrument A forward contract to purchase or sell a financial instrument that must be (or may be) net settled or physically settled by exchanging that financial instrument for cash (or some other financial asset) is a financial asset or financial liability. Therefore, because a forward contract on a financial instrument that must be (or may be) physically settled by the delivery of that financial instrument in exchange for cash is a financial asset or financial liability, the transfer of such a financial asset is within the scope of this Subtopic (see paragraph for guidance on extinguishments of liabilities) PwC

45 Introduction and scope of Topic 860 Excerpt from ASC Ownership Interest in a Consolidated Subsidiary by Its Parent If the Subsidiary Holds Nonfinancial Assets An ownership interest in a consolidated subsidiary is evidence of control of the entity s individual assets and liabilities, not all of which are financial assets, and this guidance only applies to transfers of financial assets. (Note that in the parent s [transferor s] consolidated financial statements, the subsidiary s holdings are reported as individual assets and liabilities instead of as a single investment.) The guidance in this Subtopic does not apply to a transfer of an ownership interest in a consolidated subsidiary by its parent if that consolidated subsidiary holds nonfinancial assets. Excerpt from ASC Investment in a Nonconsolidated Investee An entity that carries an investment in a subsidiary at fair value will realize its investment by disposing of it rather than by realizing the values of the underlying assets through operations. Therefore, a transfer of an investment in a subsidiary by that entity is a transfer of the investment (a financial asset), not the underlying assets and liabilities (which might include nonfinancial assets). Generally, the guidance in this Subtopic applies to a transfer of an investment in a controlled entity that has not been consolidated by an entity because that entity accounts for its investment in the controlled entity at fair value. An example of such a controlled entity is a brokerdealer or an investment company. Excerpt from ASC Reacquisition by an Entity of Its Own Securities A reacquisition by an entity of its own securities by exchanging noncash financial assets (for example, U.S. Treasury bonds or shares of an unconsolidated investee) for its common shares constitutes a distribution by an entity to its owners, as defined in FASB Concepts Statement No. 6, Elements of Financial Statements, and, therefore, is excluded from the scope of this Subtopic. Excerpt from ASC Exchange of One Form of Beneficial Interest for Another A transferor s exchange of one form of beneficial interests in financial assets that have been transferred into a trust that is consolidated by the transferor for an equivalent, but different, form of beneficial interests in the same transferred financial assets would not be a transfer under this Subtopic if the exchange is with the trust that initially issued the beneficial interests. If the exchange is not a transfer, then the provisions of paragraph B would not be applied to the transaction. PwC 1-35

46 Introduction and scope of Topic 860 Excerpt from ASC Dollar-Roll Repurchase Transactions A transfer of financial assets under a dollar-roll repurchase agreement is within the scope of this Subtopic if that agreement arises in connection with a transfer of existing securities. In contrast, dollar-roll repurchase agreements for which the underlying securities being sold do not yet exist or are to be announced (for example, to-beannounced Government National Mortgage Association [GNMA] rolls) are outside the scope of this Subtopic because those transactions do not arise in connection with a transfer of recognized financial assets. See paragraph for related guidance. Question 1-1 If a parent/sponsor sells preferred interests in a consolidated SPE subsidiary that only holds financial assets rather than selling senior interests in the financial assets themselves, would the transfer be subject to the scope of ASC 860? PwC response It depends. We believe that such transactions should be carefully assessed to determine if the substance of the transaction represents a transfer of financial assets. This is consistent with the recent views expressed by the SEC staff. As stated in the speech made by Brian Fields of the SEC at the 2009 AICPA SEC Conference, We ve recently heard of efforts to structure certain sales of beneficial interests in a manner that some believe falls outside the scope of Codification Topic 860 on transfers of financial assets. Those efforts involved selling preferred interests in a subsidiary that holds only financial assets rather than selling senior interests in the financial assets themselves. The idea seems to be that by describing the beneficial interests sold as equity in a consolidated subsidiary it may be possible to classify the proceeds received as noncontrolling equity interests rather than collateralized debt in the financial statements of the parent sponsor. For some companies this may be appealing as a kind of back up plan. That is, if derecognition is not possible for whatever reason, presentation of the proceeds received on a failed sale within shareholders equity rather than as debt may be the next best thing, or perhaps even better if those proceeds increase third party measures of capital for a distressed institution. Such strategies may raise concerns if they become more common under new FASB standards that make derecognition more difficult, so now seems like a good time to share information about how to grapple with the issues they raise. In a typical example, a bank transfers loans to a consolidated special purpose entity in exchange for all senior and subordinated interests in the newly formed entity. The senior interests, which pay a prescribed rate of return each period, are then sold to outside investors, while the junior interests are retained by the bank. The activities of the SPE are significantly limited, primarily relating to servicing and, in some cases, 1-36 PwC

47 Introduction and scope of Topic 860 rolling over assets as they mature. In this and other ways, these structures may be similar to QSPE s and other asset-backed financing structures that will more often be consolidated by their sponsors under the revised model of control in FASB Statements 166 and 167. While these structures contain only financial assets and do not have the breadth and scope of activities of a business, some believe that by describing the beneficial interests sold as legal form equity and not including an explicit maturity date they can classify securitization proceeds received as noncontrolling equity interests in the consolidated financial statements of the parent sponsor. We have reached a different view in these circumstances. Beneficial interests in such entities are essentially transfers of interests in financial asset cash flows dressed up in legal entity form, and we believe the proceeds received on such transfers should be presented as collateralized borrowings pursuant to transfer accounting requirements to the extent the underlying financial assets themselves do not qualify for derecognition. To say it again in another way, when a subsidiary is created simply to issue beneficial interests backed by financial assets rather than to engage in substantive business activities, we ve concluded that sales of interests in the subsidiary should be viewed as transfers of interests in the financial assets themselves. The objective of an assetbacked financing is to provide the beneficial interest holders with rights to a portion of financial asset cash flows and the guiding literature is contained in Codification Topic 860 on transfers of financial assets. That literature requires a transfer to be reflected either as a sale or collateralized borrowing, depending on its specific characteristicspresentation as an equity interest in the reporting entity is not a possible outcome. Question 1-2 Is a transfer of servicing rights that are contractually separated from the underlying serviced assets within the scope of ASC 860? For example, does ASC 860 apply to an entity s conveyance of mortgage servicing rights that have been separated from an underlying mortgage loan portfolio that the entity intends to retain? PwC response Yes. ASC addresses the accounting for servicing rights, including transfers of such rights on mortgages previously transferred in a transaction that met the conditions for sale accounting, mortgages owned by others and transfers of servicing rights with a subsequent subservicing agreement. The derecognition criteria for transfers of servicing rights is largely based on a determination as to whether the risks and rewards of ownership have been effectively transferred to the transferee. Conversely, the derecognition guidance in ASC through 40-5 applicable to transfers of financial assets is based on whether the transferor and its consolidated affiliates have surrendered control. PwC 1-37

48 Introduction and scope of Topic 860 Question 1-3 Could a transferor s exchange of one form of beneficial interests in financial assets that have been transferred into a trust that is not consolidated by the transferor for an equivalent, but different, form of beneficial interests in the same transferred financial assets be accounted for as a sale under ASC 860? FASB response No. Not only would this exchange not be a sale, it might not even be a transfer under ASC 860. If the exchange described is with the trust that initially issued the beneficial interests, then the exchange is not a transfer under ASC 860. ASC defines transfer as the conveyance of a noncash financial asset by and to someone other than the issuer of that financial asset. If the exchange is not a transfer, then the provisions of ASC would not be applied to the transaction. Question 1-4 Are VAT receivables considered financial assets that can be securitized in accordance with ASC 860? PwC response No. Certain assets have characteristics that are similar to financial assets but are not considered financial assets. For example, VAT, or value-added tax, is common throughout Europe and operates in a similar manner as a sales tax that is incorporated into the sales price of the product. Companies have a contractual obligation to either pay VAT on products purchased or collect VAT on products sold. The VAT amount that is paid to or received from the tax authority is determined by netting the two amounts together to derive the value-added component of the product. It is common for many start-up manufacturing companies that make large investments in property, plant, and equipment to be in a VAT receivable position, as their PP&E purchases are deductible for VAT purposes in Europe. Additionally, these start-up companies may also have lower sales in the beginning, which would create an even greater VAT receivable position. Since the collection of these VAT receivables is subject to an application process that can be cumbersome, some companies enter into transactions designed to sell these receivables. Although a valid receivable from the taxing authorities has been created, it is not considered a financial asset that is within the scope of ASC 860. The VAT is imposed by the government on the parties to the contract and does not arise as a direct result of the terms governing the contract between the two parties. In other words, the obligation is a result of taxes being imposed by the government as a consequence of the contractual obligation, and not as a consequence of the specific contractual terms of the agreement. To be a financial asset, the obligation must be created out of the specific terms of the contract (e.g., in a trade accounts receivable, the obligation to pay is inherent in the original terms to purchase the goods). VAT and other types of taxes have some of the attributes of a financial asset, but are not considered to result from a contract between two counterparties. The taxes arise 1-38 PwC

49 Introduction and scope of Topic 860 from the government s right to assess taxes. Certain receivables are partly comprised of VAT. Only the non-vat portion would be within the scope of ASC 860. Question 1-5 Is the accounting for a transfer of a lease residual affected by whether it is guaranteed or unguaranteed? PwC response Yes. ASC indicates that guaranteed lease residuals are considered financial assets and thus are within the scope of ASC 860. Unguaranteed lease residuals are not considered financial assets and therefore are outside the scope of ASC 860. All transfers of guaranteed lease residuals should be evaluated for sale treatment in accordance with paragraph ASC From the perspective of the lessor, purchasing residual-value guarantee insurance at the inception of the lease will transform an operating lease into either a direct-financing lease (DFL) or salestype lease (STL) under FAS 13. Both DFLs and STLs are considered to be financial assets within the scope of ASC 860. The guarantee ensures a fixed cash payment that is not affected by the market value of the asset Transfer of financial assets Question 1-6 If the lease residual is guaranteed, can a transferor sell a portion of the minimum lease payments while retaining the guaranteed lease residual or sell a portion of the guaranteed lease residual while retaining all of the minimum lease payments? In other words, how does one determine the unit of account for purposes of applying the participating interest guidance in ASC A? PwC response It depends. If the lease residual is guaranteed, it clearly is a financial asset subject to ASC 860. In considering whether the guaranteed lease residual is part of an entire financial asset that also includes minimum lease payments, the transferor should consider whether the lease residual was guaranteed by the lessee vs. by a third party guarantor. If the lessee guaranteed the lease residual, both the minimum lease payments and the lease residual should be viewed as a single unit of account for purposes of applying the participating interest criteria in ASC A. One of the objectives of the guidance is to ascertain that financial assets are not separated into components unless all of the components meet the participating interest definition upon a transfer. Since the minimum lease payments and the guaranteed lease residual are two components of a single financial asset, they should be viewed as one when evaluating a transfer of a portion. However, if the lease residual was unguaranteed, the entire asset would have a nonfinancial component (unguaranteed lease residual) and a financial component (minimum lease payments). In this fact pattern, the financial component or minimum lease payments would be the only component subject to ASC 860 and thus would be considered the entire financial asset, if being transferred in its entirety. PwC 1-39

50 Introduction and scope of Topic 860 Question 1-7 Company X has a variable interest in an operating company that meets the criteria of a variable interest entity (VIE) per ASC 810. The variable interest results from Company X s role as the lender to the VIE of 75 percent of the VIE s loan financing. Company X has determined that it is the primary beneficiary of the VIE and is required to consolidate it for financial-reporting purposes. Company X transfers 5 percent of its loans in the VIE (a non-controlling interest under ASC 810) to a third-party investor in the secondary market for cash. After the transfer, Company X is still considered the primary beneficiary of the VIE. The 5 percent interest transferred by Company X would be considered a financial asset, as defined in ASC 860. Does this transfer qualify for sale accounting under ASC 860? PwC response No, this transfer does not qualify for sale accounting under ASC 860 as the loan, prior to transfer, is not a recognized financial asset. Although the transfer might meet all of ASC 860 s criteria for a sale, Company X would still reflect the transfer as a secured borrowing in the consolidated financial statements. Before transferring the loan interest, Company X did not recognize the loan upon consolidation of the VIE, because the loan was eliminated as an inter-company transaction. After the transfer of the loan interest, the loan ceased to be considered an inter-company transaction because it was transferred to a third party. Therefore, the consolidated financial statements of Company X should recognize the loan (a thirdparty liability of the VIE), regardless of whether the transfer qualified as a sale. The basis of the loan would be the cash received upon the transfer to the third party. However, a discount or premium would be recognized for any cash amount that is different from the loan s par value. The scope of this question is limited to transfers of debt instruments. Question 1-8 Would a sale of the guaranteed portion of a loan meet the criteria of a participating interest and thus qualify for sale accounting under ASC ? PwC response It depends. Certain structures exist where the holder of a partially governmentguaranteed loan transfers the guaranteed portion and retains the unguaranteed portion of the loan. These financial asset transfers are very common in the SBA lending space and may involve varying structuring alternatives, including but not limited to, (i) an interest rate for the interest or portion transferred different from the coupon rate received on the underlying loan to compensate for changes in market interest rates, (ii) a contractually specified servicing fee that is higher than the minimum servicing fee required by SBA. In addition, these government-guaranteed loan transfers often provide for limited recourse to the originator. For example, SBA 1-40 PwC

51 Introduction and scope of Topic 860 loan transfers typically contain provisions that require the lender to return any premium to the transferee if the borrower prepays the loan within 90 days, or if the borrower fails to make the first three monthly payments and enters into uncured default within 275 days. Finally, some of these loans are originated with a different interest rate on the guaranteed and unguaranteed portion. For example, SBA may allow the lender to set-up these loans with a fixed rate on the guaranteed portion and a variable rate on the unguaranteed portion. As we discussed in TS 1.3.2, transfers of portions of loans will need to meet the definition of a participating interest after the most recent amendments to ASC 860. The structure described above includes a number of alternatives that, depending on the specific facts and circumstances, will result in different conclusions under the participating interest guidance. The following are some of the considerations: Interest rate differentials: If the transferor/transferee negotiate a different interest rate in the portion transferred from the portion retained by the transferor to compensate for changes in market interest rates (effectively and IO), or if the transferor/originator is transferring a loan for which the coupon rate on the guaranteed portion is different than the coupon rate on the unguaranteed portion, the difference in rates would appear to be inconsistent with the proportionate requirement in paragraph A(b) as the participating interest holders would be entitled to disproportionate cash flows from the underlying loan. However, this requirement would be met if the transferee pays either a premium or a discount to compensate for changes in market interest rates or limits transfers of these loans to those that have the same interest rate on both the guaranteed and unguaranteed portions. Servicing fees: If the transferor/transferee negotiate a servicing fee that s significantly above market (e.g., minimum 100bps. required by SBA) in exchange for a reduced upfront price, this could result in the transaction not meeting the definition of a participating interest. Paragraph A(b) excludes compensation for servicing so long as such compensation is not subordinate and is not considered to be significantly above what would fairly compensate a substitute servicer, if one was required. Even if no additional minimum servicing fee is negotiated, companies will need to evaluate the 100bps. servicing fee mandated by SBA and conclude that such a fee is not significantly above what a substitute servicer would receive as part of their evaluation of these transactions. Limited recourse provisions: If the transfer includes the retention of credit recourse by the transferor, or other forms of continuing involvement, including subordination on the collections of the retained portion to satisfy uncollected principal and interest payments on the guaranteed portion, the transaction will likely fail the criterion in paragraph A(c). Typically, SBA loan sales require the transferor to repay the premium received on the transfer if the borrower prepays within 90 days or as a result of borrower s defaults in the first 90 days following the transfer and extending up to 275 days. To the extent the recourse is limited, companies will be able to re-evaluate its previous participating interest conclusion, once the recourse obligation expires. If all the conditions of a participating interest are met after expiration of the PwC 1-41

52 Introduction and scope of Topic 860 recourse provisions, the sale accounting conditions in paragraph will need to be assessed and if met, the company will be required to derecognize the participating interest transferred. Government guarantee: Even though a third-party guarantee can and will likely result in disproportionate cash flows as a result of both the guarantee fee payments as well as the recoveries under the guarantee, the FASB reasoned that such disproportion is not the result of recourse to the transferor or other participating interest holders and thus should not be considered as part of the evaluation in paragraph A(c). However, guarantees offered by the transferor, its consolidated affiliates, or its agents, are prohibited under the participating interest guidance. Refer to TS for more implementation guidance and illustrations on the participating interest concept. Question 1-9 revised March 2016 Upon transfers of trade receivables where there is a holdback or deferred price adjustment what will be the appropriate accounting if the transfer qualifies for sale? PwC response Transferors of trade receivables under factoring arrangements with holdbacks or to CP conduits with DPP receivables that meet the conditions for sale accounting under the guidance discussed above and that do not need to consolidate the SPEs (outside of the BRE) involved in the structure should derecognize the financial assets sold and recognize any new assets obtained and liabilities incurred as part of the transfer (as discussed in ASC ). Balance sheet and income statement: The holdback and the DPP represent a new asset obtained as part of the proceeds of the sale. As such, they must be recognized at fair value on the transfer date and evaluated under ASC for subsequent measurement. Since the holdback and DPP represent a short-term receivable tied to the creditworthiness of a party other than the issuer (i.e., the transferee), the guidance specifies that such an instrument should be treated as an investment in debt securities classified as available-for-sale or trading. If accounted for as an available-for-sale security, these DPP instruments may also need to be evaluated under ASC 815 to determine if they contain an embedded derivative that may require separation. In addition, the transferor can elect the fair value option for the DPP, however, such election must be contemporaneous (i.e., made on transfer date). See FSP 6 for information on the statement of cash flows PwC

53 Introduction and scope of Topic Transfers scoped out of ASC 860 Question 1-10 Do the provisions of ASC 860 apply to not-for-profit organizations? PwC response Yes. The scope of ASC 860 makes no distinction between a for-profit and a not-forprofit entity. Question 1-11 If a foreign subsidiary of a U.S. multinational company engages in a securitization transaction, do the provisions of ASC 860 apply? PwC response Yes. Foreign subsidiaries included in the consolidated financial statements of U.S. multinational companies are required to comply with U.S. GAAP. Therefore, securitizations and other applicable transactions entered into by these entities are subject to the provisions of ASC 860. The criterion of 9(a) for legal isolation will need to be assessed in accordance with the laws and regulations of the jurisdiction in which the foreign subsidiary operates. In addition, cross-border transactions need to be carefully evaluated when assessing legal isolation. PwC 1-43

54 Chapter 2: Control criteria for transfers of financial assets revised March 2016 PwC 1

55 Control criteria for transfers of financial assets revised March 2016 Chapter overview As mentioned in the previous Chapter, the accounting for transfers of financial assets is predicated on who controls the assets after the transfer is complete. To determine the proper accounting for a transfer of financial assets, the following critical question must be answered: has the transferor (including the consolidated affiliates included in the financial statements being presented, and its agents) 1 relinquished control over the financial assets and has the transferee obtained control over those same financial assets? The general concept of ASC 860 is that transferred financial assets are considered sold if, and only if, the transferor surrenders control of financial assets to the transferee. Under ASC 860, transfers of financial assets must satisfy the control criteria set forth in ASC for the transferred financial assets to be derecognized (i.e., accounted for as a sale). As part of this determination, the following objectives and fundamental principles should be considered: Excerpt from ASC The objective of paragraph and related implementation guidance is to determine whether a transferor and its consolidated affiliates included in the financial statements being presented have surrendered control over transferred financial assets or third-party beneficial interests. This determination: a. Shall first consider whether the transferee would be consolidated by the transferor (for implementation guidance, see paragraph D) b. Shall consider the transferor s continuing involvement in the transferred financial assets c. Requires the use of judgment that shall consider all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer, even if they were not entered into at the time of the transfer. With respect to item (b), all continuing involvement by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents shall be considered continuing involvement by the transferor. In a transfer between two subsidiaries of a common parent, the transferor-subsidiary shall not consider parent involvements with the transferred financial assets in applying paragraph Excerpt from ASC C Items (b) through (c) in paragraph do not apply to a transfer of financial assets and a related repurchase financing. In transactions involving a contemporaneous transfer of a financial asset and a repurchase financing of that transferred financial asset with the same counterparty, a transferor and transferee shall separately account for the initial transfer of the financial asset and the related 1 References to a transferor throughout this chapter should be read to mean transferor and its consolidated affiliates or transferor, consolidated affiliates and its agents where the context so requires. 2-2 PwC

56 Control criteria for transfers of financial assets revised March 2016 repurchase agreement. Paragraphs A through 55-17C provide implementation guidance related to repurchase financings. Excerpt from ASC D To be eligible for sale accounting, an entire financial asset cannot be divided into components before a transfer unless all of the components meet the definition of a participating interest. The legal form of the asset and what the asset conveys to its holders shall be considered in determining what constitutes an entire financial asset (for implementation guidance, see paragraph E). An entity shall not account for a transfer of an entire financial asset or a participating interest in an entire financial asset partially as a sale and partially as a secured borrowing. Excerpt from ASC E If a transfer of a portion of an entire financial asset meets the definition of a participating interest, the transferor shall apply the guidance in the following paragraph. If a transfer of a portion of a financial asset does not meet the definition of a participating interest, the transferor and transferee shall account for the transfer in accordance with the guidance in paragraph However, if the transferor transfers an entire financial asset in portions that do not individually meet the participating interest definition, the following paragraph shall be applied to the entire financial asset once all portions have been transferred. Excerpt from ASC A transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset in which the transferor surrenders control over those financial assets shall be accounted for as a sale if and only if all of the following conditions are met: a. Isolation of transferred financial assets b. Transferee s rights to pledge or exchange [the transferred assets] c. Effective control [over the transferred assets is not maintained by the transferor, consolidated affiliates, or its agents] The guidance above sets forth three broad criteria that must be met to conclude that control over the transferred financial assets has passed to the transferee. In addition, the foregoing clarifies that transfers involving only entire financial assets, group of entire financial assets, or participating interests in entire financial assets (as defined) are eligible for potential derecognition under ASC Failure to meet any one of the above criteria, including meeting the definition of a participating interest when transferring only a portion of a financial asset, prevents the transferor from derecognizing the transferred financial assets in which case the transaction should be accounted for as a secured borrowing (refer to TS 4.2 for discussion of accounting for secured borrowings). Therefore, the questions of unit of account and control are central to the distinction between transfers of financial assets that are accounted for as sales and those that are accounted for as secured borrowings. PwC 2-3

57 Control criteria for transfers of financial assets revised March 2016 The remainder of this chapter discusses the application of ASC s three control criteria, and highlights certain implementation issues associated with each. The following figure provides a high-level decision tree for applying ASC 860 s sale accounting model. Figure 2-1* Framework for accounting for transfers of financial assets * This Figure assumes that the transferee is not consolidated by the transferor. 2-4 PwC

58 Control criteria for transfers of financial assets revised March 2016 Figure 2-2 Key questions answered in this chapter Paragraphs in ASC Page in this publication Does the transfer involve an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset? Have the transferred financial assets been isolated beyond the reach of the transferor and its creditors? Does the transferee have the right to exchange or pledge the financial assets it has received? Has the transferor given up effective control of the transferred financial assets? 4D,4E,-6A 2-5 5(a), 7 through (b), 15 through (c), 22 through Does the transfer involve an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset? For a transaction to be subject to the derecognition guidance, the transfer must meet the definition of transferred financial assets, which includes any of the following (refer to ASC ): 1. Entire financial asset 2. A group of entire financial assets 3. A participating interest in an entire financial asset Transfers of entire financial assets or group of entire financial assets involve the legal transfer of full title and ownership of the underlying assets being transferred. Conversely, transfers of a portion of a financial asset does not involve the conveyance of full title and ownership of the asset; rather, as a legal matter, the transferee obtains an interest in the asset, with the transferor retaining ownership of the underlying assets. As mentioned in TS 1.3.2, transfers involving a portion of an asset are commonly referred to as transfers of undivided interests or participations. A transfer of a portion of a financial asset needs to comply first with ASC 860 s definition of a participating interest to be eligible for potential derecognition under ASC A transfer of a portion that does not meet the participating interest PwC 2-5

59 Control criteria for transfers of financial assets revised March 2016 definition must be accounted for as a secured borrowing until such time as (1) the transferor transfers the entirety of its interest in the underlying asset to third parties, or the transferred interest subsequently meets the participating interest guidance and (2) the transferred interests also meet the sale or derecognition criteria. Refer to TS for more details on the participating interest definition, to TS 1.6 for examples of common types of transfers subject to the participating interest guidance, and to TS for implementation guidance. 2.2 Have the transferred financial assets been isolated beyond the reach of the transferor and its creditors? After determining if the transfer was that of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset, the first criterion that must be met for a transaction to qualify for sale accounting is that the transferred financial assets must be isolated from the transferor, its consolidated affiliates, and its creditors. To be considered isolated, the transfer must meet the following criteria: Excerpt from ASC (a) The transferred financial assets have been isolated from the transferor put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. Transferred financial assets are isolated in bankruptcy or other receivership only if the transferred financial assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor or any of its consolidated affiliates included in the financial statements being presented. For multiple step transfers, a bankruptcy-remote entity is not considered a consolidated affiliate for purposes of performing the isolation analysis. Notwithstanding the isolation analysis, each entity involved in the transfer is subject to the applicable guidance on whether it shall be consolidated (see paragraphs through and the guidance beginning in paragraph ). A set-off right is not an impediment to meeting the isolation condition. Derecognition of transferred financial assets is allowed only if available evidence provides reasonable assurance that the transferred financial assets have been put presumptively beyond the reach of the powers of (1) a bankruptcy trustee or (2) other creditors of the transferor or any consolidated affiliate of the transferor that is not a special-purpose corporation or other entity designed to make remote the possibility that the other entity would enter bankruptcy or other receivership. The evaluation of whether this requirement has been met should be based on an analysis of the legal implications of the terms of the sale, including in the context of the transferor s bankruptcy. Sales of financial assets directly to third parties with no continuing involvement by the transferor and its consolidated affiliates and agents (e.g., credit enhancement, servicing responsibilities, or rights to residual cash flows from the assets) will generally be straightforward and qualify for sale treatment, 2-6 PwC

60 Control criteria for transfers of financial assets revised March 2016 provided that the other criteria for sale accounting are met. Sales of financial assets with any continuing involvement by the transferor, including servicing, repurchase agreements, various forms of recourse, and ownership interests, will require a detailed analysis to determine whether the transferred financial assets were put beyond the reach of the transferor or any of its consolidated affiliates in the financial statements being presented, its bankruptcy trustee, and its creditors. The analysis of the transaction will need to be performed by a legal expert. Notwithstanding the isolation analysis, each entity involved in the transfer is subject to the applicable consolidation guidance in ASC 810. Accordingly, a transferor could be required to consolidate the trust or other legal vehicle used in the second step of the securitization, notwithstanding the isolation analysis of the transfer. If the transferor is required to consolidate the ultimate transferee, further consideration of the provisions in ASC 860 frequently may be unnecessary, at least in the context of the transferor s consolidated financial statements, as the transferred assets have not moved beyond the confines of the consolidated group. Continuing involvement refers to any involvement by the transferor or its consolidated affiliates after the transferred assets have been sold and includes any involvement that permits the transferor to receive cash flows (or other benefits) that arise from those financial assets. It also includes any involvement that obligates the transferor to provide additional cash flows or other assets to any party related to the transfer. The following are some examples of continuing involvement by the transferor or its consolidated affiliates: Providing full or limited recourse Obtaining servicing of the financial assets Having an equity interest in the transferee Put/call options on the transferred financial assets or beneficial interests Guarantees Make-whole provisions Indemnity clauses Ability to revoke the transfer Commitment to transfer additional financial assets Agreements to purchase or redeem transferred financial assets Arrangements to provide financial support Pledges of collateral Representations and warranties with respect to the transferred assets PwC 2-7

61 Control criteria for transfers of financial assets revised March 2016 The various types of continuing involvement will not have identical effects on the legal analysis Transferred financial assets with no continuing involvement by the transferor This is a one-step transaction in which the transferor transfers entire financial assets or group of entire financial assets to a third party simply for cash or other consideration not related to the transferred financial assets. The transferee is free to pledge or exchange the financial assets in any form desired. The transferor does not provide the transferee with any protection against credit losses (e.g., credit enhancement), nor does it have other forms of continuing involvement of any kind in the transferred financial assets (e.g., servicing). Transferred financial assets with no continuing involvement by the transferor generally will result in the transaction being accounted for as a sale (further information regarding sale accounting can be found in TS 3). If these transactions include the transfer of loans, they are often referred to as whole loan sales with servicing released. Figure 2-2 provides a visual depiction of a basic transfer without continuing involvement. Figure 2-2 Transfer with no continuing involvement If the transaction is structured as the transfer of a portion of a financial asset, then the participating interest guidance in TS should also be considered. The retained portion is a form of continuing involvement that should be considered in the analysis Transfer of a financial asset or group of financial assets with continuing involvement by the transferor Frequently, the transferor of financial assets or groups of financial assets has continuing involvement in the financial assets transferred in the form of a credit enhancement (i.e., an enhancement that protects the transferee from credit losses). A transferor can credit enhance the transferred assets in a variety of ways, including providing a financial guarantee or retaining subordinated interests in assets sold to third parties. In such a transfer, the financial asset or group of financial assets is commonly transferred to a trust. The trust then issues interests to third-party investors (typically in the form of debt securities) that entitle them to receive cash flows from the financial assets (these interests are often referred to as beneficial interests ). A trust may issue different classes (or tranches ) of beneficial interests, whereby a senior class of beneficial interests has a priority entitlement to the cash flows generated from the trust s financial assets; only after the senior tranche has received the contractual amount(s) owed are remaining cash collections (if any) available to pay subordinate interests. This subordination of cash flows is a form of structural credit enhancement, 2-8 PwC

62 Control criteria for transfers of financial assets revised March 2016 as credit risk related to the financial assets in the trust is borne first by the lower classes of beneficial interests. The most junior interest in the trust, typically referred to as the residual, receives any cash flows generated by the trust s financial assets that remain after all contractual claims by service providers and other investors have been paid. This residual interest is often retained by the transferor and represents a form of continuing involvement in the financial assets transferred to the trust. Even though a transferor has continuing involvement in transferred financial assets, the transfer may still be eligible for sale accounting. Achieving sale accounting under ASC 860 is not predicated on whether the transferor has any continuing involvement in the transferred assets, but rather on whether control over those assets has in fact been ceded to the transferee. Continuing involvement on the part of the transferor must be analyzed to determine whether the involvement affects legal isolation of the assets from the transferor or otherwise allows the transferor to maintain control over the transferred assets. In evaluating the transferor s continuing involvement, all available evidence shall be considered, including, but not limited to, all of the following: Explicit written arrangements Communications between the transferor and the transferee or its beneficial interest holders Unwritten arrangements customary in similar transfers. Identifying and understanding all forms of continuing involvement on the part of a transferor (and, if applicable, consolidated affiliates and agents) is vital to a fulsome analysis of the three sale accounting conditions in ASC In connection with this assessment, ASC (c) directs a transferor to consider all arrangements or agreements made contemporaneously with, or in contemplation of, a transfer, even if they were not entered into at the same time as the transfer. However, if a transfer of a financial asset is accompanied by a related repurchase financing, as defined, ASC C requires that the parties account for each exchange separately, without consideration of the other. This treatment is an exception to the requirement that a transferor take into account all contemporaneous arrangements and agreements. There is no specific guidance on how to determine whether an arrangement or agreement was entered into in contemplation of a transfer. Reporting entities must apply judgment and should consistently apply their understanding of this term in practice (for example, by articulating factors or indicators that, if present, would likely to lead to a conclusion that the arrangement meets the in contemplation of condition). In any event, the conclusion will depend on the individual facts and circumstances. In the event of a transfer of financial assets between two subsidiaries of a common parent, ASC clarifies that the transferor-subsidiary would not consider the parent s involvements with the transferred financial assets when evaluating whether, in its standalone financial statements, the transaction should be reported as PwC 2-9

63 Control criteria for transfers of financial assets revised March 2016 a sale. If, however, after the inter-subsidiary transfers, the consolidated entity transfers the same financial assets to a third party, any continuing involvement by any of the entities within the consolidated group should be considered when evaluating the sale accounting criteria in ASC Involvement by consolidated affiliates of the transferor ASC (a) and 40-8 clearly state that transferred financial assets must be isolated not only from the transferor, but also from its consolidated affiliates (other than those intended to be bankruptcy-remote) included in the financial statements being presented. From the perspective of the consolidated financial statements, a financial asset transferred by a subsidiary to a third party may or may not be isolated if another entity within the consolidated group has continuing involvement in the transferred financial assets, such as providing servicing or credit enhancements. A consolidated affiliate is defined as follows. ASC An entity whose assets and liabilities are included in the consolidated, combined, or other financial statements being presented. As noted above, an entity that is designed to make remote the possibility that it would enter bankruptcy 2 (a bankruptcy-remote entity) is not considered a consolidated affiliate for purposes of performing the isolation analysis. TS cites the typical attributes of a bankruptcy-remote entity Legal support for determination of isolation ASC 860 states that, to conclude that transferred financial assets are legally isolated, the transfer must meet the requirements in paragraph ASC (a). For transferred financial assets to be considered isolated from the transferor or any of its consolidated affiliates in the financial statements being presented, an analysis of all of the facts and circumstances surrounding the transfer should be performed. In practice, this analysis often includes consideration of whether the transfer would be deemed a true sale at law, in some circumstances, whether the transferee would be substantively consolidated into the bankruptcy estate of the transferor. Whether a transfer of financial assets satisfies the legal isolation criterion is a legal determination not an accounting judgment. A legal analysis that considers the laws of the applicable jurisdiction(s) should be performed to support the assertion that this criterion has been met. A transferor s power to require the return of the transferred financial assets arising solely from a contract with the transferee, for example, a call option or removal-ofaccounts provision, would not necessarily preclude a conclusion that transferred financial assets have been isolated from the transferor. However, such a power might 2 Unless the context suggests otherwise, references in this chapter to bankruptcy and bankruptcy law should be read broadly to include receivership, conservatorship and similar insolvency laws/regimes PwC

64 Control criteria for transfers of financial assets revised March 2016 preclude sale treatment if, through it, the transferor maintains effective control over the transferred financial assets. The legal isolation requirement focuses on whether transferred financial assets would be isolated from the transferor even in the event of bankruptcy or other receivership regardless of the transferor s credit rating or relative financial strength at the transfer date. That is, the requirement may not be considered satisfied simply because, in view of the transferor s current credit rating, the likelihood of its bankruptcy or receivership is deemed to be low. Refer to TS 2.4 for more details on the evaluation of whether the transferor maintains effective control. True-sale-at-law opinion It is not easy to determine whether a true sale has occurred in certain transactions, such as those involving SPEs that hold securitized assets or transactions in which the transferor or its consolidated affiliates retain recourse or some other form of continuing involvement in the transferred financial assets. For that reason, a truesale-at-law opinion from a qualified bankruptcy attorney is frequently obtained to support the conclusion that the transferred financial assets have been isolated. As stated in ASC A(a), in the context of U.S. bankruptcy laws, a true sale opinion is an attorney s conclusion that the transferred financial assets have been sold and are beyond the reach of the transferor s creditors and that a court would conclude that the transferred financial assets would not be included in the transferor s bankruptcy estate. In addition, ASC C states that, [f]or entities that are subject to other possible bankruptcy, conservatorship, or other receivership procedures (for example, banks subject to receivership by the Federal Deposit Insurance Corporation [FDIC]) in the United States or other jurisdictions, judgments about whether transferred financial assets have been isolated shall be made in relation to the powers of bankruptcy courts or trustees, conservators, or receivers in those jurisdictions. A transferor and its consolidated affiliates are not precluded from having recourse exposure to, or an economic interest in, a transferred financial asset for the transfer to be considered a legal true sale. However, in the U.S., the level of recourse and/or the extent of any such economic interest are among the principal factors that lawyers consider in determining whether the transfer would be considered a true sale at law. On the other hand, in certain foreign jurisdictions, a transfer may be considered a legal true sale even if the transferee has substantial (or full) recourse to the transferor for reimbursement of losses stemming from the transferred assets. Consideration of the laws of the jurisdiction that would apply in the event of the transferor s bankruptcy, as well as the laws that govern the transaction itself, usually serve as the starting point for the legal isolation analysis. Care should be taken as continuing involvement takes many forms, many of which may not, on the surface, appear to constitute retention of risks or rewards. Legal opinions should address all forms of continuing involvement by a transferor and its consolidated affiliates when evaluating whether a transfer would be respected as a PwC 2-11

65 Control criteria for transfers of financial assets revised March 2016 true sale at law. This analysis may be even more complex for transactions executed in foreign legal jurisdictions (refer to TS 7). Nonconsolidation opinion A true-sale-at-law opinion provides support that the transferred financial assets would not be considered part of the bankruptcy estate of the transferor (that is, the estate of the legal seller). However, a true-sale opinion does not address whether the transferee and thus, by extension, the transferred assets owned by the transferee -- could be substantively consolidated into the bankruptcy estate of the transferor. Depending on the circumstances, a substantive consolidation opinion may be required to support the assertion that the transferred assets have been legally isolated. Substantive consolidation is a judicial doctrine arising from the general equity powers granted to bankruptcy courts in the United States. Although no specific provision of the U.S. Bankruptcy Code expressly authorizes a court to order substantive consolidation, this concept is based on federal common law, which permits a bankruptcy court to treat a group of affiliated entities as if they are one, merging their assets and liabilities for purposes of the bankruptcy proceeding. A similar doctrine or legal convention may also exist in certain foreign jurisdictions. Given that the power to order substantive consolidation derives from the broad powers vested in the bankruptcy courts, the issue is determined on a case-by-case basis. The courts will weigh a variety of factors, which typically include the following: The organizational structures of the entities proposed to be consolidated Their intercorporate or other interorganizational relationships Their relationships with their respective creditors and other third parties The doctrine of substantive consolidation is an equitable one, so a court will examine, among other things, the impact upon the creditors of each entity if consolidation were to be ordered, and whether such parties would be unfairly prejudiced or treated more equitably by substantive consolidation. Courts have ordered substantive consolidation where the proponents have demonstrated either a harm to be avoided or a benefit to be effected generally under the circumstances and upon consideration of whether the rights of any third parties (e.g., creditors of the transferee) would be unduly prejudiced. To achieve legal isolation, a bankruptcy-remote entity (BRE) is sometimes used to facilitate a transfer of financial assets, particularly when the ultimate transferee is a special-purpose securitization entity or asset-backed financing vehicle (see TS 2.2.9). A bankruptcy-remote entity is structured to make it unlikely that: The entity itself would file for (or be placed into) bankruptcy by its parent or other parties with an interest in the entity A court would order the substantive consolidation of the entity into the bankruptcy estate of its parent PwC

66 Control criteria for transfers of financial assets revised March 2016 There is no controlling statute or authoritative case law that details the conditions a legal entity must satisfy to be considered bankruptcy-remote. However, in practice, to be deemed bankruptcy-remote, a legal entity generally has the following characteristics: Undertakes only limited activities specified in its formative document(s) Does not incur indebtedness to third parties (or, if such indebtedness is allowed, subject to stringent conditions, such as satisfactory creditor non-petition covenants) Does not commingle its assets with those of its parent or related affiliates Maintains corporate and financial records separate from its parent and its affiliates, including separate bank accounts Observes all corporate formalities on a standalone basis Has at least one independent director or manager Conducts its activities separate from its parent and affiliates Pays its obligations with its own funds (i.e., it does not use the funds of its parent to satisfy its obligations) The foregoing is not an all-inclusive list of the restrictive (or prescriptive) attributes of a BRE. When should a legal opinion be obtained? Whether to obtain a true-sale-at-law opinion and a nonconsolidation opinion is a matter of judgment, and should be determined based on the facts and circumstances of the particular transfer transaction. A legal opinion would not typically be required for a routine transfer of financial assets that does not result in any continuing involvement by the transferor and its consolidated affiliates, including BREs. The following list highlights some of the more common transactions for which we would generally expect entities to obtain a true-sale opinion and/or nonconsolidation opinion in instances in which sale accounting is being sought. This list is not meant to be an all-inclusive list of transactions that would require legal evidence to support legal isolation under ASC 860. Factoring of receivables (where transferor retains obligation to collect and remit payments to transferee, retains any form of credit recourse, transfers less than entire financial asset, or retains any other forms of continuing involvement) Loan participations Repurchase agreements, securities lending and dollar rolls PwC 2-13

67 Control criteria for transfers of financial assets revised March 2016 Securitization transactions (including those involving GSEs) Transfers of debt or equity securities with continuing involvement Any other transfer of recognized financial assets with continuing involvement The Figure 2-3 below highlights a basic decision tree that may be useful when evaluating the extent of legal evidence required for transfers of financial assets involving a transferor subject to the U.S. Bankruptcy Code. Figure 2-3 Framework for determining the extent of legal evidence required to support legal isolation under the Topic 860 There is a rebuttable presumption that legal opinions should be obtained as supporting evidence for transfers of financial assets when the transfer includes continuing involvement on the part of the transferor or its consolidated affiliates. When there is continuing involvement, we do not believe that a transfer of financial assets may be categorized as a routine transfer as discussed in ASC PwC

68 Control criteria for transfers of financial assets revised March (B)(a) above. This presumption may be overcome only when management has obtained legal opinions for previous transfers having identical (or nearly identical) facts and governed by the same laws. If these conditions are met, the previouslyissued opinions may be used to satisfy the required legal analysis for the current transaction (consistent with the guidance in ASC (B)(b).) In these instances, management should confirm that the laws and regulations in the relevant jurisdictions have not changed since the date of the earlier opinion. See additional discussion in TS With respect to securitization transactions involving SPEs that hold transferred assets in which the transferor retains economic exposure to the assets or has other forms of continuing involvement with them (e.g., a right of substitution of accounts in a revolving-period securitization), it may be difficult to determine whether a sale has, in fact, occurred. In these instances, the best form of evidence to demonstrate reasonable assurance that the legal isolation criterion has been met is a legal opinion -- as satisfaction of the legal isolation criterion in ASC (a) is ultimately a legal matter and, as such, management must necessarily rely on the opinion of a lawyer when evaluating this criterion. Since legal opinions are usually requested by rating agencies and other parties involved with these transactions, management also may use those opinions to support the legal isolation assertion, if adequate. A legal opinion is generally needed for transfers of financial assets that involve complex legal structures, continuing involvement by the transferor or its consolidated affiliates, or other legal issues that make it difficult to determine whether the isolation criterion has been met. Absent a legal opinion, for most one-step transactions in which the transferor retains economic exposure to, or has another form of continuing involvement with, the transferred assets, it would be difficult to conclude that the assets are presumptively beyond the reach of the transferor and its creditors in bankruptcy or receivership. Accordingly, when the transferor or its consolidated affiliates have any level of continuing involvement with the transfer or the transferred financial assets, we believe a true-sale-at-law opinion should be obtained to demonstrate isolation. Additionally, substantive consolidation opinions will often be required in transactions involving affiliated entities, either when acting as transferee or when involved in the transfer through some form of continuing involvement (refer to TS for more details on legal opinions that may be needed in transfers involving entities under common control). One-step securitization transactions are rare in the United States and generally result in legal isolation only when the transferor has no (or only inconsequential) ongoing involvement with the transferred assets. A legal opinion is also needed for most twostep transactions (refer to examples included in TS 1.6), because they generally involve complex legal structures or other legal issues that require specialized legal interpretation. In the case of securitizations that use a two-step structure, a legal opinion may not be required for both steps. As discussed more fully in 2.2.9, using a BRE to execute the transfer of financial assets to the ultimate transferee (the securitization trust) enhances the legal isolation of the transferred assets. This two-step construct allows the transfer to qualify for sale accounting and, at same time, makes the assets PwC 2-15

69 Control criteria for transfers of financial assets revised March 2016 attractive to investors by allowing the transferor to provide structural credit enhancement to the securitization trust. A legal opinion on these two-step securitization structures should consider the transaction taken as a whole to provide persuasive evidence that (1) the transfer to the BRE would be upheld as a true sale at law and (2) the BRE would not be substantively consolidated into the bankruptcy estate of the transferor parent Applicability of legal opinions received for previous, similar transactions In the case of a new securitization structure that is identical to a recent pre-existing securitization structure (and for which a legal opinion was obtained), a new legal opinion may not be necessary. When the two structures are not identical, the differences should be identified, and their potential implications should be evaluated. When assessing the conditions of paragraph ASC (a), the parties evaluating legal isolation should carefully consider all differences before they conclude that the legal opinion rendered with respect to the earlier structure may be relied up to support the assertion that financial assets transferred under the new arrangement will be legally isolated. A true sale opinion and, if applicable, a substantive consolidation opinion that each address the transfer in question is often the best indicator of legal isolation. However, management may be able to rely on previously-obtained legal opinion letters in certain circumstances. For example, a previously-obtained legal opinion could be used for a rollover transaction or a revolving structure, or for similar arrangements in which the transferor has continuing involvement. We discuss each of these circumstances below. Similar transfers with continuing involvement Transactions structured similarly to past deals in which the transferor has continuing involvement with the transferred assets, and for which a legal opinion was previously obtained, may not require a new legal opinion. For example, if the transferor previously obtained an opinion for a similar transaction governed by the same laws and bankruptcy regime, management may conclude that the prior opinion provides adequate evidence to support management s assertion regarding isolation of the financial assets in the current transaction. In practice, however, transfers are rarely structured in an identical way because of changes in deal specifics or in market and regulatory conditions (even if they are done with the same party). The financial assets being transferred may also have different attributes. Similar transactions with different parties are often not structured similarly enough to justify reliance on a previously obtained legal opinion. Since an attorney is typically the only party who can evaluate the impact of changes or differences in transactions, management should seek advice from legal counsel as to whether a new opinion is warranted, even when changes in the structure appear to be modest. When no legal opinion is obtained, based on an understanding that the same facts and circumstances exist in a previous transfer of financial assets for which a legal analysis 2-16 PwC

70 Control criteria for transfers of financial assets revised March 2016 exists, enough evidence should be obtained to support the assertion that the legal isolation criterion has been met. This would include an analysis of whether the legal or regulatory framework governing the current transaction has changed subsequent to the date of the previous transaction s opinion. Rollover transactions and revolving structures A transferor may also use a given securitization structure for the transfer of financial assets on more than one occasion. For example, a company transfers short-term financial assets, such as credit card receivables that have an average life of 6 12 months, to a trust that issues debt that matures in 5 10 years. Periodically, as the short-term financial assets are paid off, the transferor transfers additional financial assets to the trust to ensure that the trust holds enough assets to pay off the interest and principal of the debt. The transferor may make these additional transfers of financial assets to the trust numerous times throughout the life of the structure. Such a structure is referred to as (1) a rollover transaction, as the financial assets of the trust roll over on a regular basis or (2) a revolving structure, as the financial assets backing the debt revolve over time. For a securitization structure set up under these circumstances, management should evaluate whether there may have been changes to relevant laws, applicable regulations, or other factors that may affect the applicability of the previous opinion to the new transactions. Entities should consider the need for periodic updates of the opinion to ascertain whether the opinion previously rendered remains appropriate. Changes in the transaction structure, or changes in relevant laws and regulations, may require an updated legal analysis Use of an external legal opinion As noted above, whether a transfer meets the legal isolation condition in ASC (a) is a legal matter requiring the advice of competent counsel. Consideration of the complexities of bankruptcy statutes and related case law requires specialized expertise usually found only in law firms. As such, we believe that, as a general rule, it would be inappropriate for management to rely on an opinion by internal counsel to support the assertion that transferred financial assets have been legally isolated unless the lawyer is clearly an expert in relevant bankruptcy law. In our view, to serve as competent evidential matter, a legal opinion should be obtained from a qualified external bankruptcy attorney Management s analysis of a legal opinion AU Section 336, Using the Work of a Specialist (AU 9336), issued by the AICPA s Audit Issues Task Force, is intended to assist auditors in assessing the sufficiency of a legal opinion obtained by management to support its assertion that transferred financial assets meet the isolation criterion in paragraph ASC (a). As such, AU 9336 may be helpful to inform a transferor s management regarding the appropriate form and content of legal opinions rendered for this purpose, and the matters that it should consider when evaluating their sufficiency. Among other things, the guidance provides that, when assessing the adequacy of a lawyer s opinion, consideration be given to the following: PwC 2-17

71 Control criteria for transfers of financial assets revised March 2016 Whether the lawyer has experience in such matters: the lawyer should be wellversed in the U.S. Bankruptcy Code and relevant case law, and knowledgeable of other federal, state, or foreign laws that may govern, or bear on, the transfer. For transactions that may be affected by provisions of the Federal Deposit Insurance Act, management and the auditor should consider whether the legal specialist has experience with the rights and powers of receivers, conservators, and liquidating agents under that Act. Similar specialized expertise may be necessary in other regulated industries (for example, insurance) Whether the legal opinion rendered explicitly considers (1) the laws of the State or country intended to govern the transfer and (2) the laws of the jurisdiction that would govern the transferor s bankruptcy or receivership. As laws vary from jurisdiction to jurisdiction, a transaction that qualifies as a true sale in one jurisdiction may not qualify as such in another. Whether the transferor or its auditor is precluded from relying on a legal opinion because the letter restricts the use of the findings. The legal opinion should specifically state that the auditor is permitted to rely on the conclusions reached in the letter as evidential matter that supports management s assertion that the transferred assets have been legally isolated. Alternatively, counsel may grant such permission in a separate cover letter. Generally, if this permission is not granted, the letter is considered to contain an audit scope limitation. Findings of a lawyer that relate to the isolation of transferred financial assets are often in the form of a reasoned legal opinion that (1) is restricted to the particular facts and circumstances that are relevant to the transaction and (2) relies on analogy to legal precedents and case law that may or may not involve comparable facts. Management should ensure that the legal analysis assumes facts consistent with the transaction, and that other enumerated assumptions (regarding certain attributes of the transferor, the transferee and the transferred assets) are appropriate in the circumstances. Inconsistencies in this regard could lead to a conclusion that legal isolation of the transferred assets under ASC 860 has not been demonstrated. Moreover, a legal opinion that does not consider all forms of continuing involvement by the transferor and any of its consolidated affiliates in the financial statements being presented, or an opinion that does not consider all agreements entered into in connection with the transfer, would not be sufficient to demonstrate that the legal isolation condition has been met. A legal letter that includes an inadequate opinion, inappropriate limitations and assumptions, a disclaimer of opinion, or conditions that effectively limit the scope of the opinion to facts and circumstances that are not applicable to the transaction would not provide persuasive evidence that the transferred assets have been put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. The same would be true for a legal opinion that merely states, with no corresponding discussion of relevant statutes and case law, that a transfer is a legal true sale and, if applicable, that the transferee would not be consolidated with the transferor in the event of the latter s bankruptcy PwC

72 Control criteria for transfers of financial assets revised March 2016 Form of the opinion To provide reasonable assurance that the assets have been isolated from the transferor and any of its consolidated affiliates and its creditors, the legal opinion, should clearly state that the transfer of the financial assets in question would be considered a true sale at law. A would level of assurance generally means that there is a high probability that the financial assets have been isolated from the transferor. Note, however, that even an appropriately worded would opinion may not satisfy the requirements of ASC 860 due to assumptions or qualifications that unduly limit the circumstances on which the lawyer is opining (see further discussion below regarding assumptions and qualifications). Legal opinions stating that the transfer should be construed to be a true sale at law, would likely be a true sale at law, or that there is a substantial chance that a true sale at law has occurred are examples of opinions that do not provide sufficient evidence of isolation. Likewise, a legal opinion that includes conclusions that are expressed using some of the following language would not provide persuasive evidence that a transfer of financial assets has met the isolation criterion: We are unable to express an opinion It is our opinion, based upon limited facts We are of the view or it appears We would be prepared to make such arguments that There is a reasonable basis to conclude that In our opinion, the transfer would either be a sale or a grant of a perfected security interest In our opinion, there is a reasonable possibility In our opinion, there is a substantial chance In our opinion, the transfer should be considered a sale It is our opinion that the company will be able to assert meritorious arguments In our opinion, it is more likely than not In our opinion, the transfer would presumptively be In our opinion, it is probable that Conclusions about hypothetical transactions may not be relevant to the transaction that is the subject of management s assertions. For example, conclusions about hypothetical transactions may not contemplate all of the facts and circumstances or the provisions in the agreements of the transaction that is the subject of PwC 2-19

73 Control criteria for transfers of financial assets revised March 2016 management s assertions. As such, legal conclusions with respect to a hypothetical transaction generally do not provide sufficient evidence that transferred financial assets have been legally isolated. Examples of language that a transferor would likely find in an acceptable true-sale-atlaw and substantive consolidation opinion include: True sale at law The following are two examples of a true-sale opinion for an entity subject to the U.S. Bankruptcy Code: In the event that the Seller were to become a Debtor, it is our opinion that, in a case that is presented and properly argued, the transfer of the ownership interests in the receivables from the Seller to the Purchaser would be considered a true sale at law of the ownership interest in the receivables from the Seller to the Purchaser, and not a loan. Accordingly, the ownership interests in the receivables and the proceeds thereof (transferred to the Purchaser by such Seller in accordance with the Purchase Agreement) would not be deemed property of the Seller s estate under Section 541 of the U.S. Bankruptcy Code. We are of the opinion that a court in an insolvency, bankruptcy, or judicial proceeding under the Bankruptcy Code, which properly analyzed the law and facts, would hold that o o the transfer of the assets by the transferor to the SPE in the manner contemplated by the financing documents is a true sale at law of the assets by the transferor, the assets and payments thereunder are not property of the estate of the transferor under Bankruptcy Code Section 541, and o the automatic stay arising pursuant to U.S. Bankruptcy Code Section 362 upon the commencement of a bankruptcy case relating to the transferor is not applicable to the assets or payments thereunder of which the transferor is not in possession at the time of filing of the petition commencing such case. The following is an example of a true-sale opinion for an entity subject to receivership or conservatorship under the provisions of the Federal Deposit Insurance Act: We believe (or it is our opinion) that in a properly presented and argued case, as a legal matter, in the event the Seller were to become subject to receivership or conservatorship, the transfer of the Financial Assets from the Seller to the Purchaser would be considered a sale (or a true sale) of the Financial Assets from the Seller to the Purchaser and not a loan and, accordingly, the Financial Assets and the proceeds thereof transferred to the Purchaser by the Seller in accordance with the Purchase Agreement would not be deemed to be property of, or subject to 2-20 PwC

74 Control criteria for transfers of financial assets revised March 2016 repudiation, reclamation, recovery, or recharacterization by the receiver or conservator appointed with respect to the Seller. 3 Substantive consolidation The following are examples of a substantive consolidation opinion for (1) an entity subject to the U.S. Bankruptcy Code and (2) an entity subject to receivership or conservatorship under the provisions of the Federal Deposit Insurance Act, respectively: Based upon the assumptions of fact and the discussion set forth above, and on a reasoned analysis of analogous case law, we are of the opinion that in a properly presented and argued case, as a legal matter, in a proceeding under the U.S. Bankruptcy Code in which the Seller is a Debtor, a court would not grant an order consolidating the assets and liabilities of the Purchaser with those of the Seller in a case involving the insolvency of the Seller under the doctrine of substantive consolidation. 4 Based upon the assumptions of fact and the discussion set forth above, and on a reasoned analysis of analogous case law, we are of the opinion that in a properly presented and argued case, as a legal matter, in a receivership, conservatorship, or liquidation proceeding with respect to the Seller, a court would not grant an order consolidating the assets and liabilities of the Purchaser with those of the Seller. 4 Although a legal opinion normally will address bankruptcy matters with respect to the entity that is legal seller of the financial assets, involvement with those assets by the transferor s consolidated affiliates may require opinions at various levels to support the assertion that the transferred assets have been legally isolated in the context of the consolidated reporting entity, as discussed in the next section. Facts and assumptions In virtually all cases, a lawyer will make a number of assumptions regarding the transaction to form a conclusion about whether a transfer of financial assets is a true legal sale and, if applicable, whether a court would order the transferee s substantive consolidation into the parent s bankruptcy estate. These assumptions, along with the lawyer s understanding of the facts of the transaction, are generally cited in the forepart of the lawyer s letter. The validity of the facts and assumptions used by the lawyer in forming its conclusion must be evaluated by management to determine their propriety. In certain cases, a lawyer s enumeration of facts and assumptions may not reflect, or be consistent with, the specifics of the transaction. It is the transferor s responsibility to understand the facts and assumptions relied upon by the lawyer, and to ensure that these facts and assumptions are consistent with its understanding of the transaction. It would inappropriate for management to conclude that the opinion rendered by counsel is sufficient if it has reason to believe that the attorney s conclusion is based on incorrect 3 From AU PwC 2-21

75 Control criteria for transfers of financial assets revised March 2016 facts and assumptions, or if the letter omits material facts and assumptions that could impact counsel s analysis. EXAMPLE 2-1 Analysis of assumptions in a legal opinion Company XYZ plans to securitize its existing portfolio of customer accounts receivables. The standard terms and conditions in the sale contract giving rise to the receivable (i.e., between Company XYZ and its customer) require that the customer receives prior written notification of the transfer before any proposed transfer of accounts receivable can take effect. Company XYZ engaged a nationally recognized bankruptcy law firm to issue a true-sale-at-law opinion related to Company XYZ s proposed securitization to satisfy the criteria in paragraph ASC (a). The true-sale-at-law opinion includes the following language under the heading Assumptions of Fact: We have assumed that there are no agreements to which Company XYZ is a party or by which it is bound prohibiting, restricting or conditioning the sale or assignment of any asset other than such required consents or notices as have been obtained and given. Analysis: True-sale-at-law opinions commonly contain an assumption (such as the above) that the seller has issued all of the applicable customer notifications necessary to effect a sale of the receivables. Thus, for the legal opinion to be valid, Company XYZ must have, in fact, issued all the requisite customer notifications. If the assumption made in the legal opinion is not consistent with the facts as of the opinion s date, it would be inappropriate to place reliance on the opinion until such time as the assumption in question is consistent with the facts. Limitations and qualifications: A lawyer frequently will cite various limitations and qualifications with respect to the opinion rendered. If not clear, management should ascertain from the attorney the reasons for these limitations and qualifications, and their potential implications for the opinion. Management must conclude that these items do not call into question the sufficiency of the opinion and do not compromise the would level assurance otherwise expressed (and required) to support the legal isolation assertion Consideration of legal isolation when multiple entities within the consolidated group have continuing involvement with the transferred financial assets The analysis of legal isolation can be challenging when various entities within the consolidated group have continuing involvement with transferred assets. This analysis can be further complicated if the entities involved with the transfer are domiciled in multiple countries, and thus are subject to different legal regimes regarding matters of 2-22 PwC

76 Control criteria for transfers of financial assets revised March 2016 contract law and bankruptcy. The following fact patterns may introduce incremental complexity into the legal evaluation: The transferor and transferee are subject to different jurisdictions (bankruptcy regimes), stemming from being organized and domiciled in different countries The jurisdictions/countries in which the transferred financial assets originated differ from those of the transferor The consolidated group s continuing involvement with transferred financial assets is accomplished through entities other than the transferor, and those entities are subject to different legal jurisdictions The laws intended to govern the transfer (contract law) are not the same as those of the country in which the transferor is organized/domiciled The legal evidence for these types of transactions may require obtaining legal opinions from multiple law firms, each with expertise in the relevant jurisdiction. Expertise with respect to understanding the implications of the interaction amongst jurisdictions and concluding which laws and jurisdictions govern the various entities involved with a transfer may also be required. Chapter 7 further discusses legal opinions in foreign jurisdictions. See Figure 2-4 and Figure 2-5 below for the types of opinions that may need to be obtained for the different legal entities within a consolidated group that intends to report a transfer of financial assets as a sale. Figure 2-4 Legal opinions to be obtained by entities under common control subject to the U.S. Bankruptcy Code PwC 2-23

77 Control criteria for transfers of financial assets revised March 2016 Figure 2-5 Legal opinions to be obtained by entities under common control subject to multiple legal jurisdictions As shown in Figure 2-4, we believe that multiple legal opinions may be required when a transfer of financial assets involves various members of a consolidated group and management asserts that the legal isolation criterion in ASC (a) has been met not only in the context of the separate financial statements of the seller but also in the consolidated financial statements that include the seller and other entities involved with the transferred assets. In these circumstances, there must be sufficient legal evidence to conclude that a court charged with adjudicating the bankruptcy of the parent company would hold that the assets transferred by a subsidiary would not be considered the property of the bankruptcy estate of the parent and its subsidiaries, other than those subsidiaries intended to be bankruptcy-remote, taking into account the various forms of involvement by those subsidiaries with the transferred assets. When a transferor subsidiary is domiciled outside the U.S and is subject to laws of a foreign jurisdiction, but the parent or ultimate parent is subject to the laws of the U.S., we believe that U.S. entities should seek legal advice and consider obtaining the opinions highlighted in Figure 2-5 above. At the consolidated level, the legal isolation assertion should consider the continuing involvement of all consolidated affiliates with the transferred assets. As such, opinion(s) obtained to support legal isolation for purposes of the standalone financial statements of the transferor foreign subsidiary may need to be augmented by additional legal analyses that address relevant U.S. laws, particularly when other consolidated affiliates were previously involved with the transferred assets, or have continuing involvement with them post-transfer PwC

78 Control criteria for transfers of financial assets revised March 2016 Using the example in Figure 2-5, a legal isolation opinion should be obtained that considers both the continuing involvement resulting from the financial asset transfer between Subsidiary A and the SPE, as well as the interest rate swap agreement entered into between Subsidiary B and the SPE. This assumes that the SPE would not be consolidated by the consolidated group per the guidance in ASC 810, and that nonconsolidation legal opinions are also obtained How the two-step securitization structure meets the isolation requirement In many instances, a key motivation of the typical securitization transaction is to achieve a lower cost of funding. The credit risk in the securities issued to third parties (beneficial interests) directly affects the interest rate that the securities must pay to attract investors. A reduction in the credit risk to all or certain of those investors can take the form of credit enhancement to the assets through a third-party guarantee, subordinating the claims of certain investors to the underlying assets cash flows to other (senior) investors, or both. Further, investors do not want exposure to the credit risk of the securitization s sponsor/transferor; if this risk is deemed to exist, investors may demand a higher interest rate to compensate them for such risk. Therefore, to facilitate the execution of securitization transactions at the lowest possible funding cost, a structure called the two-step securitization has been developed in the marketplace. A two-step securitization structure is summarized in Chapter 1 (refer to TS 1.6). As noted in ASC , the two-step securitization structure, taken as a whole, is generally judged under present U.S. law to have successfully isolated the transferred assets beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. In two-step securitization transactions, the key considerations in assessing isolation are whether, relative to the first step: the transfer of the financial assets by the seller(s) to an affiliate or wholly-owned subsidiary (the BRE) would be considered a true sale at law; and, the BRE would not be required to be substantively consolidated into the sellerparent in the event of the latter s bankruptcy. The first step in the structure is required to be a true sale at law for the transferred financial assets to be isolated from the transferor. Typically, the BRE s subsequent transfer of the assets to the securitization trust or other legal vehicle would not be upheld as a true sale at law, as the BRE frequently provides credit or yield protection to the trust s third-party investors (say, by retaining the trust s subordinated notes). Consequently, in the event of the BRE s bankruptcy, the bankruptcy receiver could, in theory, reclaim the transferred financial assets and recharacterize the exchange between the BRE and the trust as a financing. However, by design, a BRE has a remote possibility of entering into bankruptcy, either by itself or by substantive consolidation in the event of bankruptcy by its parent. The BRE has a single purpose: to make it extremely difficult for a bankruptcy receiver or court to reclaim the transferred assets. PwC 2-25

79 Control criteria for transfers of financial assets revised March 2016 Because the true sale opinion addresses only the first step in most of these transactions, frequently there is no corresponding legal analysis that may be leveraged when evaluating whether the second step transfer (that is, the exchange between the BRE and securitization trust or third-party transferee) involves an entire financial asset (or group of such assets) or, conversely, a portion of a financial asset subject to the participating interest definition. Entities should focus on the legal form of the asset (interest) sold by the BRE, and what rights that asset conveys to the transferee, when evaluating whether an entire financial asset, or only a portion, has been transferred in the second step. If only a portion has been exchanged, the participating interest guidance in ASC A must be considered first in connection with the overall sale accounting evaluation Special considerations for transferors subject to FDIC receivership The FDIC originally adopted a Securitization Rule in 2000 to provide comfort that loans or other financial assets transferred by an insured depository institution ( IDI ) into a securitization trust or participation arrangement would be legally isolated from an FDIC conservatorship or receivership if, among other requirements, the transfer met all conditions for sale accounting treatment under GAAP. Assuming, therefore, that a transfer qualified for sale accounting, investors and credit rating agencies were assured that the securitized or participated assets would not be reclaimed by the FDIC in the event of the IDI s conservatorship or receivership. As a result of amendments to ASC 810 and ASC 860 issued in 2009, the FDIC adopted a new Securitization rule (the Rule ) amending the regulations that define the safe harbor protections for treatment by the FDIC as conservator or receiver of financial assets transferred by an FDIC IDI in connection with both participation or securitization activity. The Rule was effective September 30, The Rule stipulates a broad array of conditions relating to the transaction s terms and provisions that first must be satisfied for the transfer to qualify for any safe harbor protection ( Conditions ). The Rule also clarifies the application of the safe harbor to securitization and participation transactions that meet the criteria for sale accounting, as well as to those transfers that do not result in derecognition on the part of the sponsoring IDI. Scope of the Rule Assuming that a securitization or participation transaction meets the required Conditions applicable to it, the Rule provides full safe harbor protection to the underlying transferred financial assets: Participations are covered to the extent they would have otherwise met the sale accounting criteria. Securitizations completed after December 31, 2010, whose assets qualify for derecognition from the IDI s balance sheet (that is, the securitization entity is not required to be consolidated by the sponsor/transfer under ASC 810, and the transfer qualifies for sale accounting under ASC 860 guidance) PwC

80 Control criteria for transfers of financial assets revised March 2016 Securitizations completed after December 31, 2010, that do not result in derecognition of the underlying securitized assets are entitled to limited protection under the Rule. In these instances, the FDIC has not waived its power to regain control of the transferred assets. However, under the Rule, the FDIC is obligated to provide relief to investors should this occur. The FDIC is obligated to pay damages to the securitization entity s creditors (full payment of remaining outstanding par balances and accrued interest) if securitization is repudiated and its assets clawed back. If FDIC fails to perform after receivership (i.e., triggers monetary default under the terms of the securitization), the securitization s creditors can exercise prompt selfremedies, including taking possession of the financial assets. Transfers of financial assets excluded from the Rule include: Participations and or securitizations for which transfers of financial assets were made on or before December 31, Obligations of revolving or master trusts subject to the former Safe Harbor Rule if the trust was established prior to effective date of the Rule and if the trust had issued obligations, including obligations under open commitments (up to the maximum of such open commitments), prior to the effective date of the Rule. Transfers of financial assets that are not in the form of a participation or a securitization. In leveraging the audit guidance in AU 9336, management can choose between two alternate forms of legal opinions that provide acceptable isolation assurance with respect to transfers of financial assets by transferors subject to receivership or conservatorship under the provisions of the Federal Deposit Insurance Act. Either a true sale opinion similar to opinions provided to non-fdic insured transferors, or an opinion addressing isolation both prior to the appointment of the FDIC as a receiver and following the appointment of the FDIC as receiver, may be obtained. Additionally, the legal opinion must address the doctrine of substantive consolidation when the entity to which the financial assets are transferred is an affiliate of the IDI (e.g., to a BRE in a two-step transaction) and in other situations as noted by a legal specialist. In all cases, the laws of the appropriate jurisdiction(s) should be considered Does the transferee have the right to pledge or exchange the financial assets it has received? The second criterion that must be met for a transaction to qualify for sale accounting requires the transferee to obtain the right to freely pledge or exchange the transferred assets. Specifically: 4 See TS for examples of a true sale opinion and a substantive consolidation opinion appropriate in these circumstances. PwC 2-27

81 Control criteria for transfers of financial assets revised March 2016 Excerpt from ASC (b) This condition is met if both of the following conditions are met: 1. Each transferee (or, if the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities and that entity is constrained from pledging or exchanging the assets it receives, each third-party holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received. 2. No condition does both of the following: i. Constrains the transferee (or third-party holder of its beneficial interests) from taking advantage of its right to pledge or exchange ii. Provides more than a trivial benefit to the transferor (see paragraphs through 40-21). If the transferor, its consolidated affiliates included in the financial statements being presented, and its agents have no continuing involvement with the transferred financial assets, the condition under paragraph (b) is met. Upon consummation of a transfer, the transferor and transferee must determine whether, in fact, the transferee (or, if the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities and that entity is constrained from pledging or exchanging the assets it receives, each third-party holder of its beneficial interests) is able to freely pledge or exchange the assets (or beneficial interests). If the transferee (or holder) is not constrained from doing so, then the criterion is met. Conversely, if the transferee (or holder) is constrained by the transferor, consolidated affiliate, or an unaffiliated agent, and that constraint provides more than a trivial benefit to the transferor, sale treatment for the transfer would be precluded. If the transferee entity s sole purpose is to engage in securitization or asset-backed financing activities, the sale accounting analysis considers the ability of the transferee s third-party beneficial interest holders to pledge or exchange their interests. This ability to look through the transferee entity acknowledges that securitization trusts and similar asset-backed financing entities must pledge the acquired financial assets coincident with their acquisition to protect the interests of the transferee s beneficial interest holders, and may not freely dispose of or sell the assets while those interests remain outstanding. In these circumstances, the beneficial interests held by third-party investors are considered surrogates for the transferred assets themselves, and thus those beneficial interests serve as the unit of analysis or point of reference when applying ASC (b). However, depending on the nature and extent of the transferor s involvement with the securitization entity (which will likely be a VIE), the transferor may be required to consolidate it under ASC 810. Figure 2-6 below displays a decision tree illustrating one approach to determining whether the conditions in paragraph ASC (b) are met PwC

82 Control criteria for transfers of financial assets revised March 2016 Figure 2-6 Ability of transferee to pledge or exchange the transferred financial assets The determination of whether the transferee controls transferred financial assets (that is, has the ability to exchange or pledge them) or whether the transferor receives more than a trivial benefit from a constraint should be made from the perspective of the transferor. Whether the transferee is aware of an indirect benefit is irrelevant. The relevant question is: If the transferor is aware of the benefit, how should it evaluate the constraint to determine whether it has received more than a trivial benefit? For example, Company A transfers $100 of financial assets to Company B with the provision that Company A must approve any subsequent transfer of the financial assets by Company B. The approval provision should be analyzed from Company A s perspective to determine whether Company A has received more than a trivial benefit from the approval provision Constraints on pledging or exchanging financial assets or beneficial interests The determination of whether a transferee (or holder) controls a financial asset (or beneficial interest) is based on the transferee s ability to obtain all or most of the cash inflows associated with that financial asset, either by exchanging it or pledging it as collateral. The emphasis is on the ability to obtain all or most of the cash inflows, which are the primary economic benefit of a financial asset (or beneficial interest), not on the method of doing so (i.e., exchanging it or pledging it as collateral). While the guidance states that each third-party holder of the beneficial interests must have the right to pledge or exchange the assets, we do not believe that such requirement is intended to imply that a third party beneficial interest holder must exist. For example, we believe that a transfer of financial assets to a guaranteed PwC 2-29

83 Control criteria for transfers of financial assets revised March 2016 mortgage securitization entity whereby the transferor obtains 100 percent of the resulting securities may still meet this criterion. Constraints on a transferee s (or holder s) contractual right to pledge or exchange transferred financial assets may be explicitly imposed by the transfer documents or they may be inherent to the market or industry in which the assets reside. Examples include regulatory constraints (e.g., government regulations allowing only qualified parties to hold particular assets) or market restrictions (e.g., limited competition or demand for the product). Transfer restrictions can be explicit or implicit. For example, the legal documents supporting the transfer of financial assets may explicitly prohibit the transferee from subsequently selling those financial assets. However, certain transfers may be accompanied by a provision that gives the transferee the right to put (option to sell) specified assets back to the transferor at a fixed price. Such a provision may implicitly constrain the transferee from transferring the assets to a third party if there is a limited market for this type of asset or the put option is deep in-the-money, as this may create an economic incentive for the transferee to exercise the put. 5 Whether conditional or contingent call options constrain a transferee must be carefully evaluated. Constraints on the transferee that provide more than a trivial benefit to the transferor would preclude sale accounting on the basis that the transfer would fail the criterion in ASC (b). Generally, where conditional or contingent calls are involved in the transaction, the criterion in ASC (c) may be satisfied if the underlying event is not certain to occur and is outside the control of the transferor. However, once the condition or contingency is met or occurs, the provisions of the call would need to be reanalyzed to determine whether the transferor has regained effective control over the transferred asset. In contrast, an unrestricted (non-conditional) call generally precludes sale accounting (refer to TS 2.4 for more details on effective control considerations). Examples of conditions that both constrain the transferee and presumptively provide more than a trivial benefit to the transferor 6 include: Prohibition of the transferee s (or holder s) subsequent selling of the financial assets (or beneficial interests) Prohibition of the sale of the financial assets by the transferee to a competitor of the transferor, if that competitor is the only willing buyer for the type of asset concerned Transferor-imposed constraints narrowly limiting timing or terms (e.g., allowing a transferee to pledge assets only on the first day or only on terms agreed with the transferor) 5 As discussed in TS 2.4, in certain circumstances, a deep-in-money put written by a transferor to a transferee may cause the transferor to retain effective control over the underlying transferred asset. 6 TS discusses application of the more than trivial benefit criterion PwC

84 Control criteria for transfers of financial assets revised March 2016 Call option written by a transferee to the transferor on transferred assets not readily obtainable (this constrains a transferee because it might default if the call is exercised and it has previously exchanged or pledged the assets) Restrictions related to the terms of the asset (e.g., customer must consent to the subsequent transfers of its receivable) Right of transferor approval before any asset may be transferred by the transferee (unless contractually such approval cannot be unreasonably withheld) On the other hand, certain economic constraints, such as a transferee (or holder) incurring a significant tax liability upon sale of the assets (or beneficial interests), are not considered to preclude sale treatment. These types of constraints are beyond the control of the transferor. Generally, the following transferor-imposed or other conditions, in isolation, would not preclude sales treatment: Transferor s right of first refusal in response to a bona fide offer from a third party Requirement to obtain the transferor s permission to sell or pledge that is not to be unreasonably withheld Prohibition of sale to the transferor s competitor if other potential willing buyers exist (i.e., there is a sufficient population of potential buyers that are not competitors) A lack of liquidity or the absence of an active market Regulatory limitation such as on the number or nature of eligible transferees (e.g., securities issued under Securities Act Rule 144A or debt privately placed) Under ASC 860, most transferor-imposed constraints establish a presumption that the transfer fails the criterion of paragraph (b). As such, sale accounting is precluded because control has not passed to the transferee. The exceptions noted above do not, as a rule, effectively constrain a transferee from taking advantage of its rights and therefore do not preclude the related transfer from qualifying as a sale. All conditions should be considered collectively; the analysis should take into account all matters involving the transferee and the transferor, its consolidated affiliates in the financial statements being presented, and its agents. 7 Although a matter may not constrain the transferee (or holder) when considered individually, certain terms or conditions may constrain the transferee (or holder) when considered collectively. Ultimately, the analysis of the impact of conditions imposed by the transferor or by others should be specific to the facts and circumstances of the transaction. 7 If an agent is acting on behalf of a transferor, any transfer restrictions included in the transaction imposed by the agent would be considered a transferor-imposed constraint. If a more-than-trivial benefit is attributed to such constraint, then the transfer may fail the criterion in ASC (b). PwC 2-31

85 Control criteria for transfers of financial assets revised March 2016 Rights or obligations to reacquire transferred financial assets, regardless of whether they constrain the transferee, may result in the transferor s maintaining effective control over the transferred financial assets, as discussed in TS 2.4., thus precluding sale accounting under ASC (c) More than a trivial benefit If it is determined that the transferee (or holder) is constrained by either the transferor, its consolidated affiliates included in the financial statements being presented or an agent of the transferor, the next question is: does the constraint provide more than a trivial benefit to the transferor? The concept of more than a trivial benefit has not been defined, although a key condition in making such a determination is that the transferor is aware of the benefit. Generally, most restrictions imposed by the transferor would preclude sale treatment, as they would presumptively provide more than a trivial benefit to the transferor. For example, Company A transfers $100 of financial assets to Company B with the provision that Company A must approve any subsequent transfer of the financial assets by Company B. Company A is presumed to have gained more than a trivial benefit from the constraint on subsequent transfer of the assets. The fact that the transferor will always know who holds the financial asset (a prerequisite for repurchasing the financial asset) and its ability to block the financial asset from being transferred to a competitor will likely be sufficient to meet the more than trivial threshold. In practice, it is difficult to demonstrate that a transferor-imposed restriction is not providing a more-than-trivial benefit. All relevant facts and circumstances must be considered in assessing whether any constraints on the transferee (or holder) provide more than a trivial benefit to the transferor. The constraint is deemed to provide more than a trivial benefit, for example, if the transferee is constrained from selling or pledging the assets for any of the following reasons: Transferred financial assets are not readily obtainable and are subject to a call option written by the transferee to the transferor Transferor must approve the transfer of the assets Transferee is required to return the specific assets to the transferor upon the occurrence of a specific event that is within the transferor s control Transferee is required to return the specific assets upon request by the transferor Any of these constraints would preclude the condition in paragraph ASC (b) from being met and disqualify the transfer from sale treatment. Certain restrictions imposed by others may preclude sale treatment if such conditions restrict the transferee s ability to exchange or pledge the transferred assets. However, an other-than-transferor-imposed constraint does not preclude sale accounting if the 2-32 PwC

86 Control criteria for transfers of financial assets revised March 2016 transferor, its consolidated affiliates, or its agents (a) have no continuing involvement with the transferred financial assets, including servicing and recourse, or (b) are unaware of the constraint. For example, Company A transfers $100 of financial assets to Company B. Company B is subject to covenants in unrelated debt obligations under which it cannot sell the assets. Company A is unaware of the debt covenants. If Company A has no continuing involvement with the transferred financial assets, Company A does not receive a more-than-trivial benefit from the constraint. A transferor may be aware of a constraint, but if it (including its consolidated affiliates and agents) has no continuing involvement with the transferred financial assets, it cannot benefit from the constraint, and thus sale treatment is not precluded. As mentioned above, certain economic constraints, such as the transferee incurring a significant tax liability upon sale of the financial assets, are not considered to preclude sale treatment because constraints or disincentives of this type are beyond the transferor s control. 2.4 Has the transferor given up effective control over the transferred financial assets? The third criterion that must be met for a transaction to qualify for sale accounting states that the transferor may not maintain effective control over the transferred financial assets. Specifically: Excerpt from ASC (c) The transferor, its consolidated affiliates included in the financial statements being presented, or its agents do not maintain effective control over the transferred financial assets or third-party beneficial interests related to those transferred assets (see paragraph A). A transferor s effective control over the transferred financial assets includes, but is not limited to, any of the following: 1. An agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (see paragraphs through 40-27) 2. An agreement, other than through a cleanup call (see paragraphs through 40-39), that provides the transferor with both of the following: i. The unilateral ability to cause the holder to return specific financial assets ii. A more-than-trivial-benefit attributable to that ability. 3. An agreement that permits the transferee to require the transferor to repurchase the transferred financial assets at a price that is so favorable to the transferee that it is probable that the transferee will require the transferor to repurchase them (see paragraph D). PwC 2-33

87 Control criteria for transfers of financial assets revised March 2016 In evaluating the effective control criterion, the transferor must consider its continuing involvement with the transferred financial asset(s) or with third-party beneficial interests related to those transferred assets. This includes an assessment of a transferor s control over all or even a portion of the transferred financial asset or group of financial assets being evaluated for derecognition as a single unit. Under the current transfer accounting model, an entity may not account for a transfer of an entire financial asset or a participating interest in an entire financial asset partially as a sale and partially as a secured borrowing. Physically-settled call options on transferred financial assets held by the transferor warrant careful consideration when evaluating whether the transferor has, in fact, surrendered effective control over the transferred items. Figure 2-7 below summarizes how different physically settled options held by the transferor to reacquire an entire financial asset or a group of financial assets generally would be viewed under paragraph ASC (b) and 40-5(c) as part of the sale accounting evaluation. Figure 2-7 Evaluation of call options Type of option Eligible for sale accounting? A call option held by the transferor on the transferred financial assets that is for a fixed price on specified assets generally provides the transferor with a more-thantrivial benefit. However, if the call option is so far out of the money or for other reasons it is probable when the option is written that the transferor will not exercise it, the transferor does not receive a more-than-trivial benefit and, as such, sale accounting is not precluded. See TS Unconditional fixed-price call option attached to transferred entire financial assets or groups of transferred entire financial assets: On all transferred financial assets On a portion of an individual transferred asset (e.g., if the remaining principal balance reaches 20 percent of the original balance), and the arrangement does not qualify as a clean up call. Conditional call option (contingency not within the control of the transferor) No, because the transferor can unilaterally cause the holder to return the transferred financial assets and the call s fixed price provides a more-than-trivial benefit No; a call that gives the transferor the ability to unilaterally cause whomever holds a transferred financial asset to return the remaining portion of the financial asset precludes sale accounting for the entire financial asset Yes, but reassess as an unconditional call option when the condition is resolved 2-34 PwC

88 Control criteria for transfers of financial assets revised March 2016 Type of option Eligible for sale accounting? 2. Unconditional fixed-price call option attached to a transferred group of entire financial assets: On certain specified assets within a group of transferred assets, and the transferor can reclaim (call) the specific assets at any time On a portion of a group of transferred assets and the transferor cannot choose the assets Yes; however, assets subject to the call option are not eligible for sale accounting (said differently, if a transferor holds a call option to repurchase at any time a few specified individual loans from an entire portfolio of transferred loans, sale accounting is precluded only for the specified loans subject to the call, not the whole portfolio) Yes, if the ability to randomly remove assets is sufficiently limited and the transferor cannot remove specific assets 3. Unconditional fixed-price call option embedded in transferred entire financial assets or beneficial interests therein: Embedded by issuer of assets Embedded in beneficial interests Yes, because it is the issuer that holds the call, not the transferor, and thus the call does not provide the transferor with a more-than-trivial benefit In effect this is an attached call on the underlying transferred financial asset (see guidance above) 4. Unconditional freestanding fixed-price call option on transferred entire financial assets or groups of transferred entire financial assets: On assets readily obtainable On assets not readily obtainable Conditional call option No, because the call s fixed price provides a more-than-trivial benefit to the transferor No, because it provides the transferor with a more-than-trivial benefit by giving the transferor the ability to obtain assets not readily obtainable in the marketplace Yes, but reassess as an unconditional call option when the condition is resolved PwC 2-35

89 Control criteria for transfers of financial assets revised March 2016 Type of option Eligible for sale accounting? 5. Removal of accounts provisions (ROAPs) on transferred entire financial assets or groups of transferred entire financial assets: These provisions, which allow the transferor to reacquire the financial assets when an event occurs, such as default, and clean-up call options, which allow the transferor to reacquire the remaining financial assets or beneficial interests if the amount outstanding falls to a level where the costs of servicing become burdensome, generally do not preclude sale accounting. Unconditional Conditional (the transferor does not have the unilateral right to exercise) Cleanup call option Analyze as if it is either an attached or freestanding unconditional call option Yes, but reassess as an unconditional call option when the condition is resolved Yes, if the option meets the definition of a cleanup call in ASC Call option at fair value on entire financial assets or groups of entire financial assets: On assets readily obtainable On assets not readily obtainable Generally yes, as it does not convey a more-than-trivial benefit to the transferor. However, if the transferor holds a residual interest in the securitized financial assets, the call will likely provide a more-thantrivial benefit No, because it provides the transferor with a more-than-trivial benefit by giving the transferor the ability to obtain assets not readily obtainable in the marketplace Judgment is required to assess whether the transferor maintains effective control over transferred financial assets or third-party beneficial interests. The assessment must include an evaluation of multiple arrangements, which in combination might result in the transferor, its consolidated affiliates or its agents, maintaining effective control. It also must consider the control that can be exercised through the retention of thirdparty beneficial interests in the transferred assets. When assessing effective control, the transferor should only consider the involvement of an agent when the agent is acting on the transferor s behalf. That is, if the same agent is acting on behalf of both the transferor and transferee, only the involvement of the agent when acting on behalf of the transferor should be considered. ASC A includes an example of a scenario in which an investment manager (agent) acts in a fiduciary capacity on behalf of both the transferor and transferee, and states that only the investment manager s involvement when acting on the transferor s behalf should be considered in the sale accounting analysis PwC

90 Control criteria for transfers of financial assets revised March Agreements to repurchase or redeem the transferred financial assets If the transferor has the right to repurchase, redeem, or unilaterally require the holder to return the assets, it is considered to have retained effective control over the transferred financial assets and, as such, sale accounting would be precluded. The excerpts below describe the circumstances when a transfer would fail the effective control condition in paragraph ASC (c) through an agreement of the type described in ASC (c)(1). In that case, the transfer should be accounted for as a secured borrowing: Excerpt from ASC An agreement that both entitles and obligates the transferor to repurchase or redeem transferred financial assets from the transferee maintains the transferor s effective control over those assets as described in paragraph (c)(1), if all of the following conditions are met: a. The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred. To be substantially the same, the financial asset that was transferred and the financial asset that is to be repurchased or redeemed need to have all of the following characteristics: 1. The same primary obligor (except for debt guaranteed by a sovereign government, central bank, government-sponsored enterprise or agency thereof, in which circumstance the guarantor and the terms of the guarantee must be the same 2. Identical form and type so as to provide the same risks and rights 3. The same maturity (or in the circumstance of mortgage-backed pass-through and pay-through securities, similar remaining weighted-average maturities that result in approximately the same market yield) 4. Identical contractual interest rates 5. Similar assets as collateral 6. The same aggregate unpaid principal amount or principal amounts within accepted good delivery standards for the type of security involved. Participants in the mortgage-backed securities market have established parameters for what is considered acceptable delivery. These specific standards are defined by the Securities Industry and Financial Markets Association and can be found in Uniform Practices for the Clearance and Settlement of Mortgage-Backed Securities and Other Related Securities, which is published by the Securities Industry and Financial Markets Association. PwC 2-37

91 Control criteria for transfers of financial assets revised March 2016 See paragraph for implementation guidance related to these conditions. b. Subparagraph superseded by Accounting Standards Update No c. The agreement is to repurchase or redeem the financial assets before maturity, at a fixed or determinable price. d. The agreement is entered into contemporaneously with, or in contemplation of, the transfer. ASC A states that a repurchase-to-maturity transaction should be accounted for as a secured borrowing as if the transferor maintains effective control over the underlying financial assets. See TS 4.1 for additional information. Excerpt from ASC With respect to the condition in (a) in paragraph to maintain effective control under the condition in paragraph (c) as illustrated in paragraph (c)(1), the transferor must have both the contractual right and the contractual obligation to repurchase or redeem financial assets that are identical to those transferred or substantially the same as those concurrently transferred. Transfers that include only the right to reacquire, at the option of the transferor or upon certain conditions, or only the obligation to reacquire, at the option of the transferee or upon certain conditions, may not maintain the transferor's control, because the option might not be exercised or the conditions might not occur. Similarly, expectations of reacquiring the same securities without any contractual commitments (for example, as in wash sales) provide no control over the transferred securities. In connection with a borrowing transaction, a debtor may grant to a lender (the secured party) a security interest in certain financial assets to serve as collateral for its obligation. In these collateralized borrowing arrangements, it is not uncommon for the secured parties to have the ability to sell or re-pledge the collateral that has been pledged by the borrower. ASC 860 contains guidelines for assessing whether the transferor has maintained effective control over the transferred financial assets through the agreement to repurchase. See TS 4 for a discussion of the accounting for repurchase agreements, dollar rolls, and securities lending transactions Ability to unilaterally cause the return of specific transferred financial assets The transferor, its consolidated affiliates included in the financial statements being presented, or its agents cannot have the unilateral ability to cause the holder to return specific financial assets and a more-than-trivial benefit attributable to that ability, other than through a cleanup call (as that term is defined). This unilateral ability generally results from the transferor having the right to reacquire transferred financial 2-38 PwC

92 Control criteria for transfers of financial assets revised March 2016 assets (or to acquire beneficial interests in transferred assets held by an SPE). Generally, such a right would be in the form of a call attached to the transferred financial assets. It is important to note that assessing the sale accounting implications of an option or similar right to reacquire transferred financial assets does not hinge on whether the transferor intends to exercise that option or right. The simple existence of the transferor s right to acquire transferred assets may constitute effective control, not the exercise of those rights. The assessment of the implications of a right to cause the return of a transferred asset must also consider whether that right provides the transferor with more-than-atrivial benefit. As discussed in TS 2.3.2, this concept also must be considered in connection with evaluating the ability to freely pledge or exchange condition in ASC (b). As noted there, the threshold beyond which a benefit is deemed to be more than trivial is not defined; in practice, it may be difficult to demonstrate that a transferor-imposed restriction is not providing a more-than-trivial benefit. We believe that this presumption may also be true when evaluating whether a contractual provision provides the transferor with effective control. An exception to the foregoing presumption is cited in ASC , which affirms that a call option to reacquire readily obtainable assets at their current fair value does not provide the transferor with a more-than-trivial benefit. Conversely, a fixed-price call option held by the transferor that allows it to reacquire specific transferred financial assets should be presumed to provide a more-than-trivial benefit. However, if the call option is so far out of the money that it is probable when the option is written that the transferor will not exercise the call, ASC (a) indicates that the transferor does not receive a more-than-trivial benefit from the arrangement -- and thus the option does not preclude sale accounting. A fair value call may also be considered a form of effective control when the transferor holds a residual beneficial interest in the transferred financial assets or other rights to trigger the call. For example, the right to purchase the assets upon the liquidation of a securitization entity or the termination of a lease contract in which the transferor owns the underlying asset would constitute effective control. In this case, regardless of the repurchase price paid, the transferor has the ability to recoup its investment through the residual interest that it holds in the underlying financial assets. ASC clarifies that a call option embedded in a transferred financial asset should not be considered to convey effective control to the transferor: Excerpt from ASC An embedded call option would not result in the transferor s maintaining effective control because it is the issuer rather than the transferor who holds the call option and the call option does not provide more than a trivial benefit to the transferor. For example, a call embedded by the issuer of a callable bond or the borrower of a prepayable mortgage loan would not provide the transferor with effective control over the transferred financial asset. PwC 2-39

93 Control criteria for transfers of financial assets revised March 2016 In evaluating whether the transferor has effective control, the central question is whether the transferor or its consolidated affiliates or agents has the ability to initiate the call on one or more specific assets unilaterally or, conversely, whether the call becomes exercisable only in response to a specified future event outside of the transferor s control that is not certain to occur. If the call is not attached to specific transferred assets but instead consists of a freestanding fair-value call whose underlying is an asset similar to the transferred asset that is readily obtainable in the marketplace, the transferor has not maintained effective control over the transferred financial assets and sale treatment is appropriate if the other criteria in ASC 860 are met. A removal of accounts provision and a cleanup call are examples of provisions that allow for the return of financial assets to the transferor. Depending on the specific facts and circumstances of such provisions, the transferor may maintain effective control over the transferred financial assets and, if so, the transfer would not qualify for sale accounting. Removal-of-accounts provisions Removal-of-accounts provisions (ROAPs) allow the transferor to reclaim assets previously transferred. The transferor is considered to have maintained effective control (thus precluding sale accounting) if the ROAP allows the transferor to remove specific financial assets at its discretion. For example, Company A transfers financial assets to Company B and retains the right to replace one of the transferred financial assets with another similar asset. If the financial asset being replaced is chosen at the discretion of Company A (i.e., is not based on a contingent, pre-defined event or is not randomly selected) and such a provision provides a more than-trivial benefit to the transferor, Company A maintains effective control over all of the financial assets transferred. Accordingly, none of the transferred financial assets would be derecognized at the time of transfer because no transferred financial asset is beyond the reach of the transferor. When the right to reclaim transferred assets is contingent upon a third-party action or an event that is outside the control of the transferor and has not yet occurred (e.g., a default), the right is not considered to convey effective control to the transferor. In that case, the transfer could be accounted for as a sale, as long as other sale criteria are met. However, once the third-party action or event has occurred and the contingency that permits a transferor to unilaterally reclaim the transferred assets has occurred, the transferor must again recognize these assets, regardless of whether the ROAP is exercised or not, because at that point the transferor regains effective control over the previously transferred financial assets. Although the assets should be recognized, they should not be recombined with the transferor s servicing rights or other interests, as stated in ASC (refer to TS 3.4 for further discussion of the accounting for ROAPs). For example, Company A transfers financial assets to Company B in a transaction that would qualify as a sale. Company A has the right to remove specific assets in the event that a third party cancels a contract with Company B. Provided that the third party has not cancelled its contract with Company B, Company A would be considered to have given up effective control over the financial assets and thus should account for the 2-40 PwC

94 Control criteria for transfers of financial assets revised March 2016 transfer as a sale. However, if the third party cancels its contract with Company B, Company A would have regained effective control over the transferred financial assets and, accordingly, should re-recognize the assets at fair value at that time. Since the contingency has been met, Company A has the unilateral ability to remove the specific assets and, therefore, is deemed to have regained effective control. Cleanup calls The right of the servicer or its affiliates, which may be the transferor, to invoke a cleanup call (as defined) is not considered an arrangement that permits the servicer to maintain effective control over the assets transferred. Therefore, transferred assets subject to a cleanup call may qualify for derecognition, provided the other sale accounting requirements are met. Cleanup calls are an exception to the general rule that a call option exercisable solely due to the passage of time provides the transferor with effective control. A cleanup call confers effective control only when it enables the servicer to call more than a de minimis level of outstanding assets or beneficial interests. The de minimis level is deemed to be the level of outstanding assets or beneficial interests below which the cost of servicing those assets or interests becomes burdensome in relation to benefits of servicing. The point at which servicing costs become burdensome is not specifically addressed by ASC 860. In practice, a cleanup call that first becomes exercisable when the remaining aggregate outstanding principal balance of the serviced loans (or beneficial interests) represents 10% or less of the aggregate principal balance of the loans (or beneficial interests) at the transfer date is generally considered to meet the burdensome condition. However, the specific facts and circumstances of a transaction may suggest that a lower (or higher) threshold is appropriate. Parties other than the servicer or its affiliates cannot be considered to hold a cleanup call (as defined). Only a servicer suffers the consequences when the outstanding assets (or beneficial interests) fall or amortize to a level at which the cost of servicing becomes burdensome -- the definition of a cleanup call -- and any other party would be motivated by some other incentive in exercising a call. For example, consider a transaction in which two subsidiaries (A and B), each directly owned by the same parent, Company A, are involved in a transfer. Subsidiary A transfers financial assets to SPE X, a securitization entity that neither Company A nor its subsidiaries is required to consolidate. Subsidiary B obtains the servicing rights to the transferred assets. In addition, Subsidiary A has the right to purchase all, but not less than all, of the transferred assets when their outstanding aggregate balance falls below 10 percent of their aggregate balance at the transfer date. Subsidiary B has determined that its servicing costs become burdensome when 10 percent of the assets remain outstanding. This cleanup call arrangement does not cause Company A to maintain effective control of the transferred financial assets in its consolidated financial statements. Even though Subsidiary B is not consolidated by Subsidiary A, Subsidiary B is an affiliate of Subsidiary A. Under the cleanup call definition, provided the holder of the cleanup call is an affiliate of the servicer (a threshold lower than consolidated PwC 2-41

95 Control criteria for transfers of financial assets revised March 2016 affiliate), the call may be considered a cleanup call for transfer accounting purposes. In this example, the call meets the definition of a cleanup call for purposes of the separate stand-alone financial statements of Subsidiary A. Similarly, in the consolidated financial statements of Company A, the call option would also meet the definition of a cleanup call and would not preclude sale accounting. In the event that the option is set at a threshold at which the cost to service the financial assets is not burdensome in relation to the benefits of servicing, the call option would not meet the definition of a cleanup call. Such a call option precludes sale accounting for the transferred financial assets. For example, assume that Company A transfers a pool of whole loans to Company B and retains servicing. Company A has the right to purchase all, but not less than all, of the transferred loans at any time after the unamortized principal balance of the pool falls below 20 percent of the pool s balance at the transfer date. The cost of servicing is considered burdensome only when the pool balance amortizes down to 5 percent of its transferdate balance. As such, the call does not meet ASC 860 s definition of a cleanup call, and therefore is considered an option that allows Company A to maintain effective control over the transferred loans. The parties should report the transfer as a secured borrowing; sale accounting would be inappropriate in these circumstances Ability of transferee to require the transferor to repurchase at a favorable price As a general rule, a put option held by (written to) a transferee does not provide the transferor with effective control over the underlying transferred financial asset. An exception to this presumption is described in ASC (c)(3) and re-affirmed in ASC D(b). According to the guidance in those paragraphs, a transferor is considered to maintain effective control over a transferred financial asset through an agreement that permits the transferee to require the transferor to repurchase the transferred financial asset at a price that is so favorable to the transferee (at the date of the transfer) that it is probable that the transferee will require the transferor to repurchase it. This conclusion is consistent with the decision principle in ASC previously mentioned; namely, that all arrangements or agreements made with respect to transferred financial assets must be considered when evaluating whether, in fact, the transferor has surrendered control those assets. The following conditions, in isolation, would not preclude sale treatment under ASC (c)(3): Put options written by the transferor to reacquire transferred assets (or beneficial interests from the transferee) at fair value A deep out-of-the-money call option held by the transferor, if it is probable (based on an assessment at the time the option is written) that the option will not be exercised Other changes that result in the transferor regaining control of assets sold A change in law, regulation, or other circumstance may result in a transferred portion of an entire financial asset no longer meeting the conditions of a participating interest 2-42 PwC

96 Control criteria for transfers of financial assets revised March 2016 or the transferor regaining control over transferred financial assets previously recorded as a sale. If any such change occurs, the transferor is required to record the transferred assets in its statement of financial position in a manner similar to a fair value purchase and recognize a liability for the same amount. The accounting for changes that result in the transferor regaining control over transferred financial assets is further discussed in ASC through (refer to TS 3.4 for more details on the accounting for re-recognition of transferred financial assets). If a transferor subsequently consolidates an entity involved in a transfer that was previously accounted for as a sale, it is required to account for the consolidation in accordance with the applicable guidance in ASC 810. As noted above, whether the transferor exercises or intends to exercise its rights to reacquire transferred assets is irrelevant. Effective control stems from the existence of the transferor s right to re-acquire specific assets, not the exercise of those rights. For example, if the transferor has the right to repurchase a transferred receivable at a fixed price in the event the underlying obligor defaults, the transferor may recognize a sale (as long as the other sale requirements were met) at the date of the exchange. However, if the obligor subsequently defaults, the transferor must re-recognize the receivable and record a related liability as it now has the right to re-acquire the receivable, regardless of whether it intends to exercise that right. Another example is a right of first refusal with respect to a transferred financial asset. The transferor can only exercise this right in the event that an independent party makes an offer to acquire the asset from the transferee. However, once such an offer is extended, the call option becomes exercisable and, at that point, its terms and the characteristics of the underlying asset must be evaluated to determine if more-than-atrivial benefit now inures to the transferor. However, as noted above, it would be rare to conclude that a unilaterally-exercisable option does not provide the transferor with a more-than-trivial benefit. See TS for a discussion of the more-than-a-trivial benefit concept. The evaluation of contingent provisions should also be made from the perspective of the transferee. All the benefits it may realize or the risks it may be exposed to both before and after the call becomes exercisable should be carefully considered. Even if the transferee is not aware of a regulation or other provision that may affect the asset, that lack of information does not exclude the transferor from assessing those circumstances, as they may impact the transferor s ability to control the financial asset. 2.5 Chapter wrap-up The accounting and reporting requirements of ASC 860 are based on the notion of control. Transferred financial assets are considered sold if the transferor no longer controls the assets; if the transferor retains control, the exchange is deemed a secured borrowing arrangement and would be accounted for as such. A transferor has relinquished control over financial assets if the transfer meets three criteria: (1) the transferred financial assets are beyond the reach of the transferor, its consolidated affiliates or agents, and its creditors, even in bankruptcy or receivership, (2) the transferee has the right to freely pledge or exchange the financial assets (or, in some PwC 2-43

97 Control criteria for transfers of financial assets revised March 2016 instances, holders of beneficial interests in those assets may have the right to freely pledge or exchange their interests), and (3) the transferor, its consolidated affiliates or agents does not maintain effective control of the transferred financial assets (or third party beneficial interests in those assets). In practice, concluding whether a transfer meets all three of the sale accounting criteria may prove difficult. For example, a complete legal analysis of the transaction that considers all forms of involvement by the transferor and its consolidated affiliates with the transferred assets must be performed to determine whether the transferred financial assets are isolated from the transferor, its consolidated affiliates, and its creditors. All contemporaneous arrangements, and arrangements made in contemplation of the transfer, must be taken into account as part of this evaluation. Lawyers often need to be involved in the process to determine whether the transaction meets the legal isolation criterion. Legal letters must be received and analyzed, and careful structuring of transactions may be required. Based on the facts and circumstances of the transaction, the transferor must assess whether the transferee of the financial assets is constrained from pledging or exchanging the assets in question. If a constraint exists, and provides a more-thantrivial benefit to the transferor, the transfer may not be accounted for as a sale. ASC 860 does not define the term more-than-a-trivial benefit, but presumes that any constraint known to the transferor necessarily provides a more-than-trivial benefit. Judgment is required to evaluate these provisions. Finally, the transferor cannot maintain effective control over the transferred financial assets or third-party beneficial interests in those assets. Many transactions contain provisions that appear to violate this criterion by giving the transferor the right to reacquire certain transferred financial assets. ASC 860, however, provides some relief by allowing transfers to contain (1) certain removal of accounts provisions, as long as the transferor does not have the right to specifically pick the financial assets it is reacquiring, (2) cleanup call provisions that allow the transferor-servicer to call the assets when they reach a de minimis level considered administratively burdensome, and (3) other provisions that consider control of the financial assets to have been relinquished. 2.6 FASB s implementation guidance and PwC s questions and interpretive responses The information contained herein is generally based on the Implementation Guidance and Illustrations included in ASC We ve also included certain questions and interpretive responses intended to supplement discussions in this Chapter regarding the application of guidance to specific fact patterns PwC

98 Control criteria for transfers of financial assets revised March Transferred financial assets (entire, groups of, or participating interests therein) Excerpt from ASC E This implementation guidance addresses the application of what constitutes an entire financial asset. Excerpt from ASC F A loan to one borrower in accordance with a single contract that is transferred to a securitization entity before securitization shall be considered an entire financial asset. Similarly, a beneficial interest in securitized financial assets after the securitization process has been completed shall be considered an entire financial asset. In contrast, a transferred interest in an individual loan shall not be considered an entire financial asset; however, if the transferred interest meets the definition of a participating interest, the participating interest would be eligible for sale accounting. Excerpt from ASC G In a transaction in which the transferor creates an interest-only strip from a loan and transfers the interest-only strip, the interest-only strip does not meet the definition of an entire financial asset (and an interest-only strip does not meet the definition of a participating interest; therefore, sale accounting would be precluded). In contrast, if an entire financial asset is transferred to a securitization entity that it does not consolidate and the transfer meets the conditions for sale accounting, the transferor may obtain an interest-only strip as proceeds from the sale. An interest-only strip received as proceeds of a sale is an entire financial asset for purposes of evaluating any future transfers that could then be eligible for sale accounting. Excerpt from ASC H If multiple advances are made to one borrower in accordance with a single contract (such as a line of credit, credit card loan, or a construction loan), an advance on that contract would be a separate unit of account if the advance retains its identity, does not become part of a larger loan balance, and is transferred in its entirety. However, if the transferor transfers an advance in its entirety and the advance loses its identity and becomes part of a larger loan balance, the transfer would be eligible for sale accounting only if the transfer of the advance does not result in the transferor retaining any interest in the larger balance or if the transfer results in the transferor s interest in the larger balance meeting the definition of a participating interest. Similarly, if the transferor transfers an interest in an advance that has lost its identity, the interest must be a participating interest in the larger balance to be eligible for sale accounting. PwC 2-45

99 Control criteria for transfers of financial assets revised March 2016 Excerpt from ASC I Paragraph A(b) states that an allocation of specified cash flows precludes a portion from meeting the definition of a participating interest unless each cash flow is proportionately allocated to the participating interest holders. Following are several examples implementing that guidance: a. In the circumstance of an individual loan in which the borrower is required to make a contractual payment that consists of a principal amount and interest amount on the loan, the transferor and transferee shall share in the principal and interest payments on the basis of their proportionate ownership interest in the loan. b. In contrast, if the transferor is entitled to receive an amount that represents the principal payments and the transferee is entitled to receive an amount that represents the interest payments on the loan, that arrangement would not be consistent with the participating interest definition because the transferor and transferee do not share proportionately in the cash flows received from the loan. c. In other circumstances, a transferor may transfer a portion of an individual loan that represents either a senior interest or a junior interest in an individual loan. In both of those circumstances, the transferor would account for the transfer as a secured borrowing because the senior interest or junior interest in the loan do not meet the requirements to be participating interests (see paragraph A(c)). Excerpt from ASC J Given the conditions in paragraph A(b)(1), cash flows allocated as compensation for services performed that are significantly above an amount that would fairly compensate a substitute service provider would result in a disproportionate division of cash flows of the entire financial asset among the participating interest holders and, therefore, would preclude the portion of a transferred financial asset from meeting the definition of a participating interest. Examples of cash flows that are compensation for services performed include all of the following: a. Loan origination fees paid by the borrower to the transferor b. Fees necessary to arrange and complete the transfer paid by the transferee to the transferor c. Fees for servicing the financial asset. Excerpt from ASC K The transfer of a portion of an entire financial asset may result in a gain or loss on the transfer if the contractual interest rate on the entire financial asset differs from the market rate at the time of transfer. Paragraph A(b)(2) precludes a portion from meeting the definition of a participating interest if the transfer results in the transferor receiving an ownership interest in the financial asset that permits it to 2-46 PwC

100 Control criteria for transfers of financial assets revised March 2016 receive disproportionate cash flows. For example, if the transferor transfers an interest in an entire financial asset and the transferee agrees to incorporate the excess interest (between the contractual interest rate on the financial asset and the market interest rate at the date of transfer) into the contractually specified servicing fee, the excess interest would likely result in the conveyance of an interest-only strip to the transferor from the transferee. An interest-only strip would result in a disproportionate division of cash flows of the financial asset among the participating interest holders and would preclude the portion from meeting the definition of a participating interest. Excerpt from ASC L Paragraph A(c) addresses the priority of cash flows. In certain transfers, recourse is provided to the transferee that requires the transferor to reimburse any premium paid by the transferee if the underlying financial asset is prepaid within a defined time frame of the transfer date. Such recourse would preclude the transferred portion from meeting the definition of a participating interest. However, once the recourse provision expires, the transferred portion shall be reevaluated to determine if it meets the participating interest definition. Excerpt from ASC M Paragraph A(c) addresses recourse in a participating interest. Recourse in the form of an independent third-party guarantee shall be excluded from the evaluation of whether the participating interest definition is met. Similarly, cash flows allocated to a third-party guarantor for the guarantee fee shall be excluded from the determination of whether the cash flows are divided proportionately among the participating interest holders. Excerpt from ASC N Examples of standard representations and warranties (as used in paragraph A(c)) include representations and warranties about any of the following: a. The characteristics, nature, and quality of the underlying financial asset, including any of the following: 1. Characteristics of the underlying borrower 2. The type and nature of the collateral securing the underlying financial asset b. The quality, accuracy, and delivery of documentation relating to the transfer and the underlying financial asset c. The accuracy of the transferor s representations in relation to the underlying financial asset. Question 2-1 How should legal form be weighted against economic substance when applying the participating interest criteria in ASC A? PwC 2-47

101 Control criteria for transfers of financial assets revised March 2016 PwC response The participating interest definition is form-based and may result in similar transactions being accounted for differently. For example, consider a transaction where a company transfers 95 percent of the cash flows of a financial asset to an investor that is senior to the 5 percent interest retained by the company. Any credit losses are first borne by the company to the extent of its interest. The transferred portion does not meet the participating interest criteria, as credit losses are not shared proportionately between the parties. As a result, the transfer must be reported as a secured borrowing. In contrast, consider a transaction where a company legally transfers the entire financial asset and in exchange receives cash equal to 95 percent of the asset s value and a subordinated beneficial interest in the asset for the difference. The beneficial interest will first absorb any credit losses from the transferred asset. Assuming the criteria for de-recognition are satisfied, the company would account for the exchange as a sale of the financial asset in its entirety and recognize the cash and beneficial interest received at fair value. The two transactions described above are economically similar. In each case, the transferor retains first-dollar loss exposure to the extent of its 5 percent interest in the underlying loan. Nevertheless, the transferor would account for each transaction differently, stemming from the distinction that ASC 860 draws between a transferred participating interest and ownership of a beneficial interest in a transferred entire financial asset. For certain transactions, this distinction may not be trivial and, therefore, could open up the opportunity to structure transactions to reach a desired accounting result. We believe that the commercial or economic substance of terms, transactions and arrangements need to be considered in assessing whether they are viewed as substantive under the guidance. This is consistent with views expressed by the SEC staff in the past. In a speech at the 2003 AICPA SEC Conference, then-deputy Chief Accountant Scott A. Taub stated: If you find yourself working on a transaction that has been initiated or deliberately restructured in order to obtain an accounting result that would not otherwise be obtained, think very critically about what you re doing. Often, this structuring is indicative of a goal using accounting that reflects more positively on the company than the substance of the transaction warrants. In other words, these transactions often are set up to frustrate the goal of telling the truth and providing transparent financial information. Question 2-2 How would differences in rates ( coupons ) paid to the transferee or retained by the transferor impact the determination as to whether a transfer of a loan participation meets the criteria of a participating interest in ASC A? PwC response The accounting for transfers of loan participations in situations where market interest rates have changed subsequent to a loan s origination date may be significantly 2-48 PwC

102 Control criteria for transfers of financial assets revised March 2016 impacted by the participating interest rules, particularly if the transferor and transferee compensate for the change by agreeing to a pass-through rate that differs from the loan s underlying coupon rate. For example, assume that an entity originates a loan of $1,000 with a contractual coupon of 10 percent and subsequently sells a 40 percent interest in that loan in an increasing interest rate environment where the market rate for the loan is currently 12 percent. If the transferor agrees to pay the additional 2 percent to the transferee, it would be effectively agreeing to retain a recourse obligation through its commitment to continue paying a rate higher than the loan s coupon rate. This would result in a difference in the rights of the transferor when compared to the transferee and it would likely fail the criterion in ASC A(c). If the example was based on a declining interest rate environment and the transferor obtains an interest-only-strip to compensate for the difference, it would also fail to meet the participating interest definition, but under ASC A(b). On the other hand, the parties could agree to incorporate any difference between the current rate of interest and the loan s coupon rate by adjusting the participation s purchase price to yield the current market rate. The fact that a transferor may sell a portion of an entire financial asset at a gain or loss (stemming from changes in market conditions, etc., subsequent to the asset s origination) does not, in and of itself, cause the transfer to fail the participating interest rules, as the foregoing excerpt from ASC K indicates. Question 2-3 What are some other common structures affected by the participating interest criteria in ASC A? PwC response Transfers of receivables can assume many forms, including a factoring or securitization arrangement in which the transferor retains a subordinated interest in the transferred portion of a pool of receivables, transfers of undivided interests in credit card portfolios, and conveyances in which less than full title and ownership to the financial asset moves to the buyer. The legal form of the conveyance as set forth in the controlling transfer agreement, as well as other terms in that agreement (and possibly other agreements) will play a critical role in clarifying whether the transaction involves an entire financial asset or only a portion of a financial asset. Legal evidence should be obtained to support the determination of whether an entire financial asset or a portion was the subject of a transfer. PwC 2-49

103 Control criteria for transfers of financial assets revised March 2016 Question 2-4 Do third-party guarantees impact the evaluation of a participating interest? PwC response No. A transfer of a portion of a financial asset represents a participating interest if, among other things, the participating interest holders do not have recourse to any other participating interest holder (including the transferor) other than those forms cited in ASC A(c) (e.g., standard representations and warranties). ASC M states that recourse arrangements involving a third-party guarantor, and payment of related fees from the cash flows generated by the underlying asset, would not preclude the transfer from meeting the participating interest definition. However, any guarantees written by, or other obligations assumed by, the transferor with respect to a transferred portion of a financial asset (other than standard representations and warranties) would preclude the transfer from meeting the participating interest definition, since the transferor, in its role of guarantor/participating interest holder would not have the same cash flow collection priority as other participating interest holders involved with the transfer. For example, in certain loan participations, the transferor may be required to reimburse the transferee (i.e., participating bank) for any purchase price premium paid if the entire underlying loan is prepaid within a specified timeframe after the transfer date. This type of recourse is substantively different from standard representations and warranties and, as a result, would preclude the transferred portion from meeting the participating interest definition. However, if and when the recourse provision expires at a later date, the transferred portion should be reevaluated at that time to determine if it now meets the participating interest definition and therefore becomes eligible for sale accounting. Question 2-5 Should a transfer of a portion of a financial asset be reassessed after transaction date? PwC response Yes. ASC acknowledges that, in some circumstances, a transferred portion of an entire financial asset may no longer meet the conditions of a participating interest. Also, even though ASC 860 does not specifically address under what circumstances a transferred portion of an asset that initially failed to meet the participating interest definition may be considered to meet the definition at a later date, ASC L states that when a participating interest holder s recourse to the transferor expires, the transferred portion shall be reevaluated to determine if it meets the participating interest definition. As a result of the above, we believe that when the rights and/or obligations of a participating interest holder change as a result of a change in law, the passage of time, a modification to the transfer arrangement, or subsequent transfers of additional 2-50 PwC

104 Control criteria for transfers of financial assets revised March 2016 portions of the same entire financial asset, the transferor is required to reassess its previous participating interest conclusions. Question 2-6 Can an entity derecognize a portion of a gross investment in a sales-type or directfinancing lease receivable if the entity transfers only an interest in the minimum lease payments, but not the residual value? PwC response Yes, but only if the transferred portion meets the definition of a participating interest and the transfer meets the sale conditions in ASC Since an unguaranteed residual value is not considered a financial asset subject to the guidance in ASC 860, an analysis of a transfer of a portion of the minimum lease payments should not consider the unguaranteed residual value when applying the participating interest rules. On the other hand, if the transfer involves a portion of both the minimum lease payments and a guaranteed residual value, then the participating interest determination should consider whether the unit of account meets the criteria of a participating interest. We believe the unit of account depends on whether the residual value is guaranteed by the lessee or by a third-party guarantor. If the lessee guarantees the residual value, the minimum lease payments and guaranteed residual value should be viewed as a single unit of account. The following considerations apply if the residual value is guaranteed by a third-party guarantor: ASC A states that the legal form of the asset and what the asset conveys to its holders shall be considered in determining what constitutes an entire financial asset ASC M states that cash flows payable to, or contingently payable by, a third-party guarantor shall be excluded from the evaluation as to whether the participating interest definition is met ASC states that a residual value guarantee provided by a third party is part of the lessor s minimum lease payments Based on the guidance above, we would accept the view that third-party guaranteed residual values may be included or, conversely, may be excluded when evaluating whether a transfer of a portion of sales-type or direct-financing lease receivables meets the conditions of a participating interest. We also believe it would not be appropriate for an entity to analogize to this specific fact pattern when evaluating other transactions; further, once an entity selects one of the two methods (i.e., either including or excluding the guaranteed residual value from the participating interest evaluation), that method should be consistently applied and disclosed as an accounting policy election. PwC 2-51

105 Control criteria for transfers of financial assets revised March 2016 Question 2-7 How does an entity determine what is significantly above an amount that would fairly compensate a substitute service provider for purposes of ASC A(b)? PwC response The FASB did not define what is meant by not significantly above an amount that would fairly compensate a substitute servicer and neither the Board nor staff has provided any implementation guidance or bright lines to assist in this assessment. An entity s determination of when a servicing fee would represent an amount that is significantly above is inherently subjective, requires significant judgment, and should take into account quantitative as well as qualitative considerations. Some of the qualitative considerations an entity should evaluate include, but are not limited to, (i) the type of financial asset being serviced, (ii) the risks associated with providing the servicing function for particular asset types, (iii) the availability of market information on the asset type being serviced and reliability of such information, (iv) the overall servicing agreement compensation structure (i.e., other sources of ancillary income) when compared to other agreements in the marketplace, and other facts and circumstances specific to the agreement Isolation of transferred financial assets Excerpt from ASC A In the context of U.S. bankruptcy laws, a true sale opinion from an attorney is often required to support a conclusion that transferred financial assets are isolated from the transferor, any of its consolidated affiliates included in the financial statements being presented, and its creditors. In addition, a nonconsolidation opinion is often required if the transfer is to an affiliated entity. In the context of U.S. bankruptcy laws: a. A true sale opinion is an attorney s conclusion that the transferred financial assets have been sold and are beyond the reach of the transferor s creditors and that a court would conclude that the transferred financial assets would not be included in the transferor s bankruptcy estate. b. A nonconsolidation opinion is an attorney s conclusion that a court would recognize that an entity holding the transferred financial assets exists separately from the transferor. Additionally, a nonconsolidation opinion is an attorney s conclusion that a court would not order the substantive consolidation of the assets and liabilities of the entity holding the transferred financial assets and the assets and liabilities of the transferor (and its consolidated affiliates included in the financial statements being presented) in the event of the transferor s bankruptcy or receivership PwC

106 Control criteria for transfers of financial assets revised March 2016 Excerpt from ASC B A legal opinion may not be required if a transferor has a reasonable basis to conclude that the appropriate legal opinion(s) would be given if requested. For example, the transferor might reach a conclusion without consulting an attorney if either of the following conditions exists: a. The transfer is a routine transfer of financial assets that does not result in any continuing involvement by the transferor. b. The transferor had experience with other transfers with similar facts and circumstances under the same applicable laws and regulations. Excerpt from ASC C For entities that are subject to other possible bankruptcy, conservatorship, or other receivership procedures (for example, banks subject to receivership by the Federal Deposit Insurance Corporation [FDIC]) in the United States or other jurisdictions, judgments about whether transferred financial assets have been isolated shall be made in relation to the powers of bankruptcy courts or trustees, conservators, or receivers in those jurisdictions. Excerpt from ASC In certain securitizations, a corporation that, if it failed, would be subject to the U.S. Bankruptcy Code transfers financial assets to a securitization entity in exchange for cash. The entity raises that cash by issuing to investors beneficial interests that pass through all cash received from the financial assets, and the transferor has no further involvement with the trust or the transferred financial assets. Those securitizations generally would be judged as having isolated the assets because, in the absence of any continuing involvement there would be reasonable assurance that the transfer would be found to be a true sale at law that places the assets beyond the reach of the transferor, its consolidated affiliates (that are not bankruptcy-remote entities) included in the financial statements being presented, and its creditors, even in bankruptcy or other receivership. Excerpt from ASC In other securitizations, a similar corporation transfers financial assets to a securitization entity in exchange for cash and beneficial interests in the transferred financial assets. That entity raises the cash by issuing to investors commercial paper that gives them a senior beneficial interest in cash received from the financial assets. The beneficial interests obtained by the transferring corporation represent a junior interest to be reduced by any credit losses on the financial assets in the entity. The senior beneficial interests (commercial paper) are highly rated by credit rating agencies only if both the credit enhancement from the junior interest is sufficient and the transferor is highly rated. Excerpt from ASC Depending on facts and circumstances, those single-step securitizations often would be judged in the United States as not having isolated the financial assets, because the PwC 2-53

107 Control criteria for transfers of financial assets revised March 2016 nature of the continuing involvement may make it difficult to obtain reasonable assurance that the transfer would be found to be a true sale at law that places the financial assets beyond the reach of the transferor, its consolidated affiliates (that are not bankruptcy-remote entities) included in the financial statements being presented, and its creditors in U.S. bankruptcy (see paragraph ). If the transferor fell into bankruptcy and the transfer was found not to be a true sale at law, investors in the transferred financial assets might be subjected to an automatic stay that would delay payments due them, and they might have to share in bankruptcy expenses and suffer further losses if the transfer was recharacterized as a secured loan. Excerpt from ASC Other securitizations use multiple transfers intended to isolate transferred financial assets beyond the reach of the transferor, its consolidated affiliates (that are not bankruptcy-remote entities) included in the financial statements being presented, and its creditors, even in bankruptcy. The series of transactions in a typical two-tier structure taken as a whole may satisfy the isolation test because the design of the structure achieves isolation. The two-step securitizations, taken as a whole, generally would be judged under present U.S. law as having isolated the financial assets beyond the reach of the transferor, its consolidated affiliates (that are not bankruptcy-remote entities) included in the financial statements being presented, and its creditors, even in bankruptcy or other receivership. However, each entity involved in a transfer shall be evaluated under the consolidation guidance in Topic 810. Accordingly, a transferor could be required to consolidate the trust or other legal vehicle used in the second step of the securitization, notwithstanding the isolation analysis of the transfer. Excerpt from ASC For example, two-step structures involve the following: a. First, the corporation transfers a group of financial assets to a special-purpose corporation that, although wholly owned, is so designed that the possibility is remote that the transferor, its consolidated affiliates (that are not bankruptcyremote entities) included in the financial statements being presented, or its creditors could reclaim the financial assets. This first transfer is designed to be judged to be a true sale at law, in part because the transferor does not provide excessive credit or yield protection to the special-purpose corporation, and the transferred financial assets are likely to be judged beyond the reach of the transferor, its consolidated affiliates (that are not bankruptcy-remote entities) included in the financial statements being presented, or the transferor s creditors even in bankruptcy or other receivership. b. Second, the special-purpose corporation transfers a group of financial assets to a trust or other legal vehicle with a sufficient increase in the credit or yield protection on the second transfer (provided by a transferor s junior beneficial interest or other means) to merit the high credit rating sought by third-party investors who buy senior beneficial interests in the trust. Because of that aspect of its design, that second transfer might not be judged to be a true sale at law and, thus, the transferred financial assets could at least in theory be reached by a bankruptcy trustee for the special-purpose corporation PwC

108 Control criteria for transfers of financial assets revised March 2016 c. However, the special-purpose corporation is designed to make remote the possibility that it would enter bankruptcy, either by itself or by substantive consolidation into a bankruptcy of its parent should that occur. For example, its charter forbids it from undertaking any other business or incurring any liabilities, so that there can be no creditors to petition to place it in bankruptcy. Furthermore, its dedication to a single purpose is intended to make it extremely unlikely, even if it somehow entered bankruptcy, that a receiver under the U.S. Bankruptcy Code could reclaim the transferred financial assets because it has no other assets to substitute for the transferred financial assets. Excerpt from ASC The powers of receivers for entities not subject to the U.S. Bankruptcy Code (for example, banks subject to receivership by the Federal Deposit Insurance Corporation [FDIC]) vary considerably, and therefore some receivers may be able to reach financial assets transferred under a particular arrangement and others may not. A securitization may isolate transferred financial assets from a transferor subject to such a receiver and its creditors even though it is accomplished by only one transfer directly to a securitization entity that issues beneficial interests to investors and the transferor provides credit or yield protection. For entities that are subject to other possible bankruptcy, conservatorship, or other receivership procedures in the United States or other jurisdictions, judgments about whether transferred financial assets have been isolated need to be made in relation to the powers of bankruptcy courts or trustees, conservators, or receivers in those jurisdictions. Excerpt from ASC A Depending on the facts and circumstances, transferred financial assets can be isolated from the transferor if the Federal Deposit Insurance Corporation (FDIC) would be the receiver should the transferor fail. In July 2000, the FDIC adopted a final rule, Treatment by the Federal Deposit Insurance Corporation as Conservator or Receiver of Financial Assets Transferred by an Insured Depository Institution in Connection with a Securitization or Participation. The final rule modifies the FDIC s receivership powers so that, subject to certain conditions, it shall not recover, reclaim, or recharacterize as property of the institution or the receivership any financial assets transferred by an insured depository institution that meet all conditions for sale accounting treatment under GAAP, other than the legal isolation condition in connection with a securitization or participation. PwC 2-55

109 Control criteria for transfers of financial assets revised March 2016 Excerpt from ASC B Financial assets transferred by an entity subject to possible receivership by the FDIC are isolated from the transferor if the FDIC or another creditor either cannot require return of the transferred financial assets or can only require return in receivership, after a default, and in exchange for payment of, at a minimum, principal and interest earned (at the contractual yield) to the date investors are paid. Excerpt from ASC Conversely, financial assets transferred by an entity shall not be considered isolated from the transferor if circumstances can arise under which the transferor can require their return, but only in exchange for payment of principal and interest earned (at the contractual yield) to the date investors are paid, unless the transferor s power to require the return of the transferred financial assets arises solely from a contract with the transferee. A noncontractual power to require the return of transferred assets is inconsistent with the limitations in paragraph (a) that, to be accounted for as having been sold, transferred financial assets shall be isolated from the transferor. That is the circumstance even if the noncontractual power appears unlikely to be exercised or is dependent on the uncertain future actions of other entities (for example, insufficiency of collections on underlying transferred financial assets or determinations by court of law). Under that guidance, a single-step securitization commonly used by financial institutions subject to receivership by the FDIC and sometimes used by other entities is likely not to be judged as having isolated the assets. One reason for that is because it would be difficult to obtain reasonable assurance that the transferor would be unable to recover the transferred financial assets under the equitable right of redemption available to secured debtors, after default, under U.S. law. Excerpt from ASC A For entities that are subject to possible receivership under jurisdictions other than the FDIC or the U.S. Bankruptcy Code, whether assets transferred by an entity can be considered isolated from the transferor depends on the circumstances that apply to those types of entities. As discussed in paragraph , for entities that are subject to other possible bankruptcy, conservatorship, or other receivership procedures in the United States or other jurisdictions, judgments about whether transferred financial assets have been isolated need to be made in relation to the powers of bankruptcy courts or trustees, conservators, or receivers in those jurisdictions. The same sorts of judgments may need to be made in relation to powers of the transferor or its creditors. Excerpt from ASC A transfer from one subsidiary (the transferor) to another subsidiary (the transferee) of a common parent would be accounted for as a sale in each subsidiary s separateentity financial statements if both of the following requirements are met: a. All of the conditions in paragraph (including the condition on isolation of the transferred financial assets) are met PwC

110 Control criteria for transfers of financial assets revised March 2016 b. The transferee s assets and liabilities are not consolidated into the separate-entity financial statements of the transferor. Paragraph states that, in a transfer between two subsidiaries of a common parent, the transferor-subsidiary shall not consider parent involvements with the transferred financial assets in applying paragraph Excerpt from ASC If the transferee was an equity method investee of the transferor, only the investment and not the investee s assets and liabilities would be reported in the transferor subsidiary s separate-entity financial statements. Therefore, the transferee would not be a consolidated affiliate of the transferor, and such a transfer could isolate the transferred financial assets and be accounted for as a sale if all other conditions of paragraph are met. Excerpt from ASC A Repurchase Financings The purpose of this implementation guidance is to illustrate the characteristics of a transaction comprising an initial transfer and a repurchase financing and to preclude an analogy to other financing transactions that are outside the scope of the guidance in paragraph C, which states that items (b) through (c) in paragraph do not apply to a transfer of financial assets and a related repurchase financing. Excerpt from ASC B The diagram in the preceding paragraph depicts the following three transfers of a financial asset that typically occur in the transactions within the scope of the guidance in paragraph C: a. The initial transferor transfers a financial asset to the initial transferee in return for cash. PwC 2-57

111 Control criteria for transfers of financial assets revised March 2016 b. The initial transferee enters into a repurchase financing with the initial transferor. The initial transferee transfers the previously transferred financial asset to the initial transferor as collateral for the financing. The initial transferee receives cash from the initial transferor. As part of the repurchase financing, the initial transferee is obligated to repurchase the financial asset (or substantially the same financial asset) at a fixed price within a prescribed time period. c. The initial transferee makes the required payment to the initial transferor under the terms of the repurchase financing. Upon receipt of payment, the initial transferor returns the transferred asset (or substantially the same asset) to the initial transferee. Excerpt from ASC C Whether or not the parties agree to net settle the steps in items (a) and (b) of the preceding paragraph shall not affect whether the transactions are within the scope of the guidance for repurchase financings in paragraph C Question 2-8 When would arrangements or agreements be considered to be made contemporaneous with, or in contemplation of, the transfer and thus part of the assessment of whether the derecognition criteria in paragraph ASC are met? PwC response ASC 860 provides no prescriptive guidance to assist transferors in determining whether other arrangements or agreements entered into contemporaneous with, or in contemplation of, a transfer, should be considered in the sale accounting analysis. However, we believe that the following factors (not an exhaustive list) should be considered when making this assessment: The separate arrangements or agreements seem to lack a valid business purpose. That is, there is no apparent reason as to why the multiple arrangements or agreements, one of which includes the transfer, were entered into separately. The execution of the agreements or arrangements is contingent upon one another. That is, either the transferee or the transferor would have not entered into the transaction if one of the agreements or arrangements was not executed. We understand that the identification of agreements or arrangements that meet the conditions above requires significant professional judgment, but expect such judgments to be part of a transferor s discussion with its legal counsel involved in the evaluation of the legal isolation and ultimately considered in such legal opinions PwC

112 Control criteria for transfers of financial assets revised March 2016 Question 2-9 What does the term consolidated affiliate mean in the context of evaluating all forms of continuing involvement by the transferor with transferred financial assets? PwC response As discussed previously, ASC affirms the general decision principle that the sale accounting analysis must consider all forms of continuing involvement by the transferor and any of its consolidated affiliates included in the financial statements being presented. Consistent with this principle, ASC also requires that the analysis of the legal isolation requirement consider not only the transferor but also its consolidated affiliates included in the financial statements being presented. To illustrate the application of this concept, assume a transferor obtains a subordinated beneficial interest in transferred financial assets and has a wholly owned subsidiary responsible for their servicing. In addition, the ultimate parent company provides a limited recourse guarantee (credit enhancement) to the transferee on the transferred financial assets. Assume there are no other involvements with the transferred financial assets by any other entity affiliated with the transferor. The legal analysis for the stand-alone financial statements of the transferor would be required to consider the transferor s continuing involvement through the subordinated interest as well as the servicing function, since such servicing is performed by an entity that consolidates into the transferor s separate financial statements. The guarantee issued by the ultimate parent company would not play a role in the legal isolation analysis at the transferor s separate financial statement level, but would be part of the continuing involvement to consider when evaluating the transfer from the perspective of the consolidated financial statements of the ultimate parent since, at that level, both the transferor and the wholly owned subsidiary of the transferor are consolidated by the parent. In the above example, it may be possible to meet the sale accounting requirements and derecognize the transferred financial asset in the separate stand-alone financial statements of the transferor, assuming that a satisfactory legal opinion can be obtained to support the legal isolation assertion at that level. However, if, as a consequence of the credit enhancement written by the parent, counsel cannot render the opinions necessary to support the assertion that the transferred financial have been isolated in the event of the bankruptcy of the parent company (and consolidated affiliates), the transfer must be reported as a secured borrowing in the parent s consolidated financial statements. There are other scenarios in which the legal isolation condition warrants evaluation at different levels within a consolidated reporting group, potentially involving multiple true sale and substantive consolidation opinions. The analysis may become more difficult when entities subject to the laws of foreign jurisdictions are involved. In any event, it is important for companies to consider the continuing involvement of all entities within the consolidated group (for consolidated financial statement purposes) and to drill down to the different separate stand-alone financial statement PwC 2-59

113 Control criteria for transfers of financial assets revised March 2016 requirements of the legal entities involved in a transfer. Legal evidence will be required to support the company s assertion that the transferred financial assets have been isolated from the transferor and its consolidated affiliates, even in bankruptcy or receivership, at each level within the reporting group for which separate financial statements will be issued. Question 2-10 What type of evidence is sufficient to provide reasonable assurance that transferred assets are isolated beyond the reach of the transferor under ASC 860? PwC response ASC 860 provides only limited guidance as to the type and amount of evidence that must be obtained to conclude that transferred financial assets have been isolated from the transferor according to the criterion of paragraph (a). Paragraph states that [d]erecognition of transferred financial assets is appropriate only if the available evidence provides reasonable assurance that the transferred financial assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor or any of its consolidated affiliates (that are not bankruptcy-remote entities) included in the financial statements being presented and its creditors. The guidance in ASC 860 further explains that the nature and extent of support to satisfy this assertion depends on the facts and circumstances of each transaction and that all available evidence that either supports or questions an assertion should be considered. ASC cites certain matters that may be relevant when making this assessment, including (1) whether the contract or circumstances permit the transferor to revoke the transfer, (2) the legal consequences of the transfer in the jurisdiction in which bankruptcy or other receivership would take place, including whether a transfer of financial assets would likely be deemed a true sale at law (see ASC A) or otherwise isolated (see ASC B), (3) whether the transferor is affiliated with the transferee, and (4) consideration of other factors pertinent under applicable law. Although written for auditors, AU 9336 provides helpful guidance for management in evaluating whether the available evidence provides reasonable assurance that the transferred financial assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver (refer also to ASC through excerpted above). For entities subject to receivership or conservatorship under the Federal Deposit Insurance Act, the guidance in ASC A (excerpted above) is relevant; see also TS for additional discussion PwC

114 Control criteria for transfers of financial assets revised March 2016 Question 2-11 How should a foreign subsidiary of a U.S. multinational company demonstrate that it has satisfied the criteria in paragraph (a) when a transfer of financial assets is executed in a foreign jurisdiction? PwC response The legal isolation condition applies to all transfers of financial assets, regardless of the laws that govern the transaction and/or entities involved. Accordingly, in its assessment of whether legal isolation has been achieved, counsel s analysis should be based on the statutes of the country that would apply to the transferor in the event of its bankruptcy, and the laws of the country intended to govern the exchange. The statutes and legal principles in foreign jurisdictions frequently will differ from those that govern entities subject to Federal and state laws in the U.S. (Refer to TS 7 for a further discussion.) Question 2-12 In many servicing arrangements, cash receipts from serviced assets are initially remitted to a collection account in the name of the servicer and are subsequently transferred to an operating account in the name of the transferee. In certain jurisdictions, the servicer s collection account becomes part of its bankruptcy estate (if it files for bankruptcy protection). Under ASC 860, will such a situation prevent sale treatment for a transfer of assets because the cash collections are not bankruptcyremote? PwC response Generally, no. The servicing function is separate from the asset-transfer transaction and represents a separate risk of loss. The criteria outlined in ASC are intended to apply solely to the initial transfer of the assets and not to the subsequent collection of payments by the servicer. However, if the transferor utilizes a special purpose entity to isolate the transferred assets and continues to service the assets, the transferor typically obtains a substantive non-consolidation opinion. In addition to the legal opinion that the transfer is a true sale at law, the substantive non-consolidation opinion is written by the transferor s external counsel to support the transferor s assertion regarding paragraph (a). The substantive non-consolidation opinion will consider any potential commingling of assets between the transferor and the special purpose entity. If a substantive non-consolidation opinion as described in TS (Example 2-1) cannot be obtained by the transferor, the criteria in paragraph (a) would not be met and the transfer would be accounted for as a secured borrowing. PwC 2-61

115 Control criteria for transfers of financial assets revised March Transferee right to pledge or exchange the financial assets Excerpt from ASC In a transaction in which a transferee (that is not an entity whose sole purpose is to engage in securitization or asset-backed financing activities) is precluded from exchanging the transferred financial assets but obtains the unconstrained right to pledge them, the determination of whether the sale condition in paragraph (b) is met depends on the facts and circumstances. In a transfer of financial assets, a transferee s right to both pledge and exchange transferred financial assets suggests that the transferor has surrendered its control over those financial assets. However, more careful analysis is warranted if the transferee may only pledge the transferred financial assets. Excerpt from ASC An entity transfers financial assets to a transferee that is significantly limited in its ability to pledge or exchange the transferred financial assets (the transferee is not an entity whose sole purpose is to engage in securitization or asset-backed financing activities). The transferor receives cash in return for the transferred financial assets, and has no continuing involvement with the transferred assets. The transfer described in this example meets the condition in paragraph (b). Excerpt from ASC While the condition in paragraph (b) is met in the example described in the previous paragraph, in general, for transfers in which the transferor does have any continuing involvement, an evaluation shall be made as to whether the condition in paragraph (b) has been met. Excerpt from ASC For a transfer to fail to meet the condition in paragraph (b), the transferee must be constrained from pledging or exchanging the transferred financial asset and the transferor must receive more than a trivial benefit as a result of the constraint. Excerpt from ASC Judgment is necessary to determine whether a requirement to obtain the transferor s permission to sell or exchange should preclude sale accounting. For example, in certain loan participation agreements involving transfers of participating interests, the transferor is required to approve any subsequent transfers or pledges of the interests in the loans held by the transferee. Whether that requirement would be a constraint that would prevent the transferee from taking advantage of its right to pledge or to exchange the transferred financial asset and, therefore, accounting for the transfer as a sale, depends on the nature of the requirement for approval. Excerpt from ASC A prohibition on sale to the transferor s competitor may or may not constrain a transferee from pledging or exchanging the financial asset, depending on how many 2-62 PwC

116 Control criteria for transfers of financial assets revised March 2016 other potential buyers exist. If there are many other potential willing buyers, the prohibition would not be constraining. In contrast, if that competitor were the only potential willing buyer (other than the transferor), then the condition would be constraining. Excerpt from ASC Issuing beneficial interests in the form of securities issued under Rule 144A presumptively would not constrain a transferee s ability to transfer those beneficial interests for purposes of this Subtopic. The primary limitation imposed by Rule 144A is that a potential buyer must be a sophisticated investor. If a large number of qualified buyers exist, the holder could transfer those securities to many potential buyers and, thereby, realize the full economic benefit of the assets. In such circumstances, the requirements of Rule 144A would not be a constraint that precludes sale accounting under paragraph (b). Question 2-13 How should the ability to pledge or exchange criterion in ASC (b) be applied to transfers of financial assets to securitization (and similar asset-backed securitization) entities? PwC response Securitization entities (and similar entities whose sole purpose is to engage in assetbacked financing activities) frequently must pledge or similarly lock up acquired financial assets co-incident with the issuance of beneficial interests that fund the exchange. ASC (b) clarifies that arrangements that allow a transferee to pledge assets only on the day they are obtained are considered to constrain the transferee and presumptively provide the transferor with more than a trivial benefit. As such, absent the look through model discussed in the next paragraph, transfers of financial assets to securitization and similar entities would fail the condition in ASC (b). Under the look through model, the unit of analysis for purposes of applying ASC (b) are beneficial interests in the transferred assets held by third parties not the transferred assets themselves. This approach may be applied only in instances where the sole purpose of the transferee is to engage in securitization or asset-backed financing activities. As noted in TS 2.3, in these circumstances, the beneficial interests are considered surrogates for the transferred assets themselves. This look through provision should not be construed to require that each transfer must have a third-party holder for the transaction to meet the ability to freely pledge or exchange requirement. In fact, based on discussions with the FASB staff, it is our understanding that the words each third-party were included in the criterion to allow potential transfers in which the transferor is required to hold a certain amount of securities/beneficial interests (and thus is precluded from pledging or exchanging them) to achieve sale accounting, provided that the third-party holders, if any, could pledge or exchange their interests. We do not expect to see many instances in which PwC 2-63

117 Control criteria for transfers of financial assets revised March 2016 the transferor is the only holder of the beneficial interests and is also precluded from pledging or exchanging all of the securities retained, but to the extent these scenarios exist, careful consideration of the transferability limitation and its impact on the transaction s compliance with ASC (b) should be performed and documented. When evaluating whether derecognition accounting is appropriate for transactions involving securitization and similar special-purpose entities, the reporting entity must consider whether the transferor and any of the consolidated affiliates included in the financial statements being presented have retained control over the financial assets in question through other arrangements. Under ASC 810, the transferor may have a controlling financial interest in an entity used in securitization and asset-backed financing transactions. Also, guaranteed mortgage securitizations, in which the transferor obtains 100% of the securities issued by the unconsolidated SPE trust as proceeds from the transfer, must be evaluated to determine if by virtue of holding 100 percent interest in the trust, the transferor can unilaterally dissolve the unconsolidated SPE (and thus retain control over the transferred assets). If so, sale accounting may be precluded under the effective control criteria in ASC (c). Question 2-14 How does a lack of continuing involvement affect an entity s evaluation of the right to pledge or exchange criterion in ASC (b)? PwC response ASC A indicates that if the transferor has no continuing involvement with transferred financial assets, the lack of continuing involvement would be a determinative factor in concluding that the condition in ASC (b) is satisfied even if the transferee is constrained from pledging or exchanging the assets under arrangements involving parties other than the transferor, consolidated affiliates, or its agents. In these instances, the transferor is not considered to receive a more-than-trivial benefit from the constraint. Accordingly, the criterion in ASC (b) would be met even if the transferee is constrained. A transferor is still required to assess whether the transfer satisfies the other conditions for sale accounting. As the implementation guidance in ASC A and 55-79B indicates, continuing involvement is intended to be applied broadly, and can take many forms, including contractual undertakings that are normal course in many transfers of financial assets. For example, recourse arrangements that obligate a transferor to compensate a transferee for defects in the eligibility of transferred trade receivables or loans is a form of continuing involvement PwC

118 Control criteria for transfers of financial assets revised March 2016 Question 2-15 How do restrictions on the sale of transferred assets to several competitors, rather than a single competitor, impact the analysis under ASC (b)? PwC response As long as there is a reasonable population of potential buyers, a provision that prohibits the transferee from selling a transferred financial asset to a single competitor would not violate the ability to pledge or exchange condition. Similarly, restrictions on sales to several competitors would not be problematic if a reasonable population of potential buyers for the transferred asset exists. Question 2-16 ASC (b) indicates that a requirement to obtain the transferor s permission to sell or pledge that is not to be unreasonably withheld would not represent a condition that constrains a transferee from taking advantage of its right to sell or pledge financial assets. How should the phrase transferor s permission to sell or pledge that is not to be unreasonably withheld be interpreted? PwC response In evaluating whether a transferor may unreasonably withhold its permission for the transferee to sell or pledge the transferred assets, one must consider why this restriction was initially imposed. Conditions such as obtaining the transferor s permission to sell or pledge transferred assets may be imposed by a transferor for business or competitive purposes, and not to control the future economic benefits of the transferred assets. Accordingly, if the transferor is looking to protect itself from a competitive standpoint, one must look to whether willing and qualified buyers exist beyond the transferor and its competitors. A significant constraint would exist if the transferor was the only other willing buyer and sale to the transferor s competitors was prohibited. In addition, a transferor s right of first refusal would generally not constrain a transferee, because the right would not compel or force the transferee to sell the assets and the transferee would be in a position to receive the sum offered by exchanging the financial asset, albeit possibly from the transferor rather than the third party. Question 2-17 A transferor initiates a plan to sell large blocks of receivables over a two-year period to reduce its credit risk. The transferor transfers the first block of receivables. To prevent the transferee from competing with it during the transferor s next sale, the transferor restricts the transferee from selling or pledging the receivables for a period of 90 days. Does this restriction prevent sale treatment under paragraph ASC (b)? Would the response be the same if the restriction were for one week or one year? PwC 2-65

119 Control criteria for transfers of financial assets revised March 2016 PwC response Yes to both questions. Sale treatment is precluded, until the sale restriction lapses. As noted in the response to Question 2-13, transferor-imposed contractual constraints that narrowly limit timing or terms such as those that allow the transferee to pledge only on the day the assets are obtained or only on the terms agreed to by the transferor, constrain the transferee and presumptively provide more than a trivial benefit to the transferor. Under this arrangement, the transferor benefits from knowing who currently owns the receivables and, further, the restriction ensures that transferor will not be competing with the transferee as it seeks to sell additional receivables. By constraining the transferee, the transferor has not surrendered control over the transferred assets. The transferor and transferee would initially account for the transfer as a secured borrowing, regardless of the length of the restriction. After the restriction is removed, the transfer would be recorded as a sale if the other conditions for derecognition are also met at that time Transferor retaining effective control Excerpt from ASC The following provides implementation guidance related to the effective control condition and related examples in paragraph (c), specifically: a. An agreement that both entitles and obligates the transferor to repurchase or redeem the transferred financial assets before maturity (see paragraph (c)(1)): 1. Whether financial assets exchanged are substantially the same 2. Subparagraph superseded by Accounting Standards Update No b. An agreement that provides the transferor with the unilateral ability to cause the holder to return specific financial assets, other than through a cleanup call (see paragraph (c)(2)): 1. Rights to reacquire (call) transferred assets. c. An agreement that permits the transferee to require the transferor to repurchase the transferred financial asset at a price that is so favorable to the transferee that it is probable that the transferee will require the transferor to repurchase the transferred financial asset. Excerpt from ASC This guidance addresses criteria that must be met for a transfer to fail the condition in paragraph (c) through an agreement of the type described in paragraph (c)(1), precluding sale accounting and resulting, instead, in securedborrowing accounting. The following are examples of whether securities exchanged are substantially the same as discussed in paragraph : 2-66 PwC

120 Control criteria for transfers of financial assets revised March 2016 a. The same primary obligor (see paragraph (a)(1)). The exchange of pools of single-family loans would not meet this criterion because the mortgages comprising the pool do not have the same primary obligor, and would therefore not be considered substantially the same. b. Identical form and type (see paragraph (a)(2)). The following exchanges would not meet this criterion: 1. GNMA I securities for GNMA II securities 2. Loans to foreign debtors that are otherwise the same except for different U.S. foreign tax credit benefits (because such differences in the tax receipts associated with the loans result in instruments that vary in form and type) 3. Commercial paper for redeemable preferred stock. c. The same maturity (or in the case of mortgage-backed pass-through and paythrough securities, similar remaining weighted-average maturities that result in approximately the same market yield) (see paragraph (a)(3)). The exchange of a fast-pay GNMA certificate (that is, a certificate with underlying mortgage loans that have a high prepayment record) for a slow-pay GNMA certificate would not meet this criterion because differences in the expected remaining lives of the certificates result in different market yields. d. Similar assets as collateral (see paragraph (a)(5)). Mortgage-backed pass-through and pay-through securities must be collateralized by a similar pool of mortgages, such as single-family residential mortgages, to meet this characteristic. Excerpt from ASC Rights or obligations to reacquire transferred financial assets may result in the transferor s maintaining effective control over the transferred assets, therefore precluding sale accounting under paragraph (c). The following guidance addresses how different types of rights of a transferor to reacquire (call) transferred assets affect sale accounting, specifically: a. Removal-of-accounts provisions (see paragraphs through 40-39) b. Call options (see paragraphs and ) c. Other arrangements. Excerpt from ASC The following are examples of application of effective control principles to removal-ofaccounts provisions: a. An unconditional removal-of-accounts provision that allows the transferor to specify the financial assets that may be removed from a group of financial assets precludes sale accounting for all financial assets in the group that might be PwC 2-67

121 Control criteria for transfers of financial assets revised March 2016 specified if such a provision allows the transferor unilaterally to remove specific financial assets and provides a more-than-trivial benefit to the transferor (see paragraph (a)), even if the transferor s right to remove specific financial assets from a group of transferred financial assets is limited, for example, to 10 percent of the fair value of the financial assets transferred and all of the financial assets are smaller than that 10 percent. In that circumstance, none of the transferred financial assets would be derecognized at the time of transfer because no transferred financial asset is beyond the reach of the transferor. If the transferor reclaims all the financial assets it can and thereby extinguishes its option, its control has expired and the rest of the financial assets have been sold at that time. b. A removal-of-accounts provision that provides the right to random removal of excess financial assets from a group of transferred financial assets up to 10 percent of the fair value of the financial assets transferred (all financial assets in the group are less than this 10 percent of the fair value of transferred financial assets) does not preclude sale accounting if the transferor has no other interest in the group. The transferor has, in essence, obtained a 10 percent beneficial interest in the group and should account for it as such. This treatment is permitted because the removal-of-accounts provision is sufficiently limited and the transferor cannot unilaterally remove specific transferred financial assets, because the timing of the removal (when the excess develops) and the assets being removed (which are randomly determined) are not under the control of the transferor (see paragraph ). c. A removal-of-accounts provision conditioned on a transferor s decision to exit some portion of its business precludes sale accounting for all financial assets that might be affected, because it permits the transferor unilaterally to remove specific financial assets and provides a more-than-trivial-benefit to the transferor (see paragraph (b)). d. A removal-of-accounts provision for defaulted receivables does not preclude sale accounting at the time of transfer, because the removal would be allowed only after a third party s action (default) and could not be caused unilaterally by the transferor (see paragraph (b)). However, once the default has occurred, the transferor would have the unilateral ability to remove those specific financial assets and would need to recognize the defaulted receivable if that ability provides a more-than-trivial benefit to the transferor. e. A removal-of-accounts provision conditioned on a third-party cancellation, or expiration without renewal, of an affinity or private-label arrangement does not preclude sale accounting at the time of transfer, because the removal would be allowed only after a third party s action (cancellation) or decision not to act (expiration) and could not be caused unilaterally by the transferor (see paragraph (c)). However, once the cancellation or expiration has occurred, the transferor would have the unilateral ability to remove specific financial assets and would need to recognize those financial assets if that ability provides a more-thantrivial benefit to the transferor PwC

122 Control criteria for transfers of financial assets revised March 2016 f. Because the transferor could not cause the reacquisition unilaterally a transferor does not maintain effective control through a removal-of-accounts provision that obligates the transferor to reacquire transferred financial assets from a securitization entity only after either: 1. A specified failure of the servicer to properly service the transferred financial assets that could result in the loss of a third-party guarantee 2. Third-party beneficial interest holders require a securitization entity to repurchase that beneficial interest. Excerpt from ASC The following are other examples of the application of effective control principles: a. In a loan participation, the lead bank (that is also the transferor) allows the participating bank to resell but reserves the right to call at any time from whoever holds it and can enforce the call option by cutting off the flow of interest at the call date; such a call option precludes sale accounting. b. In a securitization, a call option permits the transferor to reclaim all of the transferred financial assets from the securitization entity at any time; such a call option precludes sale accounting unless both of the following conditions exist: 1. The call option is an option to call, at fair value, a financial asset that is readily obtainable in the marketplace. 2. The transferor does not hold a residual beneficial interest in the transferred financial assets (see paragraph ). c. A transferor-servicer transfers a group of entire financial assets to a securitization entity and has the right to call all of the financial assets when the group amortizes to 20 percent of its value (determined at the date of transfer). The transferorservicer determines that at that level of financial assets, its cost of servicing them would not be burdensome in relation to the benefits of servicing, and therefore that the call option is not a cleanup call. Such a call option precludes sale accounting for the entire group of transferred financial assets (see paragraph ). d. If the third-party beneficial interests contain an embedded option and the transferor holds the residual interest in the securitization entity, the combination has the same kind of effective control as a scheduled auction provision if the transferor holds a residual beneficial interest. Sale accounting would be precluded for all of the transferred financial assets affected by the call option. e. If the third-party beneficial interests in a securitization entity pay off first (a socalled turbo structure, where principal payments and prepayments are allocated on a non-pro rata basis, as discussed in paragraph ), the transferor may not maintain effective control over transferred financial assets (see PwC 2-69

123 Control criteria for transfers of financial assets revised March 2016 paragraph ). To some extent, these repayments are contractual cash flows of the underlying assets, but repayments also result from prepayments in the underlying assets (that is, the prepayment options in the underlying assets are mirrored in the third-party beneficial interests). In this circumstance, call options embedded in the third-party beneficial interests result from the options embedded in the underlying assets (that is, they are held by the underlying borrowers rather than the transferor), and thus do not preclude sale accounting. f. A transferor s contractual right to repurchase, at any time, a loan that is not a readily obtainable financial asset would preclude sale accounting, because the transferor s contractual right to repurchase is effectively a call option of the type described in paragraph (c)(2). Excerpt from ASC A This guidance illustrates the concept in paragraph that a transferor maintains effective control if it has a right to reclaim specific transferred assets by paying fair value and also holds the residual interest in the transferred financial assets. If a transferor holds the residual interest in securitized financial assets and can reclaim the transferred financial assets at termination of the securitization entity by purchasing them in an auction, and thus at what might appear to be fair value, then sale accounting for the transfer of those financial assets it can reclaim would be precluded. Such circumstances provide the transferor with a more-than-trivial benefit and effective control over the financial assets, because it can pay any price it chooses in the auction and recover any excess paid over fair value through its residual interest in the transferred financial assets. Excerpt from ASC B Sale accounting is not appropriate if a cleanup call on a group of financial assets in a securitization entity is held by a party other than the servicer. A transferor s call option on the transferred financial assets in the securitization entity is not a cleanup call for accounting purposes because it is not the servicer or an affiliate of the servicer. Excerpt from ASC C In a securitization transaction involving not-readily-obtainable financial assets, a transferor that is also the servicer may hold a cleanup call if it enters into a subservicing arrangement with a third party without precluding sale accounting. Under a subservicing arrangement, the transferor remains the servicer from the perspective of the securitization entity because the securitization entity does not have an agreement with the subservicer (that is, the transferor remains liable if the subservicer fails to perform under the subservicing arrangement). However, if the transferor sells the servicing rights to a third party (that is, the agreement for servicing is between the securitization entity and the third party after the sale of the servicing rights), then the transferor could not hold a cleanup call without precluding sale accounting. Excerpt from ASC D This implementation guidance addresses the application of paragraph (c)(3) through the following examples: 2-70 PwC

124 Control criteria for transfers of financial assets revised March 2016 a. A put option written to the transferee generally does not provide the transferor with effective control over the transferred financial asset under paragraph (c)(3). b. A put option that is sufficiently deep in the money when it is written would, under that paragraph, provide the transferor effective control over the transferred financial asset because it is probable that the transferee will exercise the option and the transferor will be required to repurchase the transferred financial asset. c. A sufficiently out-of-the-money put option held by the transferee would not provide the transferor with effective control over the transferred financial asset if it is probable when the option is written that the option will not be exercised. d. A put option held by the transferee at fair value would not provide the transferor with effective control over the transferred financial asset. Question 2-18 Does the presence of an agent serving both the transferor and transferee cause a transfer to fail sale accounting under ASC (c)? PwC response When assessing whether it retains effective control over a transferred financial asset, a transferor must consider all continuing involvement by it, its consolidated affiliates included in the financial statements being presented, and its agents. However, ASC A clarifies that the transferor needs to consider the involvements of an agent only when the agent acts for and on behalf of the transferor. If the transferor and transferee have the same agent, the agent s activities on behalf of the transferee should not be considered in the transferor s assessment of effective control. For example, an investment manager may act as a fiduciary (agent) for both the transferor and the transferee; therefore, the transferor need only consider the involvements of the investment manager if it is acting on its behalf. The agent that serves as an investment manager of an investment company (fund) has a fiduciary responsibility to perform its duties in the best interests of the investors in the managed fund. An investment manager executing transfers of securities between funds under common management is not necessarily acting on behalf of the transferor, but rather as an agent of both the transferor and transferee, and its decisions are intended to be fair and equitable for both the transferor fund and the transferee fund. As a result, absent an explicit agreement that entitles the transferor fund to reacquire the transferred financial assets, we do not believe that an agent with full investment discretion, as described above, would cause the transferor to fail the requirements for sale accounting. PwC 2-71

125 Control criteria for transfers of financial assets revised March 2016 Question 2-19 Would the transfer of a group of receivables in which the transferor retains a fixedprice call option that allows the transferor to repurchase the entire group of receivables when it reaches a pre-specified level be an impediment to sale accounting under ASC (c)(2)? PwC response It depends. Paragraph ASC (c)(2) states that a transferor maintains effective control through a call option, other than through a cleanup call that provides the transferor with both: the unilateral ability to cause the holder to return specific financial assets, and a more than-trivial-benefit attributable to that ability. If, in the example above, the call option does not meet the definition of a cleanup call, then sale accounting would be precluded for the entire group of transferred receivables. ASC A clarifies that a transfer of an entire financial asset or a participating interest in an entire financial asset may not be accounted for partially as a sale and partially as a secured borrowing. Similarly, if a transferor has the ability to repurchase from a group of transferred receivables any loans it chooses, up to some specified limit that right provides the transferor with the unilateral ability to cause the holder to return specific financial assets. If the option provides the transferor with a more-than-trivial-benefit attributable to that ability, the sale of the entire group of financial assets would fail sale accounting. Question 2-20 If Company A issues a callable debt instrument to Company B, can Company B obtain sale accounting treatment on a subsequent transfer of the financial instrument with the embedded call option? PwC response Yes. Sale accounting would not be precluded for Company B. The call option was embedded by, and is held by, Company A, the issuer of the underlying debt instrument. The call does not cause the transferor (Company B) to maintain effective control because the issuer (Company A the issuer), not the transferor, holds the call. Alternatively, assume Company B transfers financial assets to a securitization entity. The SPE issues beneficial interests containing a fixed-price call option that allows Company B to acquire those interests from its holders at any time. In these circumstances, Company B retains effective control over the financial assets held by the trust and, as such, sale accounting would be precluded PwC

126 Control criteria for transfers of financial assets revised March 2016 Question 2-21 ASC 860 indicates that a cleanup call on transferred financial assets would not prohibit sale accounting. When evaluating whether a call option qualifies as a cleanup call under ASC 860, what factors should be considered? PwC response A cleanup call is defined in ASC as [a]n option held by the servicer or its affiliate, which may be the transferor, to purchase the remaining transferred financial assets, or the remaining beneficial interests not held by the transferor, its affiliates, or its agents in an entity (or in a series of beneficial interests in transferred financial assets within an entity) if the amount of outstanding financial assets or beneficial interests falls to a level at which the cost of servicing those assets or beneficial interests becomes burdensome in relation to the benefits of servicing. The threshold at which the costs of servicing would be considered burdensome is not specified in the guidance. Current practice has generally accepted a level of 10 percent or less of the aggregate par value of the financial assets (as of the transfer date) as the presumptive level where this condition is first deemed to exist. However, in instances where the strike is set at a level greater than 10 percent, the call may qualify as a cleanup call for sale accounting purposes if it can be demonstrated that the servicing cost will likely be burdensome in relation to the benefits that will inure to the servicer at that threshold. Conversely, depending on the structure and nature of the underlying assets, the cost of servicing may not be burdensome even at a 10 percent threshold. If a cleanup call provision exists, a careful analysis of the circumstances should be performed to demonstrate that the costs to the servicer are burdensome. Note that a cleanup call must be held by the servicer or its affiliates (which may be the transferor) to achieve sale accounting. If, subsequent to the transfer, a transferorservicer sells the servicing rights and retains the call option, re-recognition of the financial assets subject to the call may be required. Question 2-23 Would sale treatment be precluded in situations where the transferor retains an attached call option on financial assets that are not readily obtainable? PwC response Sale treatment would be precluded. A transferor does not relinquish control when it holds an attached call on specific financial assets that are not readily obtainable, regardless of whether the call s strike price is fixed, otherwise determinable, or at fair value. Additionally, this attached call will result in more than a trivial benefit to the transferor. A call option or forward contract on non-readily obtainable financial assets provides the transferor with control over those assets. These contracts will likely constrain the transferee, as it must be in a position to obtain the financial asset to comply with its PwC 2-73

127 Control criteria for transfers of financial assets revised March 2016 obligations under the call or forward contract. Since the underlying assets are not readily obtainable, it is likely that the option or forward will constrain the transferee from selling or otherwise monetizing them. A constraint may exist during the term of the contract (American option) or only at maturity (European option or forward contract). ASC 860 does not distinguish between these types of constraints. When analyzing whether option contracts are possible constraints, the economic terms must be analyzed to assess the probability that the option will be exercised. The probability analysis is made when the contract is written and when circumstances change. Generally, the following conclusions are appropriate when analyzing call options held by a transferor on financial assets that are not readily obtainable: At the money constraint because it provides the transferor with the right to acquire an asset that is not readily obtainable for a fixed price In the money constraint because it provides the transferor with the right to acquire an asset that is not readily obtainable for a fixed price Out of the money may not be a constraint if it is probable (when the option is written) that it will not be exercised Question 2-24 Company A is in the construction business and has a long-term construction and sale agreement (CSA) with Company X to build certain capital projects for fixed fees. Larger projects completed by Company A under the CSA take several years to complete and typically have resulted in long-term receivables payable by Company X in instalments over periods that range from several years to over a decade. Under the CSA, Company A provides Company X with a one year product warranty from the date each project is completed and accepted by Company X, and also passes through to Company X all third party manufacturer equipment and material warranties for materials that go into the construction of such projects. If Company A defaults on any of its warranty obligations, Company X can withhold payment of any amounts payable to Company A under any contract to compensate for such losses. Company A has entered into a master purchase agreement (MPA) with Company Z, pursuant to which Company A is obligated to sell, and Company Z is obligated to purchase, receivables from completed projects arising from the CSA between Company A and Company X. Company A s only involvement with the transferred receivables consists of the following recourse arrangements, which entitle Company Z to put the transferred receivables to Company A, and re-coup the purchase price paid, in response to the following: a. Company A violates its general representations to Company Z with respect to the transferred receivables, or b. The receivables are reduced, abated or set off by the Company X as a result of actions or failures on the part of Company A, such as: i. Company A fails to render required services under the CSA agreement 2-74 PwC

128 Control criteria for transfers of financial assets revised March 2016 ii. Company A defaults on any other contract with Company X The first condition is linked only to the services performed under the specific contract that generated the transferred receivable. However, the second condition is unrelated to the receivable s underlying contract; instead, it effectively grants Company X a right of offset with respect to its obligations to Company A, including obligations arising from events that have not yet (and ultimately may not) occur. Do product and service warranties result in Company A retaining effective control over the receivables sold to Company Z under the MPA, thus precluding accounting for those transfers as a sale? PwC response No. None of the conditions in the MPA results in Company A maintaining effective control over the receivables sold to Company Z under ASC (c). If Company A were to default on its obligations to Company X, Company X can withhold payment under any of its contracts with Company A. As a result, Company Z would not collect the entire amount due on the affected receivables purchased from Company X. In that scenario, Company Z can put the receivables back to Company A and recover its investment. Thus, in effect, Company A would repurchase all or part of the transferred receivable. Theoretically, Company A could cause an act of default, but that action would not, in and of itself, allow it to regain control of the receivables affected by such action. Repurchase of the receivables does not automatically result from Company A s default; multiple events outside of the control of Company A would have to occur first to allow Company A to regain control -- namely, Company A first must default on one or more of its obligations to Company X. Company X then would have to act by withholding payments on receivables owned by Company Z. Only then would Company Z have the right to put the receivables back to Company A. We believe that the existence of such multiple events, which necessarily must take place before Company A can regain control of the receivables, means that Company A is not in a position to initiate an action that allows it to unilaterally re-assert effective control over the transferred receivables. Regarding the CSA and MPA, Company A s obligations vis-à-vis the service warranty and other set-off provisions are akin to general representations and warranties made with respect to a transferred financial asset. Therefore, the product and service warranties do not give Company A the ability to unilaterally cause Company X to return specific financial assets. PwC 2-75

129 Control criteria for transfers of financial assets revised March 2016 Question 2-25 Would a transfer of financial assets with a simultaneous sale to the transferee of a put allowing the transferee to sell the assets back to the transferor violate the sale accounting criteria? PwC response It depends. ASC 860 requires the use of judgment that shall consider all arrangements or agreements made contemporaneously with, or in contemplation of, a transfer, even if they were not entered into at the time of the transfer. The guidance does not prohibit sale treatment for the transfer of financial assets accompanied by a put option written to the transferee if the transferee is not restricted from selling or pledging the asset and the requirements of paragraph (a) (legal isolation) are met. However, a put option on a financial asset that is not readily obtainable may benefit the transferor and effectively constrain the transferee if the option is sufficiently deep-in-the-money at the date of issuance such that the put option is likely to be exercised by the transferee. Said differently, the transferee is unlikely to sell the assets to a third party at current market value in view of the higher price it could receive from the transferor. Thus, the transferor will likely reacquire the transferred financial asset (refer to ASC D cited above). Accordingly, in-the-money put contracts need to be evaluated carefully to assess whether, for sale accounting purposes, the option held by the transferee should be considered a constructive forward contract due to the option s beneficial economic terms. If deemed a constructive forward contract involving transferred assets that are not readily obtainable, the transferee is presumptively constrained as it cannot sell the asset in the market and still be assured that it can repurchase the asset and benefit from the put s beneficial terms. The economic benefit of the put to the transferee constitutes a potential constraint on what it can do with the asset, and therefore may cause the transfer to fail to meet the condition in ASC (b). If sale accounting is deemed appropriate, the put option should be recorded at its fair value, which would reduce the gain on the transaction. The valuation of the put may be difficult. Further, care should be taken to ensure that the counsel s true sale analysis explicitly considers the put option; in certain jurisdictions, a put option held by the transferee may jeopardize the legal isolation assertion. Question 2-26 Are wash-sale transactions, in which a transferor sells a financial asset for cash and repurchases the same asset shortly thereafter (generally within days) at its current fair value, treated as financings under ASC 860? PwC response No. ASC clarifies that a wash-sale transaction is to be accounted for as a sale unless the transferor and transferee execute a contract concurrent with the transfer that allows the transferor to repurchase or redeem the transferred financial asset at a later date. In the absence of any such arrangement, the transferor is not 2-76 PwC

130 Control criteria for transfers of financial assets revised March 2016 considered to maintain effective control over the transferred financial asset, even if it repurchases the asset within a short period of time. Accordingly, the sale criteria in paragraph are satisfied in these instances, and de-recognition is appropriate. Considering the short-term nature of the separate sale and purchase transaction and considering ASC 860 s requirements to evaluate all arrangements entered into in contemplation of a transfer, some factors to consider that would support sale accounting for a wash-sale include: Sale and subsequent purchase executed on readily obtainable assets No contemporaneous agreement exists that entitles and obligates the seller to repurchase the readily obtainable financial assets at a later date The sale and subsequent purchase are not executed with the same counterparty Question 2-27 A transferor retains an option to repurchase, at par a group of transferred loans. The option becomes exercisable 10 years after the transfer date. The contractual maturities of the transferred loans range between 20 and 30 years. How should this option be assessed under ASC (c) when evaluating whether the transferor has maintained effective control over the loans? PwC response The repurchase option will likely preclude sale treatment under ASC (c). Under ASC (c)(2), a transferor is considered to maintain effective control over transferred financial assets if there is an agreement that provides the transferor with the unilateral ability to cause the holder to return specific financial assets and provides more than a trivial-benefit to the transferor. Absent the borrowers prepayment of the loans (or another maturity event), the option becomes exercisable when the non-call period lapses (i.e., after 10 years). Although there is no implementation guidance in ASC 860 that addresses this specific fact pattern, a similar fact pattern is discussed in ASC (c). In that subparagraph s fact pattern, a transferor holds an option that allows it repurchase a group of transferred assets when the group amortizes to 20 percent of its value (determined at the transfer date). The arrangement does not meet the conditions to be considered a cleanup call. The guidance asserts that sale accounting is precluded in this instance, as the option allows the transferor to unilaterally cause the return of the transferred group of assets once an event certain to occur takes place namely, amortization of the loan pool to 20 percent of its initial value assuming that the loans have not been prepaid. We believe that the passage of time principle that underlies the guidance in ASC (c) is applicable to the fact pattern in this example. As such, the ability of the transferor to repurchase the loans after 10 years would preclude sale accounting at the transfer date. Despite the 10-year non-call period, the transferor is still considered to maintain effective control; exercise of the option is not contingent upon an event that may (or may not) occur. PwC 2-77

131 Chapter 3: Accounting for sales-type transfers PwC 1

132 Accounting for sales-type transfers Chapter overview In Chapter 1 (refer to TS 1), we defined what ASC 860 considers a transfer of financial assets. In this Chapter, we discuss the accounting for a transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset that qualifies for sale accounting. ASC 860 defines a transfer of financial assets as the conveyance of a non-cash financial asset by and to someone other than the issuer of that financial asset. Thus, a transfer includes selling a receivable, putting the receivable into a securitization trust, or posting it as collateral but excludes the origination of that receivable, the settlement of that receivable, or the restructuring of that receivable into a security in a troubled debt restructuring. The accounting for a transfer of financial assets depends on whether the transfer qualifies for sale accounting. If it does, the transferred financial assets are derecognized. If it does not, the transfer is accounted for as a secured borrowing (refer to TS 4). This Chapter discusses the accounting for transfers of financial assets that qualify for sale accounting, including the initial recognition of the sale and the subsequent accounting for assets retained and received, as well as liabilities incurred in qualifying transfers by the transferor and transferee. 3-2 PwC

133 Accounting for sales-type transfers Figure 3-1 Framework for accounting for transfers of financial assets 1 1 For the purposes of this figure, the consolidation models in ASC 810 are not incorporated. In determining whether the transferee is a consolidated affiliate of the transferor, these models must be considered. PwC 3-3

134 Accounting for sales-type transfers Key questions answered in this chapter Paragraphs in ASC Page in this publication How should a transferor account for a transfer of an entire or group of entire financial assets that qualify for sale accounting? How should a transferor account for a transfer of a participating interest in an entire financial asset that qualifies for sale accounting? How should a transferor subsequently account for financial instruments obtained or created as part of a sale of financial assets? How should a transferor account for beneficial interests obtained in a transfer that qualifies as a sale? How should a transferor account for the rerecognition of financial assets previously sold? How should a transferee account for transfers of financial assets? 25-1, 40-1B , N/A through , How should a transferor account for a transfer of entire financial assets, group of entire financial assets, or participating interests in entire financial assets that qualify for sale accounting? For a transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset to qualify for sale accounting, a transferor and any of its consolidated affiliates included in the financial statements being presented must surrender control over the transferred financial assets. The surrender of control is defined in the sale criteria of ASC and 40-5 (refer to TS 2 for further information). If the transferor has surrendered control of the transferred financial assets, the transfer qualifies for sale accounting. The assets should be derecognized from the transferor s balance sheet, and any resulting gain or loss on the transfer should be recognized. ASC 860 describes the accounting that a transferor must apply to a sale of a participating interest that meets the conditions for sale accounting. In addition, it describes the accounting that a transferor must apply to a sale of an entire or group of entire financial assets. The guidance for both reads as follows: 3-4 PwC

135 Accounting for sales-type transfers Excerpt from ASC A Sale of a Participating Interest Upon completion of a transfer of a participating interest that satisfies the conditions in paragraph to be accounted for as a sale, the transferor (seller) shall: a. Allocate the previous carrying amount of the entire financial asset between both of the following on the basis of their relative fair values at the date of the transfer: 1. The participating interests sold 2. The participating interest that continues to be held by the transferor b. Derecognize the participating interest(s) sold c. Apply the guidance in paragraphs and on recognition and measurement of assets obtained and liabilities incurred in the sale d. Recognize in earnings any gain or loss on the sale e. Report any participating interest(s) that continue to be held by the transferor as the difference between the following amounts measured at the date of the transfer: 1. The previous carrying amount of the entire financial asset 2. The amount derecognized. Excerpt from ASC B Sale of an Entire Financial Asset or Group of Entire Financial Assets Upon completion of a transfer of an entire financial asset or a group of entire financial assets that satisfies the conditions in paragraph to be accounted for as a sale, the transferor (seller) shall: a. Derecognize the transferred financial assets b. Apply the guidance in paragraphs and on recognition and measurement of assets obtained and liabilities incurred in the sale c. Recognize in earnings any gain or loss on the sale If the transferred financial asset was accounted for under Topic 320 as available for sale before the transfer, item (a) requires that the amount in other comprehensive income be recognized in earnings at the date of transfer. As described above, when accounting for a transfer of an entire financial asset(s) or a participating interest that qualifies as a sale, the assets transferred in the sale must be PwC 3-5

136 Accounting for sales-type transfers derecognized from the transferor s balance sheet. To determine the amount that must be derecognized, entities need to distinguish between a participating interest in a financial asset and an entire financial asset(s). If a participating interest was sold, the transferor must allocate the previous carrying amount of the entire financial asset between the participating interest sold and retained. ASC 860 requires this allocation, (described in further detail below) to be based on the relative fair values of the participating interest transferred and the participating interest the transferor continues to hold. That is, the participating interest retained is not part of the proceeds of the sale. Conversely, if an entire financial asset(s) was sold, the transferor recognizes all assets obtained (including beneficial interests in the transferred financial assets) as part of the proceeds of the sale. As a result, no relative fair value allocation is required in sales of financial assets, unless the sale is of a participating interest. In addition to the derecognition guidance above, a transferor should consider the sale accounting recognition guidance included in ASC and ASC This guidance requires that upon completion of a transfer that qualifies as a sale, the transferor (seller) shall also recognize at fair value any assets obtained or liabilities incurred in the sale, including but not limited to, any of the following: Cash 2 Servicing assets 2 Servicing liabilities 2 In a sale of an entire financial asset or a group of entire financial assets, any of the following: o o o o The transferor s beneficial interest in the transferred financial assets 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 securitizations) Swaps (for example, provisions that convert interest rates from fixed to variable). See examples included in TS for illustration of this guidance. The transferor should separately recognize any servicing assets obtained or servicing liabilities incurred in the transfer at their fair values. ASC 860 requires that certain assets and liabilities embedded in complex financial asset transfers, such as interest- 2 In transfers of participating interests in entire financial assets, only cash, servicing assets and servicing liabilities may be obtained as part of the transfer. That is, no beneficial interests, put or call options, forward commitments, swaps, etc., may be obtained in a transfer of a portion of a financial asset for the transfer to comply with the definition of a participating interest. 3-6 PwC

137 Accounting for sales-type transfers rate swaps, credit derivatives and recourse obligations, be separately identified and initially recognized at fair value. Most transfers of financial assets are accounted for and recorded at the settlement date, excluding transfers in specialized industries that require accounting on the trade date for assets and settlement date for liabilities (e.g., investment-company and broker-dealer accounting). The guidance in ASC 860 does not modify or address whether contracts to purchase or sell securities should be accounted for at trade or settlement date. The remainder of this section discusses certain components of the accounting described above, including more details and examples on the differences between a transfer of a participating interest and a transfer of an entire financial asset or a group of entire financial assets Derecognition of transferred financial assets When recording a transfer of financial assets that qualifies for sale accounting, the transferor must first derecognize the financial assets transferred. If the sale was that of a participating interest, the carrying amount of the entire financial asset on the transferor s financial statements must be allocated between the participating interest transferred and retained by the transferor based on the relative fair value of each of the interests (ASC A). However, if the sale was that of an entire financial asset(s), the transferor recognizes all assets obtained (including beneficial interests) and liabilities incurred as part of the net proceeds of the sale (ASC ). That is, all assets obtained and liabilities incurred are recorded initially at fair value and not based on an allocated cost basis. Consider the following examples: Company A transfers a participating interest that meets the criteria within ASC 860 in an entire financial asset with a carrying amount of $100 and a fair value of $200 to a trust. Company A retains a participating interest in the entire financial asset with a fair value of $50 (therefore, the participating interest held by the trust has a fair value of $150) and receives cash of $150. The carrying amount of the participating interest sold would be allocated as follows: $25 (25 percent or $50/$200 of the carrying amount) to the interest retained by the transferor and $75 (75 percent or $150/$200) to the interest sold to the trust. After the carrying amount of the participating interests is allocated to both the interest retained by the transferor and the interest transferred to the trust, the transferor should derecognize the portion attributable to the interest transferred. Using the example above, the transferor would derecognize $75 ($100 $25) from the financial assets on its balance sheet and would recognize a gain on sale of $75, which is the difference between the consideration received of $150 and the allocated amount to the interest transferred or $75. Consider the same facts above with the following two exceptions. First, the transfer was that of a group of entire financial assets and not of a participating interest and, second, the transferor obtained a beneficial interest with a fair value of $50 as part of the transfer instead of retaining a participating interest. Under this scenario, Company A would derecognize the entire carrying amount of $100 and would recognize a beneficial interest at fair value or $50 on its balance sheet. Under this scenario the gain on sale ($100) would be the difference between the net proceeds PwC 3-7

138 Accounting for sales-type transfers received ($150 in cash plus the beneficial interest of $50) and the carrying amount of the financial assets prior to the transfer or $100. As can be noted in the examples above, the gain on sale under the participating interest scenario would be lower ($75) when compared to the transfer of an entire financial asset ($100). This is because under the participating interest rules, the retained interest needs to be allocated based on the relative fair value of the previous carrying amount whereas in the transfer of an entire financial asset or group of entire financial assets, the beneficial interest obtained is considered part of the net proceeds of the sale. If the transfer of the entire financial asset(s) described in the example above included a credit enhancement provided by the transferor, the fair value of the beneficial interest ($50 in our example) may have been impacted. ASC provides guidance to assist in making the determination as to whether any retained credit risk (credit enhancements) is a separate liability or part of a beneficial interest that has been obtained by the transferor. The guidance requires transferors to focus on the source of cash flows in the event of a claim by the transferee. If the transferee can only look to the cash flows from the underlying financial assets, the transferor has obtained a portion of the credit risk only through the interest it obtained and a separate obligation shall not be recognized. In contrast, if the transferor could be obligated for more than the cash flows provided by the interest it obtained and, therefore, could be required to reimburse the transferee for credit-related losses on the underlying assets, the transferor shall record a separate liability. It is not appropriate for the transferor to defer any portion of a resulting gain or loss (or to eliminate gain on sale accounting, as it is sometimes described in practice). Perspectives on common situations in the marketplace today are discussed below: Fair value of credit enhancements In certain sale transactions, the transferor must provide a credit enhancement in the form of a cash reserve account to complete the transaction. The transferor makes a funding deposit into a cash reserve account, or cash flows collected by the securitization entity attributable to the residual tranche held by the transferor are accumulated in the cash reserve account for possible distribution to the other beneficial interest holders if specified collection targets are not met. However, if those collection targets are met, distributions are made from the cash reserve account to the transferor as holder of the residual tranche beneficial interest. To estimate the fair value of a credit enhancement, a number of assumptions may need to be considered, including but not limited to, when cash will be available to the transferor. the period of time during which its use of the financial asset is restricted. when reinvestment income will be received. potential credit losses. 3-8 PwC

139 Accounting for sales-type transfers market spreads. an appropriate discount rate. These assumptions should be based on market participant assumptions consistent with the guidance in ASC 820, Fair Value Measurements and Disclosures. Accrued interest receivable Accrued interest receivables (AIR) are receivables for accrued fee and finance charge income, whether billed but uncollected or accrued but unbilled. ASC 860 clarified that AIR should be accounted for as a beneficial interest in cases where the right to receive AIR (if and when collected) has been transferred to a trust as part of a securitization transaction. Therefore, any AIR should be included as part of the proceeds from the sale in a transfer of entire financial assets or a group of entire financial assets. AIR related to securitized and sold receivables should not be classified as loans receivable or other terminology that implies it has not been subordinated to the senior interests in the securitization Assets obtained and liabilities incurred (proceeds received in the transfer) Assets obtained (including a transferor s beneficial interest in the transferred financial assets) and liabilities incurred by the transferor in a sale of entire financial asset(s) are recognized at fair value on the transferor s financial statements. A participating interest retained is recognized based on an allocation of the previous carrying amount between the participating interest sold and the participating interest retained. The guidance discusses how to account for assets obtained and liabilities incurred in a sale of financial assets and how to determine the amount of net proceeds. Excerpt from ASC The proceeds from a sale of financial assets consist of the cash and any other assets obtained, including beneficial interests and separately recognized servicing assets, in the transfer less any liabilities incurred, including separately recognized servicing liabilities. Any asset obtained is part of the proceeds from the sale. Any liability incurred, even if it is related to the transferred financial assets, is a reduction of the proceeds. Any derivative financial instrument entered into concurrently with a transfer of financial assets is either an asset obtained or a liability incurred and part of the proceeds received in the transfer. All proceeds and reductions of proceeds from a sale shall be initially measured at fair value. The net proceeds received in a sale of financial assets equals the total assets obtained in the transfer, including any cash, beneficial interests, derivatives, servicing assets, or other assets, less any liabilities incurred. For transfers of participating interests, ASC limits the assets and liabilities that may be obtained or incurred, respectively, to cash, servicing assets and servicing liabilities. In addition to cash and other typical forms of consideration, new assets (e.g., call options, swaps, and forward sale agreements) are initially recognized at fair value as proceeds from the sale. PwC 3-9

140 Accounting for sales-type transfers Liabilities incurred (e.g., recourse obligations, puts, swaps, servicing liabilities) are recognized at fair value as reductions of proceeds from the sale. Therefore, assets obtained or liabilities incurred affect the amount of gain or loss on a transfer of financial assets accounted for as a sale. Determining the fair values of many of these assets and liabilities may require the valuation services of an expert such as an investment banker or independent appraiser. Guidance on accounting for common assets obtained and liabilities incurred in sale transactions is outlined below: Cash Any cash received on the sale of financial assets should be recognized as an asset and as proceeds from the sale. Beneficial interests As part of a transfer of entire financial asset(s), the transferor may obtain the rights to receive all or portions of specified cash inflows received by a trust or other entity, including, but not limited to, senior and subordinated shares of interest, principal, or other cash inflows to be passed-through or paid-through, premiums due to guarantors, commercial paper obligations, and residual interests, whether in the form of debt or equity. ASC 860 requires that these rights be recognized separately. The separately recognized beneficial interest is considered part of the sale transaction s proceeds and must be initially recognized at fair value (refer to TS for more information on accounting for beneficial interests). This differs from the previous ASC 860 model, which required a transferor to recognize any beneficial interest in the transferred financial assets based on the allocated carrying amount of the transferred assets between the assets sold and the financial assets retained using a relative fair value calculation. Beneficial interests may be determined to be derivative instruments in their entirety or may contain embedded derivatives requiring bifurcation under ASC 815. Refer to PwC s Guide, Accounting for Derivative Instruments and Hedging Activities, Chapter 3, and to TS 3.3 within this Chapter for more details. Derivatives An instrument must meet the definition of a derivative in ASC to be accounted for as a derivative measured initially and subsequently at fair value under ASC 815. Derivatives measured at fair value include derivatives embedded in hybrid financial instruments that require bifurcation under ASC Derivatives obtained (purchased or written) Any derivatives obtained, whether held or written by the transferor in a transfer of entire financial asset(s), should be recognized at their fair values. Therefore, derivatives obtained can be recognized as assets (i.e., proceeds on the sale) or liabilities (i.e., reduction of proceeds on the sale). Derivatives obtained in sale transactions often include call options, put options, and swaps PwC

141 Accounting for sales-type transfers Derivatives created (purchased or written) Securitizations of entire financial asset(s) may involve the transfer of fixed rate receivables to a trust that, in turn, issues variable-rate certificates. Sometimes the transferor enters into an agreement with the trust to swap the fixed rate on the receivables for a floating rate. In other situations, the transferor may sell fixedrate receivables to a trust and hold the residual interest in the trust (without any further obligation), while the trust issues floating-rate certificates to third-party investors. In the second scenario, if interest rates rise enough, the trust may use the cash flows collected from the fixed-rate receivables to liquidate the floating-rate certificates; in effect, the transferor will not realize any value from its residual interest (i.e., the trust will have no cash remaining after paying the third-party investors). In this case, the transferor does not need to recognize an additional asset or liability because the transferor has no further obligation beyond the residual interest in the trust. However, in the first scenario, if the transferor agrees to reimburse third-party investors beyond the cash collected from the trust, the transferor is required to recognize the incremental liability at each date on which the receivables are sold to the trust. Derivatives created should be recognized at fair value as either assets (i.e., proceeds on the sale) or liabilities (i.e., reduction of proceeds on the sale). Servicing rights As part of a transfer of financial assets, the transferor may retain the contractual right to service the transferred financial assets. ASC 860 requires that this right to service financial assets be recognized separately as either an asset or a liability when represents a compensation at a level that is other than adequate. This includes only situations in which an entity enters a servicing contract through a transfer of financial assets that meets the requirements for sale accounting and thereby assumes the obligation to service those financial assets or purchase a stand alone servicing contract in a separate transaction. The separately recognized servicing asset or servicing liability is considered part of the sale transaction s proceeds and must be initially recognized at fair value (refer to TS 5 for more information on accounting for servicing assets or servicing liabilities). Forward sale agreements The master trust structure has become the predominant structure used in the credit card securitization market for transfers of entire or a group of entire financial assets. In this structure, a credit card issuer establishes a single trust that can accept numerous transfers of account receivables and issue additional securities. All securities issued by the master trust are supported by the cash flows from the receivables contributed to it. Under normal circumstances, the life cycle of credit card asset-backed securities (ABS) is divided into two periods: the revolving period and the amortization period. Generally, the average life of a credit card receivable (either fixed or floating rate) is about 6 12 months but the issued ABS could have a term of 5 10 years. To fund the PwC 3-11

142 Accounting for sales-type transfers ABS, a credit card master trust has a revolving period. During this period, investors only receive interest payments. Principal collections on the receivables are used to purchase new receivables or to purchase a portion of the seller s interest if there are too few new receivables generated by the designated accounts. The revolving period is used to maintain a stable average life and to create more certainty of principal collections for the expected maturity date. After the end of the revolving period, the amortization period begins, and principal collections are used to repay investors in the ABS. This amortization period may be longer or shorter depending on the monthly payment rate of the accounts in the master trust. The required reinvestment of principal payments in new receivables after the original transfer is effectively a forward sales contract between the transferor (originator of receivables) and the transferee (trust or securitization entity). ASC 860 requires that the transferor recognize the implied forward sales contract at fair value as proceeds on the sale (or a reduction in the proceeds of the sale, if the forward sales contract is a liability) when the first receivables are sold under the revolving sales agreement, even though the contract to sell receivables may have been entered into prior to the first transfer of receivables. If the contract calls for forward sales to occur at the market rate, there is unlikely to be significant value in the forward sales contract. However, if the forward sales contract calls for the sale of receivables at fixed terms (e.g., interest rate) that are different from the current forward-market rates on the date of first transfer, value may exist for the contract. For example, if the agreed-upon contractual rate paid to investors in a trust is 6 percent and the forward-market rate for those investments is 7 percent on the date of first transfer, the implicit forward contract s value to the transferor would be approximately the present value of the 1 percent of the amount of the investment for each year remaining in the revolving structure after the receivables already transferred have been collected. Other assets obtained Other assets received on the sale of financial assets should be recognized at fair value as proceeds from the sale. Recourse obligations A transferor of entire financial assets or groups of entire financial assets may retain an obligation to compensate the transferee for debtors failure to make payments when they become due, an obligation known as a recourse obligation. Typically, a higher cash price is received for loans sold with recourse to compensate the seller for assuming the credit risk. Recourse obligations related to the sale of entire of groups of entire receivables with recourse should initially be recognized as a liability at fair value at the transfer date. Transferors of portions of entire financial assets cannot retain any recourse obligations (outside of standard representations and warranties) as one of the conditions to meet the definition of a participating interest and account for the transfer as a sale. Any recourse obligations on the part of the transferor in its role as participating interest holder would fail the participating interest criterion in ASC A(c) and thereby be accounted for as a secured borrowing PwC

143 Accounting for sales-type transfers Guarantees From time to time, in order to provide an enhanced credit protection, a transferor or third party may guarantee the performance of the transferred financial asset(s). Any performance guarantees provided in the transfer transaction should be accounted for under ASC 460, Guarantees. Because the accounting for credit enhancement(s) may vary depending on how the specific arrangement is structured, it is necessary to understand the terms of the contractual arrangements. Arrangements referred to as financial guarantees and insurance contracts that relate to an underlying borrower s credit event should be evaluated to determine whether the arrangements qualify for the financial guarantee scope exception in ASC or as a derivative contract that must be accounted for under ASC 815. Other liabilities incurred Other liabilities incurred through the sale of financial assets should be recognized at fair value as a reduction of the proceeds from the sale Calculation of gain or loss on sale For sales of entire financial assets or group of entire financial assets, any gain or loss on the transaction should then be calculated as the net proceeds received on the sale less the carrying amount of the financial assets sold. As described above, the net proceeds of the sale represent the fair value of any assets obtained or liabilities incurred as part of the transaction, including, but not limited to, cash, beneficial interests, put or call options held or written, forward commitments, swaps, recourse obligations, and servicing assets and servicing liabilities, if applicable. For sales of portions of entire financial assets (participating interests), any gain or loss on the transaction should then be calculated as the net proceeds received on the sale less the basis (allocated carrying amount) of the participating interest sold. As described above, the proceeds of the sale represent the fair value of any assets obtained or liabilities incurred as part of the transaction. For a portion of an entire financial asset to meet the definition of a participating interest, the assets obtained, outside of proceeds received from the transfer, including cash, servicing assets, or other receivables, and liabilities incurred, including servicing liabilities, cannot result in the interest holders having disproportionate cash flows in order to meet the criteria in ASC A (refer to TS for more details on the participating interest definition). Example 3-1 illustrates the accounting to be applied by the transferor in a typical sale of entire financial asset(s) (loans), with servicing obtained. This example includes the accounting for the receipt of assets other than cash as part of the proceeds, including both a beneficial interest and a call option, the accounting for the assumption of a liability as part of the proceeds, and the gain or loss to be recorded on the sale. PwC 3-13

144 Accounting for sales-type transfers EXAMPLE 3-1 Recording sales of entire financial asset(s), proceeds of cash, beneficial interest, derivatives, other liabilities, and servicing Company A (the transferor) sells a group of individual loans in their entirety with a fair value of $1,100 and a carrying amount of $1,000. Company A will continue to service the loans. Company A retains an option to purchase loans from the transferee that are similar to the loans sold (which are readily obtainable in the marketplace) and assumes a limited recourse obligation to repurchase delinquent loans. The service contract is based on a compensation level that is other than adequate. Assume that the transfer qualifies for sale accounting. Company A receives cash of $940 and securities backed solely by the transferred loans with a fair value of $110. Category Fair values Net proceeds Cash proceeds $940 Cash received $ 940 Beneficial interest 110 Plus: Beneficial Interest 110 Call option 20 Plus: Call option 20 Servicing asset 90 Plus: Servicing asset 90 Recourse obligation (60) Less: Recourse obligation (60) Net proceeds $1,100 Calculation of gain on sale Cash $ 940 Add assets obtained or deduct liabilities incurred: Beneficial interest 110 Call option 20 Servicing asset 90 Recourse obligation (60) Total 1,100 Less carrying value of assets sold (1,000) Gain on sale $ PwC

145 Accounting for sales-type transfers Journal entry Dr Cr Cash $940 Call option 20 Beneficial interest 110 Servicing asset 90 Loans $1,000 Recourse obligation 60 Gain on sale 100 To record transfer and servicing asset Analysis of balance sheet before and after sale of entire or group of entire financial assets Before sale After sale Cash $ $ 940 Call option 20 Servicing asset 90 Beneficial interest 110 Loans 1,000 Total assets $1,000 $1,160 Recourse obligation $ $ 60 Shareholders equity 1,000 1,100 Total liabilities and shareholders equity $1,000 $1,160 Note that the fair value of the beneficial interest and servicing rights is included in the proceeds received in conjunction with the transfer. ASC 860 requires that, upon completion of a transfer of financial assets, all assets obtained, including beneficial interests and servicing rights be recognized and measured at fair value. Accordingly, beneficial interests and servicing rights are treated as proceeds received in conjunction with the transfer. Example 3-2 illustrates the accounting to be applied by the transferor in a sale of a participating interest. This example illustrates that sales of participating interests under the guidance in ASC 860 would still require the transferor to use the relative fair value model to measure the portion of the financial asset that is not considered sold. PwC 3-15

146 Accounting for sales-type transfers EXAMPLE 3-2 Recording sales of participating interests Company A (the transferor) transfers a portion of an entire loan with a fair value of $990 and retains a portion with a fair value of $110. The total carrying amount of the entire loan prior to the transfer is $1,000. Company A will continue to service the entire loan after the transfer. The service contract is based on a compensation level that is other than adequate. Assume that the portion meets the definition of a participating interest in ASC A and that the transfer qualifies for sale accounting under ASC Company A receives cash of $915. Category Fair values Net proceeds Cash proceeds $915 Cash received $ 915 Participating interest retained 110 Servicing asset 75 Servicing asset 75 Net proceeds $ 990 Carrying amount based on relative fair values Category Fair value Percentage of total fair value Allocated carrying value Participating interest sold $ % $ 900 Participating interest retained Total $1, % $1,000 Calculation of gain on sale Cash $915 Servicing asset 75 Less allocated carrying value of assets sold (900) Gain on sale $ 90 Journal entry Dr Cr Cash $ 915 Servicing asset 75 Loans $ 900 Gain on sale 90 To record transfer and servicing asset 3-16 PwC

147 Accounting for sales-type transfers Analysis of balance sheet before and after sale of participating interest in entire financial asset Before sale After sale Cash $ $ 915 Servicing asset 75 Loans 1, Total assets $1,000 $1,090 Shareholders equity $1,000 $1,090 Total liabilities and shareholders equity $1,000 $1,090 In comparing the gain on sale calculations in Example 3-1 (transfer of entire financial asset(s)) and Example 3-2 (participating interest), one of the key amendments to ASC 860 becomes evident. While a beneficial interest in transfers of entire or group of entire financial assets is considered a new asset obtained by the transferor as proceeds, the amended guidance in ASC 860 specifies that a portion of a financial asset that is retained by the transferor in a transfer of a participating interest of an entire financial asset is not a new or obtained asset, but rather a retained interest that should not be measured at fair value. This is because, in the FASB s view, a participating interest retained has risk characteristics that are identical before and after the transfer. As a result, for all transfers completed after the effective date of the most recent amendments to ASC 860, a participating interest that is retained by the transferor shall be initially measured by allocating the previous carrying amount between the participating interest sold and the participating interest retained. In addition, the servicing asset recognized on the participating interest transfer is calculated based only on the portion of the financial asset sold. 3.2 How should a transferor subsequently account for financial instruments obtained or created as part of a sale of financial assets? The previous section discussed how certain assets obtained or liabilities incurred as part of a sale transaction should be initially recognized. ASC 860 provides very limited guidance on how some of these assets or liabilities should be accounted for subsequent to the sale transaction. ASC includes some considerations on subsequent accounting for the following instruments: a. Financial assets subject to prepayment (refer to TS 3.3). b. Beneficial interests (refer to TS 3.3). c. Transaction costs. d. Recourse obligations. PwC 3-17

148 Accounting for sales-type transfers Transaction costs As stated in ASC , these costs, when related to the sale of receivables, may be recognized over the initial and reinvestment periods in a rational and systematic manner unless the transaction results in a loss. Transaction costs for a past sale are not an asset and thus are part of the gain or loss on sale. In a credit card securitization, however, some of the transaction costs incurred at the outset relate to the future sales that are to occur during the revolving period, and thus can qualify for deferral (i.e., recognized as an asset and amortized). In addition, ASC establishes the subsequent accounting for servicing rights. Servicing rights ASC allows entities the option of subsequently accounting for each class of servicing assets and servicing liabilities by using one of the following methods: Amortizing servicing assets or servicing liabilities 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), and assessing servicing assets for impairment or the adequacy of servicing liabilities at each reporting date Measuring servicing assets or servicing liabilities at fair value at each reporting date and reporting changes in fair value of servicing assets and servicing liabilities in earnings in the period in which the changes occur Chapter 5 (refer to TS 5) discusses the accounting for servicing assets and servicing liabilities in further detail. Outside of the discussion above, all other assets or liabilities should be accounted for using the accounting guidance that would otherwise be applicable, regardless of the method of acquisition. The following represents a discussion of the day two accounting model for financial instruments in secured structures: Derivatives obtained (purchased or written) Derivatives obtained as part of sale transactions, such as call options, put options, or swaps, are initially recognized at fair value. Derivatives that meet the definition of a derivative under ASC 815 should also be recognized at fair value in subsequent periods, with changes in that fair value recognized in earnings in accordance with ASC 815. Derivatives created (purchased or written) If the transferor agrees to reimburse the third-party investors beyond the cash collected from the trust, the transferor would need to recognize the fair value of the credit risk obligation at each date on which the receivables are sold to the trust. Instruments that meet the definition of a derivative under ASC 815 and were created by the sale transaction would be recognized at fair value as either assets (i.e., proceeds 3-18 PwC

149 Accounting for sales-type transfers on the sale) or liabilities (i.e., reduction of proceeds on the sale). ASC 860 does not specify the accounting for assets and liabilities created from a transfer of financial assets, but such derivatives should also be recognized at fair value in subsequent periods, with changes in that fair value recognized in earnings. Forward sale agreements The subsequent accounting for a forward sale agreement will depend on the facts and circumstances of the agreement. If the forward sale agreement meets the definition of a derivative under ASC 815, it should be accounted for as a derivative and recorded at fair value with changes in that fair value recognized in income. However, in practice, forward sale agreements provide for physical delivery and may not meet the definition of a derivative under ASC 815. This is because forward sale agreements generally require the transferor to physically deliver to the trust financial assets that are not readily convertible to cash (other than certain mortgage loans) and cannot be settled net. A careful analysis of the facts and circumstances of the forward sale agreement should be performed to determine whether it meets the definition of a derivative, and in particular ASC Other assets obtained Other assets obtained through the sale of financial assets should be subsequently accounted for using the accounting guidance that would apply to the assets regardless of their method of acquisition. The subsequent accounting should consider the nature of the asset and how such items are accounted for when they exist in other transactional situations. Recourse obligations and guarantees ASC 860 does not provide guidance on the subsequent measurement of retained recourse obligations. The first step that should be considered is whether the recourse obligation meets the definition of a derivative under ASC 815 and, if so, whether it is eligible for the scope exception of ASC If the recourse obligation fails to meet the financial guarantee scope exception in ASC 815, it must be subsequently accounted for at fair value with changes in fair value recognized in current earnings. If the recourse obligation does not require subsequent accounting under ASC 815, subsequent accounting at fair value would be inappropriate, unless the fair value option in ASC 825 is elected. Although ASC 460 does not address the accounting subsequent to the establishment of a guarantee liability (a recourse obligation would meet the characteristics of a guarantee in ASC 460), it states that the guarantee would be reduced by a credit to earnings, as the guarantor is released from risk under the guarantee. ASC 460 also states that depending on the nature of the guarantee, the guarantor s release from risk has typically been recognized over the term of the guarantee (a) only upon either expiration or settlement of the guarantee, (b) by a systematic and rational amortization method, or (c) as the fair value of the guarantee changes. How the guarantor is released from risk will depend on the nature of the guarantee. The guarantor could be released by means of expiration or settlement of the guarantee or the release might occur ratably over the life of the guarantee, recognized through PwC 3-19

150 Accounting for sales-type transfers systematic and rational amortization. The recognition and subsequent adjustment of the contingent liability for the retained recourse obligation should be performed under ASC 450. ASC 460 clarifies that such Topic may not be used to support subsequent accounting at fair value (i.e., the subsequent accounting for a guarantee cannot be at fair value unless required by other GAAP, such as ASC 815 or elected under the fair value option in ASC 825). The terms of the arrangements should be analyzed to determine whether they are, in fact, recourse. Though often termed nonrecourse, early payment default programs require the seller to repurchase any loan sold under this type of program that becomes delinquent during a specified time period. If the borrower is not delinquent on its loan payments during the specified time period, the recourse provision becomes void and the loan transfer becomes fully nonrecourse. One instance of an arrangement that requires analysis is the Department of Veteran Affairs (VA) No-bid arrangement. In this case, the VA provides a guarantee on qualifying mortgages, but the VA guarantee is limited. The mortgage banking entity may be required to fund any deficiency in excess of the VA guarantee if the loan goes to foreclosure. Even in instances where mortgage banking entities sell loans without recourse, they remain liable to the purchaser for standard representations and warranties made at the time of sale (e.g., underwriting criteria and file documentation). The mortgage banker could be required to repurchase a defaulted loan from an investor, if the loan subsequently does not meet the representations made to the investor. Other liabilities incurred Other liabilities incurred on the sale of financial assets should be subsequently accounted for under the applicable literature. The subsequent accounting should consider the nature of the liability and how such items are accounted for when they exist in other situations. 3.3 How should a transferor account for beneficial interests obtained in a transfer that qualifies as a sale? Many secured structures result in the transfer of financial assets to a securitization entity through one or multiple steps. The securitization entity issues to third parties interests in the cash flows generated by the entire financial assets or group of entire financial assets that it holds. These interests are commonly referred to as beneficial interests, and are defined as: 3-20 PwC

151 Accounting for sales-type transfers ASC Beneficial Interests Rights to receive all or portions of specified cash inflows received by a trust or other entity, including, but not limited to, senior and subordinated shares of interest, principal, or other cash inflows to be passed-through or paid-through, premiums due to guarantors, commercial paper obligations, and residual interests whether in the form of debt or equity. Beneficial interests can take many different forms, such as securities, notes, or commercial paper. Examples of beneficial interests in securitizations include mortgage-backed securities, asset-backed securities, credit-linked notes, collateralized debt obligations, and interest-only or principal-only strips. The primary investors in beneficial interests in securitizations are insurance companies, banks, broker-dealers, hedge funds, pension funds, and other individuals or companies that maintain a significant investment or trading portfolio. However, the transferor of financial assets in a secured structure often obtains an interest in the assets held by the trust. The interest obtained by the transferor has historically been referred to as a retained interest. After the effective date of the most recent amendments to ASC 860, it is expected that the term retained interest will be mostly used to refer to the portion of an entire financial asset that was retained by the transferor in a transfer of a participating interest that meets the conditions for sale accounting. As a result and to avoid confusion, all interests obtained in transfers of entire financial asset(s) will be referred to in the remainder of this Chapter as beneficial interests General accounting guidance for beneficial interests Assets and liabilities recorded as a result of ASC 860 should be accounted for under existing generally accepted accounting principles. For example, debt securities resulting from the transfer of financial assets are required to be accounted for under ASC 320, while derivatives are required to be accounted for under ASC 815. Specifically, the accounting for beneficial interests in securitizations is generally governed by: Excerpt from ASC Financial assets, except for instruments that are within the scope of ASC , that can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment shall be subsequently measured like investments in debt securities classified as available-for-sale or trading under ASC 320. Examples of such financial assets include, but are not limited to, interest-only-strips, other beneficial interests, loans or other receivables. Financial assets are subject to prepayment risk when they can be contractually prepaid or otherwise settled in a way that would prevent the holder from recovering PwC 3-21

152 Accounting for sales-type transfers substantially all of its recorded investment. The term substantially all is not defined in ASC 860. However, based on other accounting literature, we interpret substantially all to mean 90 percent of the investment. When interest-only strips, loans, beneficial interests or other receivables can be contractually prepaid or otherwise settled in a way that would prevent the holder from recovering substantially all of its recorded investment (except for those that are within the scope of ASC 815), they should be recognized at fair value by classifying the financial assets as available-for-sale (AFS) or trading securities consistent with the guidance in ASC 320, even if such instruments are not in the form of securities within the scope of that Topic. However, other provisions of that Topic, such as those addressing disclosures, are not required to be applied when the instruments are not in the form of securities. Changes in the fair values of these financial assets would also be recognized in accordance with ASC 320 through other comprehensive income (OCI) for AFS securities and through income for trading securities. A security may not be classified as held-to-maturity if it can be prepaid in a manner where the investor would not recover its principal. Consideration should also be given to ASC for certain beneficial interests in its scope (see TS 3.3.3). Prepayment options may be exercised due to (1) changes in interest rates or credit spreads, (2) the use of surplus liquidity, (3) the availability of alternative financing arrangements, or (4) other factors resulting in the acceleration of cash inflows. For example, when interest rates fell early in the first decade of the 2000s, a surge in mortgage refinancings occurred. Many of the higher-rate mortgages that were being refinanced at that time had been securitized into collateralized mortgage obligations (CMOs) and sold to investors at a substantial premium. Those investors holding a CMO with an estimated life of 14 years found that their investment principal had been repaid after only a few years and that the repayment amount was substantially less than their original investment. The requirement in paragraph does not apply to situations in which events that are not the result of contractual provisions, for example, borrower default or changes in the value of an instrument s denominated currency relative to the entity s functional currency, cause the holder not to recover substantially all of its recorded investment. Figure 3-2 lists examples of financial assets that are subject to prepayment risk PwC

153 Accounting for sales-type transfers Figure 3-2 Examples of financial assets subject to prepayment risk Asset-backed securities Mortgage-backed securities High-rate debt instruments CMOs Purchased interest-only strips Interest-only strips obtained as proceeds of a sale Real estate mortgage investment conduit (REMIC) interests Securitized receivables Certain repurchase agreements To determine the appropriate accounting for beneficial interests, specifically interestonly strips (IOs) and principal-only strips (POs), it must first be determined whether they are subject to the derivative provisions of ASC 815. ASC 815 states that only the simplest separations of interest payments and principal payments qualify for the exemption from derivative accounting afforded to IOs and POs. The exception is limited to IOs and POs that (1) represent the right to receive only a specified proportion of the contractual interest cash flows of a specific debt instrument or a specified proportion of the contractual principal cash flows of that debt instrument and (2) do not incorporate any terms not present in the original debt instrument. For example, allocating a portion of the interest and principal cash flows of a debt instrument to compensate another entity for stripping (i.e., separating the principal and interest cash flows) or servicing the instrument would meet the exception, as long as the servicing compensation was not greater than adequate as defined by ASC 860. The allocation of a portion of the interest or principal cash flows to provide for a guarantee or for servicing in an amount greater than adequate compensation would not meet the exception (refer to TS for further discussion on adequate compensation for servicing). ASC 815 requires that beneficial interests in securitization transactions, also referred to as securitized interests, be analyzed to determine whether they are freestanding derivatives in their entirety or whether they are hybrid financial instruments that contain embedded derivatives that would require bifurcation from the host contract. ASC 815 provides guidelines that an entity should follow when determining whether the beneficial interest contains an embedded derivative that requires bifurcation. Refer to PwC s Guide, Accounting for Derivative Instruments and Hedging Activities, Chapter Accounting for certificated transferor s beneficial interests The SEC staff has indicated that a certificated beneficial interest in a securitization (i.e., a beneficial interest backed by a transferable certificate of ownership) is a security under ASC 320 and should be accounted for and disclosed in accordance with that guidance (i.e., classified as held-to-maturity, available-for-sale, or trading). The SEC staff has challenged registrants that have not accounted for certificated PwC 3-23

154 Accounting for sales-type transfers beneficial interests under ASC 320. The staff has also indicated that noncertificated beneficial interests with prepayment risk (i.e., interests that can be contractually prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment) should, in accordance with ASC 860, be measured as investments in debt securities classified as available-for-sale or trading under ASC 320. Certificated and noncertificated beneficial interests are subject to the bifurcation analysis required under ASC 815 (see discussion above) Recognition of interest income and impairment of beneficial interests with prepayment risk ASC addresses how interest income and impairment should be accounted for with respect to certain beneficial interests. It requires that interest income be recognized over the life of the beneficial interest based on the accretable yield determined by periodically estimating cash flows expected to be collected. ASC defines the accretable yield as the excess of all cash flows attributable to the beneficial interest estimated at the evaluation date over the reference amount. The reference amount is equal to: (1) the initial investment less (2) cash received to date less (3) other-than-temporary impairments recognized to date plus (4) the yield accreted to date. Changes in estimated cash flows are accounted for prospectively as a change in estimate in conformity with ASC 250, with the amount of periodic accretion adjusted over the remaining life of the beneficial interest. The same amount of interest income should be recognized each period regardless of whether the beneficial interest is classified as held-to-maturity, available-for-sale, or trading (if applicable). If the fair value of the beneficial interest has declined below its reference amount, an entity shall determine whether the decline is other than temporary. The entity shall apply the impairment of securities guidance beginning in ASC to determine whether an other than temporary impairment should be recognized. If an adverse change in cash flows expected to be collected has occurred, an other than temporary impairment of the beneficial interest is considered to have occurred, and a write-down of the beneficial interest s reference amount shall be recognized, also in accordance with the provisions of ASC 320. The remainder of this subsection discusses ASC in further detail. Scope of ASC The scope of ASC includes the following beneficial interests in securitized financial assets: Debt securities under ASC 320 or securities that are not debt in form but must be accounted for as such in accordance with ASC Securitized financial assets that have contractual cash flows (e.g., loans, receivables, debt securities, and guaranteed lease residuals) but not commonstock equity securities, which do not involve contractual cash flows PwC

155 Accounting for sales-type transfers Trading securities under ASC 320 when an entity s accounting practice is to report interest income for these investments. For example, certain entities, such as banks and investment companies, are required by their regulators to report interest income on trading securities that are marked to market as separate line items in their income statements, even though such securities are accounted for at fair value. Certain beneficial interests are excluded from the scope of ASC , including beneficial interests that: Cause the holder of the beneficial interest to consolidate the entity that issued the beneficial interest. Are within the scope of ASC Are in securitized financial assets that have a high credit quality (e.g., an internal credit rating of AA or better) and cannot be contractually prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment (e.g., securitized financial assets that are guaranteed by the U.S. government, its agencies, or other creditworthy guarantors, and loans or securities that are sufficiently collateralized to ensure that the possibility of credit loss is remote). Do not have contractual cash flows, such as common stock or other equity securities (investors in these types of beneficial interests should consider the guidance in ASC 815 and ASC 320). Are neither (1) debt securities under ASC 320 or (2) accounted for in a manner that is similar to debt securities under ASC 860, such as servicing assets or servicing liabilities. The following decision tree provides a summary of guidance for determining whether a beneficial interest is within the scope of ASC PwC 3-25

156 Accounting for sales-type transfers Figure 3-3 Decision tree for determining whether a beneficial interest (BI) is within the scope of ASC Recognition of interest income under ASC ASC requires that interest income on beneficial interests be recognized using the effective-yield method. Generally, under the effective-yield method, the investor recognizes interest income over the life of the beneficial interest using a constant effective yield. The effective yield is the internal rate of return on the investment based on the cost, the stated interest rate, and the cash flows expected to be collected of the investment over its life. Under ASC , the cash-flow projections must be updated throughout the life of the beneficial interest. Therefore, the effective yield, or the internal rate of return, used in the effective-yield method for beneficial interests may not be constant. The internal rate of return (and the future cash flows expected to be collected) on the investment may change due to a variety of factors, including prepayments, credit concerns, and changes in interest rates. Under the effective-yield model, an entity is not required to adjust the reference amount of the underlying beneficial interest, unless it has recognized an other-than PwC

157 Accounting for sales-type transfers temporary impairment. If a change in the cash-flow estimates has not resulted in an impairment that is other than temporary, any adjustment to the accretable yield of the beneficial interest and the internal rate of return used in the effective-yield method, based on changes in the future cash flows expected to be collected, should be prospectively accounted for as a change in estimate in conformity with the provisions of ASC 250. That is, a holder would calculate a new internal rate of return, taking into consideration the current reference amount of the beneficial interest and the revised accretable yield, and begin to prospectively accrue interest income based on that new rate. In estimating future cash flows, an entity must consider credit-related losses, prepayments, and delays in cash flow in its forecasts. The new internal rate of return must be recalculated each time the expected future cash flows change. The internal rate of return used in the effective-yield method will generally be different than the market discount rate used to measure the beneficial interest at fair value. The market discount rate used to measure the fair value of the beneficial interest will also change due to market factors (e.g., changes in credit, interest rate, and liquidity risk). The internal rate of return used to measure the interest income on the beneficial interest and the market discount rate used to measure the fair value of the beneficial interest will be the same at the acquisition date of the beneficial interest and at the time when the reference amount of the beneficial interest is written down to its fair value. Otherwise, these two rates may not be the same. Impairment recognition under ASC Cash flow estimates are critical in applying ASC for two reasons: (1) to determine the appropriate interest income that is to be recognized (see discussion above) and (2) in most cases, to estimate fair value for use in determining whether a beneficial interest is impaired. ASC requires that impairment be recognized on the carrying amount of the beneficial interest if both of the following conditions are satisfied: The fair value of the beneficial interest is less than its reference amount. The fair value of the beneficial interest should be based on the price that would be received to sell the security in an orderly transaction between market participants at the measurement date (i.e., based on market participant assumptions about current information and events) consistent with the guidance in ASC 820. The most recent evaluation determines that there has been an adverse change in cash flows expected to be collected from the cash flows previously projected. In determining whether there has been an adverse change in cash flows expected to be collected, an entity must consider both the timing and the amount of cash flows expected to be collected. To determine whether a change is adverse, a holder of a beneficial interest must compare the present value of the remaining cash flows expected to be collected at the initial transaction date (or at the last date previously revised) against the present value of the cash flows expected to be collected at the current financial reporting date. The cash flows should be discounted at a rate equal to the current internal rate of return used to accrete the beneficial interest. If the present value of the original cash flows estimated at the initial transaction date (or the last date previously revised) is greater than the PwC 3-27

158 Accounting for sales-type transfers present value of the current estimated cash flows, the change is considered adverse. If the above criteria are met, the beneficial interest s reference amount must be written down to a new reference amount, consistent with the provisions of ASC If only the first criterion is met, an entity would still need to consider the provisions of ASC 320 in determining whether an other than temporary impairment should be recorded. Under this scenario, the recognition of impairment would be contingent on whether the entity intends to sell the security or whether it is more likely than not that it will be required to sell the security before recovery. If the beneficial interest was classified as held-to-maturity, the carrying amount of the beneficial interest would be written down to a revised reference amount or to its fair value, depending on the conclusions reached under ASC 320, with either a portion of the offset recorded in OCI and a portion in earnings, in cases where both criteria were met and the credit loss was bifurcated from the non-credit component, or with the entire amount recorded in earnings, in cases where the entity intends to sell or it is more likely than not that it will be required to sell before recovery. If the beneficial interest was classified as available-for-sale, the beneficial interest would already be recorded at fair value, and the write-down of the carrying amount would be reflected as a partial or entire realization of the loss recorded in accumulated other comprehensive income through earnings, depending on the conclusions reached under ASC 320. For beneficial interests classified as trading, any change in fair value of the beneficial interest would already have been recorded in earnings. If the above criteria are not met, no impairment charge should be recognized and the internal rate of return used to accrete the beneficial interest should not be adjusted, unless an adjustment occurred to the accretable yield of the beneficial interest. After a holder recognizes an other-than-temporary impairment, with both the noncredit and credit component of the previous unrealized loss recognized in earnings in accordance with ASC 320, the internal rate of return of the beneficial interest would be the market discount rate that a market participant uses in determining the fair value of the beneficial interests. If the holder bifurcates the credit vs. non credit component of the loss (i.e., recognizes the credit component in earnings and the noncredit component in OCI), the internal rate of return of the beneficial interest would be closer to the market discount rate, but would still be different due to certain valuation assumptions (i.e., credit spreads, risk premiums) that are market based in nature and are not yet reflected in the reference amount of the beneficial interest, since they would have been captured in the non-credit component of the loss and recognized in OCI. Similar to ASC 320, ASC specifies that, after an other-than-temporary impairment for a held-to-maturity or available-for-sale security has been recorded, the holder is not permitted to realize a recovery in the fair value of the beneficial interest through the income statement. Rather, the subsequent increase in fair value may result in an adjustment to the accretable yield of the beneficial interest prospectively as a change in estimate. When a change in the accretable yield occurs, the internal rate of return used to accrete interest income may no longer be the 3-28 PwC

159 Accounting for sales-type transfers market discount rate that a market participant would use in determining the fair value of the beneficial interest. The following table highlights calculations that can be used to determine whether a change in cash flows expected to be collected is favorable or unfavorable based on both the timing and the changes in cash flows expected to be collected at the end of period X1. The discount rate that an entity uses to evaluate an adverse change in cash flows should represent the internal rate of return that the entity uses to recognize interest income on the beneficial interest. In other words, cash flows should be discounted at the rate that the entity uses to accrete the beneficial interest income. Scenario 1 Gross cash decrease, but timing is favorable X1 X2 X3 X4 X5 Gross cash NPV at 15% Original estimate $ 25 $ 25 $ 25 $ 20 $ 8 $103 Present value $72.50 Revision at end of X Present value Conclusion: Although there is an adverse change in gross cash flows expected to be collected, there is also a favorable change in the timing of cash flows, which, when discounted at the securities current yield, results in an overall favorable change. The change in yield is recognized prospectively. Scenario 2 Gross cash decrease X1 X2 X3 X4 X5 Gross cash NPV at 15% Original estimate $ 25 $ 25 $ 25 $ 25 $ 5 $105 Present value $73.86 Revision at end of X Present value Conclusion: Although the timing of future cash flows expected to be collected is unchanged from X2 to X5, gross cash flows expected to be collected decrease in X1, creating an adverse change when the cash flows are discounted at the securities current yield. Therefore, if the fair value of the beneficial interest is greater than or equal to its reference amount, the change in yield is recognized prospectively. If the fair value of the beneficial interest is less than its reference amount, an other-than-temporary impairment should be recognized. PwC 3-29

160 Accounting for sales-type transfers Scenario 3 Gross cash increase X1 X2 X3 X4 X5 Gross cash NPV at 15% Original estimate $ 25 $ 25 $ 25 $ 25 $ 5 $105 Present value $73.86 Revision at end of X Present value Conclusion: Although the timing of future cash flows expected to be collected is unchanged from X2 to X5, there is a favorable change in cash flows expected to be collected in X1, which is also reflected when the cash flows are discounted at the securities current yield. The change in yield is recognized prospectively. Scenario 4 Gross cash unchanged, but timing Is unfavorable X1 X2 X3 X4 X5 Gross cash NPV at 15% Original estimate $ 25 $ 20 $ 20 $ 30 $ 0 $95 Present value $67.16 Revision at end of X Present value Conclusion: Although gross cash flows expected to be collected are unchanged, there is an adverse change in timing, which is also reflected when the cash flows are discounted at the securities current yield. Therefore, if the fair value of the beneficial interest is greater than or equal to its reference amount, the change in yield is recognized prospectively. If the fair value of the beneficial interest is less than its reference amount, an other-than-temporary impairment should be recognized. Scenario 5 Assume prepayment at par at end of year 2, five-year beneficial interest at 10% interest per annum X1 X2 X3 X4 X5 Gross cash Original estimate $ 20 $ 20 $ 20 $ 20 $ 220 $300 NPV at 15% Present value $200 At end of X Present value Conclusion: The impact of the timing or amounts (favorable or unfavorable) on the analysis is affected by the current discount rate PwC

161 Accounting for sales-type transfers Scenario conclusions: (a) no impairment is recognized, (b) the yield is changed prospectively, or (c) if the fair value of the beneficial interest is greater than or equal to its reference amount, the change in yield is recognized prospectively. If the fair value of the beneficial interest is less than its reference amount, an other-thantemporary impairment should be recognized (refer to Figure 3-3 above for further analysis). Refer to the decision tree below for additional information on determining whether impairment recognition is necessary. Figure 3-4 Decision tree for determining whether impairment recognition is necessary As a result of the amendments to ASC , impairment charges are expected to be recognized more consistently for securities under the scope of ASC 320 or ASC Subsequent accounting for accrued interest receivable An accrued interest receivable (AIR) accounted for as a beneficial interest under ASC 860 is not required to be subsequently measured as an investment in debt securities classified as available-for-sale or trading under ASC 320 and ASC 860. An AIR cannot be contractually prepaid or settled in such a way that the owner would not recover substantially all of its recorded investment, and thus is an asset type that is not specifically addressed by ASC 860. Instead, entities should follow existing applicable PwC 3-31

162 Accounting for sales-type transfers accounting standards to subsequently account for the AIR asset. For example, ASC 450 addresses the accounting for various loss contingencies, including whether the receivables are collectible. 3.4 How should a transferor account for the rerecognition of financial assets previously sold? Certain events may occur that can result in a transferor regaining control of a previously derecognized (i.e., sold) financial asset. For example, a contingent call option that is conditional on an event, and held on the financial asset may be potentially exercisable at a later date if the contingency is resolved. As a result, the transferor would effectively control the financial asset. The guidance describes the accounting for these re-recognition events. Excerpt from ASC A change in law, or other circumstance may result in a transferred portion of an entire financial asset no longer meeting the conditions of a participating interest (ASC A) or the transferor s regaining control of transferred financial assets after a transfer that was previously accounted as a sale, because one or more of the conditions in ASC are no longer met. See the related guidance beginning in paragraph The repurchase of the transferee s financial assets raises the question of how beneficial interests held by a transferor should be accounted for when the underlying assets are re-recognized under the provisions of ASC 860. Should the transferor recognize a gain or loss? Should a loan loss allowance initially be recorded for loans that do not meet the definition of a security when they are re-recognized? ASC 860 clarifies these questions in paragraphs through Generally, the underlying assets previously transferred in a transaction that met sale accounting are re-recognized as a result of removal of account provisions or other call options. Prior to the most recent amendments to ASC 860 re-recognition events also resulted from QSPEs becoming nonqualifying under the previous guidance. However, entities will still need to look to ASC through to conclude whether previously transferred financial assets should be re-recognized or not, including transactions completed with securitization entities. Certain securitization transactions include removal-of-accounts provisions or ROAPs. ROAPs allow the transferor to reclaim financial assets previously transferred. When the right to reclaim these transferred financial assets is contingent upon a third-party action (outside the control of the transferor) that has not yet occurred, ROAPs would not preclude the transfer from being accounted for as a sale. However, once the third-party action or contingent event has occurred to permit a transferor to unilaterally reclaim the transferred financial assets, the transferor must recognize these financial assets. The recognition is necessary regardless of whether the ROAP is actually exercised because the transferor has regained effective control over 3-32 PwC

163 Accounting for sales-type transfers the previously transferred financial assets. The financial assets should be re-recorded at fair value, with a corresponding liability in the transferor s financial statements. In instances in which the re-recognition is triggered by a credit event (i.e., meeting a delinquency threshold), the transferor should consider whether the re-recognized loan is subject to the guidance in ASC ASC through reaffirms that transferred financial assets subject to ROAPs should be recorded at fair value. Any related servicing rights or beneficial interests should remain on the books until all of the transferred financial assets are actually repurchased. Since the loans are initially recorded at fair value, no loan loss reserves should be initially recorded. Any amount paid in excess of fair value would be a loss. No gain or loss should be initially recorded as a result of a loan becoming eligible for repurchase subject to a ROAP. Subsequent impairment of the value of the loans should be recorded as a loan-loss reserve. (Refer to TS for more information on ROAPs.) The following table summarizes the accounting for re-recognition under the scenarios described above. Figure 3-5 Accounting for re-recognition events Re-recognition upon transfer under ROAP or other contingent call How should a transferor s beneficial interest be accounted for upon rerecognition of its underlying transferred financial assets under paragraph ? Should a gain or loss be recognized upon recognition? If a ROAP or contingent call is exercised, should a gain or loss be recognized on the transfer of financial assets under paragraph ? Upon re-recognition, should a loanloss allowance be recognized for loans that do not meet the definition of a security? Does the accounting change for the servicing assets related to the transferred financial assets rerecognized under paragraph ? Periodically evaluated for impairment, no gain or loss at re-recognition date. Yes, except if the ROAP or contingent call is accounted for as a derivative under ASC 815 or is not at-the-money, resulting in the fair value of the repurchased financial assets being more or less than the related obligation to the transferee. No. No, a servicing asset or liability should continue to be recognized separately. PwC 3-33

164 Accounting for sales-type transfers Re-recognition upon transfer under ROAP or other contingent call After a paragraph event, should the transferor account for its beneficial interest in the original transaction separately from the rerecognized financial assets? Yes, unless a subsequent event results in the transferor reclaiming those assets under a ROAP (or consolidation of the securitization entity). Example 3-3 is based on the examples in ASC through It summarizes the guidance for applying the provisions of ASC to a transfer of financial assets to a securitization entity that subsequently fails the sale criteria. EXAMPLE 3-3 Transferor s interest accounted for as an available-for-sale security with a servicing asset (see also Example 10: Recognition of transferred assets and subsequent accounting for transferor s interest and a servicing asset in section ASC ) On January 2, 20X1, Company A originates $1,000 of loans, yielding 10.5 percent interest for their estimated life of nine years. At a future date, Company A transfers the loans in their entirety to an unconsolidated securitization entity and accounts for the transfer as a sale. Company A receives as proceeds $1,000 cash plus an interest that entitles it to receive 1 percent of the contractual interest (an interest-only strip or I/O strip). Company A will continue to service the loans for a fee of 100 basis points. The guarantor, a third party, receives 50 basis points as a guarantee fee. At the date of transfer: The fair value of the servicing asset is $40. The total fair value of the loans including servicing is $1,040. The fair value of the interest-only strip (I/O strip) is $60. The following journal entries would be booked by the transferor upon origination and subsequently on the date of transfer. Loans $1,000 Cash $1,000 Cash $1,000 Servicing asset 40 I/O strip (AFS) 60 Loans $1,000 Gain on sale PwC

165 Accounting for sales-type transfers On December 1, 20X1, an event occurs that results in the transfer not meeting the conditions for sale accounting. The fair value of the originally transferred financial assets that remain outstanding in the entity on that date is $929. The fair value of the beneficial interests (in the form of an IO strip) on that date is $58. The fair value of the servicing asset on that date is $38. Therefore, subsequent to the ASC event, the following entry should be booked on December 1, 20X1, to recognize the remaining outstanding loans on the transferor s books along with the obligation to pass to the entity the cash flows associated with those loans. To record the I/O fair value change during the period. Other comprehensive income $2 I/O strip (AFS) $2 Once the event occurred on December 1, 20X1, the entity recognized previously sold loans with the obligation to pass the cash flows associated with those loans to the Securitization entity. Loans $929 Due to securitization entity $929 Once a servicing asset is recognized, it should not be added back to the underlying financial assets. Even when the transferor has regained control over the underlying financial asset via the re-recognition event, the related servicing asset should continue to be separately recognized and accounted for under ASC 860 if the assets remain securitized (refer to TS 5 for further information on the accounting for servicing assets and servicing liabilities). The transferor should continue to account for the beneficial interest in the entity at fair value and recognize any changes in fair value in other comprehensive income. The above entries do not address the potential effects of ASC 810 and its impact on the accounting. If under ASC 810, the transferor is required to consolidate the entity, the consolidation guidance of ASC through 30-6 must be followed. The entries also assume the interest-only strip does not need to be accounted for as a derivative instrument or that it contains an embedded derivative that needs to be accounted for under ASC 815. Additionally, the effects of ASC 860 would be eliminated in consolidation. 3.5 How should a transferee account for transfers of financial assets? The guidance discusses how the transferee should account for transfers that qualify for sale accounting as well as those that do not qualify for sale accounting. PwC 3-35

166 Accounting for sales-type transfers Excerpt from ASC Sale Accounting by Transferee The transferee shall recognize all assets obtained (including any participating interest(s) obtained) and any liabilities incurred. Excerpt from ASC The transferee shall initially measure, at fair value, any asset obtained or liability recognized under paragraph Excerpt from ASC The guidance beginning in paragraph discusses the transferor s accounting upon regaining control of financial assets sold. In such circumstances, the former transferee would derecognize the transferred financial assets on that date, as if it had sold the transferred financial assets in exchange for a receivable from the transferor. Excerpt from ASC Secured Borrowing Accounting by Transferee The transferor and transferee shall account for a transfer as a secured borrowing with pledge of collateral in either of the following circumstances: a. If a transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset does not meet the conditions for a sale in paragraph b. If a transfer of a portion of an entire financial asset does not meet the definition of a participating interest. ASC 860 indicates that the accounting by the transferee should be symmetrical to the accounting by the transferor (i.e., sold financial assets would be considered purchased by the transferee). In practice, the accounting by the transferee depends on the evidence or the information available to it and whether that information is also symmetrical. 3.6 Chapter wrap-up If a transfer of entire financial asset(s) qualify(ies) for sale accounting, the transferor should generally derecognize the transferred financial assets and recognize any assets obtained (including a transferor s beneficial interest in the transferred financial assets) or liabilities incurred as part of the transfer at their fair value. If a transfer of a participating interest qualifies for sale accounting, the transferor should generally derecognize the portion of the financial asset that was sold based on the relative fair value of the participating interest sold and the participating interest that continues to be held by the transferor, and recognize any assets obtained or liabilities incurred as 3-36 PwC

167 Accounting for sales-type transfers part of the transfer at their fair value. Any gain or loss on the sale should be calculated as the difference between the basis of assets transferred and the net proceeds received on the sale (i.e., assets obtained less liabilities incurred). ASC 860 does not discuss how these assets obtained or liabilities incurred should be accounted for subsequent to the sale transaction, with the exception of financial assets subject to prepayment which are addressed in ASC Rather, those assets and liabilities should be accounted for using the accounting guidance that would otherwise be applicable, regardless of the method of acquisition. Rights to receive all or portions of specified cash inflows in a securitization entity are referred to as beneficial interests. These rights include senior and subordinated shares of interest, principal, or other cash inflows to be passed-through or paid-through, premiums due to guarantors, commercial paper obligations, and residual interests whether in the form of debt or equity. Beneficial interests can take many forms. However, they are typically securities or notes accounted for under ASC 320. If the beneficial interest is subject to prepayment risk, interest income and impairment recognition on the beneficial interest is generally governed by ASC , unless the beneficial interest is subject to the guidance in ASC ASC 815 requires that beneficial interests be analyzed to determine whether they meet the definition of a derivative in their entirety or whether they contain an embedded derivative that requires bifurcation. The analysis can be difficult and requires a review of all of the contractual terms of the beneficial interests, as well as the payoff structure of the securitization entity and the assets it holds. Generally, if a securitization entity ceases to meet the criteria for sale accounting, the financial assets transferred to it should be re-recognized by the transferor. Finally, the accounting by the transferee (i.e., the securitization entity or other trust in a two-step transfer) should be symmetrical to the accounting by the transferor. 3.7 FASB s implementation guidance and PwC s questions and interpretive responses The information contained herein is generally based on the Implementation Guidance and Illustrations included in ASC We ve also included certain questions and interpretive responses intended to supplement discussions in this Chapter regarding the application of guidance to specific fact patterns Accounting for sales ASC includes the following implementation guidance: PwC 3-37

168 Accounting for sales-type transfers Excerpt from ASC Example 1: Recording Transfers with Proceeds of Cash, Derivative Instruments, and Other Liabilities This Example illustrates the guidance in paragraphs and Entity A transfers entire loans with a carrying amount of $1,000 to an unconsolidated securitization entity and receives proceeds with a fair value of $1,030, and the transfer is accounted for as a sale. Entity A undertakes no obligation to service and assumes a limited recourse obligation to repurchase delinquent loans. Entity A agrees to provide the transferee a return at a variable rate of interest even though the contractual terms of the loan are fixed rate in nature (that provision is effectively an interest rate swap). Excerpt from ASC This Example has the following assumptions. Fair Values Cash proceeds $ 1,050 Interest rate swap asset 40 Recourse obligation 60 Net Proceeds Cash received $ 1,050 Plus: Interest rate swap asset 40 Less: Recourse obligation (60) Net proceeds $ 1,030 Gain Sale Net proceeds $ 1,030 Less: Carrying amount of loans sold (1,000) Gain on sale $ 30 Excerpt from ASC The following journal entry is made by Entity A. Journal Entry Cash $1,050 Interest rate swap asset 40 Loans $1,000 Recourse obligation 60 Gain on sale 30 To record transfer 3-38 PwC

169 Accounting for sales-type transfers Excerpt from ASC Example 2: Recording Transfers of Participating Interests This Example illustrates the guidance in paragraph This Example assumes the conditions for a sale in paragraph are met. Entity B transfers a nine-tenths participating interest in a loan with a fair value of $1,100 and a carrying amount of $1,000, and the transfer is accounted for as a sale. The servicing contract has a fair value of zero because Entity B estimates that the benefits of servicing are just adequate to compensate it for its servicing responsibilities. Excerpt from ASC This Example has the following assumptions. Fair Values Cash proceeds for nine-tenths participating interest sold ($1,100 9/10) $ 990 One-tenth participating interest that continues to be held by the transferor ($1,100 1/10) 110 Allocated Carrying Amount Based on Relative Fair Values Fair Value Percentage of Total Fair Value Allocated Carrying Amount Nine-tenths participating interest sold $ $ 900 One-tenth participating interest that continues to be held by the transferor Total $1, $1,000 Gain on Sale Net proceeds $ 990 Less: Carrying amount of loans sold (900) Gain on sale $ 90 Excerpt from ASC The following journal entry is made by Entity B. Journal Entry Cash $990 Loans $ 900 Gain on sale 90 To record transfer PwC 3-39

170 Accounting for sales-type transfers Excerpt from ASC Example 5: Transfer of lease financing receivables with residual values This Example illustrates the guidance in paragraph At the beginning of the second year in a 10-year sales-type lease, Entity E transfers for $505 a nine-tenths participating interest in the minimum lease payments to an independent third party, and the transfer is accounted for as a sale. Entity E retains a one-tenth participating interest in the minimum lease payments and a 100 percent interest in the unguaranteed residual value of leased equipment, which is not subject to the requirements of this Subtopic as discussed in paragraph because it is not a financial asset and, therefore, is excluded from the analysis of whether the transfer of the nine-tenths participating interest in the minimum lease payments meets the definition of a participating interest. The servicing asset has a fair value of zero because Entity E estimates that the benefits of servicing are just adequate to compensate it for its servicing responsibilities. The carrying amounts and related gain computation are as follows. Carrying Amounts Minimum lease payments $ 540 Unearned income related to minimum lease payments 370 Gross investment in minimum lease ayments 910 Unguaranteed residual value $ 30 Unearned income related to unguaranteed residual value 60 Gross investment in unguaranteed residual value 90 Total gross investment in financing lease receivable $1,000 Gain on Sale Cash received $ 505 Nine-tenths of carrying amount of gross investment in minimum lease payments $819 Nine-tenths of carrying amount of unearned income related to minimum lease payments 333 Net carrying amount of minimum lease payments sold 486 Gain on sale $ PwC

171 Accounting for sales-type transfers Excerpt from ASC The following journal entry is made by Entity E. Journal Entry Cash $505 Unearned income 333 Lease receivable $ 819 Gain on sale 19 To record sale of nine-tenths of the minimum lease payments at the beginning of Year 2 Excerpt from ASC Example 10: Rerecognition of Transferred Assets and Subsequent Accounting for Transferor s Interest and a Servicing Asset This Example illustrates the accounting for a sale of loans in their entirety by a transferor to an unconsolidated entity and the subsequent accounting for the transferor s interest and a servicing asset. In this Example, the transferor s interest is an interest-only strip that is accounted for at fair value in the same manner as an available-for-sale security under paragraph Excerpt from ASC This Example has the following assumptions. Excerpt from ASC On January 2, 20X1, Entity I (the transferor) originates $1,000 of loans, yielding 10.5 percent interest income for their estimated life of 9 years. Entity I later transfers the loans in their entirety to an unconsolidated entity and accounts for the transfer as a sale. Entity I receives as proceeds $1,000 cash plus a beneficial interest that entitles it to receive 1 percent of the contractual interest (an interest-only strip receivable). Entity I will continue to service the loans for a fee of 100 basis points. The guarantor, a third party, receives 50 basis points as a guarantee fee. Excerpt from ASC At the date of transfer, the following facts are assumed. a. The fair value of the servicing asset is $40. b. The total fair value of the loans including servicing is $1,040. c. The fair value of the interest-income strip receivable is $60. PwC 3-41

172 Accounting for sales-type transfers Excerpt from ASCS On December 1, 20X1, an event occurs that results in the transfer not meeting the conditions for sale accounting. The fair value of the originally transferred financial assets that remain outstanding in the entity on that date is $929. The fair value of Entity I s interest (in the form of an interest-only strip) on that date is $58. The fair value of the servicing asset on that date is $38. The guarantee that was entered into by the entity does not trade with the underlying financial assets. The fees on this guarantee will be paid as part of the cash waterfall. Excerpt from ASC All cash flows from the financial assets transferred to the trust are initially sent directly to the trust and then distributed in order of priority. The priority of payments in the cash waterfall is as follows: servicing fees, guarantees, amounts due to outside beneficial interest holders, and amounts due to Transferor s beneficial interest. Excerpt from ASC Paragraph superseded by ASU Excerpt from ASC The following journal entries would be made. January 2, 20X1 Cash $1,000 Transferor s interest (available for sale) 60 Servicing asset 40 Loans $1,000 Gain on sale 100 To record the sale of the assets and to recognize Entity I s interest and a servicing asset at fair value. December 1, 20X1 Other comprehensive income $ 2 Entity I s interest (available for sale) $ 2 To subsequently measure Entity I s interest in the same manner as an available-forsale security PwC

173 Accounting for sales-type transfers Excerpt from ASC The following illustrates the accounting entry to be made after the event occurs that results in the transfer not meeting the conditions for sale accounting. December 1, 20X1 Loans $ 929 Due to Securitization Entity $ 929 To recognize the previously sold loans on Entity I s books along with the obligation to pass the cash flows associated with those loans to Securitization Entity. Excerpt from ASC Entity I would account for the re-recognized financial assets and transferor s interests as follows: a. Entity I would continue to account for transferor s interests (in accordance with paragraph ) at fair value with changes in fair value recognized in other comprehensive income b. Entity I would account for the loans at cost plus accrued interest in accordance with Subtopic In addition, ASC includes the following relevant guidance on accounting for debt securities after a transfer: Excerpt from ASC An entity may transfer debt securities to an unconsolidated entity that has a predetermined life in exchange for cash and the right to receive proceeds from the eventual sale of the securities. For example, a third party holds a beneficial interest that is initially worth 25 percent of the fair value of the assets of the entity at the date of transfer. The entity is required to sell the transferred securities at a predetermined date and liquidate the entity at that time. Assume the facts in that example and the following additional facts: a. The beneficial interests are issued in the form of debt securities. b. Before the transfer, the debt securities were accounted for as available-for-sale securities in accordance with Topic 320. Excerpt from ASC In that example, whether the transferor may classify the debt securities as trading at the time of the transfer depends on whether the transfer is accounted for as a sale or as a secured borrowing: PwC 3-43

174 Accounting for sales-type transfers a. Sale. If a transfer of a group of entire financial assets satisfies the conditions to be accounted for as a sale, Subtopic requires that any assets obtained or liabilities incurred in the transfer be recognized (see paragraph ) and initially measured at fair value (see paragraph ). If the transfer in the example is accounted for as a sale, the transferor would account for the debt securities received as new assets and would have the option to classify the debt securities received as trading securities. b. Secured borrowing. If the transfer is accounted for as a secured borrowing, paragraph requires the transferor to continue to report the transferred debt securities in its statement of financial position with no change in their measurement (that is, basis of accounting). Paragraph , which explains that transfers into or from the trading category should be rare, would continue to apply. Excerpt from ASC If the transferred financial assets were not securities subject to the guidance in Topic 320 before the transfer that was accounted for as a sale but the beneficial interests were issued in the form of debt securities or in the form of equity securities that have readily determinable fair values, then the transferor would have the opportunity to decide the appropriate classification of the beneficial interests received as proceeds from the sale. Excerpt from ASC A transfer from one subsidiary (the transferor) to another subsidiary (the transferee) of a common parent would be accounted for as a sale in each subsidiary s separateentity financial statements if both of the following requirements are met: a. All of the conditions in paragraph (including the condition on isolation of the transferred financial assets) are met. b. The transferee s assets and liabilities are not consolidated into the separate-entity financial statements of the transferor. Paragraph states that, in a transfer between two subsidiaries of a common parent, the transferor-subsidiary shall not consider parent involvements with the transferred financial assets in applying paragraph Excerpt from ASC If the transferee was an equity method investee of the transferor, only the investment and not the investee s assets and liabilities would be reported in the transferor subsidiary s separate-entity financial statements. Therefore, the transferee would not be a consolidated affiliate of the transferor, and such a transfer could isolate the transferred financial assets and be accounted for as a sale if all other conditions of paragraph are met PwC

175 Accounting for sales-type transfers Question 3-1 How do the changes to the initial measurement provisions of ASC impact the transferor s recognition of gain or loss on a securitization transaction of entire financial asset(s) that meets the conditions for sale accounting? PwC response ASC changes the initial measurement requirements for beneficial interests obtained by the transferor as consideration for the transferred of the entire financial asset, which may significantly impact the transferor s recognition of gain/loss on sale for transfers of entire or group of entire financial assets. The beneficial interest obtained will now be initially recognized at fair value (i.e., the sum of any cash or other assets received, including beneficial interests and separately recognized servicing assets less any liabilities incurred, including separately recognized servicing liabilities ) rather than by an allocation of the previous carrying amount of the financial assets transferred between the financial assets sold and the financial assets retained based on their relative fair values on the date of transfer. This will result in higher gains or losses recognized under the new guidance, since the beneficial interests will now be considered an obtained or received asset rather than a retained asset. A new financial asset obtained or received will now be part of the proceeds of sale. Under the old guidance, the FASB had concluded that a transferor s beneficial interests in transferred financial assets did not constitute newly created assets that should initially be measured and recognized at fair value. Question 3-2 Must a transferor recognize in earnings the gain or loss that results from a transfer of financial asset(s) or a transfer of a participating interest in a financial asset that is accounted for as a sale, or may the transferor elect to defer recognizing the resulting gain or loss in certain circumstances? PwC response ASC through 25-3 require that upon the completion of a transfer of financial assets that satisfies the conditions to be accounted for as a sale, any resulting gain or loss must be recognized in earnings. In addition, ASC states in part, It is not appropriate for the transferor to defer any portion of a resulting gain or loss (or to eliminate gain on sale accounting, as it is sometimes described in practice) Subsequent accounting for assets obtained or liabilities incurred Excerpt from ASC Trust liquidation methods that allocate receipts of principal or interest between beneficial interest holders and transferors in proportions different from their stated percentage of ownership interests do not affect whether the transferor should obtain sale accounting and derecognize those transferred assets, assuming the trust is not required to be consolidated by the transferor. However, both turbo and bullet PwC 3-45

176 Accounting for sales-type transfers provisions in securitization structures (as discussed in paragraph ) should be taken into consideration in determining the fair values of assets obtained by the transferor and transferee. Excerpt from ASC While, under the circumstances described, the accrued interest receivable is a transferor s interest, it is not required to be subsequently measured like an investment in debt securities classified as available for sale or trading under Topic 320 or the Transfers and Servicing Topic because the accrued interest receivable cannot be contractually prepaid or settled in such a way that the owner would not recover substantially all of its recorded investment. Entities should follow existing applicable accounting standards, including Topic 450, in subsequent accounting for the accrued interest receivable asset. Excerpt from ASC Options Embedded in Transferred Securities This guidance addresses transactions that involve the sale of a marketable security to a third-party buyer, with the buyer s having an option to put the security back to the seller at a specified future date or dates for a fixed price. Because of the put option, the seller generally receives a premium price for the security. Excerpt from ASC If the transfer is accounted for as a sale, a put option that enables the holder to require the writer of the option to reacquire for cash or other assets a marketable security or an equity instrument issued by a third party should be accounted for as a derivative by both the holder and the writer, provided the put option meets the definition of a derivative in paragraph (including meeting the net settlement requirement, which may be met if the option can be net settled in cash or other assets or if the asset required to be delivered is readily convertible to cash). If multiple put options exist, recognition of the multiple put options as liabilities, and initial measurement at fair value, are required. Excerpt from ASC A put option that is issued as part of a transfer being accounted for as a sale that is not accounted for as a derivative under Subtopic would be considered a guarantee under paragraph (b) and would be subject to its initial recognition, initial measurement, and disclosure requirements. If the written put option is accounted for as a derivative under Subtopic by the seller-transferor, then the put option would be subject to only the disclosure requirements of Topic PwC

177 Accounting for sales-type transfers Excerpt from ASC If the transaction is accounted for as a secured borrowing under Subtopic , any difference between the sale proceeds and the put price shall be accrued as interest expense, and any impairment of the underlying security would generally not be recognized. The difference between the original sale price and the put price should be amortized over the period to the first date the securities are eligible to be put back. If the transfer is accounted for as a secured borrowing, the put option falls under paragraph , which provides a scope exception for a derivative instrument (such as the put option) that serves as an impediment to sale accounting under Subtopic The guidance in paragraph may also be relevant. Excerpt from ASC Credit Risk Associated with Transferred Assets A transferor may hold some portion of the credit risk associated with a transfer of an entire financial asset or group of entire financial assets. For example, a transferor may incur a liability to reimburse the transferee, up to a certain limit, for a failure of debtors to pay when due (a recourse liability). In that circumstance, a liability should be separately recognized and initially measured at fair value. That liability should be subsequently measured according to accounting pronouncements for measuring similar liabilities. In other circumstances, a transferor may provide credit enhancement through its ownership of a beneficial interest in the transferred financial assets if that beneficial interest is not paid until the other investors in the transferred financial assets are paid, thereby resulting in the transferor absorbing much of the related credit risk. As a result, the beneficial interests that are obtained by the transferor should be initially recognized according to paragraph Excerpt from ASC A If the transfer does not consist of an entire financial asset or group of entire financial assets, the transferred financial asset must meet the definition of a participating interest. Paragraph A(c)(4) states that, to meet that definition, participating interest holders shall have no recourse to the transferor (or its consolidated affiliates included in the financial statements being presented or its agents) or to each other, other than any of the following: a. Standard representations and warranties b. Ongoing contractual obligations to service the entire financial asset and administer the transfer contract c. Contractual obligations to share in any set-off benefits received by any participating interest holder. That recourse would result in the transfer being accounted for as a secured borrowing under Subtopic PwC 3-47

178 Accounting for sales-type transfers Excerpt from ASC Transfer of a Bond Purchased at a Premium Assume an entity transfers a bond to an unconsolidated entity for cash and beneficial interests. When the transferor purchased the bond, it paid a premium for it (or bought it at a discount), and that premium (or discount) was not fully amortized (or accreted) at the date of the transfer. In other words, the carrying amount of the bond included a premium (or discount) at the date of the transfer. If the transfer of the bond is accounted for as a secured borrowing under Subtopic , the transferor would continue to amortize (or accrete) the premium (or discount) because paragraph requires that the transferor continue to report the transferred financial assets in its statement of financial position with no change in their measurement (that is, basis of accounting).if the transfer of the bond satisfies the conditions to be accounted for as a sale, any beneficial interests received as proceeds would be initially recognized at fair value. As a result, the previously existing premium (or discount) would not continue to be amortized (or accreted); rather, the unamortized (or nonaccreted) amount would be included in the calculation of the gain (or loss) as of the transfer date. Excerpt from ASC Sales or Securitizations of Lease Financing Receivables A transferor of lease financing receivables shall allocate the gross investment in receivables between minimum lease payments, residual values guaranteed at inception, and residual values not guaranteed at inception using the individual carrying amounts of those components at the date of transfer. Those transferors also shall record a servicing asset or liability in accordance with Subtopic , if appropriate. Excerpt from ASC See paragraph for further discussion of lease financing receivables. Excerpt from ASC Forward Contracts in Revolving-Period Securitizations The requirement that all financial assets obtained and liabilities incurred by the transferor of a securitization that qualifies as a sale shall be recognized and measured as provided in this Subtopic includes the implicit forward contract to sell additional financial assets during a revolving period. Such a forward contract may become valuable or onerous to the transferor as interest rates and other market conditions change PwC

179 Accounting for sales-type transfers Excerpt from ASC The value of the forward contract implicit in a revolving-period securitization arises from the difference between the agreed-upon rate of return to investors on their beneficial interests in the trust and current market rates of return on similar investments. For example, if the agreed-upon annual rate of return to investors in a trust is 6 percent, and later market rates of return for those investments increased to 7 percent, the forward contract s value to the transferor (and burden to the investors) would approximate the present value of 1 percent of the amount of the investment for each year remaining in the revolving structure after the receivables already transferred have been collected. If a forward contract to sell receivables is entered into at the market rate, its value at inception may be zero. Changes in the fair value of the forward contract are likely to be greater if the investors receive a fixed rate than if the investors receive a rate that varies based on changes in market rates. Excerpt from ASC Gain or loss recognition for revolving-period receivables sold to a securitization trust is limited to receivables that exist and have been sold Subsequent accounting for beneficial interests Excerpt from ASC The receivables for accrued fee and finance charge income on an investors portion of the transferred credit card receivables, whether billed but uncollected or accrued but unbilled, are commonly referred to as accrued interest receivable. The following addresses how the accrued interest receivable related to securitized and sold receivables should be accounted for and reported under this Subtopic. This guidance applies to credit card securitizations as well as other kinds of securitizations. Excerpt from ASC The right to receive the accrued interest receivable, if and when collected, is transferred to the securitization trust. Generally, if a securitization transaction meets the criteria for sale treatment and the accrued interest receivable is subordinated either because the asset has been isolated from the transferor (see paragraph ) or because of the operation of the cash flow distribution (or waterfall) through the securitization trust, the total accrued interest receivable should be considered to be one of the components of the sale transaction. Therefore, under the circumstances described, the accrued interest receivable asset should be accounted for as a transferor s interest. It is inappropriate to report the accrued interest receivable related to securitized and sold receivables as loans receivable or other terminology implying that it has not been subordinated to the senior interests in the securitization. PwC 3-49

180 Accounting for sales-type transfers Excerpt from ASC Financial Assets Subject to Prepayment The following is implementation guidance related to the subsequent measurement of various types of financial assets subject to prepayment, specifically: a. Instruments that can be prepaid or otherwise settled in such a way that the holder would not recover substantially all of the recorded investment b. Loan that can be prepaid or otherwise settled in such a way that the holder would not recover substantially all of the recorded investment at initial acquisition c. Classification of a residual tranche in a securitization as held to maturity. Excerpt from ASC Instruments That Can Be Prepaid or Otherwise Settled in Such a Way That the Holder Would Not Recover Substantially All of the Recorded Investment The following discusses whether the following types of instruments are subject to the subsequent measurement guidance in paragraph : a. A financial asset that is not a debt security denominated in a foreign currency b. A note for which the repayment amount is indexed to the creditworthiness of a party other than the issuer Excerpt from ASC Investing in a financial asset that is denominated in a foreign currency often exposes an entity to foreign currency exchange rate risk; however, that risk is not addressed in paragraph Excerpt from ASC A financial asset that is not a debt security under Topic 320 is not subject to the requirements of paragraph because it is denominated in a foreign currency. Excerpt from ASC An entity is not required to measure such an investment like a debt security under paragraph unless it has provisions that allow it to be contractually prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment, as denominated in the foreign currency. For example, an investment denominated in deutsche marks by an entity with a U.S. dollar functional currency would not be subject to that paragraph if the contract requires that substantially all of the invested deutsche marks be repaid PwC

181 Accounting for sales-type transfers Excerpt from ASC A note for which the repayment amount is indexed to the creditworthiness of a party other than the issuer is subject to the provisions of paragraph because the event that might cause the holder to receive less than substantially all of its recorded investment is based on a contractual provision, not on a default by the borrower (that is, the issuer of the note). That contractual provision indexes the payment terms of the note to a default by a third party unrelated to the issuer of the note. If that note is within the scope of Subtopic the guidance of paragraph would not apply. Excerpt from ASC Loan That Can Be Prepaid or Otherwise Settled in Such a Way That the Holder Would Not Recover Substantially All of the Recorded Investment at Initial Acquisition A loan (that is not a debt security) that when initially obtained could be contractually prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment may be reclassified as held for investment later in its life (that is, at a date that is so close to the financial asset s maturity that the holder would recover substantially all of its recorded investment even if it was prepaid). That is, the loan would no longer be required to be measured in accordance with the guidance in paragraph if both of the following conditions are met: a. It would no longer be possible for the holder not to recover substantially all of its recorded investment upon contractual prepayment or settlement. b. The conditions for amortized cost accounting are met (for example, paragraphs and ). However, any unrealized holding gain or loss arising under the available-for-sale classification that exists at the date of the reclassification would continue to be reported in other comprehensive income but should be amortized over the remaining life of the loan as an adjustment of yield. (The loan would not be classified as held to maturity because under Topic 320 only debt securities may be classified as held to maturity.) Excerpt from ASC Classification of a Residual Tranche in a Securitization as Held to Maturity Whether a residual tranche debt security in a securitization of financial assets (for example, receivables) using a securitization entity can be classified as held to maturity depends on the facts and circumstances. If the contractual provisions of the residual tranche debt security provide that the residual tranche can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment, paragraph precludes the residual tranche debt security from being accounted for as held to maturity. In contrast, if the only way that the holder of the residual tranche would not recover substantially all of its recorded investment would be in response to a default by the borrower (debtor), then a held-to maturity classification is acceptable if the conditions specified for a held-to-maturity classification in paragraphs (c) and (a) have been met. PwC 3-51

182 Accounting for sales-type transfers Question 3-3 ASC requires that financial assets, except for instruments that are within the scope of ASC 815, that can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment subsequently be measured like investments in debt securities classified as availablefor-sale or trading under ASC 320. Does that requirement result in those financial assets being included in the scope of ASC 320? PwC response Whether those financial assets are included in the scope of ASC 320 depends on the form of the assets. However, in either case, the measurement principles of ASC 320, including the provisions for recognizing and measuring impairment, should be applied. Interest-only strips and similar interests that meet the definition of securities in ASC are included in the scope of ASC 320; therefore, all relevant provisions of that Statement (for example, the disclosures) should be applied. Those interests should be classified as available-for-sale or trading pursuant to the provisions of ASC Interest-only strips and similar interests that are not in the form of securities (as defined in ASC 320) are not within the scope of ASC 320 but should be measured like investments in debt securities classified as available-for-sale or trading. In that case, all of the measurement provisions, including those addressing recognition and measurement of impairment, should be followed. However, other provisions of ASC 320, such as those addressing disclosures, are not required to be applied Re-recognition of previously sold assets Excerpt from ASC Regaining Control through a Removal-of-Accounts Provision This guidance addresses implementation of paragraph Under that paragraph s guidance, if the removal-of-accounts provision is not exercised, the financial assets are recognized because the transferor now can unilaterally cause the transferee to return those specific financial assets and, therefore, the transferor once again has effective control over those transferred financial assets (see paragraphs through 25-10). Excerpt from ASC Similarly, when a contingency related to a transferor s contingent right has been met, the transferor generally must account for the repurchase of a specific subset of the financial assets transferred to and held by the entity. At that point, the transfer fails the criterion in paragraph (c)(2) because the transferor has the unilateral right to purchase a specific transferred financial asset. The transferor must do so regardless of whether it intends to exercise its call option PwC

183 Accounting for sales-type transfers Excerpt from ASC Although this guidance uses removal-of-accounts provisions as an example, the guidance is not limited to removal-of-accounts provisions. Contingent rights can arise in many other situations. See paragraphs through for more information. Question 3-4 If, subsequent to a transfer where the sale criteria were satisfied, the transferor repurchases the financial assets from a third-party investor pursuant to a separate repurchase agreement (that either entitles or obligates the transferor to repurchase) or repurchases the transferred financial assets in the open market, must the initial sale be reversed? PwC response No, assuming the subsequent repurchase agreement was not made in contemplation of the transfer, as required by ASC (c) and ASC through A financial asset transfer is evaluated for sale treatment at the time of transfer, and if the initial transfer qualifies as a sale, the assets are derecognized from the transferor s financial statements. A subsequent repurchase of the assets by the transferor represents a separate transaction, which would require evaluation to determine whether it constitutes a purchase or a financing transaction. The repurchase should be recorded in accordance with the terms of the agreement or the amount paid. If, at the date of the repurchase, the transaction is considered a purchase and not a financing, the transferor has effective control over the assets, and the assets must be recognized as such by the transferor. See also TS section for additional accounting consideration related to linked repurchase financing transactions. Question 3-5 Can the accounting for transferred financial assets that previously satisfied the ASC 860 criteria for sale accounting be reversed? PwC response The accounting for the transferred financial assets should be reversed (i.e., the assets reacquired should be recognized at fair value at the reacquisition date although prior gains/losses should not be reversed) for an existing transaction if there is a change in the applicable law or if the transferor regains control over the financial assets previously accounted for as a sale. The assessment of whether the accounting for the transferred financial assets can be reversed is based on the facts and circumstances surrounding each transaction and any modifications made to the transaction. Generally, a non-substantive change will not impact the original accounting for a securitization transaction. A non-substantive change may result from a change that doesn t require the approval of the beneficial PwC 3-53

184 Accounting for sales-type transfers interest holders. Approval is legally required if a change can significantly affect the beneficial interest holders (BIHs). If the change is substantive or if one or more of the sale conditions are no longer met, the change should be accounted for as a purchase of the financial assets from the former transferee. A transferor that regains control of the assets as described in ASC must record those assets at fair value in accordance with the guidance beginning in ASC PwC

185 Chapter 4: Accounting for financingtype transfers revised March 2016 PwC 4-1

186 Accounting for financing-type transfers revised March Chapter overview ASC 860 provides a model for distinguishing between transfers of financial assets that are accounted for as sales and those that are accounted for as secured borrowings (financings). As discussed in TS 2, a transfer of financial assets qualifies for sale accounting if the transferor of the financial assets relinquishes control over the assets. If the transferor does not relinquish control, the transfer is accounted for as a secured borrowing because the transaction is more akin to a financing arrangement, with the transferor borrowing cash and granting the lender-transferee a security interest in the financial assets to serve as collateral for its obligation. The lender-transferee may be permitted to sell or repledge (i.e., transfer) this collateral. The lender-transferee may or may not have recourse against the transferor s other assets. Certain transfers of financial assets are structured in a manner that leads to secured borrowing accounting by the counterparties. Typically, the transferor transfers financial assets in exchange for cash and agrees to reacquire them at a future date. The commitment to repurchase the financial assets allows transferors (typically financial institutions) to obtain and/or use funds based on the value of the transferred financial asset (collateral) used to secure the transactions, while ultimately maintaining control over the collateral. Although these transactions can take various forms, three of the most common are: Repurchase agreements. The transferor sells a financial asset, typically a fixed income security, to an entity that acts as the secured party (the asset serves as collateral) in exchange for cash. At the same time, the transferor enters into an agreement to repurchase the same security from the secured party at a future date. Dollar rolls. The transferor sells a mortgage-backed security (MBS) to an entity that acts as secured party (the MBS serve as collateral) in exchange for cash. At the same time, the secured party enters into an agreement to repurchase a similar (but not identical) MBS from the secured party at a future date. Securities lending. The owner of securities (typically equity securities) lends them to a third party for a fee. The lender generally requires that the borrower provide collateral that consists of cash, standby letters of credit, or other securities. Many securities lending agreements are open-ended, with no explicit maturity date; either party may unwind the agreement after first notifying the other, at which time the parties re-exchange the borrowed securities and related collateral. Under the secured borrowing accounting model, the transferor recognizes cash received from the borrowing and an obligation to return it in the future. A detailed analysis of the facts and circumstances of the controlling agreement must be performed to determine the correct accounting for any non-cash collateral pledged as part of the agreement. The remainder of this chapter discusses the criteria for determining whether a transfer of financial assets qualifies as a secured borrowing, the general accounting model for secured borrowings and collateral, and the 4-2 PwC

187 Accounting for financing-type transfers revised March 2016 application of that accounting model to repurchase agreements, dollar rolls, and securities lending transactions. The following figure provides a high-level decision tree for applying ASC 860 s sale accounting model. Figure 4-1* Framework for accounting for transfers of financial assets * This Figure assumes that the transferee is not consolidated by the transferor. PwC 4-3

188 Accounting for financing-type transfers revised March When should a transfer be accounted for as a secured borrowing? A transfer of financial assets should either be accounted for as a sale or, if the transfer fails to meet any of ASC 860 s criteria for sale accounting, as a secured borrowing. The criteria to determine whether a transfer should be reported as a sale are described in ASC and 40-5 (refer to TS 2). These criteria also apply when determining the proper accounting for financial assets transferred in connection with repurchase agreements, dollar rolls, and securities lending transactions. Excerpt from ASC The transferor and transferee shall account for a transfer as a secured borrowing with pledge of collateral in either of the following circumstances: a. If a transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset does not meet the conditions for a sale in paragraph b. If a transfer of a portion of an entire financial asset does not meet the definition of a participating interest. The transferor shall continue to report the transferred financial asset in its statement of financial position with no change in the asset s measurement (that is, basis of accounting). An example of a transaction that must be accounted for as a secured borrowing is one in which the transferor maintains effective control of the transferred financial assets through (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them, (2) an agreement that provides the transferor with both the ability to unilaterally cause the holder to return specific financial assets and a more-thantrivial-benefit (other than through a clean-up call), or (3) an agreement that permits the transferee to require that the transferor repurchase the transferred financial assets at a price that is so favorable to the transferee that it is probable that the transferee will require the transferor to repurchase them. ASC lists the conditions that must be met for a transferor to maintain effective control over the transferred financial assets through an agreement that both entitles and obligates the transferor to repurchase or redeem transferred financial assets from the transferee. Excerpt from ASC An agreement that both entitles and obligates the transferor to repurchase or redeem transferred financial assets from the transferee maintains the transferor s effective control over those assets as described in paragraph (c)(1), if all of the following conditions are met: 4-4 PwC

189 Accounting for financing-type transfers revised March 2016 a. The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred. To be substantially the same, the financial asset that was transferred and the financial asset that is to be repurchased or redeemed need to have all of the following characteristics: 1. The same primary obligor (except for debt guaranteed by a sovereign government, central bank, government-sponsored enterprise or agency thereof, in which circumstance the guarantor and the terms of the guarantee must be the same) 2. Identical form and type so as to provide the same risks and rights 3. The same maturity (or in the circumstance of mortgage-backed pass-through and pay-through securities, similar remaining weighted-average maturities that result in approximately the same market yield) 4. Identical contractual interest rates 5. Similar assets as collateral 6. The same aggregate unpaid principal amount or principal amounts within accepted good delivery standards for the type of security involved. Participants in the mortgage-backed securities market have established parameters for what is considered acceptable delivery. These specific standards are defined by the Securities Industry and Financial Markets Association and can be found in Uniform Practices for the Clearance and Settlement of Mortgage-Backed Securities and Other Related Securities, which is published by the Securities Industry and Financial Markets Association. See paragraph for implementation guidance related to these conditions. b. Subparagraph superseded by Accounting Standards Update c. The agreement is to repurchase or redeem the financial assets before maturity, at a fixed or determinable price. d. The agreement is entered into contemporaneously with, or in contemplation of, the transfer. Excerpt from ASC A Notwithstanding the characteristic in paragraph that refers to a repurchase of the same (or substantially the same) financial asset, a repurchase-tomaturity transaction shall be accounted for as a secured borrowing as if the transferor maintains effective control. If the conditions for maintaining effective control are met, the transfer should be accounted for as a secured borrowing. However, if any of the conditions are not met, and assuming that the other sale criteria in ASC have been satisfied, the PwC 4-5

190 Accounting for financing-type transfers revised March 2016 transaction should be accounted for as a sale by the transferor and a purchase by the transferee. In June 2014, the FASB released ASU , Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. ASU made the following amendments to the guidance in ASC 860. Requires that a repurchase-to-maturity transaction be accounted for as a secured borrowing in all cases (see ASC A cited above) Eliminated the linked accounting model for repurchase financings, as defined; ASU directs that the accounting for the two legs of repurchase financings (the initial transfer of the financial asset and the related repurchase agreement) be evaluated separately 1 Requires transferors of pledged collateral arising from repurchase agreements and securities lending transactions to provide more information about the related obligation reported on their balance sheet Requires transferors to provide more information about certain transfers of financial assets reported as sales in which the transferor retains substantially all of the exposure to the transferred asset s economic return during the term of the transaction The accounting changes in ASU were effective for public business entities for the first interim or annual period beginning after December 15, For all other entities, the accounting changes were effective for annual periods beginning after December 15, 2014, and interim periods beginning after December 15, The new disclosures were required to be presented for annual periods beginning after December 15, However, with respect to interim periods, the effective dates of the new disclosure requirements are staggered, and differ for public business entities and other reporting enterprises. Some interim disclosures were effective for public business entities for interim periods beginning after December 15, 2014, while others were effective for periods beginning after March 15, Interim disclosures for all other entities were effective for periods beginning after December 15, Financial assets that are the same or substantially the same To demonstrate that a transferor has maintained effective control over transferred financial assets that underlie a repurchase agreement or securities lending transaction, the financial assets to be repurchased or redeemed must be the same or substantially the same as those transferred. ASC (a) (excerpted above) clarifies when the financial assets (typically -- but not always -- securities) are considered substantially the same. 1 Evaluating the accounting for each leg separately is an exception to the general requirement that a transferor must consider all forms of continuing involvement with a transferred financial asset, and all agreements made contemporaneously with or in contemplation of the transfer, in connection with the de-recognition analysis (see ASC C). 4-6 PwC

191 Accounting for financing-type transfers revised March 2016 The determination of whether a security is substantially the same should be based on a comparison of the key terms and attributes of the financial assets. The criteria in ASC (a) are satisfied if the financial asset to be repurchased or redeemed in a secured borrowing (1) has the same obligor as the transferred asset; (2) is the same type (e.g., common stock, preferred stock, bond) as the transferred asset; (3) has the same maturity as the transferred asset; (4) has an identical interest rate, if the transferred asset is a debt instrument; (5) is backed by collateral similar to that which backs the transferred asset (if the transferred asset is backed by collateral); and (6) has the same unpaid principal balance as the transferred asset Repurchase or redemption before maturity at a fixed or determinable price The agreement to repurchase or redeem the transferred financial assets must cite a repurchase or redemption date prior to the maturity of the transferred financial assets at a fixed or determinable price. The latter condition is not met when, for example, the repurchase price for the transferred financial asset is not explicitly stated or determinable based on the terms of the contract. As mentioned in TS 4.1, a repurchase-to-maturity transaction (that is, a repurchase agreement whose settlement date coincides with the maturity date of the underlying financial asset) should be accounted for as a secured borrowing in all cases, regardless of whether the transferor reacquires the financial asset at settlement Timing of repurchase agreement's execution If the transferor enters into an agreement to repurchase or redeem the financial assets at a time other than the time that it transfers the financial assets, effective control over those financial assets may be maintained by the transferor. The condition in ASC relating to the contractual right or obligation to repurchase the transferred financial assets may not be circumvented by executing the repurchase agreement at a point in time other than contemporaneously with the underlying transfer. If an agreement to repurchase a transferred asset is executed in contemplation of a transfer (even if the contract is entered into at a time other than the transfer) the transaction would meet the criterion in ASC (d). 4.3 What is the general accounting model for secured borrowings? If a transfer of financial assets fails to meet the definition of a participating interest (if applicable) or does not meet the sale criteria in ASC , the exchange must be accounted for as a secured borrowing. Generally, under the secured borrowing accounting model, the transferor is obligated to: Recognize any cash received as an asset Record the obligation to return the cash as a liability Continue to apply the appropriate GAAP to the financial assets transferred PwC 4-7

192 Accounting for financing-type transfers revised March 2016 Apply the collateral accounting and reporting provisions of ASC 860 (as discussed throughout this Chapter) to the financial assets transferred (i.e., account for the transferred assets as a pledge of collateral for the deemed borrowing arrangement) If the transferor is required to consolidate the transferee (for example, when the transferee is a VIE and the transferor is the primary beneficiary of the VIE transferee) the secured borrowing is eliminated in consolidation. In that case, this accounting treatment would not be reflected in the transferor s consolidated financial statements. 4.4 When should collateral be recognized by its recipient? As noted above, if a transfer of financial assets fails to meet ASC 860 s sale accounting requirements, the exchange is be accounted for as a secured borrowing with a pledge of collateral. As such, as a general principle, the transferor continues to report the transferred assets on its balance sheet, and is considered to have conveyed a security interest in those assets to the transferee in exchange for cash or other proceeds. 2 In these circumstances, ASC prescribes how (1) the transferred financial assets and (2) the corresponding consideration received from the transferee are to be accounted for and reported by the two parties Cash collateral Accounting by transferor In securities lending or repurchase agreement transactions where cash is received as collateral (consideration for transferred financial assets), the transferor recognizes the cash as proceeds of the secured borrowing. The cash received should be recognized as the transferor s asset as shall investments made with the cash, even if made by agents or in pools with other securities lenders along with the obligation to return the cash. Accounting by transferee The transferee derecognizes the cash collateral surrendered to the transferor because it is a fungible asset, which makes it impossible to determine whether it has been used by the transferor. 2 Note that this financial accounting characterization may be inconsistent with the legal form of the transfer and the provisions in the underlying agreements; for example, in the typical repurchase agreement or securities lending transaction executed in the U.S., the transferee acquires legal title to (i.e., a property interest in) the transferred financial assets -- not a security interest. 4-8 PwC

193 Accounting for financing-type transfers revised March Noncash collateral Accounting by transferor The noncash collateral (i.e., securities, letters of credit) received by the transferor in a securities lending or repurchase agreement transaction is generally recognized as proceeds of the secured borrowing. This is dependent on whether the transferor has the ability to freely pledge or exchange the collateral received. To the extent that the collateral consists of letters of credit or other financial instruments that the holder is not permitted by contract or custom to sell or repledge, the transferor does not recognize the collateral received (nor a corresponding obligation to return) as it does not control the collateral. Accounting by both transferor and transferee In addition, in securities lending and repurchase agreement transactions accounted for as secured borrowings, the transferor should continue to recognize on its balance sheet the financial assets subject to the transfer. However, if the other party (transferee) has the right to freely pledge and exchange the assets, these financial assets must be reclassified to indicate that they have been pledged as collateral. If the transferor defaults under the related contract and thus may no longer redeem (reacquire) the collateral, the financial assets should be derecognized and recognized as assets by the other party (transferee). ASC provides guidance in different scenarios for the recognition of collateral by secured parties. Excerpt from ASC The accounting for noncash collateral by the obligor (or debtor) and the secured party depends on whether the secured party has the right to sell or repledge the collateral and on whether the obligor has defaulted. Noncash collateral shall be accounted for as follows: a. If the secured party (transferee) has the right by contract or custom to sell or repledge the collateral, then paragraph requires that the obligor (transferor) reclassify that asset and report that asset in its statement of financial position separately (for example, as security pledged to creditors) from other assets not so encumbered. b. If the secured party (transferee) sells collateral pledged to it, it shall recognize the proceeds from the sale and its obligation to return the collateral. The sale of the collateral is a transfer subject to the provisions of this Topic. c. If the obligor (transferor) defaults under the terms of the secured contract and is no longer entitled to redeem the pledged asset, it shall derecognize the pledged asset as required by paragraph and the secured party (transferee) shall recognize the collateral as its asset. (See paragraph for guidance on the secured party s initial measurement of collateral recognized. See paragraph for further guidance if the debtor has sold the collateral.) PwC 4-9

194 Accounting for financing-type transfers revised March 2016 d. Except as provided in paragraph the obligor (transferor) shall continue to carry the collateral as its asset, and the secured party (transferee) shall not recognize the pledged asset. The following summarizes the key accounting results stemming from the application of the foregoing guidance: Securities or other noncash financial asset received by the transferee as collateral should continue to be recognized on the transferor s balance sheet (subject to reclassification if the transferee has the right to sell or repledge the collateral). If the transferee sells the noncash collateral, it should recognize the proceeds it receives from the transaction and record a liability for its obligation to return the collateral. Prior to any such sale, the pledged asset should not be recognized on the transferee s balance sheet unless the transferor has defaulted under the related agreement. If the transferor defaults and is no longer entitled to redeem the assets pledged as collateral, it should derecognize the collateral and the transferee should either (1) recognize the collateral as its own asset at fair value or (2) derecognize any obligation to return the collateral (if an obligation was previously recognized). The following chart provides a decision tree with three key considerations for evaluating who should recognize collateral PwC

195 Accounting for financing-type transfers revised March 2016 Figure 4-3 Example decision tree for collateral recognition 4.5 What is the appropriate accounting for a repurchase agreement? Repurchase agreements (often referred to as repos ) are transactions by which the transferor transfers a financial asset (usually a debt security) to a transferee in exchange for cash. Simultaneously, the transferor enters into an agreement to reacquire the security on a specified future date for an amount equal to the cash received plus a stipulated interest factor. Banks, dealers, other financial institutions, and corporate investors commonly use repos for purposes such as obtaining short-term funds, earning a profit on arbitrage, or meeting Federal Reserve requirements. Most transferors are attracted to repos because their maturities are relatively flexible (i.e., can be shorter or longer as needed), compared to other short term financings such as commercial paper or certificates of deposit. The transferee, who is often a dealer financing its trading inventory, will pay a lower rate than it would on a collateralized bank loan. PwC 4-11

196 Accounting for financing-type transfers revised March 2016 Parties to repo transactions are referred to in a variety of ways. The following chart presents the terms that are commonly used to identify them. Figure 4-4 The parties in repos Repos can be structured in many different ways, with varying maturities. For example, common repurchase agreements include the following: Standard repos, which have specified maturity dates that can range from overnight to several months. Repos with a specified maturity date can generally be rolled over or extended by mutual agreement of the parties. Open repos, which do not have maturity dates and therefore can be terminated by the transferee or transferor at any time, on short notice. Tri-party repos, in which the securities are not delivered to the transferee. The securities are held by a custodian (usually a clearing bank), subject to an agreement signed by all three parties to the transaction. The transferor cannot obtain the collateral until it pays the transferee the amount owed under the contract (the collateral s repurchase price), thus providing security to the transferee in the event of default by the transferor Accounting for repurchase agreements Consistent with the ASC 860 model, the accounting for repos depends on whether the transfer of the underlying financial asset qualifies for sale accounting under ASC Most repos are accounted for as secured borrowing transactions, as the terms of the underlying repurchase agreement satisfy (by design) the effective control requirements in ASC Specifically, repos accounted for as secured borrowing transactions obligate the transferor to repurchase financial assets at a fixed or determinable price, and also have the following characteristics: 4-12 PwC

197 Accounting for financing-type transfers revised March 2016 The term of the repo does not extend past the maturity date of the transferred financial assets The financial assets to be repurchased are the same or substantially the same as the ones that were originally transferred Transfers of financial assets subject to repurchase agreements that meet these conditions, fail the criterion for sale accounting under paragraph ASC (c). Accordingly, consistent with the secured borrowing accounting model, the transferor should recognize the cash received, record the obligation to repurchase the transferred financial asset, and apply the collateral-related accounting and reporting provisions in paragraph ASC As previously mentioned, repurchase-to-maturity transactions, as defined in ASC 860, are required to be accounted for as secured borrowings in all cases. Although rare, a repo transaction may qualify for sale accounting. For example, a repurchase agreement may not obligate the transferee to return or re-sell to the transferor a financial asset that meets all of ASC s substantially the same conditions. In these circumstances, the transferor is not considered to have retained effective control over the transferred asset. ASC , as amended and clarified by ASU , re-affirms that, in these instances, the repo transaction may qualify for de-recognition, but only if the exchange meets the two remaining sale accounting criteria in ASC If these conditions are satisfied, sale accounting is appropriate, in which case the transferred financial assets should be derecognized, accompanied by the recognition of proceeds received and liabilities assumed, including the forward purchase contract, at their current fair value. The latter may be subject to derivative accounting under ASC 815. The following chart illustrates the general sequence of decisions for companies that participate in repurchase agreements and similar transfer transactions. PwC 4-13

198 Accounting for financing-type transfers revised March 2016 Figure 4-5 Accounting for repurchase transactions Additional accounting considerations for repurchase agreements are summarized below: In some repo transactions, the transferor may receive letters of credit and other securities instead of cash for the transferred securities. The accounting for these transactions is the same as the accounting for securities lending transactions (see discussion in TS 4.7. Provided that they can be sold or repledged by the transferor (and thus converted into cash), the letters of credit or securities are accounted for as if they were cash (i.e., recognized on the transferor s balance sheet). Some repurchase agreements call for the repurchase of securities that need not be identical to the securities transferred. To support the assertion that a transferor has maintained effective control over a transferred financial asset through an agreement to repurchase or redeem it, the financial asset to be repurchased or redeemed must be substantially the same as the transferred item. Because the securities sold and repurchased can be similar but not identical, a careful analysis of the transaction is necessary to determine whether the transferor has, in fact, maintained effective control over the assets. In a custodial or tri-party arrangement, control over the assets is not surrendered and a reclassification entry from securities to securities pledged to creditors is not required, as the secured party (transferee) does not have the right to pledge or sell the collateral held in the account PwC

199 Accounting for financing-type transfers revised March 2016 A repo to maturity should be accounted for as a secured borrowing. The examples below illustrate the specific accounting for the following three different repurchase agreements: (1) a standard repo accounted for as a secured borrowing, where the transferee does not sell or repledge the security, (2) a standard repo accounted for as a secured borrowing, where the transferee sells or repledges the security, and (3) a tri-party repo arrangement, accounted for as a secured borrowing. See FSP 22.6 for a discussion of the various disclosure requirements for transfers of financial assets reported as secured borrowings, including those pertaining to the related collateral. EXAMPLE 4-1 Standard repo accounted for as a secured borrowing Transferee does not sell or repledge the transferred security Company A (transferor) transfers a security with a fair value of $1,000 to Company B (transferee) in exchange for $980 in cash. Company A agrees to repurchase the security in 35 days. The fair value of the security remains constant. Company A s return from investing the cash is $5, based on an approximate 5 percent annual rate for 35 days. Company B receives a fee (interest) of $4 from Company A, based on an approximate 4 percent annual rate for 35 days. Although Company B may sell or repledge the security, it does not do so during the transaction. The transaction qualifies for secured borrowing treatment. The following journal entries show the accounting treatment for this arrangement. Company A Transferor Company B Transferee At inception: At inception: Cash $980 Reverse repo agreements $980 Obligation under repo Cash $980 agreements $980 To record the receipt of cash and obligation under the repo agreement Securities pledged to Company B $1,000 Securities $1,000 To reclassify pledged security that the secured party has the right to sell or repledge To record transfer of cash to the repo counterparty in exchange for pledged security (noncash collateral) Company B does not recognize the security on its balance sheet. An obligation to return the pledged security is only recorded when Company B sells the security. Money market instrument $980 Cash $980 To record investment of cash collateral At conclusion: At conclusion: Cash $985 Cash $984 Interest income $5 Reverse repo agreements $980 Money market instrument $980 Interest income $4 PwC 4-15

200 Accounting for financing-type transfers revised March 2016 To record results of short term cash investment To record receipt of cash upon maturity (unwind) of reverse repo agreement. [Note: Interest income should be recorded on the accrual basis of accounting over the term of each reverse repo agreement.] Securities $1,000 Securities pledged to Company B $1,000 To reclassify security no longer pledged Obligation under repo agreements $980 Interest expense $4 Cash $984 To record repayment of repo principal and interest. [Note: Interest income and expense should be recorded on the accrual basis of accounting over the term of the investments and each repo agreement, respectively.] EXAMPLE 4-2 Standard repo accounted for as a secured borrowing Transferee sells or repledges the transferred security Company C (transferor) transfers a security with a fair value of $1,000 to Company D (transferee) in exchange for $980 in cash. Company C agrees to repurchase the security in 35 days. The fair value of the security remains constant. Company C s return from investing the cash is $5, based on an approximate 5 percent annual rate for 35 days. Company D receives a fee (interest) of $4 from Company C, based on an approximate 4 percent annual rate for 35 days. Company D repledges the security upon receipt and later returns the same security to Company C. Company D s return from investing the cash collateral is $2, based on a 2 percent annual rate for 35 days. The transaction qualifies for secured borrowing treatment. The following journal entries show the accounting treatment for this arrangement. Company C Transferor Company D Transferee At inception: At inception: Cash $980 Reverse repo agreements $980 Obligation under repo Cash $980 agreements $980 To record the receipt of cash and obligation under the repo agreement Securities pledged to Company D $1,000 To record transfer of cash to the repo counterparty in exchange for pledged security (noncash collateral) Company D does not recognize the security on its balance sheet. An obligation to return the pledged security is only recorded when Company D sells the security PwC

201 Accounting for financing-type transfers revised March 2016 Securities $1,000 To reclassify pledged security that the secured party has the right to sell or repledge Money market instrument $980 Cash $980 Cash $980 Obligations under repo agreements $980 To record investment of cash collateral To record the repledge of collateral Money market investment $980 Cash $980 To record investment of cash received from repledging security At conclusion: At conclusion: Cash $985 Cash $982 Interest income $5 Interest Income $2 Money market instrument $980 Money market instrument $980 To record results of short term cash To record results of short term cash investment investment Securities $1,000 Securities pledged to Company D $1,000 To reclassify security no longer pledged Obligation under repo agreements $980 Obligations under repo agreements $980 Cash $980 To record return of repledged security and cash collateral [Note: interest expense omitted for sake of simplicity.] Cash $984 Interest expense $4 Reverse repo agreements $980 Cash $984 Interest income $4 To record repayment of repo principal and interest. [Note: Interest income and expense should be recorded on the accrual basis of accounting over the term of the investments and each repo agreement, respectively.] To record the receipt of cash upon maturity (unwind) of reverse repo agreement. [Note: Interest income should be recorded on the accrual basis of accounting over the term of each reverse repo agreement.] PwC 4-17

202 Accounting for financing-type transfers revised March 2016 EXAMPLE 4-3 Tri-party agreement accounted for as a secured borrowing Company E (transferor) transfers a security with a fair value of $1,000 to a third-party custodian in exchange for a loan of $980 cash from Company F (transferee). Company E agrees to repurchase the security in 35 days. The fair value of the security remains constant. Company E s return from investing the cash is $5, based on a 5 percent annual rate for 35 days. Company F receives a fee (interest) of $4 from Company E, based on a 4 percent annual rate for 35 days. Company F cannot sell or repledge the security, as it is held by the custodian. The transaction qualifies for secured borrowing treatment. The following journal entries show the accounting treatment for this arrangement. Company E Transferor At inception: Company F Transferee At inception: Cash $980 Reverse repo agreements $980 Obligation under repo Cash $980 agreements $980 To record the receipt of cash and obligation under the repo agreement To record transfer of cash to the repo counterparty in exchange for pledged security (noncash collateral) The transferor does not reclassify the securities as the transferee does not have the right to sell or repledge them. This example contrasts with the previous two, which stipulated that the transferee can sell/repledge the collateral. Money market instrument $980 Cash $980 To record investment of cash collateral At conclusion: At conclusion: Cash $985 Interest income $5 Money market instrument $980 To record results of short term cash investment 4-18 PwC

203 Accounting for financing-type transfers revised March 2016 Obligation under repo agreements $980 Cash $984 Interest expense $4 Reverse repo agreements $980 Cash $984 Interest income $4 To record the repayment of repo principal and interest. [Note: Interest income and expense should be recorded on the accrual basis of accounting over the term of the investments and each repo agreement, respectively.] To record the receipt of cash upon maturity (unwind) of reverse repo agreement. [Note: Interest income should be recorded on the accrual basis of accounting over the term of each reverse repo agreement.] 4.6 What is the appropriate accounting for a dollar roll? Pooling homogeneous residential mortgages so that an MBS may be created is a common practice in the mortgage market. The Government National Mortgage Association ( Ginnie Mae, a U.S. government corporation with the Department of Housing and Urban Development), the Federal National Mortgage Association ( Fannie Mae ), and the Federal Home Loan Mortgage Corporation ( Freddie Mac ) each purchase conforming residential mortgage loans from various originators (lenders). The loans are pooled and MBS are issued in accordance with the terms of the respective entity s securitization platform. Since the financial crisis in 2008, the new-issue market for MBS in the U.S. has consisted principally of securitizations sponsored by Ginnie Mae, Fannie Mae, and Freddie Mac. Issues of private label MBS have declined significantly. Dealers must finance their securities inventory and frequently take trading positions in the cash and forward markets (i.e., when issued securities). A special type of repo, known as the dollar roll, is commonly used to provide funding for this segment of the market. At a high level, a dollar roll is similar to a standard repurchase agreement. The arrangement is intended to provide short-term financing to a dealer or other party having funding needs, collateralized by MBS. In a dollar roll, the transferee lends cash against MBS collateral acquired from the repo counterparty (transferor). Upon maturity of the contract, the transferee must return MBS collateral that is similar, but necessarily identical, to the collateral received. The type of collateral that may be delivered upon unwind is subject to specified criteria. In this respect, a dollar roll differs from a standard repo because the securities sold and repurchased can be similar but not identical. The FASB Codification Master Glossary defines dollar rolls as follows. PwC 4-19

204 Accounting for financing-type transfers revised March 2016 Definition from ASC Master Glossary Government National Mortgage Association Rolls: The term Government National Mortgage Association (GNMA) rolls has been used broadly to refer to a variety of transactions involving mortgage-backed securities, frequently those issued by the GNMA. There are four basic types of transactions: a. Type 1. Reverse repurchase agreements for which the exact same security is received at the end of the repurchase period (vanilla repo) b. Type 2. Fixed coupon dollar reverse repurchase agreements (dollar repo) c. Type 3. Fixed coupon dollar reverse repurchase agreements that are rolled at their maturities, that is, renewed in lieu of taking delivery of an underlying security (GNMA roll) d. Type 4. Forward commitment dollar rolls (also referred to as to-be-announced GNMA forward contracts or to-be-announced GNMA rolls), for which the underlying security does not yet exist. Dollar rolls involving Types 1, 2, and 3 are each subject to the guidance in ASC 860, as the security transferred under the repurchase agreement is a recognized financial asset at the date of the initial exchange. Conversely, Type 4 dollar rolls fall outside the scope of ASC 860, since the TBA security cannot be a recognized financial asset at the time of the transaction (the security does not yet exist). These Type 4 dollar roll transactions should be accounted for based on relevant guidance in ASC 815. The most popular dollar rolls in the marketplace are fixed coupon and yield maintenance agreements. In a fixed coupon agreement, the securities repurchased have the same stated interest rate and similar maturities as the securities sold. Thus, the securities repurchased are generally priced to result in the same yield as the securities sold. The seller (i.e., the borrower) retains control over the future economic benefits of the securities sold and assumes no additional market risk. In a yield maintenance agreement, the securities repurchased may have a different stated interest rate than that of the securities sold. Therefore, they are generally priced to result in different yields, as specified in the agreement, or may carry provisions that can significantly alter the economics of the transaction (e.g., a par cap provision that limits the repurchase price to a stipulated percentage of the face amount of the certificate). The seller (i.e., the borrower) surrenders control over the future economic benefits of the securities sold and assumes additional market risk Accounting for dollar rolls Consistent with the guidance for secured borrowings, the proper accounting for dollar rolls is predicated on whether the transaction meets the criteria for sale accounting in ASC As with repos, it is appropriate to focus first on the condition in ASC (c) and evaluate whether the transferor has maintained effective control over the underlying transferred financial assets (the transferred MBS in this instance). As previously discussed, to assert that a transferor has maintained effective 4-20 PwC

205 Accounting for financing-type transfers revised March 2016 control over a transferred security through a repurchase agreement, the security to be repurchased or redeemed must be substantially the same, based on applying the criteria in ASC Because the securities sold and required to be repurchased in a dollar roll can be similar but not identical, a careful analysis of the dollar roll transaction is necessary to determine whether the transferor has, in fact, maintained effective control over the MBS sold. Even if a transferor is deemed to have surrendered effective control over the security underlying a dollar roll transaction, de-recognition of the security is appropriate only if the remaining two conditions in ASC are also satisfied. 4.7 What is the appropriate accounting for a securities lending transaction? Owners of securities often lend these financial assets to third parties for a fee. The securities may be lent for a definite or an indefinite period. Securities lending programs are often managed by custodians to earn additional income for clients. The securities lender (i.e., the transferor) generally requires the borrower to provide collateral, which can be cash, standby letters of credit, or other securities. The collateral typically has a value higher than that of the borrowed securities (i.e., there is overcollateralization). If the collateral is cash, the transferor typically earns a return by investing it at a rate higher than the rate paid or rebated to the transferee. If the collateral is not cash (i.e., standby letters of credit, or other securities), the transferor typically receives a fee for lending the securities. Distributions (e.g., dividends) received on the securities lent (and collateral received, if applicable) during the term of the agreement inure to the transferor and securities borrower, respectively. If the collateral consists of securities, these assets are typically valued daily and adjusted frequently to reflect changes in the market price of the securities transferred. Securities lending transactions are designed to minimize credit risk. The borrower of the securities may use them to make delivery on a short position or settle a customer sale transaction that has failed. If a dealer sells a security that it does not own, the dealer must borrow the security temporarily to settle the transaction Accounting for securities lending Since securities lending transactions involve the transfer of a financial asset (typically a debt or equity security), the proper accounting for the exchange is predicated on whether the transaction meets the criteria in ASC for sale accounting. If so, ASC A, provides further guidance regarding the accounting for securities lending transactions. PwC 4-21

206 Accounting for financing-type transfers revised March 2016 Excerpt from ASC A If the conditions in paragraph are met, a securities lending transaction should be accounted for as follows: a. By the transferor as a sale of the loaned securities for proceeds consisting of the cash collateral and a forward repurchase commitment. If the collateral in a transaction that meets the conditions in paragraph is a financial asset that the holder is permitted by contract or custom to sell or repledge, that financial asset is proceeds of the sale of the loaned securities. b. By the transferee as a purchase of the borrowed securities in exchange for the collateral and a forward resale commitment. During the term of that agreement, the transferor has surrendered control over the securities transferred and the transferee has obtained control over those securities with the ability to sell or transfer them at will. In that circumstance, creditors of the transferor have a claim only to the collateral and the forward repurchase commitment. The guidance above reiterates that securities loaned should be accounted for as a sale if the transfer meets the criteria in ASC If so, the lender should derecognize the transferred securities, recognize the collateral received (cash and/or other securities, provided that the lender can sell or repledge the latter) as an asset, and record a forward repurchase commitment. Depending on the economics of the transaction and the carrying value of securities sold, a gain or loss may also be recorded. In practice, however, securities lending transactions are generally structured to ensure that the underlying transfer does not meet the conditions for sale accounting. ASC provides guidance on the accounting treatment of securities lending transactions required to be reported as secured borrowings. Excerpt from ASC Many securities lending transactions are accompanied by an agreement that both entitles and obligates the transferor to repurchase or redeem the transferred financial assets before their maturity. Paragraph states that an agreement that both entitles and obligates the transferor to repurchase or redeem transferred financial assets from the transferee maintains the transferor s effective control over those assets as described in paragraph (c)(1), if all of the conditions in paragraph are met. Those transactions shall be accounted for as secured borrowings, in which either cash or securities that the holder is permitted by contract or custom to sell or repledge received as collateral are considered the amount borrowed, the securities loaned are considered pledged as collateral against the cash borrowed and reclassified as set forth in paragraph (a), and any rebate paid to the transferee of securities is interest on the cash the transferor is considered to have borrowed PwC

207 Accounting for financing-type transfers revised March 2016 Therefore, a securities lending arrangement that results in the transferor maintaining effective control of the transferred financial assets (as described in ASC ) should be accounted for as a secured borrowing. Under the secured borrowing accounting model: Any cash, standby letters of credit, or other securities received as collateral should be considered the amount borrowed by the transferor and recognized as an asset on its financial statements (provided that any such non-cash collateral can be sold or repledged by the transferor). The securities loaned are considered pledged as collateral against the amount borrowed and may require reclassification under the collateral provision of ASC Any rebate paid to the transferee should be considered an interest payment on the amount borrowed by the transferor and should be recognized over the life of the contract. ASC further clarifies that cash or securities received as collateral for securities loaned (and any investments made with that cash) should be recognized as an asset by the lender (provided that the securities received can be sold or repledged), regardless of whether the transaction is accounted for as a sale or secured borrowing. The securities lender should also recognize as a liability for the obligation to return the collateral. The examples below illustrate the specific accounting for three different securities lending transactions reported as secured borrowings: (1) the securities lender (i.e., the transferor) receives cash as collateral and the borrower of securities sells the securities upon receipt, with the latter subsequently buying similar securities to return to the securities lender, (2) the securities lender receives treasury securities as collateral and the securities borrower does not sell the securities, and (3) the securities lender receives treasury securities as collateral and the borrower of securities sells the securities upon receipt, with the latter subsequently buying similar securities to return to the securities lender. EXAMPLE 4-4 Securities lending transaction treated as a secured borrowing Cash pledged as collateral Company A (transferor) lends securities with a carrying amount of $1,000 to Company B (transferee) for 35 days. Company B pledges $1,020 in cash as collateral to Company A. Company A s return from investing the collateral is $5, based on an annual rate of 5 percent. Company A has agreed to rebate $4 to Company B, based on an annual rate of 4 percent. The fair value of the transferred securities remains constant. Company B (the borrower of securities) sells the securities upon receipt and later buys similar securities to return to Company A (the securities lender). The transaction PwC 4-23

208 Accounting for financing-type transfers revised March 2016 qualifies for secured borrowing treatment. The following journal entries show the accounting treatment for this arrangement. Company A Transferor (Lender of stock) At inception: Cash $1,020 Company B Transferee (Borrower of stock) At inception: Receivable under securities borrowing agreements $1,020 Payable under securities lending agreements $1,020 Cash $1,020 To record the receipt of cash in exchange for loaned security, and related obligation To record transfer of cash to the securities lender in exchange for borrowed security (noncash collateral) Securities pledged to Company B $1,000 Cash $1,000 Securities $1,000 To reclassify loaned security that the secured party has the right to sell or pledge Money market instrument $1,020 Cash $1,020 Obligation to return borrowed securities $1,000 To record sale of borrowed security to third party and obligation to return Note: the transferee s investment of the proceeds from the sale of the borrowed security is omitted from this example To record investment of cash collateral At conclusion: At conclusion: Cash $1,025 Cash $1,024 Interest income $5 Receivable under securities borrowing agreements $1,020 Money market instrument $1,020 Interest income (rebate) $4 To record results of short term cash investment Securities $1,000 To record the receipt of cash collateral and rebate interest upon return of borrowed security [Note: Interest income should be recorded on the accrual basis of accounting over the term of each securities borrowing agreement.] Obligation to return borrowed securities $1,000 Securities pledged to Company B $1,000 Cash $1,000 To reclassify security no longer pledged To record the repurchase of security borrowed and redelivery of security to lender [Note: interest expense omitted for sake of simplicity.] Payable under securities lending agreements $1, PwC

209 Accounting for financing-type transfers revised March 2016 Interest expense (rebate) $4 Cash $1,024 To record repayment of cash collateral and interest [Note: Interest income and expense should be recorded on the accrual basis of accounting over the term of the investments and each securities lending agreement, respectively.] EXAMPLE 4-5 Securities lending transaction accounted for as a secured borrowing Securities pledged as collateral and borrower does not sell the securities (security for security transfer) Company E (transferor) lends common stock (Security X) with a fair value of $1,010 to Company F (transferee) for 35 days. Company F pledges treasury securities (Security Y) with a fair value of $1,020 as collateral to Company E. Company E and Company F receive no return on investment because no cash is exchanged. However, Company F pays a fee of $1 to Company E, based on an annual rate of 1 percent. The fair value of Security X remains constant. Company F (the borrower of securities) does not sell Security X after receiving it from Company E (the securities lender). The transaction qualifies for secured borrowing treatment. The following journal entries show the accounting treatment for this arrangement. Company E Transferor of Security X (Lender of stock) At inception: Securities (Y) $1,020 Payable under securities lending agreements $1,020 Company F Transferee of Security X (Borrower of stock) At inception: No entry is required by Company F for the transfer of Security Y as it is not deemed to be collateral (see ASC ). To record the receipt of Security Y (in lieu of cash collateral) that the transferor can sell or pledge, in exchange for loaned Security X Cash or securities collateral that the transferor can sell or repledge is considered the amount borrowed under a secured borrowing. Company F is not required to recognize the borrowed Security X on its balance sheet. The obligation to return the Security X is recorded only if Security X is sold or Company E defaults. Securities pledged to Company F $1,010 Securities (X) $1,010 To reclassify pledged/loaned security that the secured party has the right to sell or repledge PwC 4-25

210 Accounting for financing-type transfers revised March 2016 At conclusion: At conclusion: Securities (X) $1,010 Security lending fee $1 Securities pledged to $1,010 Cash $1 To reclassify Security X no longer pledged To record fee paid to lender of Security X Payable under securities loan agreements $1,020 Securities (Y) $1,020 To record repayment/redelivery of Security Y Cash $1 Security lending fee $1 To record fee for received for lending Security X to transferee EXAMPLE 4-6 Securities lending transaction accounted for as a secured borrowing Securities pledged as collateral and borrower sells the securities Company D enters into a short position by selling Security S to a third party. Company C (transferor) lends common stock (Security S) with a fair value of $1,010 to Company D (transferee) for 35 days. Company D pledges treasury securities (Security T) with a fair value of $1,020 as collateral to Company C. Company C and Company D receive no return on investment because no cash is exchanged. However, Company D pays a fee of $1 to Company C, based on an annual rate of 1 percent. The fair value of Security S remains constant throughout the life of the arrangement. Company D (the borrower of securities) sells Security S upon receipt and later buys similar securities to return to the Company C (the securities lender). The transaction qualifies for secured borrowing treatment. The following journal entries show the accounting treatment for this arrangement. Company C Transferor of Security S (Lender) At inception: Company D Transferee of Security S (Borrower) At inception: Securities (T) $1,020 Receivable from broker $1,010 Payable under securities loan agreements $1,020 To record the receipt of Security T (in lieu of cash collateral) that the transferor can sell or repledge, in exchange for loaned Security S Securities (S) pledged to Company D $1,010 Short position (S) $1,010 To record short sale of Security S on trade date [Note: receipt of cash from broker on settlement is omitted for sake of simplicity] Securities (S) $1, PwC

211 Accounting for financing-type transfers revised March 2016 Securities (S) $1,010 To reclassify pledged/loaned Security S that the secured party has the right to sell or repledge Obligation to return borrowed securities $1,010 To record borrowed Security S, and the resulting obligation to return, when it is received to settle the short position Short position (S) $1,010 Securities (S) $1,010 To record delivery of Security S to the buyer of S under the short sale on settlement date No entry is required by Company D for the transfer of Security T, as it is not deemed to be collateral. At conclusion: At conclusion: Securities (S) $1,010 Securities (S) $1,010 Securities pledged to Cash $1,010 Company D $1,010 To reclassify Security S no longer pledged Payable under securities lending agreements $1,020 To purchase shorted Security S in the marketplace Obligation to return borrowed securities $1,010 Securities (T) $1,020 Securities (S) $1,010 To record repayment/redelivery of Security T To record delivery of borrowed Security S to lender Cash $1 Security borrowing fee $1 Security lending fee $1 Cash $1 To record fee received for lending Security S to transferee To record fee paid to lender of Security S 4.8 Chapter wrap-up One of the main objectives of ASC 860 is to provide guidance for determining when a transfer of financial assets will result in sale accounting (de-recognition of the assets) by the transferor. ASC provides criteria that must be met for sale accounting to be appropriate. If any one of the criteria in ASC is not satisfied, the transaction must be accounted for as a secured borrowing. As discussed in TS , if the transfer involves only a portion of a financial asset, the participating interest criteria in ASC A must be evaluated first in connection with the sale accounting analysis. PwC 4-27

212 Accounting for financing-type transfers revised March 2016 Transactions that are accounted for as secured borrowings can take many different forms. These forms can range from sale transactions that fail the sale accounting requirements (i.e., failed sales ) to certain transfer transactions that act as secured borrowing arrangements structured to achieve finance accounting treatment (e.g., repos, dollar rolls, and securities lending arrangements). As many of these secured borrowing arrangements obligate the transferor to repurchase or redeem the transferred financial assets at a future date, determining whether the transferor maintains effective control over the assets must be performed, consistent with the guidance in ASC (c). If the transferor maintains effective control over the financial assets, the transaction will be accounted for as a secured borrowing. If the transferor does not maintain effective control of the financial assets, the transaction will be accounted for as a sale, as long as the other criteria in ASC have been met. ASC provides further guidance for determining whether a transferor of financial assets in a borrowing arrangement, having agreed to repurchase or redeem the transferred financial assets at a future date, maintains effective control of the transferred assets. However, ASC A stipulates that, without exception, a repurchase-to-maturity transaction is to be reported as a secured borrowing as the transferor is deemed to maintain effective control over the underlying financial asset, even in those instances where the parties intend to (or may) settle the contract through a net cash payment. Generally, in a secured borrowing, the transferor should recognize any cash received on the transfer as an asset, record the obligation to return the cash as a liability, and apply the collateral provisions of ASC 860 to the financial assets transferred. The transferee similarly is required to report the exchange as a secured lending arrangement, and thus recognizes a receivable from (loan to) the transferor. However, the underlying transferred financial asset continues to be recognized in the transferor s financial statements. The general principle is clear: if the transferor maintains effective control over the transferred financial assets through an agreement to repurchase or redeem them (or substantially similar assets) at a later date, the transaction should be accounted for as a secured borrowing. If, however, it is determined that the transferor does not maintain effective control, the transaction may qualify for sale accounting but derecognition is appropriate only if the other two sale accounting criteria in ASC have been satisfied. In all cases, considering that transfers of financial assets frequently occur in the context of a structured transaction, each exchange should be reviewed carefully. 4.9 PwC s questions and interpretive responses The following questions and interpretive responses are intended to supplement discussions in this Chapter regarding the application of guidance to specific fact patterns PwC

213 Accounting for financing-type transfers revised March 2016 Question 4-1 Are the collateral accounting requirements limited to transfers by or to broker-dealer entities, or do they apply to other types of borrowings, such as the origination of corporate debt and standard bank loans? PwC response The collateral accounting provisions of ASC apply to all transfers of financial assets pledged as collateral in a transaction accounted for as a secured borrowing. Accordingly, they apply not only to repurchase agreement, dollar-rolls, securities lending arrangements, and similar transactions in which cash is obtained in exchange for financial assets that the transferor is entitled and obligated to repurchase or redeem, but also to other transactions having similar provisions. However, as noted in ASC , those collateral accounting provisions do not apply to cash, or securities that can be sold or pledged for cash, received as so-called collateral for noncash financial assets, for example, in certain securities lending transactions. Such cash or securities that can be sold or pledged for cash are accounted for as proceeds of either a sale or a borrowing. Question 4-2 How should a transferor measure transferred collateral that must be reclassified (for example, as securities pledged to creditors)? PwC response ASC (a) requires that transferred collateral that the secured party can, by contract or custom, sell or repledge be reclassified and reported separately by the transferor. That paragraph, however, does not change the transferor s measurement of that collateral. Because the transferor continues to effectively control the collateral, it should not derecognize the collateral, and should continue to apply the measurement principles in effect prior to the transfer. For example, securities reclassified from the AFS category to securities pledged to creditors should continue to be measured at fair value, with changes in fair value reported in comprehensive income (subject to impairment), while debt securities reclassified from the held-tomaturity category to securities pledged to creditors should continue to be measured at amortized cost (subject to impairment). Question 4-3 Does ASC 860 provide guidance on subsequent measurement of a secured party s (transferee s) obligation to return transferred collateral that it recognized in accordance with ASC (b)? PwC response No. ASC 860 generally does not address subsequent measurement of transferred financial assets or the obligation to return transferred collateral. ASC PwC 4-29

214 Accounting for financing-type transfers revised March 2016 affirms that the liability to return such collateral should be measured in accordance with other relevant accounting pronouncements. For example, a bank or savings institution that, as transferee, sells transferred collateral is required to subsequently measure that liability like a short sale at fair value. ASC and 35-1 establish that obligations incurred in short sales should be reported as liabilities and re-measured to fair value through the income statement at each reporting date. Question 4-4 Can a repo party and a reverse-repo party to the same transaction account for that transaction differently? For instance, can the transferor account for the transaction as a financing, while the transferee accounts for it as a buy/sell arrangement? PwC response No. The FASB has concluded that, in concept, the same transaction should be accounted for in the same way. The Board believes that the transferor and transferee should account for financial asset transfer transactions in a consistent and symmetrical manner (refer to paragraphs and ). Therefore, under ASC 860, if a transferor accounts for qualifying transactions as secured borrowings, the transferee should account for the same transactions as secured loans. Accordingly, ASC 860 prohibits the transaction from being accounted for as a financing arrangement by the transferor and a buy/sell transaction by the transferee. In practice, however, it is possible that certain transfers may be reported differently by the transferor and transferee, primarily as a result of some of the judgments involved in evaluating these transactions (e.g., lack of persuasive evidence to support legal isolation). Question 4-5 Are most standard repo transactions treated as financings under ASC 860? PwC response Generally, yes. In most standard repo transactions, the following conditions exist: the term of the transferred security will exceed the term of the transaction and the security to be returned will generally be the same, or substantially the same, as the security originally transferred. Security-for-security transactions must be analyzed to determine which entity is the lender. The analysis should consider trade agreements or confirmations, the party that pays a fee, and the party that is designated as the lender (if there is one). Question 4-6 In a repo or securities lending arrangement where collateral is required to be recognized by the transferee/secured party under ASC (c), how should the collateral be initially and subsequently measured? 4-30 PwC

215 Accounting for financing-type transfers revised March 2016 PwC response ASC indicates that the transferee/secured party should initially measure collateral at fair value. However, ASC 860 does not address how the collateral should be subsequently measured. We believe that collateral recognized by a transferee/secured party should be subsequently measured by a method that is consistent with existing accounting policies for such assets. Question 4-7 Are forward contracts (or rollovers of forward contracts) that were not initiated with a simultaneously physically settled transaction subject to ASC 860? PwC response No. ASC 860 does not apply to such contracts because there has been no transfer of financial assets. Accordingly, such transactions will continue to be treated as forward trades. The forward purchase contract should be evaluated under ASC 815 and ASC 450. Question 4-8 Do the collateral recognition provisions of ASC 860 apply only to financial assets that are received as collateral or to all assets that are received as collateral? PwC response ASC 860 defines collateral as personal or real property in which a security interest has been given, thereby indicating that collateral can be something other than a financial asset. As such, ASC 860 applies to all assets received as collateral in connection with a transfer of financial assets. Question 4-9 Trades (including pair-offs) that are provided by clearing corporations for dollar rolls and other repos are usually recorded on a net basis by the clearing corporation. That is, the party to the trade settles its position on a net basis at the end of the day. This practice complicates or prevents the analysis of individual trades, since only the endof-day positions are provided by the clearing corporation. Under ASC 860, must each individual trade be analyzed to determine whether it should be accounted for as a secured borrowing? Or can the provisions of ASC 860 be applied to the end-of-day positions? PwC response Irrespective of whether the clearing corporation steps into the shoes of the trade counterparty (e.g., through novation), we believe that the provisions of ASC 860 should be applied to the end-of-day positions. ASC 860 implies that each individual transaction requires evaluation. The terms of the transaction and the rights and obligations under the assigned positions with the clearing corporation will need to be assessed. Practically, the assigned positions with the clearing house reflect the future PwC 4-31

216 Accounting for financing-type transfers revised March 2016 legal rights and obligations of the parties to the transactions. Therefore, we believe that an analysis of the end-of-day positions is consistent with the requirements of ASC 860. Question 4-10 Should a broker in a margin loan transaction recognize collateral under ASC 860 if the borrower is able to revoke the transfer of the securities to the broker by either repaying the margin loan or by substituting other collateral? PwC response The broker should not recognize the collateral on its books because it does not effectively control the collateral. Question 4-11 Would it be appropriate for a reporting entity to include gains and losses arising from repurchase agreements reported as sales in the same line item as interest cost attributable to other repurchase agreements reported as secured borrowings? PwC response ASC B mandates that any gain or loss arising from a transfer reported as a sale be included in earnings. However, ASC 860 does not address how a transferor should classify those gains or losses in its income statement. As a general rule, we believe that the classification of such amounts should conform to the characterization of the underlying transfer under ASC 860. Accordingly, for example, the cost associated with a repurchase agreement accounted for as a financing (the difference between the cash proceeds received at inception and the amount paid to repurchase the transferred security upon the agreement s maturity) should be characterized as interest expense in the transferor s income statement. On the other hand, we do not think it would be appropriate to characterize as interest cost the loss reported by a transferor upon de-recognizing non-interest bearing trade accounts receivable sold to a factor even though, arguably, that loss is attributable, at least in part, to the factor s imputation of a financing cost into the receivables purchase price. Question 4-12 If an entity enters into a repurchase agreement for a security that has been classified as held-to-maturity, and the transaction allows a similar (but not necessarily substantially the same) security to be returned and, as a result, the transaction qualifies for sale accounting, would this taint the entity s held-to-maturity portfolio? PwC response Yes. In this situation, the transferor would not maintain effective control over the security because a similar security (but not substantially the same security) could be 4-32 PwC

217 Accounting for financing-type transfers revised March 2016 returned. Accordingly, assuming that the other sale accounting criteria in ASC 860 were satisfied, the recorded sale would taint the entity s held-to-maturity portfolio. Conversely, the return of a security that is substantially the same would not taint the entity s held-to-maturity classification. In that case, the repurchase agreement would be reported as a secured borrowing; there would be no sale for financial reporting purposes that would call into question the propriety of the held-to-maturity assertion. Question 4-13 What are some of the operational issues that should be considered by those parties attempting to comply with ASC 860, while entering into secured borrowings, repurchase, and other similar arrangements? PwC response Broker-dealers and other parties to secured borrowings and similar arrangements must maintain systems to obtain the information necessary for financial reporting purposes under ASC 860. For repurchase and secured borrowing arrangements, systems must identify collateral arrangements by transaction. Systems also need to provide information for accounting and disclosure purposes, including the type of transaction executed and the securities received or provided as collateral (including their fair values). Systems and control considerations include the following: Systems that identify financing agreements (lending and borrowing). Enhanced flow of data from the front office systems to inventory systems and stock records (e.g., buys and sells versus financings and certain collateral movements). Identification of obligations to return securities. Accounting systems to recognize (1) trading gains and losses versus (2) interest income and expense, for income statement classification. Reconciliations among the affected systems to ensure that financial transactions are posting properly and are accurately presented. Systems to accumulate and aggregate information about repurchase agreements, repurchase-to-maturity transactions, and securities lending transactions to facilitate a transferor s compliance with the related disclosure requirements in ASC (added by ASU ). PwC 4-33

218 Chapter 5: Servicing of financial assets PwC 1

219 Servicing of financial assets Chapter overview Servicing the contractual right to service or administer many of the functions associated with a financial asset can be a major profit center for companies. The variety and complexity of today s financial instruments and transactions have allowed companies, entire lines of business and profitable revenue streams to grow around servicing. At the same time, however, servicing can create significant risk for those institutions holding the servicing rights. In these situations, strategic actions are required to manage the downside risk. Further, with the proposed changes to capital requirements under Basel III, certain institutions may find it more expensive to hold servicing assets. The ASC 860 accounting model for servicing rights allows an accounting framework that moderates the volatility caused by asymmetrical accounting for servicing rights and the related hedging activities. The guidance requires that all servicing assets and liabilities be measured initially at fair value and provides an option for day two accounting at either fair value or under the amortization method. This reflects the view that fair value is considered the most relevant measurement attribute for financial instruments and that because servicing assets and liabilities have characteristics that are similar to financial instruments, the use of fair value measures should apply to them as well. If elected, ASC 860 enables the day two fair values of servicing assets and liabilities to be aligned with the fair values of the financial instruments often used to mitigate or hedge their risk. This Chapter discusses the accounting for, transfers of, and regulatory requirements associated with servicing rights. It also introduces servicing standards (i.e., Uniform Single Attestation Program for Mortgage Bankers (USAP) and Regulation AB) and accounting requirements that servicers of financial assets may be required to follow. Key questions answered in this chapter Paragraphs in ASC Page in this publication When and how should the right to service an entire, a group of entire, or a participating interest in an entire financial asset be separately recognized and accounted for? How should the sale of servicing rights be accounted for? Are there standards that servicers of financial assets are required to follow? 50-25, and N/A PwC

220 Servicing of financial assets 5.1 Overview Servicing is inherent in all financial assets. Servicing rights are most often associated with assets such as mortgage loans, credit card receivables, automobile loans, and trade receivables. The contractual right to service financial assets held by a third party can be developed or acquired through a variety of means, including explicitly through a contract or implicitly through the origination of a financial asset. For example, the contractual right to service a mortgage loan can be generated by new mortgage loan originations through retail branches, direct sales, brokers or correspondents, 1 bulk acquisitions, or flow acquisitions (negotiated contract or fixed price over a period of time). Many activities fall under the umbrella of servicing, including the following: Collecting principal, interest, and escrow payments from borrowers. Paying taxes and insurance from escrowed funds. Monitoring delinquencies. Workouts/restructurings. Executing foreclosures. Remitting fees to guarantors, trustees, and others providing services. Accounting for and remitting principal and interest payments to the holders of beneficial interests in the financial assets. The benefits of servicing contracts are typically made up of several components, often including contractually specified servicing fees, and other ancillary sources of income, such as float and late charges. In some cases (e.g. mortgage servicing contracts), the contractually specified servicing fees are set at a level above what is necessary to generate enough cash flow to maintain profitable servicing operations. This is done in order to capture a significant portion of the profitability of the servicing contract in the form of future cashflows. Creating this skin-in-the-game is intended to align the interests of the servicer with that of the MBS holders and borrowers (i.e., serve as collateral). A consequence of structuring the servicing contract in this manner, however, is that on a stand-alone basis, the servicing contract encapsulates more compensation than that which would adequately compensate the servicer for performing the required servicing duties. Therefore, this contract would be recognized as a servicing asset when all the requirements of ASC 860 have been met. Refer to TS and for further discussion about when servicing rights should be separately recognized. Risks also accompany servicing rights. The fair value of a servicing right is generally subject to interest rate and prepayment risks. Prepayments are typically driven (in 1 Typically a correspondent is an entity that originates loans in its own name and then sells them to a sponsor who typically serves as the underwriter. PwC 5-3

221 Servicing of financial assets part) by an individual consumer s sensitivity to changing interest rates, which are difficult to predict. Additionally, servicers of mortgage loans and other asset-backed securities may be subject to specific servicing standards. As a result, they may also face operational, regulatory, and reputational risks. Companies often manage, or protect against, the financial risks of servicing (the unexpected change in fair value) associated with early prepayment by using derivative financial instruments and investment securities. Typical risk management products include interest rate floors, caps, swaps and swaptions, agency mortgage-backed securities, forward contracts, Treasury and Eurodollar futures contracts, and options on futures contracts. 5.2 When and how should the right to service an entire, a group of entire, or a participating interest in an entire financial asset be separately recognized and accounted for? Servicing rights only become distinct assets or liabilities that require separate accounting when they are contractually separated from the underlying financial assets and represent compensation at a level that is other than adequate. ASC 860 prescribes a uniform approach to the accounting for servicing of all types of financial assets under which a net servicing asset or liability is recognized for each servicing contract. ASC 860 permits a fair value measurement method that simplifies the accounting for servicing rights and reduces the volatility that results from the asymmetric accounting for servicing rights (in instances in which the servicing rights are hedged with derivative instruments). As an alternative election, under the amortization method, servicing rights are accounted for at the lower of cost or fair value. In this nine-part section, we discuss the following: Determining when servicing rights should be separately recognized (TS 5.2.1). Determining whether a servicing asset or a servicing liability should be recorded (TS 5.2.2). Initial measurement of separately recognized servicing rights (TS 5.2.3). Subsequent measurement of separately recognized servicing rights (TS 5.2.4). Classes of servicing assets and servicing liabilities (TS 5.2.5). Fair value measurement method for measuring servicing rights (TS 5.2.6). Amortization method for measuring servicing rights (TS 5.2.7). 5-4 PwC

222 Servicing of financial assets Distinguishing servicing assets from IO strips (TS 5.2.8). Hedging considerations for servicing assets and servicing liabilities (TS 5.2.9) Determining when servicing rights should be separately recognized The guidance in ASC 860 discusses when a servicing right should be accounted for separately. Excerpt from ASC An entity shall recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in any of the following situations: a. A servicer s transfer of any of the following, if that transfer meets the requirements for sale accounting: 1. An entire financial asset 2. A group of entire financial assets 3. A participating interest in an entire financial asset, in which circumstance the transferor shall recognize a servicing asset or a servicing liability only related to the participating interest sold. b. Subparagraph superseded by Accounting Standards Update No c. An acquisition or assumption of a servicing obligation that does not relate to financial assets of the servicer or its consolidated affiliates included in the financial statements being presented. Example 1 (see paragraph ) illustrates accounting for a sale of receivables with servicing obtained by the transferor. Excerpt from ASC A servicer that transfers or securitizes financial assets in a transaction that does not meet the requirements for sale accounting and is accounted for as a secured borrowing with the underlying financial assets remaining on the transferor s balance sheet shall not recognize a servicing asset or a servicing liability. Excerpt from ASC A servicer that recognizes a servicing asset or servicing liability shall account for the contract to service financial assets separately from those financial assets. PwC 5-5

223 Servicing of financial assets Excerpt from ASC An entity that transfers its financial assets to an unconsolidated entity in a transfer that qualifies as a sale in which the transferor obtains the resulting securities and classifies them as debt securities held to maturity in accordance with Topic 320 may either separately recognize its servicing assets or servicing liabilities or report those servicing assets or servicing liabilities together with the asset being serviced. Under ASC 860, as amended, companies are no longer permitted to separately recognize a servicing asset or liability for so called guaranteed mortgage securitization transactions in which the transferor retains all of the resulting securities, unless the transfer meets the conditions for sale treatment. Rather, a separate servicing asset or servicing liability should only be recognized if the servicing right is contractually separated from the financial asset being serviced through a transfer of the entire financial asset(s) or a participating interest in an entire financial asset to a third party that qualifies for sale accounting. In addition, a servicing asset or servicing liability shall also be recognized every time a company undertakes an obligation to service financial assets (i.e., the acquisition or assumption of the right to service a financial asset from a third party). Accordingly, servicing rights related to failed sales (i.e., secured borrowings) or transfers to SPEs that are consolidated under ASC 810, would not qualify for separate recognition under ASC 860. Also, recognition of servicing assets or servicing liabilities for revolving-period receivables shall be limited to the servicing for the receivables that exist and have been transferred. As new receivables are transferred into the revolving-period structure, rights to service these receivables shall be recognized, to the extent each and every transfer to the structure meets the conditions for sale accounting Determining whether a servicing asset or a servicing liability should be recorded ASC discusses some of the critical considerations when determining whether a servicing asset or a servicing liability that qualifies for separate recognition should be recognized. The guidance establishes that servicing contracts for which the servicer s benefits of servicing are expected to more than adequately compensate the servicer will result in a servicing asset and contracts in which the benefits of servicing are not expected to adequately compensate the servicer would result in a servicing liability. A servicer of financial assets receives revenues from contractually specified servicing fees, and other ancillary sources of income, including float and late charges. This income represents the benefits of servicing. In most cases, servicing contracts are structured such that the benefits of servicing are expected to more than adequately compensate the servicer for performing the servicing. In these cases, a servicing asset should be recognized based on its full fair value. ASC 860 defines benefits of servicing and adequate compensation, respectively, as follows: 5-6 PwC

224 Servicing of financial assets ASC Benefits of Servicing: Revenues from contractually specified servicing fees, late charges, and other ancillary sources, including float. Adequate Compensation: The amount of benefits of servicing that would fairly compensate a substitute servicer should one be required, which includes the profit that would be demanded in the marketplace. It is the amount demanded by the marketplace to perform the specific type of servicing. Adequate compensation is determined by the marketplace; it does not vary according to the specific servicing costs of the servicer. Likewise, a servicing liability is recognized at fair value when the benefits are not expected to adequately compensate a servicer for performing the servicing. If a servicer is just adequately compensated, no servicing asset or liability should be recorded. How does one determine whether a servicer is more than adequately compensated? Adequate compensation is a market concept and should be made independent of the servicer s internal cost structure. A servicer s level of compensation should be compared to the level of compensation demanded by current market prices (i.e., the cost to service that servicers of similar assets would assume when buying the servicing in the marketplace, plus the profit margin they would demand). Because the determination of a servicing asset or liability is based on the fair value of servicing rather than the entity s actual cost of service, a company s actual costs to service are irrelevant to determining whether a servicing asset or liability should be recorded. As a result, an efficient servicer could end up recording a liability, even if it can profitably perform the servicing below the contractually specified fee or adequate compensation. Likewise, an inefficient servicer may be able to establish an asset, even though its actual costs to service may be higher. From a profit and loss perspective, actual costs incurred in servicing, as well as fees earned, should be grouped together with impact of the servicing asset/liability changes in the fair value recognized as they occur or through amortization, which would cause the economic effect to flow through the income statement, effecting the servicing contracts actual yield. This includes efficiencies/inefficiencies in the entity s own operations that would be captured in the actual costs incurred when compared to the impact of fair value of the servicing asset or servicing liability. If a servicer is not adequately compensated by marketplace standards, a servicing liability should be recorded at fair value, even though the contractually specified fee may cover the servicing costs of that particular servicer. Since the determination as to whether the servicer is adequately compensated is based on the amount demanded by the marketplace, a contractual provision establishing the amount to be paid to a replacement servicer should not be utilized as the sole basis for determining fair value of servicing in the marketplace. However, that contractual provision would be a relevant provision for evaluating the overall fair value of the servicing contract. Therefore, the amount that would be paid to a replacement servicer, should one be required, under the terms of the servicing contract can be more or less than adequate compensation. If a servicer s internal servicing costs exceeded its compensation, no PwC 5-7

225 Servicing of financial assets servicing liability would be recorded as long as (1) the compensation represented what a substitute servicer would demand in the market, and/or (2) the servicer had the ability to sell its servicing rights to a substitute servicer, or to subcontract the servicing without incurring a loss. In these cases, the servicer s internal servicing costs in excess of its servicing revenues should be recognized as a period cost during the term of the servicing contract. If, however, a servicer is contractually precluded from transferring its servicing rights or unable to subcontract the servicing without incurring a loss, a liability (at the time the servicing contract is entered into or assumed) equal to the unfavorable commitment for the contract s remaining term should be recorded using a market based cost assumption when determining the fair value of the liability. The objective when estimating the value of servicing is to determine fair value (that is, what the market would pay or charge to assume servicing). Therefore, when estimating either the benefits of servicing or the servicing costs to determine if the contract provides the servicer with more than just adequate compensation, only the benefits or costs that the market would consider shall be included in the estimation model(s). As stated in the guidance, a servicing asset might become a servicing liability and vice versa, if circumstances change. Also, the initial measurement of servicing might be zero if the benefits of servicing are determined to be just equal to adequate compensation (note: this does not mean that the fair value of the servicing cashflows is zero, instead the recognition of the servicing contract s value may be zero after consideration of a reasonable profit margin), regardless of the servicer s own servicing costs. It is important to note that the subsequent measurement of a recognized servicing asset or liability, as well as the measurement of a servicing contract that resulted in no asset or liability due to compensation being just adequate, will be subsequently impacted by the measurement method elected by the entity performing the servicing function. For example, a non recognized servicing asset or liability due to a determination that benefits of servicing are equal to just adequate compensation, can result in subsequent earnings charges if the servicing contract relates to a servicing class measured at fair value or to a class measured at amortized cost and the servicing contract subsequent fair value results in an increased obligation (from zero fair value to a liability). To summarize, servicing contracts which contain compensation in excess of what would be deemed adequate for performing the servicing as a market participant will result in the initial recognition of a servicing asset. While potentially still resulting in a positive fair value (as contracts with profit margins will do), servicing contracts which contain only a reasonable profit margin equal to that of an average market participant are initially recognized at a zero value. Finally, contracts which do not contain sufficient profit margin to be considered reasonable to the average market participant are recorded as a liability Initial measurement of separately recognized servicing rights ASC 860 further requires that separately recognized servicing rights be measured initially at fair value. ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Measurements of the fair value of servicing 5-8 PwC

226 Servicing of financial assets rights may consider the present value of expected cash flows, including both future inflows of servicing revenues and outflows of costs related to servicing. Refer to TS for a further discussion of fair value measurements of servicing rights Subsequent measurement of separately recognized servicing rights ASC 860 provides guidance on the measurement attribute for servicing assets and servicing liabilities subsequent to initial recognition. Excerpt from ASC An entity shall subsequently measure each class of servicing assets and servicing liabilities using either of the following methods: a. Amortization method. Amortize servicing assets or servicing liabilities 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), and assess servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date. b. Fair value measurement method. Measure servicing assets or servicing liabilities at fair value at each reporting date and report changes in fair value of servicing assets and servicing liabilities in earnings in the period in which the changes occur. Excerpt from ASC A A servicing asset may become a servicing liability, or vice versa, if circumstances change. In summary, the guidance allows entities to account for servicing assets and servicing liabilities subsequent to initial measurement and recognition (i.e., on Day 2 and thereafter) at either amortized cost subject to an impairment test or fair value, both of which are discussed later in this section (refer to TS through 5.2.7) Classes of servicing assets and servicing liabilities Different elections for subsequent measurement can be made for different classes of servicing assets or servicing liabilities. An entity can elect to subsequently measure a class of servicing assets or servicing liabilities at fair value, thus enabling potential offset of the changes in fair value of the servicing assets or servicing liabilities with any related derivative hedging instrument. Entities must elect and apply one of the methods for each class of servicing assets and servicing liabilities. The fair value election is irrevocable and can be made at the beginning of any fiscal year. For example, if a calendar year-end company elects to subsequently account for Class A servicing assets at fair value on January 1, 2010, the company cannot change to the amortization method in any subsequent period. However, this does not prevent the company from electing to subsequently value its Class B servicing assets at PwC 5-9

227 Servicing of financial assets amortized cost. If the fair value election is made, changes in the fair value of servicing rights should be recognized in earnings at each reporting date. ASC requires that classes of servicing assets and servicing liabilities be identified based on one or both of the following: (a) the availability of market inputs used to determine the fair value of servicing assets or servicing liabilities and/or (b) an entity s method for managing the risks of its servicing assets or servicing liabilities. The number of classes will affect a company s disclosures because a number of the disclosures are required by class of servicing assets and servicing liabilities (refer to TS 5.3). There is not a set approach for identifying classes of servicing assets or servicing liabilities. Some favor the use of the fair value measurement attribute for servicing assets or servicing liabilities to broadly define classes based on the risks of their servicing assets or servicing liabilities. Others favor a more narrow definition based on their risk management strategies and the nature of the assumptions used in their fair value calculations. When defining classes of servicing assets and liabilities, the company should consider grouping them by the nature of the assumptions underlying the fair value of the servicing assets or servicing liabilities (e.g., prepayment and default rates). The fair value of servicing assets or servicing liabilities is generally determined using valuation models that incorporate a number of different assumptions because quoted market prices for servicing rights are generally not available (refer to TS 5.2.8). The assumptions would be derived from observable market data for similar items or data developed within the company. In other cases, a company may find it more appropriate to base the grouping on its risk management strategies when electing the fair value measurement method for certain of its servicing assets and servicing liabilities. The risks of servicing assets and servicing liabilities will often differ among asset types, and companies may manage those risks separately. A company may use derivative financial instruments or available-for-sale (AFS) securities to economically hedge the risks, or may not hedge the risks at all. As a result, a company s method for defining classes may differ depending on the complexity of its risk management strategies. Factors such as the nature of the collateral, fixed or floating interest rates, commercial or consumer loans, credit quality, and tenor (which all impact customer prepayment rates) may influence how an entity manages its risk exposure and, ultimately, how it defines its classes. ASC 860 allows for a voluntary election of different accounting methods for each class of servicing. We believe this election is analogous to the election made for hedge accounting on a derivative-by-derivative basis in ASC 815. ASC 815 requires detailed documentation due to the elective nature of the accounting. When the fair value measurement method is elected, we believe that it is beneficial for that election to be supported by concurrent documentation or a pre-existing documented policy for automatic election. As the fair value method can be elected at the beginning of any fiscal year, concurrent would mean that a company documents its election at the beginning of the fiscal year in which it applies the fair value method to that specific class of servicing assets or servicing liabilities PwC

228 Servicing of financial assets If the right to service a new class of financial assets is contractually undertaken, we would encourage the election of a subsequent measurement method to be documented on the date on which the company acquires that right Fair value measurement method ASC 860 allows entities to subsequently account for servicing assets and servicing liabilities, even for those servicing contracts that resulted in compensation equal to adequate compensation and thus no asset or liability is initially recognized. Using the fair value measurement method involves making an election by class of servicing assets or servicing liabilities. If the fair value measurement method has been elected, an entity is required to measure classes of servicing assets or servicing liabilities at fair value at each reporting date, with changes in fair value recorded in earnings in the period during which they occur. ASC 860 does not define how fair value must be measured. However, irrespective of whether the fair value or the amortization method is elected, an entity shall consider the nature of the assets being serviced as a factor in determining the fair value of a servicing asset or servicing liability. The types of assets being serviced will impact the amount required to adequately compensate the servicer. ASC provides an example which addresses these differences by distinguishing between the amount of effort that would be required to service a home equity loan from a credit card receivable or a small business administration loan. Some entities look to proxies, such as sub-servicing contracts, to help determine what adequate compensation, including a reasonable profit margin, would be for different assets being serviced. ASC 820 provides guidance on how to measure fair value in situations where GAAP requires fair value measurements. ASC 820 as amended by ASU was effective for years beginning after November 15, Under ASC 820, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 s definition of fair value retains the exchange price notion contained in earlier GAAP definitions of fair value. However, it clarifies that the basis for a fair-value measurement is the market price at which a company would sell or otherwise dispose of assets or transfer liabilities (i.e., an exit price), not the market price that an entity pays to acquire assets or assume liabilities (i.e., not an entry price). ASC 820 further requires that the price used be based on the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The most advantageous market is the market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transportation costs. The 2011 amendment included a clarification that the principal market is the market with the greatest volume and level of activity for the asset or liability, not necessarily the market with the greatest volume of activity for the particular reporting entity. This is true as long as the entity has access to that market. This represents a change from prior U.S. GAAP, which had indicated that the principal market is the market in which the reporting entity transacts with the greatest volume and level of activity for the asset or liability. This change emphasized the importance of the market participant s PwC 5-11

229 Servicing of financial assets perspective. However, the principal market is presumed to be the market in which the reporting entity normally transacts, unless there is evidence to the contrary. Reporting entities do not have to do exhaustive searches for other markets where the asset or liability may have more activity. Practice is not expected to change except where it is evident there is another active market with greater activity for the asset or liability than the one in which the reporting entity transacts. ASC 820 requires that an entity maximize the use of observable inputs and minimize the use of unobservable inputs. Observable inputs that reflect quoted prices in active markets for identical assets or liabilities are the best evidence of fair value. Markets that provide quoted prices may include exchange, dealer, and principal-to-principal markets. Quotation and pricing services may also provide observable price quotations. However, there is no exchange market that provides both price quotations and an active market in servicing rights. Care should be exercised when evaluating quoted prices to ensure that the prices used are representative of the servicing rights being valued. Prices can vary significantly based on the underlying characteristics of the loans. Quoted prices for newly originated individual servicing rights on agency-conforming mortgage loans may be more readily available than quoted prices for other types of mortgage loans, which may require the use of alternative valuation methods. If quoted prices are not available, the estimate of fair value should be based on the best information available, given the circumstances. Often, in these cases, the prices of similar assets and liabilities represent the best information. If neither quoted market prices for the servicing assets or liabilities nor quoted market prices for similar servicing assets or liabilities are available, fair value should be estimated using other valuation techniques. These may include a present value of estimated future cash flows, option-pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis. Some companies, especially in the banking industry, have placed reliance on mark-tomodel accounting (i.e., discounted cash flow analysis which may not have appropriate benchmarks to market evidence) to value their servicing assets. This reliance on modeled values is partly responsible for one banking regulation, Bulletin , Risk Modeling and Model Validation, which was replaced in 2011 by Bulletin , Supervisory Guidance on Model Risk Management, issued by the Office of the Comptroller of the Currency and discussed later in this Chapter. Regardless of the valuation technique used, the fair value of servicing assets or liabilities should represent the present value of a stream of cash flows, composed primarily of the servicing fees collected by the servicer, net of cash outflows for performing the administrative tasks of servicing (e.g., collecting cash from borrowers, paying real estate taxes and hazard insurance, and remitting cash to third parties). It should also include all fees such as late payment fees, legal document preparation fees, and a variety of other charges contractually due to the servicer. In determining the exact stream of cash flows that will be collected by the servicer (and, therefore, the fair value of the servicing rights), both the amount and timing of cash flows are forecasted based on a number of assumptions PwC

230 Servicing of financial assets The assumptions used in the model should be reasonable and supportable. All available evidence should be considered when estimating expected future cash flows. When servicing rights are valued using discounted cash flow analysis, the assumptions used in the valuation (primarily prepayment speed, discount rate, delinquency and default rates, escrow earnings rates and the cost to service) should be consistent with the assumptions that would be used by a market participant independently evaluating the same portfolio of servicing for purchase. In many situations, assumptions that market participants would use in computing the fair value of servicing rights are not available due to a limited number of market participants, imperfect information, or other conditions. In such cases, companies will likely need to estimate expected cash flows related to servicing activities using their own historical cash flow experience as a basis for formulating assumptions. ASC 820 allows this approach only to the extent that an entity can demonstrate that its own assumptions provide a reasonable proxy for market participant assumptions. It is also important to evaluate the nature of the cash flows that are included in the computation to ensure that they are consistent with the types of cash flows that a market participant would use to determine fair value. For mortgage servicing rights, observable inputs regarding assumptions used can be obtained from independent servicing brokers in the market and from other sources, such as peer and industry group surveys. In addition, many mortgage servicers engage external third-party appraisers to value their mortgage servicing rights. Estimated future net servicing income includes estimated future cash inflows and outflows related to servicing. Estimates of cash inflows or servicing revenues should include servicing fees and other ancillary revenue, including float and late charges. Estimates of cash outflows or servicing costs should include direct costs associated with performing the servicing function and appropriate allocations of other costs. Estimated future servicing costs should be determined on a market value basis. Many mortgage servicers use specialized software programs to compute estimated fair value, while others rely on spreadsheets. The requirements under Section 404 of the Sarbanes-Oxley Act of 2002 have increased the attention on controls related to the development and maintenance of spreadsheets as well as increased attention on controls related to a Company s use of service organizations and use of specialists. Critical assumptions used to determine estimated fair value generally include servicing fee to be earned, prepayment and default rates, discount rate, cost of servicing, float income, ancillary fees, default estimates, interest income on escrow and P&I balances, inflation factors, and interest paid on escrows. Each of these assumptions is discussed in further detail below: Servicing fee to be earned: Under ASC 860, the servicing fee to be earned is equal to the contractual servicing fee retained after the financial asset is sold. For agency loan sales (e.g., FNMA, FHLMC, GNMA), the interest income exceeding contractually specified servicing fees (excess servicing), should be treated as part of the mortgage servicing right. The seller can generally control the amount of excess servicing created in agency loan sales by buying up or down the standard guarantee fee and as a result, this excess servicing fee is part of the contractual PwC 5-13

231 Servicing of financial assets arrangement with the agencies and it is specifically related to the servicing function (refer to TS for more details). However, for non-agency loan sales and securitizations, the servicing fee to be earned is limited to the amount contractually stated in the loan sale contract (i.e., the seller cannot control the amount of excess by buying up or down the guarantee fee). Any cash flows retained in excess of the contractual servicing fee specifically stated in the loan sale contract is considered part of the transferor s interests and must be accounted for in accordance with the guidance in ASC Prepayment and default rates: Prepayment and default rates are used to estimate the length of the life of the servicing right and timing of the estimated cash flows. Because many factors impact prepayment activity, predicting the actual cash flows of a financial instrument can be complex. Therefore, the factors outlined in the table below should be considered when determining or assessing prepayment assumptions for mortgage loans. Consideration Current interest rates Regional economy Products offered in the marketplace Regional demographics Company experience Distressed regional economies Level of loans due to second mortgages Impact Lower interest rates provide borrowers incentive to refinance. Some homeowners may, despite low interest rates, be unable to refinance their loans because they have little or no equity in their homes due to declining property values. New products, such as no points or no closing costs loans, may stimulate prepayments. Certain areas of the country have historically experienced higher prepayment rates than others. This partly stems from local demographics. For instance, a particular area may be more transient than other parts of the country. Actual experience of the company compared to others in the same geographic and/or demographic area. Local economic troubles may result in high foreclosure rates (with foreclosures representing a type of prepayment). Many homeowners hold little or no equity in their homes due to the growth of home equity loans and lines of credit (HELOCs), which respectively represent term loans or ineffect credit cards secured by equity in a residence beyond the first mortgage. In the mortgage servicing industry, two measurements of prepayment activity are commonly used: (1) Public Securities Administration (PSA) and (2) Constant Prepayment Rate (CPR) PwC

232 Servicing of financial assets The PSA model, often referred to as prepayment speed assumption, assumes relatively low prepayments will occur during the first 30 months (the ramp-up period) of a loan pool s life, after which the prepayment activity rate will stabilize. Base measurement PSA assumes a 0.2 percent prepayment level during month one, 0.4 percent during month two, 0.6 percent during month three and continuing at 0.2 percent increments through to month 30, at which point prepayments level off at 6 percent annually for the remaining life of the loan. This base measurement is referred to as 100 PSA. A 200 PSA represents double the base. Accordingly, 100 PSA equals 6 percent annual prepayment rates, 200 PSA equals 12 percent annual prepayment rates, and so on after the ramp-up period. CPR is a prepayment model that assumes constant prepayment activity throughout the life of a loan pool. CPR is measured in terms of percentages. Accordingly, a 10 percent CPR is the equivalent of an annual 10 percent principal reduction. Prepayment estimates such as PSA and CPR are available from a wide variety of services, including several investment banks and information services. Third-party prepayment models are also used to estimate prepayments. These models often provide prepayment speeds that better approximate actual prepayment activity than the static PSA or CPR prepayment rates. Entities may also use internally developed prepayment speeds that are simply client-specific estimates of the timing of prepayments for a loan pool. More often than not, these vectors are derivatives of a standard CPR rate with either a ramp up or ramp down period of prepayments designed to reflect unique expected prepayment performance in a newly originated loan pool or to reflect unique current market conditions. The objective should always be to use prepayment estimates that accurately reflect the loans underlying the servicing rights being evaluated and that are representative of market participant assumptions. In cases involving pools of geographically dispersed mortgages, this measure may be based on national prepayment estimates. Estimates other than national prepayment estimates might be used in cases where an entity can demonstrate that loans differ from a geographically dispersed pool of mortgages. Float income: Income is earned on balances held in trust by servicers from the date a loan payment is received from the borrower to the date funds are forwarded to investors. The benefit of this float accrues to the servicer through interest earned or a reduced cost of funds. Ancillary fees: Ancillary fees are those fees that a mortgage servicer receives in addition to the contractual servicing fee. These fees typically consist of late fees, but also may include telephone payment fees, third-party promotional fees, charges for lost coupon books, as well as other fees. Costs of servicing: Servicing costs represent the expenses born by the Servicer for performing functions outlined in the associated Servicing Agreement and include the costs associated with processing payments, managing delinquent and defaulting loans, and monitoring and administering escrow accounts. Those costs represent the Servicer s legal obligations under the contract agreement. Interest income/expense on escrow and trust balances: Many mortgage bankers use escrow and P&I balances as compensating balances for borrowings; PwC 5-15

233 Servicing of financial assets therefore such balances have a value based on interest savings. Several states in the U.S. require mortgage servicers to pay interest to borrowers on amounts escrowed throughout the life of the loan. This cost is considered a cost of servicing and should be considered in the cash flow analysis. Inflation factors: An inflation or similar factor should be included in the calculation of estimated future costs of servicing. Discount rate: A discount rate is a rate at which the expected cash flows are discounted to arrive at the net present value of servicing income. This rate should reflect market conditions and implicit discount rates used by market participants in evaluating servicing transactions, which in turn reflect the yields expected to be earned on those transactions. The discount rate should be determined according to a reasonable and consistently applied methodology. Three pieces of guidance have been issued by the Office of the Comptroller of the Currency (OCC): (1) Bulletin , Interagency Advisory on Mortgage Banking, (2) Bulletin , Risk Modelling and Model Validation, replaced by Bulletin and (3) Bulletin , Supervisory Guidance for Model Risk Management. Although all those bulletins are applicable to banking regulated entities, they contain guidance that may be helpful for all types of servicers and are described below. Interagency advisory on mortgage banking: The advisory draws attention to prevailing regulatory concerns that came to light in 2003, particularly those pertaining to the valuation and hedging of mortgage servicing assets. The advisory provides an updated inventory of supervisory guidance regarding mortgage banking activities. Banking institutions with significant risk exposures involving mortgage assets will be subjected to greater scrutiny of their mortgage activities during examinations. In particular, examinations focus on the validation of reasonable and supportable market-based assumptions when valuing mortgage servicing assets. The advisory highlights the following aspects of supervisory attention: Use of unsupported assumptions in valuation models. Inappropriate use of assumptions when estimating servicing income, including retention benefits, deferred tax benefits, captive reinsurance premiums, and cross-sell opportunities. Disregard of comparable market data while over-relying on peer group surveys. Frequent changing of assumptions from period to period. Inconsistent use of assumptions in valuation, bidding, pricing, and hedging activities. Lack of segregation of duties among the valuation, hedging, and accounting functions. Failure to assess actual cash flow performance compared to those modeled, validate models, or update the models for new information PwC

234 Servicing of financial assets The advisory emphasizes active corporate governance, including the need for comprehensive policies and procedures to facilitate appropriate control of mortgage banking activities. Mortgage banking enterprises should establish limits on concentrations of mortgage banking assets and comply with their primary regulator s policy on interest rate risk. The advisory also reiterates the importance of accurate regulatory reporting. In this regard, supervisory expectations include documentation of at least a quarterly evaluation of mortgage servicing assets for impairment, accurate and reliable management information systems, and qualified and expert internal audit staff to evaluate the risks, design, and effectiveness of the institution s controls over mortgage banking activities. Risk modeling and model validation: Each of the banking regulators have increased their examination focus on model validation in recognition of the fact that computer-based models are increasingly used to estimate risk exposure, analyze business strategies, and estimate fair values of financial instruments and acquisitions. The OCC bulletin which replaced OCC bulletin characterizes risks arising from the development and use of financial models and provides guidance to mitigate such risks through comprehensive model testing and validation. The bulletin highlights that rigorous model validation plays a critical role in model risk management; however, sound development, implementation, and use of models are also vital elements. Furthermore, model risk management encompasses governance and control mechanisms such as board and senior management oversight, policies and procedures, controls and compliance, and an appropriate incentive and organizational structure Amortization method If an entity elects the amortization method for subsequent measurement of the servicing rights, the initial carrying value (i.e., the Day 1 fair value) is amortized over the expected period of estimated net servicing income or loss and assessed for impairment or increased obligation at each reporting date. An increase in the fair value of servicing liabilities above their carrying amount is required when using the amortization method. Accordingly, if there are significant changes in the amount or timing of actual or expected future cash flows relative to the cash flows previously projected and if the fair value of the servicing liability exceeds its carrying value, the servicer will revise its earlier estimates and recognize the increased obligation as a loss in earnings. OCC Bulletin also discusses a number of concerns related to the amortization method that were noted in examinations of mortgage servicers. These concerns are summarized below and warrant continued attention: Inadequate amortization of the remaining cost basis of servicing rights. Failure to properly stratify servicing rights for impairment testing purposes. Continued use of a valuation allowance for impairment testing purposes versus the recording of a direct write-down. PwC 5-17

235 Servicing of financial assets The following discussion details the guidance in ASC 860 related to the amortization method and each of the concerns noted in the OCC bulletin. Amortization: Servicing assets are to be amortized in proportion to, and over the period of, estimated net servicing income. Servicing liabilities are to be amortized in proportion to, and over the period of, estimated net servicing loss. Companies often determine the amount of the servicing asset (liability) to be amortized during a given period by calculating the undiscounted net servicing income (loss) for the period, divided by the total estimated undiscounted net servicing income (loss). The resulting percentage represents the amount of the originally recorded servicing asset (liability) to be amortized during the period. This is sometimes referred to as the expected over expected cash flow or proportionate to income methodology where a given period s amortization rate is equal to the ratio of that period s expected net cash flow over the total expected net cash flow for the life of the servicing asset. For this purpose, the same estimated undiscounted cash flows used in the fair value calculation should be used. This expectation over expected cash flow methodology is only one example of an amortization method. Other methods may be appropriate. Figure 5-1 below demonstrates the application of the amortization requirement. Figure 5-1 Amortization of servicing assets or servicing liabilities Assume that a servicer of residential mortgages has the following specifications for a portion of a loan portfolio: Total undiscounted net servicing income (contractual revenues less the servicer s internal servicing costs) is estimated to be $290,000. The initial fair value recorded for the servicing asset is $160,000. The undiscounted net servicing income to be received in years one through five is estimated at $23,200, $22,475, $21,750, $21,025, and $20,300, respectively. (For simplicity, only the first five years are shown here; the total net undiscounted income of $290,000 includes all years comprising the weighted-average term of the loan pool.) The amortization amounts to be recorded in years one through five would be as follows: 5-18 PwC

236 Servicing of financial assets Year Servicing asset carrying value Cumulative amortization percentage Cumulative amortization expense Current period amortization expense Undisc d net servicing income per year Cumulative undisc d net servicing income Total estimated undisc d net servicing income A B C D E F G A = A (initial value) C B = F/G C = A (initial value) B D = C (current year) C (prior year) F = F (prior year) + E (current year) Initial value $160,000 $290, , % $12,800 $12,800 $23,200 $ 23, , ,200 12,400 22,475 45, , ,200 12,000 21,750 67, , ,800 11,600 21,025 88, , ,000 11,200 20, ,750 The estimates of undiscounted cash flows should be updated for actual experience at each valuation date. Stratification: ASC 860 requires that servicing assets subsequently measured using the amortization method be evaluated for impairment based on a stratification of the predominant risk characteristics of the underlying financial assets, which may include interest rates, type of asset, term, origination date, and geographic location. ASC 860 does not require that the most predominant risk characteristic or more than one predominant risk characteristic be used to stratify the servicing assets for purposes of evaluating and measuring impairment. A servicer must exercise judgment when determining how to stratify servicing assets (i.e., when selecting the most appropriate characteristic(s) for stratification). While the SEC staff has not published a formal position on its expectations regarding stratification, it has indicated that registrants should be prepared to explain their rationale for not using interest rates as a predominant risk characteristic to stratify their servicing assets and servicing liabilities. In addition, as discussed in ASC , once an entity determines the predominant risk characteristics it will use in identifying the resulting stratums within each class of servicing assets subsequently measured using the amortization method, that decision shall be applied consistently unless significant changes in economic facts and circumstances clearly indicate a change is warranted. An entity may use different stratification criteria for the purposes of ASC 860 impairment testing and for the purposes of grouping similar assets to be designated as a hedged portfolio in a fair value hedge under ASC 815. Impairment: ASC 860 requires that servicing assets accounted for using the amortization method should be periodically evaluated for impairment. Impairment should be recognized through the use of a valuation allowance for each individual stratum for the amount by which the amortized cost of the servicing asset exceeds fair value for that stratum. Subsequent increases in fair value can be recorded by reducing PwC 5-19

237 Servicing of financial assets the valuation allowance up to an amount that results in the servicing asset being carried at its remaining amortized cost. Therefore, although subsequent increases in fair value can be recognized by reducing the valuation allowance, such adjustments are limited to the remaining amortized cost of the asset. Additionally, the fair value of a servicing liability should be evaluated subsequently for changes due to alterations in the assumptions underlying the initial valuation (e.g., changes in prepayment rates and discount rates). If there is a change in a servicing liability, the servicer should revise its earlier estimates and recognize the increased obligation and a charge to earnings. Figure 5-2 demonstrates the application of the impairment requirement when applying the amortization method for subsequent measurement. Figure 5-2 Analysis of measurement of servicing assets Stratum A Stratum B Stratum C Stratum D Stratum E Total Risk characteristics of underlying financial assets WAC 8.633% WAM years WAC 9.002% WAM years WAC % WAM years WAC % WAM years WAC 9.792% WAM years Type Residential Type Residential Commercial Real Estate* Commercial and Industrial* Type All other * Size 100m 500m Size 100m 500m Size 500m 5mm Size 500m 5mm Size 227m Geographic West * Geographic Geographic U.S. Geographic U.S. Geographic U.S. East * N/A N/A N/A N/A N/A Amortized carrying value $22,019,877 $14,729,704 $18,038,444 $17,123,119 $2,181,036 $74,092,180 Fair value based on net present value of estimated future cash flows $21,641,291 $14,883,595 $18,987,622 $16,741,912 $2,447,136 $74,701,556 Fair value in excess of (below) amortized carrying value $ (378,586) $ 153,891 $ 949,178 $ (381,207) $ 266,100 $ 609,376 Valuation allowance required $ (378,586) $ (381,207) $ (759,793) * Predominant risk characteristic used to stratify the servicing assets. In practice, the typical characteristics used to stratify are based on the note rate band and/or product type. WAC Weighted average coupon WAM Weighted average maturity Notes: No valuation allowance is recorded in Stratum B, C, and E because the fair value of the servicing asset exceeds its amortized carrying value. Valuation allowances are required for Stratum A and D because the fair value of the servicing asset is below its amortized carrying value PwC

238 Servicing of financial assets Stratum with a fair value in excess of amortized carrying value can not be netted against those with a fair value that is below the amortized carrying value. Restratification/addition of new strata: The predominant risk characteristics used to identify strata should be consistently applied and should generally remain constant. Changes to the strata will likely affect the valuation allowance required. There may be rare instances where restratification may be required; in these cases, entities are encouraged to prepare documentation that describes the rationale for the change. For example, restratification or additional strata may have been necessary as a result of a significant downward shift in interest rates, which may not have been contemplated in the establishment of the original strata. Direct write-off: ASC 860 does not address how to determine whether a direct write-off of servicing assets or a valuation allowance for temporary impairment is appropriate. This determination should be addressed on a case-by-case basis using the unique facts and circumstances of each case. We recommend that an entity consider the degree of impairment in an individual stratum and perform sensitivity analyses to determine how much of the valuation allowance can be recovered under various scenarios. Generally, the portion of the valuation allowance that is not expected to be recovered in stressed scenarios should be written off against the gross carrying amount of the servicing asset or liability. We recommend that entities establish a policy on how and when they will determine whether a write-off should be recorded and that such a policy be documented and followed in a consistent manner Distinguishing servicing assets from IO strips ASC 860 requires separate accounting for rights to future income that exceed contractually specified servicing fees. These rights are not considered servicing assets. Rather, they are financial assets effectively, interest-only (IO) strips. ASC specifies that such assets should be measured like investments in debt securities classified as available-for-sale or trading under ASC 320, if not subject to derivative accounting under ASC 815 (refer to TS 3.3 for more guidance). Accordingly, interest revenues earned in addition to a contractual servicing fee should be evaluated to determine whether an IO strip should be recorded. We believe that, absent a contractually specified servicing fee, if the servicer were to lose the entire difference between the rate received and the rate passed through to the investor upon termination or transfer of the servicing contract, the entire interest spread represents the contractually specified servicing fee. Otherwise, the contractually specified servicing fee represents only the fee that would cease to be received by the servicer if the servicing contract were terminated. If the servicer were to determine that it has no servicing fee (i.e., that no interest spread would be lost upon termination or transfer of the servicing contract, and that there is no contractually specified servicing fee), then the right to receive the interest spread should be treated as an IO strip and the obligation to service should be evaluated as a servicing liability. PwC 5-21

239 Servicing of financial assets Figure 5-3 Illustrative example of the application of ASC 860 to servicing obtained on transferred financial assets Bank A is in the business of originating, securitizing, and selling residential mortgages. From time to time, and depending on market conditions and its investment strategy, Bank A will sell certain loans it originated. On January 2, 20X5, Bank A securitizes a $200,000,000 pool of residential mortgages for sale in the secondary market. At the time of securitization, Investor B purchases the new securities with the terms outlined below, and Bank A records the transaction in accordance with ASC 860. Four different scenarios are presented, outlining the accounting under different levels of servicing fees and beneficial interests in the pool. Terms of securitization applicable to all scenarios: Pool size: $200,000,000 Weighted average fixed coupon: 10% Weighted average contractual maturity: 15 years Weighted average expected maturity: 8 years Allowance for loan losses allocated to the total asset pool: 35 basis points $700,000 Market compensation to service the pool: 40 basis points Recourse to Bank A: Standard representations and warranties regarding documentation defects Payment remittance terms: Monthly Investor put options: All loans 90 days or more delinquent, in year 1 only Carrying amount of loans transferred: $199,300,000 ($200,000,000 $700,000) 5-22 PwC

240 Servicing of financial assets Scenario 1 Scenario 2 Scenario 3 Scenario 4 Additional terms of securitization: Contractual servicing rate 2% 1% 0.40% 0% Interest-only strip None 1% 1.60% 1% Interest rate to Investor B 8% 8% 8% 9% Fair value: Fair value of loans sold $ 207,500,000 $ 207,500,000 $ 207,500,000 $ 213,125,000 Proceeds: Cash proceeds $ 207,500,000 $ 207,500,000 $ 207,500,000 $ 213,125,000 Fair value of servicing rights 15,000,000 5,625,000 a (3,225,000) b Fair value of interest-only strip 9,375,000 14,500,000 9,375,000 Total $ 222,500,000 $ 222,500,000 $ 222,000,000 $ 219,275,000 Analysis of gain on transfer: Total proceeds received $ 222,500,000 $ 222,500,000 $ 222,000,000 $ 219,275,000 Carrying amount of loans transferred (199,300,000) (199,300,000) (199,300,000) (199,300,000) Recourse obligation at fair value (225,000) (225,000) (225,000) (225,000) Put obligation at fair value (90,000) (90,000) (90,000) (90,000) Total gain/(loss) $ 22,885,000 $ 22,885,000 $ 22,385,000 $ 19,660,000 a No servicing asset is recorded as the servicer determines that it is just adequately compensated (i.e., no fair value). b Because no contractual servicing fee is specified, a servicing liability is recorded. PwC 5-23

241 Servicing of financial assets Bank A journal entries Scenario 1 Scenario 2 Scenario 3 Scenario 4 DR CR DR CR DR CR DR CR Cash $207,500,000 $207,500,000 $207,500,000 $213,125,000 Servicing asset 15,000,000 5,625,000 Interest-only strip receivable 9,375,000 14,500,000 9,375,000 Allowance for possible loan losses 700, , , ,000 Loans $200,000,000 $200,000,000 $200,000,000 $200,000,000 Recourse obligation 225, , , ,000 Put option 90,000 90,000 90,000 90,000 Servicing liability 3,225,000 Gain on sale of loans 22,885,000 22,885,000 22,385,000 19,660,000 Totals $223,200,000 $223,200,000 $223,200,000 $223,200,000 $222,700,000 $222,700,000 $223,200,000 $223,200,000 To record the transfer of securitized loans in accordance with ASC 860. Accounting implications and issues associated with the various scenarios Scenario 1 Scenario 2 Scenario 3 Scenario 4 Servicing asset or servicing liability is initially recorded at fair value X X X Servicing asset is subject to ASC impairment testing (Amortization Method only) X X Servicing asset may be subject to regulatory capital limitation for certain financial institutions X X Interest-only strip is initially recorded at fair value X X X Interest-only strip must be accounted for under ASC X X X Servicer may consider hedging its servicing asset X X Servicer may be required to increase its servicing liability if subsequent events increase the fair value of the liability above the carrying amount X 5-24 PwC

242 Servicing of financial assets Hedging considerations As mentioned earlier, both interest rate and prepayment risks can affect the fair value of a servicing right. Companies may hedge these risks using derivative financial instruments and investment securities. Instruments typically used to hedge servicing rights include interest rate floors, caps, swaps and swaptions, agency mortgagebacked securities forward contracts, Treasury and Eurodollar futures contracts, and options on futures contracts. ASC 815 requires that all derivatives be recognized as assets or liabilities on the statement of financial position and measured at fair value. Under the amortization method, the related servicing assets and liabilities need to be recognized at the lower of amortized cost and market value. Income statement volatility exists when the fair value changes in the derivatives are recognized in earnings, although only adverse changes in the fair value of the servicing assets or servicing liabilities are recognized. As a result, entities might consider applying ASC 815 hedge accounting provisions to hedge the fair value of their servicing rights accounted for under the amortization method. The fair values of the servicing rights may be hedged with derivative financial instruments. However, the application of hedge accounting under ASC 815 is complex. That is why ASC 860 allows servicing assets and liabilities to be subsequently recognized at fair value under the fair value measurement method. This method reduces income statement volatility and the difficulty of achieving hedge accounting for such transactions. 5.3 What are the financial statement presentation and disclosure requirements for servicing rights under ASC 860? revised March 2016 Guidance can now be found in FSP How should the sale of servicing rights be accounted for? The right to service financial assets may be sold to a third party. Agreements to sell mortgage servicing rights may contain certain protection provisions that could affect the amount ultimately paid to the seller. For example, the seller may agree to adjust the sale price for loan prepayments, defaults, or foreclosures that occur within a specified period of time. Most of the agreements also contain representation and warranty provisions that cover agency eligibility (requirements to be eligible to perform servicing) defects within specified time periods General guidance In accordance with the guidance in ASC , a transfer of servicing rights related to loans previously sold and to transfers of servicing rights relating to loans PwC 5-25

243 Servicing of financial assets that are retained by the transferor qualifies as a sale at the date on which title passes, if substantially all risks and rewards of ownership have irrevocably passed to the transferee and any protection provisions retained by the transferor are minor and can be reasonably estimated. If a sale is recognized and minor protection provisions exist, a liability should be accrued for the estimated obligation associated with those provisions. The transferor retains only minor protection provisions if (a) the obligation associated with those provisions is estimated to be no more than 10 percent of the sales price and (b) risk of prepayment is retained by the transferor for no more than 120 days. ASC also notes that a temporary subservicing agreement in which the transferor subservices the loans for a short period of time (generally found in sales of servicing rights) would not necessarily preclude recognition of a sale at the closing date. Additionally, ASC establishes certain other criteria that should be considered when determining whether the transfer of servicing rights qualifies as a sale: Whether the transferor has received written approval from the investor, if required. Whether the transferee is a currently approved seller/servicer and is not at risk of losing approved status. For a sale in which the transferor finances a portion of the sale price, whether an adequate non-refundable down payment has been received (necessary to demonstrate the buyer s commitment to pay the remaining sales price) and whether the note receivable from the transferee provides full recourse to the buyer. Nonrecourse notes or notes with limited recourse do not satisfy this criterion. Temporary servicing performed by the transferor for a short time should be compensated in accordance with a subservicing agreement that provides adequate compensation. In general, three to six months may elapse between the time a company enters into a contract to sell servicing rights and the time the loan portfolio to be serviced is actually delivered. These delays may result from the purchaser s inability to accept immediate delivery, the seller s inability to immediately transfer the servicing records and loan files, difficulties in obtaining necessary investor approval, requirements to give advance notification to mortgagors, or other planning considerations. Issues relating to the transfer of risks and rewards between buyers and sellers of servicing rights may be complex and should be carefully considered Sale of mortgage servicing rights with a subservicing agreement ASC provides guidance on accounting for the transfer of mortgage servicing rights to an unrelated entity at a gain and the parties also enter into an agreement that requires the transferor to continue to perform the loan servicing for a fixed-dollar amount per loan (a subservicing agreement). The guidance provides that 5-26 PwC

244 Servicing of financial assets if the significant risks and rewards of ownership related to the mortgage servicing rights are transferred to the transferee, the servicing rights should be derecognized, but income on the transaction should be deferred. It also states that the transaction should be accounted for as a sale and that any gain should be deferred provided that substantially all the risk and rewards inherent in owning the servicing rights were transferred to the buyer. If the servicing of mortgage loans is expected to result in a loss, that loss should be recognized currently. Changes in the fair value of servicing assets or servicing liabilities measured at fair value should be included in earnings in the period during which those changes occur, with any additional change in fair value from the last measurement date to the sale date included in earnings at the sale date. An assumption of a servicing obligation does not result in separate recognition of a servicing liability, unless substantially all the risks and rewards inherent in the servicing liability have been effectively transferred. Any derecognition of a servicing liability should comply with the requirements established in ASC Sales of mortgage servicing rights for participation in an income stream ASC states that gain recognition on the sale of the right to service mortgage loans owned by other parties is appropriate at the sale date. If the sales price is based on a participation in future payments, the amount of the gain recognized should be based on all available information, including the amount of gain that would be recognized if the servicing rights were sold outright for a fixed cash price. Changes in the fair value of servicing assets or liabilities measured subsequently at fair value should be included in earnings in the period during which those changes occur, with any additional change in fair value from the last measurement date to the sale date included in earnings at that time. 5.5 Are there standards that servicers of financial assets are required to follow? When servicing financial assets, the servicer typically needs to adhere to certain minimum servicing standards. These servicing standards may be specified by the servicing agreement or required by law. Typical minimum servicing standards are discussed below Uniform single attestation program for mortgage bankers Entities that service residential mortgage loans for investors may be required to engage an independent accountant to provide assurance relating to management s written assertions about compliance with the minimum servicing standards set forth in the Uniform Single Attestation Program for Mortgage Bankers (USAP). The USAP was developed by the Mortgage Bankers Association of America and is intended to provide the minimum servicing standards with which an investor should expect a servicing entity to comply. For other types of mortgages, such as commercial mortgages, this requirement is called Minimum Servicing. PwC 5-27

245 Servicing of financial assets Under USAP, management is required to provide an assertion regarding the entity s compliance with the applicable servicing criteria over the reporting period. The auditor is required to test an entity s compliance with the applicable servicing criteria before concluding whether management s assertion is appropriate. The auditor s testing is performed in accordance with Statement on Standards for Attestation Engagements No. 10, Compliance Attestation, issued by the AICPA. Auditors will also need to meet the independence requirements under the AICPA guidelines. The testing is performed on a sample of loans serviced on the particular servicing platform rather than by tests of specific securitization transactions or particular whole loan sales with servicing retained. Reports by management and the auditor must generally be furnished to investors no later than 90 days after the period end. The auditor s opinion includes an opinion on management s assertion regarding a servicing entity s compliance with the minimum servicing standards in the USAP. Specific findings or exceptions, on a criterion by criterion basis, are not generally reported unless the auditor concludes that management s assertion is not fairly stated in all material respects. USAP requires that the auditor obtain a written assertion about the entity s compliance with the minimum servicing standards and a management representation letter. The minimum servicing standards under the USAP include the following: A fidelity bond and an errors and omissions policy shall be in effect on the servicing entity throughout the reporting period in the amount of coverage represented to investors in management s assertion. Mortgage payments shall be deposited in the custodial bank accounts and related bank clearing accounts within two business days of receipt. Disbursements by wire transfer on behalf of a mortgagor or investor shall be made only by authorized personnel. Funds of the servicing entity shall be advanced in cases where there is an overdraft in an investor or mortgagor s account. Each custodial account shall be maintained at a federally insured depository institution in trust for the applicable investor. Unissued checks shall be safeguarded so as to prevent unauthorized access. Reconciliations shall be prepared on a monthly basis for all custodial bank accounts and related bank clearing accounts. They shall be mathematically accurate, prepared within 45 calendar days after cut-off, reviewed and approved by someone independent of the preparer, and have documented explanations of reconciling items, as well as documented resolution of reconciling items within 90 days of identification PwC

246 Servicing of financial assets Investor reports shall agree with, or reconcile to, investors records on a monthly basis as to the unpaid principal balance and number of loans serviced by the servicing entity. Amounts remitted to investors per the servicer s investor reports shall agree with cancelled checks, or other forms of payment, or custodial bank statements. Mortgage payments made in accordance with the mortgagor s loan documents shall be posted to the applicable mortgagor s records within two business days of receipt. Mortgage payments shall be allocated to principal, interest, insurance, taxes, or other escrow items in accordance with the mortgagor s loan documents. Mortgage payments identified as loan payoffs shall be allocated in accordance with the mortgagor s loan documents. The servicing entity s mortgage loan records shall agree with, or reconcile to, the records of the mortgagor with respect to the unpaid principal balance on a monthly basis. Records documenting collection efforts shall be maintained during the period when a loan is in default and shall be updated at least monthly. Adjustments on ARM loans shall be computed based on the related mortgage note and any ARM rider. Escrow accounts shall be analyzed, in accordance with the mortgagor s loan documents, on at least an annual basis. Interest on escrow accounts shall be paid, or credited, to mortgagors in accordance with applicable state laws. Escrow funds held in trust for a mortgagor shall be returned to the mortgagor within 30 calendar days of payoff of the mortgage loan. Tax and insurance payments shall be made on or before the penalty or insurance policy expiration dates, as indicated on tax bills and insurance premium notices, provided that the billing documentation has been received by the servicing entity at least 30 calendar days prior to those dates. Any late payment penalties paid in conjunction with a payment of a tax bill or insurance premium notice shall be paid from the servicing entity s funds and not charged to the mortgagor, unless the late payment was due to the mortgagor s error or omission. Disbursements made on behalf of a mortgagor or investor shall be posted within 2 business days to the mortgagor or investor s records, which are maintained by the servicing entity. PwC 5-29

247 Servicing of financial assets Regulation AB The registration, disclosure, and reporting requirements for publicly issued assetbacked securities (ABS) are governed by the Securities Act of 1933 and the Securities Exchange Act of However, when these laws were created, the modern assetbacked securitization market did not exist. For this reason, the process of ABS registration has been revised several times by Congress and the SEC to better suit the needs of the ABS market. The SEC s Regulation AB consolidated and codified existing interpretations, primarily company-specific positions to clarify the registration requirements of the Securities Act of 1933 for ABS offerings. Regulation AB affects all publicly issued ABS with offer dates after December 31, Regulation AB introduced numerous changes to the composition, registration, disclosure and reporting requirements associated with a public transaction of an ABS. Importantly, Regulation AB addresses servicing and revises the required disclosures and standards surrounding the servicing function in sections 1108 and 1122 of Regulation AB. Regulation AB instituted the following three key changes to the regulatory environment for ABS: 1. Annual servicing assertion and accountant s attestation process: Each servicer is required to formally assess its compliance with the Servicing Criteria in Section A servicer assessment report, along with an attestation by an entity s auditor, must be prepared or received to comply with Regulation AB. 2. Changes to the required disclosures associated with securities registration: The Form S-3 for ABS, described in Regulation AB, specifies incremental information that must be reported in the registration documents. 3. Changes to the reporting requirements for ABS: Regulation AB requires the reporting on periodic distribution and pool performance information on new Form 10-D Other servicing standards The servicer institution or other financial institutions may originate the serviced loans. When an institution services mortgage loans for service agents such as GNMA, FNMA, or FHLMC, institutions must meet certain minimum net worth requirements. Inability to meet the requirements may result in termination of the service contracts. These agencies have also detailed servicing guidelines that servicers may be required to follow Servicing reform During January 2011, the Federal Housing Finance Agency ( FHFA ) commenced an initiative to evaluate the servicing compensation model and determine alternative models for the industry. During September 2011, FHFA released a whitepaper, 5-30 PwC

248 Servicing of financial assets entitled Alternative Mortgage Servicing Compensation Discussion Paper. The whitepaper discussed the shortcomings of the current structure of servicing compensation and proposed two alternative options. The options included a Reserve Account Model and a Fee for Service Model. The implementation of each model may significantly impact each entity that has servicing activities. As of May 2013, these models have not been finalized. 5.6 Chapter wrap-up A servicing asset should be recorded when the benefits are expected to more than adequately compensate the servicer, while a servicing liability should be recorded when the benefits are not expected to adequately compensate the servicer. Under ASC 860, servicing assets and servicing liabilities should not be separately recognized for transfers of financial assets that do not qualify for sale accounting. Servicing assets and liabilities should only be recognized if the servicing right is contractually separated from the financial asset being serviced through a transfer of financial assets that qualifies for sale accounting or the acquisition or assumption of the right to service the financial assets from a third party. Servicing rights should initially be measured at fair value and may be measured subsequently at fair value or at amortized cost, subject to an impairment test. This accounting election must be made by class of servicing assets or servicing liabilities. The accounting for transfers of servicing rights should be evaluated to determine whether sale treatment is appropriate. A transfer of servicing rights qualifies as a sale if substantially all risks and rewards of ownership have irrevocably passed to the transferee and if protection provisions retained by the transferor are minor and can be reasonably estimated. This guidance also provides the accounting for a transfer of mortgage servicing rights where the transferor continues to perform the servicing under a subservicing arrangement. 5.7 FASB s implementation guidance and PwC s questions and interpretive responses The information contained herein is generally based on the Implementation Guidance and Illustrations included in ASC We ve also included certain questions and interpretive responses intended to supplement discussions in this Chapter regarding the application of guidance to specific fact patterns Recognition Excerpt from ASC The following guidance addresses the accounting for servicing assets and servicing liabilities in certain transactions, specifically: a. Recognition of servicing upon sale of a participating interest PwC 5-31

249 Servicing of financial assets b. Servicer not entitled to receive a contractually specified servicing fee c. Servicing assets assumed without cash payment d. Subservicing contracts. Recognition of Servicing upon Sale of a Participating Interest Excerpt from ASC If the entity that transfers a portion of a loan under a participation agreement that meets the definition of a participating interest and qualifies for sale accounting under Subtopic obtains the right to receive benefits of servicing that more than adequately compensate it for servicing the loan, and the entity would continue to service the loan regardless of the transfer because it retains part of the participated loan, the entity shall record a servicing asset for the portion of the loan it sold. The assumption that the entity would service the loan because it retains part of the participated loan does not affect the requirement to recognize a servicing asset. Conversely, an entity could not avoid recording a servicing liability if the benefits of servicing are not expected to adequately compensate the servicer for performing the servicing. However, if the benefits of servicing are significantly above an amount that would fairly compensate a substitute service provider, should one be required, the transferred portion does not meet the definition of a participating interest, and, therefore, the transfer does not qualify for sale accounting (see paragraph A(b)). Servicer is Not Entitled to Receive a Contractually Specified Servicing Fee Excerpt from ASC The following guidance addresses whether an entity should recognize a servicing liability if it transfers all or some of a financial asset that meets the definition of a participating interest that is accounted for as a sale and undertakes an obligation to service the asset but is not entitled to receive a contractually specified servicing fee. In the circumstances described, the transferor-servicer would be required to recognize a servicing liability at fair value if the benefits of servicing are less than adequate compensation. The requirements in paragraph apply even if it is not customary to charge a contractually specified servicing fee. Example 1, Case C (paragraph ) illustrates a transaction in which a transferor agrees to service loans without explicit compensation. Servicing Assets Assumed without Cash Payment Excerpt from ASC The following guidance addresses transactions in which servicing assets are assumed without cash payment, and the appropriate offsetting entry by the transferee PwC

250 Servicing of financial assets Excerpt from ASC The offsetting entry depends on whether an exchange or capital transaction has occurred. If an exchange has occurred, then the transaction should be recorded based on the facts and circumstances. For example, the servicing asset may represent consideration for goods or services provided by the transferee to the transferor of the servicing. In that case, the offsetting entry by the transferee would be the same as if cash was received in exchange for the goods and services (that is, revenue or a liability as appropriate). Excerpt from ASC The servicing assets also might be received in full or partial satisfaction of a receivable from the transferor of the servicing. In those cases, the offsetting entry by the transferee would be to derecognize all or part of the receivable satisfied in the exchange. Another possibility is that an investor is in substance making a capital contribution to the investee (the party receiving the servicing asset, that is, the transferee) in exchange for an increased ownership interest. In that case, the investee should recognize an increase in equity from a contribution by owner. Subservicing Contracts Excerpt from ASC A transferor may transfer mortgage loans in their entirety to a third party in a transfer that is accounted for as a sale and undertake an obligation to service the loans. After the transfer, the transferor enters into a subservicing arrangement with a third party. Excerpt from ASC If the transferor s benefits of servicing exceed its obligation under the subservicing contract, that differential shall not be accounted for as an interest-only strip. Rather, the transferor should account for the two transactions separately. First, the transferor should account for the transfer of mortgage loans in accordance with Subtopic The obligation to service the loans should be initially recognized and measured at fair value according to paragraph as proceeds obtained from the sale of the mortgage loans. Second, the transferor should account for the subcontract with the subservicer. Question 5-1 Would ASC 860 apply if a broker were to bring a bank and a borrower together in a brokered loan transaction and simultaneously enter into a servicing contract with the bank upon origination of the loan? PwC response Yes. ASC 860 applies to any separate purchase or assumption of a servicing contract, regardless of whether a transfer of financial assets is connected to it, as outlined in ASC Upon purchase or assumption of a servicing contract, the servicer PwC 5-33

251 Servicing of financial assets records a servicing asset at its fair value. A servicing liability should be recognized at its fair value when the servicer is less than adequately compensated. Question 5-2 If the transfer of financial asset(s) does not meet the criteria for sale accounting, can an entity recognize a separate servicing asset? PwC response No. Under ASC , no servicing asset or servicing liability should be recognized when a servicer transfers financial assets in a transaction that does not meet the requirements for sale accounting (i.e., the transfer is accounted for as a secured borrowing with the underlying financial assets remaining on the transferor s balance sheet). However, if the entity transfers a participating interest in a financial asset that qualifies for sale accounting, then, in accordance with ASC , the entity will record a servicing asset for the portion of the loan it sold. The assumption that the entity would service the loan because it retains part of the participated loan does not affect the requirement to recognize a servicing asset. Question 5-3 Can an entity bifurcate the servicing fee it receives under a servicing contract into a base servicing fee and interest only strip? PwC response It depends. An entity should account separately for rights to future interest income from the serviced assets that exceed the contractually specified servicing fees. Under ASC , whether a right to future interest income from serviced assets should be accounted for as an interest only strip, a servicing asset, or a combination of thereof, depends on whether a servicer would continue to receive that amount if a substitute servicer began to service the assets. Therefore, an entity will need to determine whether it would continue to receive a portion of the right to future interest income from the serviced assets if servicing was shifted to another servicer. This will often require a legal interpretation of the servicing contract and how the contractually specified servicing fees is defined. If it is determined that the entire right to future interest income from serviced assets would shift to another servicer, then the total amount received would be considered the contractually specified servicing fee and would not be able to bifurcate the fees received into a servicing asset and an interest only strip PwC

252 Servicing of financial assets Question 5-4 What unit of account should be considered when applying the MSR derecognition guidance in ASC ? PwC response ASC defines servicing assets and servicing liabilities as contracts to service financial assets. Therefore, we believe the derecognition guidance outlined in ASC should be applied at the servicing contract level. A servicing asset is created when the benefits of servicing, under a contract to service financial assets, is expected to more than adequately compensate the servicer for performing the servicing. Similarly, a servicing liability is created when the estimated future revenues from contractually specified servicing fees, late charges, and other ancillary revenues, under a contract to service financial assets, are not expected to adequately compensate the servicer. Since the MSR is created at the contract level, it should be analyzed for derecognition at the servicing contract level. PwC 5-35

253 Chapter 6: Taxation PwC 1

254 Taxation Chapter overview Because the tax implications of a securitization transaction can be significant, entities should consider tax issues before entering into a securitization transaction. Often, securitizations are structured to minimize tax costs. The most common example is a securitization designed as a secured borrowing for tax purposes to avoid recognition of a potential taxable gain upon transfer of financial assets. As discussed below, the determination of whether a transaction is a sale or a secured borrowing for tax purposes depends on a number of factors, not just the accounting treatment. As such, a transaction may be a sale/secured borrowing for tax purposes even though it is treated as a secured borrowing/sale for accounting purposes. Securitizations are generally structured to avoid any additional taxation at the SPE level. This is accomplished by using pass-through entities and by ensuring that the entities cannot be recharacterized as taxable entities. This chapter discusses the U.S. tax implications of securitization transactions and does not consider any foreign tax consequences. It addresses the most important issues facing the sponsor of an asset securitization transaction or a similar arrangement. These key issues include the following: Sale versus secured borrowing, with a focus on when a securitization qualifies as a sale or secured borrowing for tax purposes, Tax entities, with a focus on the real estate mortgage investment conduit (REMIC) and trusts, Taxation of debt instrument holders, with a focus on the definitions of original issue discount and market discount, Taxable mortgage pools, and Servicing assets and liabilities. Key questions answered in this chapter Page in this publication How is a securitization transaction determined to be a sale or a secured borrowing for tax purposes? 6-3 What tax entities should be used in a securitization? 6-12 How are the holders of debt instruments in securitizations taxed? 6-26 What are Taxable Mortgage Pools? 6-30 How are servicing assets and servicing liabilities treated for tax purposes? PwC

255 Taxation 6.1 How is a securitization transaction determined to be a sale or a secured borrowing for tax purposes? One of the most fundamental issues of asset securitizations is determining whether these transactions are sales or secured borrowings for tax purposes. A securitization must be characterized as a sale or secured borrowing before its structure is finalized. Therefore, characterizing a securitization is the first issue addressed in this Chapter. There is an important distinction between a sale and a secured borrowing arrangement for tax purposes. Sale transaction: The sponsor (i.e., the transferor) recognizes a gain or loss, and the transferee is treated as the owner of the transferred financial assets. As discussed below, REMICs and other structures, may defer the recognition of tax gains or losses. Secured borrowing transaction: The transferor retains ownership of the financial assets and recognizes income on payments from the obligors that are offset by deductions for interest payments made to the investors. The original issue discount provisions of the tax rules apply to both the issuer and investor in determining the deductible interest expense and includible interest income, respectively. A sponsor s tax objectives may assist it in deciding whether to structure a transaction to achieve a tax sale or secured borrowing treatment. For example, a sponsor may want tax sale treatment if it has losses that can offset any gain from the transaction. Sometimes a gain is unavoidable, as in the case where mortgages must be financed through a REMIC. The determination of whether a securitization results in a sale or secured borrowing for tax purposes is made on the basis of all facts and circumstances of the transaction (the economics of the transaction). Notwithstanding, REMIC transactions are treated as sales or partial sales if certain standards are met, which will be discussed in TS 6.2 of this Chapter. Because no objective tax standard exists, transactions may be treated as secured borrowing/sale for tax purposes and sale/secured borrowing for GAAP purposes Securitization structures For purely nontax reasons, most securitizations are achieved through a two-step structure. The steps are as follows: Step one: Financial assets are transferred from the transferor (i.e., the originator) to a BRE, which is usually a wholly-owned subsidiary of the transferor. This transfer is carefully evaluated to ensure that it will qualify as a legal sale and satisfy the isolation criteria of the accounting guidance, as discussed in Chapter 2 (refer to TS 2.1). PwC 6-3

256 Taxation For tax purposes, step one is typically treated in one of three ways, depending on the economics of the transaction or the type of entity: Intercompany transaction rules defer recognition of any gain or loss where the BRE and transferor are members of the same consolidated group. No gain or loss is recognized if the financial assets are transferred to a BRE that is disregarded for purposes of determining tax liability. No gain or loss is recognized (in certain instances) if the transaction is treated as a secured borrowing from the BRE. A gain or loss may be recognized in the first step of the two-step structure for state and local tax purposes. Cross-border transactions should also be taken into consideration, as the laws of foreign jurisdictions impact the transfer and the creation of securitization vehicles. Step two: The BRE transfers the financial assets to a trust. The trust then issues beneficial interests in the assets or securities that are collateralized by the assets. The tax analysis is identical in cases where the BRE transfers the assets directly to a transferee, for example, a syndicate of banks. The securities are often notes or certificates. The terms of the second step determine whether the transfer can be characterized as a sale or a loan for tax purposes. The distinction between a sale and a secured borrowing for tax purposes is further clarified below: If the transaction is a sale: The sponsor, for example, transfers financial assets in exchange for all the equity interests in an entity and then sells some or all of those equity interests. If the transaction is a secured borrowing: The trust is essentially disregarded and the sponsor is treated as having borrowed money from the investors (the issued securities are treated as debt instruments for tax purposes). Fact-specific criteria determine whether a transfer of receivables or other financial asset in step two should be treated as a sale or as a loan for federal income tax purposes. Generally, the determination depends on whether the sponsor (BRE and its affiliates) of the securitization relinquishes, either directly or indirectly, substantial incidents of ownership of the receivables to the ultimate investor. If the sponsor relinquishes substantial incidents of ownership, the transaction should be treated as a tax sale. Otherwise, the transaction should be treated as a secured borrowing arrangement, with the understanding that the sponsor has effectively pledged the receivables as security Tests to determine whether a transaction is a sale or a secured borrowing for tax purposes Congress, the courts, and the Internal Revenue Service (IRS) have yet to develop a precise test to determine whether a financial asset transfer is a sale or a secured 6-4 PwC

257 Taxation borrowing. A multitude of revenue rulings, administrative rulings, and court decisions have addressed the question of sale vs. loan. 1 In establishing whether a sale has occurred, securitization sponsors generally rely on the case law and administrative rulings that focus on all facts associated with a transaction. For example, in a 1971 tax memorandum, 2 the IRS provided a detailed facts-and-circumstances analysis of the features that constitute a sale of receivables. The facts-and-circumstances analysis generally emphasizes (1) the intent of the parties and (2) the extent to which the benefits and burdens of ownership have been retained or transferred. Intent of parties: The intent of the parties is a factor that helps to determine whether a transaction should be treated as a sale or a secured borrowing. For example, if both parties agree that the transaction should be treated as a sale, that fact is helpful to the analysis. However, intent is only a small factor in the facts-and-circumstances test. The benefits and burdens of ownership typically can outweigh intent. Benefits and burdens of ownership: One of the basic principles of federal income tax law is that the substance of a transaction, rather than its form, governs the treatment of the transaction. In situations where the transferor retains many of the burdens and benefits of ownership even though formal title has been transferred, a number of court cases have ruled that the transfer of formal title should be disregarded and the transaction should be treated as a secured borrowing. In short, mere transfer of legal title or classification of a transaction for GAAP or legal purposes does not necessarily give rise to a sale for tax purposes. If the transferor relinquishes substantial ownership interests, the transaction will be treated as a tax sale. Otherwise, it will be treated as a secured borrowing in which the transferor pledges the receivables as security. Some transactions combine sales and secured borrowings. Moreover, if a REMIC is utilized, the transaction is automatically treated as a sale or partial sale under the REMIC rules. In other words, REMIC securitization sale analysis is not governed by the facts-and-circumstances or substance-over-form tests applicable to other securitizations Substance over form: A question of debt versus equity An investment in securities is an advance of money to the issuer in exchange for certain rights against the issuer. The question is whether such rights constitute a debt or equity investment. Analyses of the economic substance of many securitizations have indicated that the asset-backed securities should be characterized as the sponsor s debt, even when accounting treatment may be contrary (treatment as an accounting sale as opposed to a tax financing). As mentioned previously, U.S. tax law generally requires a transaction to be characterized and treated based on its substance, not its form. Notwithstanding the above, it is worth noting that a taxpayer, who has ability to structure a transaction, should attempt to ensure the form is consistent with the 1 Among these are Revenue Ruling 54-43, C.B. 119; Town & Country Food Co. v. Commissioner 51 T.C. 1049; United Surgical Steel v. Commissioner 54 T.C (1970). 2 Gen.Couns. Mem (Sept 9, 1971). PwC 6-5

258 Taxation economics. The mere fact that a security is called a note, bond, or other name that identifies it as a debt instrument does not determine its tax treatment. Moreover, classification of a security as debt for GAAP, regulatory, or other purposes does not determine its tax treatment. To determine whether a security substantively constitutes debt or equity, the courts have adopted a facts-and-circumstances test as explained below: In a secured borrowing, all securities issued to third parties should be classified as debt for tax purposes. A debt instrument connotes a borrowing whereby the debtor has the obligation and ability to repay the principal amount within a certain time period. A debt instrument provides little upside appreciation in the investment apart from a stated interest amount to the lender and entails less downside risk than an equity investment. In a sale, at least a portion of the securities should be classified as equity for tax purposes. An equity investment (such as stock) connotes an investment whereby the issuer has no obligation to repay the original investment, but the investor is entitled to any appreciation if the business succeeds. In other words, an equity investor has the benefits and burdens of owning the enterprise. The courts have tried to keep the tax characterization of securities consistent with these notions. Accordingly, the courts have ruled that an equity interest represents embarking on a corporate venture and taking the risks of loss attendant upon it so that one might share the profits of its success. 3 The courts have defined debt instruments as constituting, among other things, an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor s income or lack thereof. 4 Such definitions contemplate that an equity investment assumes ownership of the business venture and assets, while a debt instrument does not. Unfortunately, the distinction between debt and equity is not always clear because many securities bear attributes of both. This generally occurs with respect to the subordinated classes of securities in securitizations. The courts have tried to resolve this ambiguity by relying on certain factors in the facts-and-circumstances-based determination. 3 See Farley Realty Corp. v. Comm r, 279 F. 2d 701 (2d Cir. 1960). 4 See Gilbert v. Comm r, 248 F.2d 399, 402 (4th Cir. 1957), cert. denied, 359 U.S (1959). 6-6 PwC

259 Taxation Facts and circumstances test With respect to securitizations, the facts-and-circumstances test can be divided into the following two separate analyses: The first determines who owns the financial assets or the business venture. If the issuer or sponsor of the securities owns the financial assets, the securities should be treated as debt. The second evaluates the rights conferred under the terms of the securities. If these rights are not limited to typical creditor rights, the securities may be treated as equity. Who owns the assets or business venture? In determining whether a holder of securities in a securitization has ownership rights to the issuer s assets, the issue is whether the holder of the securities bears a risk of loss and an opportunity for profit on the underlying assets. This test is different for securitizations than it is for the analysis of securities issued by operating companies. This is because the underlying assets are often debt instruments rather than assets that produce continuing growth potential. In this analysis, no single factor is determinative. For federal income tax purposes, the characterization of an instrument will often depend on the terms of the instrument and all of the surrounding facts and circumstances. Furthermore, the weight given to any factor depends on the overall effect of the instrument s debt and equity features. The securities in a securitization are normally treated as equity if they demonstrate many of the following features. If they do not demonstrate the following features, they are normally treated as debt: Ability to profit from reinvestment proceeds that result from the difference between (1) the cash flows received on the issuer s assets and (2) the payment on the issued securities (i.e., the difference between monthly paid assets and quarterly paid notes, or the float). Ability to participate in residual cash flow from the assets once payments have been made on senior securities (i.e., the spread). Ability to participate in the profits of the issuer. De facto provision of credit enhancement by providing overcollateralization to the other classes of securities that are senior to the security being analyzed, so that the security being analyzed is subject to the primary risks of loss if the underlying assets fail to pay as expected. This overcollateralization is similar to the debt-equity ratio set forth in Section 385 of the Internal Revenue Code (IRC) that is used for debt equity analysis in operating assets. In the context of securitizations, overcollateralization is generally the extent to which the value of underlying assets exceeds the principal PwC 6-7

260 Taxation amount of securities issued. In securitizations, this is generally the extent to which the value of the issuer s assets exceeds the principal amount of the securities issued to third parties. It is important to note, however, that there are instances where subordinated classes of securities, called notes, are treated, or are at risk of being treated, as equity for federal income tax purposes since the holders bear the risk of loss and participate in the profits of the issuer. The amount of overcollateralization required for an instrument to be treated as a debt instrument is dependent on the amount of risk associated with the underlying assets. Provision of other forms of credit enhancement to other classes, such as subordination of rights to float, spread, or profits. In short, a security typically will be treated as debt where the investor is insulated from risk of loss on the underlying assets and does not have the ability to participate in the profits of the issuer. What rights have been conferred to the investor? The next level of analysis examines whether a security in a securitization confers the typical rights of a creditor or the typical rights of an equity investor. A security with the following features typically confers creditors rights: Takes the legal form of debt or is intended to be treated as debt. Provides the right to receive a sum certain on demand (i.e., a principal amount that the debtor is required by law to repay and that the issuer of the security, at the time of issuance, has the ability to repay). However, contingent rights to repayment of principal generally indicate equity treatment. Provides a reasonably foreseeable fixed maturity or redemption date on which the principal amount will be repaid. Although debt treatment has been found in other circumstances, a security payable on demand or within thirty years is generally required for debt treatment. Provides for interest payments irrespective of net earnings. These interest payments must generally be calculated on the principal amount of the debt obligation at a fixed or variable rate. Provides the holder with the right to enforce payment in the event of default. Note that in the event of default of a debt instrument, the debt instrument generally provides the holder with the right to enforce payment under the terms of the debt instrument or at law. This generally consists of collecting all amounts due (principal and accrued interest plus expenses) whether directly or through methods such as foreclosure or garnishment. Does not give the holder voting or management rights. The ability to vote or participate in management of the company generally indicates equity. Confers a market rate of interest commensurate with debt instruments (i.e., investor is not being compensated for equity risk). Congress and the IRS have 6-8 PwC

261 Taxation appeared to adopt a rate approach to the treatment or special treatment of debt instruments, some of which are based on rates that are based on the applicable federal rate plus a spread. Application of the rules to securitizations Typical classification Rationale Junior classes of securities Senior classes of security Equity The distributions represent participation in the spread, float, and other profits on the issuer s assets. They provide credit enhancement to the most senior classes of securities by means of overcollateralization and bear first or second risk of loss (the holders of the securities bear the first risk of loss if the underlying assets do not perform). They generally do not confer any of the creditor s rights to the holders. Note that in many of the earlier CDO transactions, preference shares were issued in a nominal form of note. This however, did not change their characterization as equity since, substantively, they provided all of the other indicia of debt. Debt Holders are limited to payments of principal and interest and do not participate in the profits of the issuer. Holders bear little risk of loss on the underlying assets (likely return of principal) since credit enhancement is provided to them by subordinated classes or other methods (such a lack of risk of loss is indicative of the investment grade rating). Some securities that have characteristics of both debt and equity are difficult to analyze. For example, a mezzanine security may take the form of a debt instrument and confer most of the creditor s rights. However, the security s subordinate features can cause the holder to bear risk on the underlying assets that are typical of an equity instrument, and the return on the investment may approximate a return that is typical of an equity investment. Therefore, there is a risk that mezzanine securities will be recharacterized as equity. Such recharacterization can have negative consequences for holders. For example, if a note is recharacterized as equity, foreign holders could unexpectedly become subject to withholding taxes on distributions. It is important to note that tax opinion levels can vary with respect to the classes of notes. Senior notes generally are accompanied by a tax opinion that they will be characterized as debt. If a tax opinion accompanies subordinate classes, the opinion will typically say that they should be characterized as debt or that it is more likely than not that they will be PwC 6-9

262 Taxation characterized as debt. As discussed below, regular interests in REMICS are treated as per se debt, and therefore, the analysis above is not required. In certain securitizations, such as CDOs, it is not uncommon for mezzanine notes to provide, in addition to an interest-based return, a return based in part on the profits of the issuer, known as an equity kicker. Such provisions greatly complicate the determination of whether such notes are debt or equity. Note that there are instances in which notes with equity kickers are treated as debt instruments under the contingent payment debt instrument (CPDI) rules, which subjects the interest payments, including the equity kicker, to special tax accounting rules. The CPDI rules generally treat the debt instrument and the equity kicker as one instrument Sale considerations A securitization is characterized as a tax sale or secured borrowing at the time of closing. Therefore, a sponsor needs to structure the transaction to get the desired characterization before closing. The sponsor of a transaction may want to characterize that transaction as a tax sale or partial tax sale. If a transaction is characterized as a sale for tax purposes, the sponsor should consider several operative tax rules, including the rule that determines how a gain or loss is calculated. Gain and loss calculations in a tax sale or partial sale Section 1001(a) of the IRC defines gain or loss from the sale or other disposition of property as the excess of the amount realized over the adjusted basis of the property. Section 1001(b) of the IRC defines the amount realized as the sum of any money received plus the fair market value of the property (other than money) received (i.e., proceeds). The adjusted basis of a capital asset that is purchased by the taxpayer is generally equal to its acquisition cost, plus or minus any amortization of discount or premium. A taxpayer s adjusted basis is then compared with the net proceeds realized on the sale or exchange to determine whether a gain or loss should be realized on the transaction. Example: simplified securitization sales In a straight sale, the sponsor would recognize upon sale the excess of any proceeds received over the basis in the financial assets. If a loan was purchased in year 1 for $100 and sold in year 2 for $150, the sponsor would simply recognize a gain of $50. Whether this gain should be characterized as short-term or long-term depends on how long the sponsor held the financial asset. If the second step of a two-step transaction was designed to be treated as a sale or partial sale for tax purposes, the securities (issued by the trust) would typically represent fractional ownership interests. For example, in a transaction involving pooled financial assets (in securitizations, the group of assets are often referred to as a pool), ownership of each financial asset is transferred on a pro rata basis to the certificate owners that hold undivided interests in the pool and include in income all items of income, deductions, and credits attributable to their pro rata interests. The 6-10 PwC

263 Taxation sponsor recognizes a gain by allocating its basis in the underlying financial assets to the securities and then by comparing the cash received from the investor to its basis in the securities sold. For example, assume a sponsor has $100 of mortgage loans. The sponsor transfers the mortgages to a trust and receives two securities, Class A and Class B. The sponsor sells the Class A security to an investor for $60, and the fair value of the Class B security is $50. The sponsor would allocate the basis to the Class A security as follows: 60/ = Consequently, the sponsor would have a gain of $5.46 on the sale of the Class A security to the investors. Partnerships A partial sale securitization can also be structured as a partnership for tax purposes. In such instances, the originator and certificate holders are treated as partners. The financial assets of the trust are treated as pooled financial assets, whereby the interests of the originator and the certificate holders are measured by the cash flow of those financial assets. In most transactions where investors are treated as partners, the gain or loss calculation discussed above would be applicable to the sponsor in determining the gain to be recognized. That is, sales cannot be disguised through partnerships to avoid gain recognition. Standard repurchase agreements and dollar rolls Standard repurchase agreements (repos) are often classified as secured borrowings rather than sales because in a repo, one party sells a debt instrument to another party under an agreement to repurchase the instrument at a fixed price and at a fixed time before its maturity. The first party (seller and repurchaser) retains all of the economic benefits and burdens of the debt instrument, as well as the power to control its disposition. The second party (purchaser) presumably holds the debt instrument for return to the seller. Since no true sale occurs, the seller does not recognize any gain or loss for tax purposes. However, this is not the case when the purchaser has the right to pledge or dispose of the debt instrument, subject to an obligation to return a similar but not necessarily identical security. This type of transaction, called a dollar roll, is viewed as a sale for tax purposes that triggers a gain or a loss for the seller. Securities lending In a securities lending agreement, the owner of securities (the securities lender) exchanges securities with a borrower (the securities borrower) that is obligated to deliver to the securities lender a like security at a future date. The securities borrower puts up collateral to indicate that he can redeliver equivalent securities. The securities lender receives a fee. The arrangement to exchange a security for a like security at a future date generally requires the recognition of gain or loss by the securities lender, unless the transfer PwC 6-11

264 Taxation meets certain requirements under Section 1058 of the IRC, as is the case with an obligation to return identical securities. 6.2 What tax entities should be used in a securitization? Tax entities provide the essential framework for financial asset securitizations. The choice of entity is particularly relevant when a transfer from an SPE to a trust is a sale for tax purposes. The type of tax entity or securitization funding vehicle dictates (1) the timing of income or loss recognition on the sale of the financial assets and (2) the treatment of the assets, liabilities, and ownership interest(s) of the trust. The following two statutory entities facilitate the issuance of securities backed by debt obligations: Real Estate Mortgage Investment Conduit or REMIC, which is used to issue mortgage-backed securities. Financial Asset Securitization Investment Trust or FASIT, which was used to issue securities backed by non-mortgage or debt obligations, and was introduced by the Small Business Job Protection Act of 1996 but repealed on October 22, Other types of entities including partnerships, grantor trusts, real estate investment trusts (REITs), and fully taxable corporations are used in financial asset securitizations. All of these entities have unique tax attributes that are described and compared in Figure 6-1. Until the American Jobs Creation Act of 2004 (the 2004 Act ), there was no statutory tax entity that facilitated revolving-period mortgage securitizations. Before 2004, most of these transactions had been structured as a secured borrowing for tax purposes. The majority were structured as single-maturity debt financings, which were preferable to taxable mortgage pools (as discussed later in this Chapter). The 2004 Act allowed REMICs to finance revolving mortgages. A mortgage securitization that is structured outside the statutory provisions of a REMIC or, prior to its repeal a FASIT, may be restricted regarding the types of securities it can issue. Typically, such an entity can issue senior and subordinated classes but not in sequential pay classes with varying maturities that do not match the maturities of the underlying assets. Figure 6-1 Comparison of attributes of tax entities The following chart is a general outline of the federal income tax implications for domestic and foreign investors of classifying SPEs. It does not include any discussion of state and local taxation because each state and locality may have its own rules concerning taxation of SPEs. Generally, SPEs are created to receive pass-through 6-12 PwC

265 Taxation treatment. There is always a possibility, however, that the conduit entity will fail to meet the SPE qualification requirements and will be classified as an association, taxable as a corporation, that does not benefit from pass-through treatment. Distinguishing characteristics Tax treatment Asset type Types of interests Other limitations Grantor trust Two criteria for qualification: o Fixed investment trust o Single class of certificates (except for senior/ subordinated and coupon strips) Holder of interest is treated as owner of an undivided interest in each trust asset Market discount, market premium and OID rules may apply on the collateral held to a holder s interest Entity Generally not subject to tax Gain/Loss Generally no gain/loss recognized on contribution of property to a grantor trust; gain/loss recognized upon sale of certificates Investor Taxed as owner of a ratable portion of trust assets, including income received on the assets and deductions for reasonable expenses, if any, paid by the trust; character of income to trust flows through to investor Any type of receivable (e.g., auto loans, franchise loans, etc.) Certificates of beneficial interest in underlying financial assets, referred to as pass-through certificates Pass-through certificates may include: o Stripped passthrough certificates o Senior and subordinated pass-through certificates Trustee has no power to vary trust investments Cannot issue sequential pay or varying maturity date interests Limitations on deductions by individuals, estates, and trusts as certificate holders Excess fees may constitute stripped certificates (coupons) Partnership Must have at least two members Legal structure may be a Limited Liability Company to provide liability protection to all members and to otherwise resemble a corporation, while qualifying as a partnership for federal tax purposes Entity Generally not subject to tax Gain/Loss Generally no gain/loss recognized on contribution of property to a partnership in exchange for a partnership interest unless there is a disguised sale or the interests are sold Any type of receivable (e.g., auto loans, franchise loans, etc.) Debt obligations of partnership General partnership interests Limited partnership interests Unincorporated entities must be able to elect or default to partnership classification under the checkthe-box rules Publicly Traded Partnership (PTP) rules may result in partnership being treated as an association taxable as a corporation for federal tax purposes PwC 6-13

266 Taxation Distinguishing characteristics Tax treatment Asset type Types of interests Other limitations Partnership (continued) Under the entity classification ( check the box ) regulations, an eligible entity may choose partnership tax classification Default rules under the check-the-box regulations treat a domestic eligible entity with two or more members as a partnership Foreign eligible entities default to a classification based on whether any member has unlimited liability Investor Partner must recognize a distributive share of partnership income, gain, loss, deductions, and credit, if any, in the taxable year in which the partnership s taxable year ends, regardless of whether any distributions were made Tax allocations must be in compliance with IRC tax provisions and regulations REIT A security that may sell equity on the major exchanges and represents an investment in real estate directly, either through properties or mortgages Subject to tax as a domestic corporation on its real estate investment trust taxable income Dividends paid deduction eliminates corporate tax on currently distributed earnings Must invest primarily in (and not hold as a dealer) real estate or real property mortgages N/A Must have at least 100 shareholders, meet an ownership diversification test, and distribute substantially all of its income annually 6-14 PwC

267 Taxation Distinguishing characteristics Tax treatment Asset type Types of interests Other limitations REMIC Legal form is generally a trust or segregated pool of assets, but can be also corporation or partnership, Requirements: o Must make REMIC election o All interests must be regular or residual interests o One class of residual interests o Must have calendar tax year o Reasonable arrangements ensuring: Residual not held by disqualifying organization Information for application of tax on disqualifying organization available by entity Intent of REMIC legislation is to create an exclusive vehicle for issuing multiple classes of mortgagebacked securities to avoid entitylevel tax Issuance of multiple class mortgagebacked securities in non-remic form may have taxable mortgage pool implications Entity Generally not subject to tax except for prohibited transactions, tax on certain contributions, and tax on net income from foreclosure property Gain/Loss Seller deferred gain or loss created upon contribution of property to REMIC. Adjusted basis of regular and residual interests received in the transfer equals the aggregate adjusted basis of the property transferred, allocated among interests in proportion to their respective FMVs. Gain/loss recognized upon sale of interests, amortization of non recognized gain/loss if interests held by issuer Investor Regular interest holder: o Taxed in same manner as holder of a debt instrument o Must use accrual method of accounting for income recognition o Portion of gain may be recharacterized as ordinary income 110% rule Substantially all of the assets consist of qualified mortgages and permitted investments Qualified mortgage: any obligation that is principally secured by an interest in real property, including regular interests in other REMICs, and that either: o Is transferred to or purchased by the REMIC on or before the start-up day, or o Within the three-month period beginning on the start-up day o Certain increases in the loan described above pursuant to the original terms of the loan and purchased pursuant to a fixed price contract Permitted investment: o Cash flow investment o Qualified reserve assets o Foreclosure property Regular Interest: o Issued on the start-up day with fixed terms o Designated as a regular interest o Interest payments are payable based on a fixed rate or to extent provided in regulations, at a variable rate, or interest payments consist of a specified portion of the interest payments on qualified mortgages and such portion does not vary during the period such regular interest is outstanding Residual Interest: o Issued on the start-up day o Designated as a residual interest o Any interest in REMIC other than a regular interest One class only Distributions must be pro-rata Cannot vary the composition of mortgage assets Special rules for income from residual interests: o Subject to the full statutory withholding rate for certain non- U.S. persons o Excess inclusion rules do not apply to certain financial institutions Revolving assets permitted Qualified replacement mortgage only if part of bona fide replacement (e.g., defective obligation within a specified period) PwC 6-15

268 Taxation Distinguishing characteristics Tax treatment Asset type Types of interests Other limitations REMIC (continued) Excess inclusion concept: o Minimum taxable income for residual holder o Equals the excess of taxable income over the sum of daily accruals with respect to such interest for days during the calendar quarter while held by such holder o Daily accruals are determined by allocating to each day in the quarter a ratable portion of the product of the adjusted issue price of such interest at the beginning of such quarter and 120 percent of the long-term federal rate Prohibited transaction and other entity taxes Residual interest holder: o Taxed on all net income of the REMIC not taken into account by holders of regular interests o Recognizes taxable income/net loss daily, generally determined under accrual method o Character ordinary income/loss o Excess inclusion income generally cannot be offset by net operating losses o Excess inclusion is unrelated business taxable income for tax-exempt investors o Indefinite carry-forward of losses o Extended wash-sale rule any purchase of a residual interest in any REMIC or any interest in a taxable mortgage pool within six months before or after selling a residual interest will result in loss disallowance o Withholding tax applicable for certain non-u.s. persons 6-16 PwC

269 Taxation Distinguishing characteristics Tax treatment Asset type Types of interests Other limitations Corporation Entity level tax Typically parent/subsidiar y structure Minimize tax liability through interest expense deductions at the subsidiary level and utilize dividends received deduction (DRD) at the parent level Entity Subject to tax on net income Investors Debt holders subject to debt rules; equity holders subject to tax on dividend income (typically 100% dividends received deduction for parent) Any type of receivable (e.g., auto loans, franchise loans, etc.) Generally debt Minimal equity If not part of a consolidated group, implications of double taxation (i.e., entity and investor levels) Legal trust (secured borrowing for tax purposes) Sponsor is treated as issuer of certificates May be a sale of the assets to the trust and issuance of certificates of beneficial interests in the trust under GAAP and a true sale at law Entity Trust not recognized for tax purposes. Sponsor is tax owner of assets and continues to recognize income on the assets, offset by tax deduction attributable to interest expense on debt issued Gain/ Loss No gain or loss since transfer to trust not recognized for tax purposes Debt Holders Taxed in same manner as holder of any other debt instrument Typically used for auto loans, credit card receivables and other non mortgage receivables Debt of sponsor, not trust Must have elements supporting a secured borrowing for tax purposes (e.g., sponsor retains benefits and burdens of ownership) Tax rules may prevent classification of transaction as tax loan if specifically provided that such transfer is a sale or exchange for tax purposes (e.g., REMIC rules for mortgages) Real estate mortgage investment conduit (REMIC) The REMIC is the most common means of securitizing mortgage loans. REMIC is a tax characterization rather than a type of legal entity. Therefore, its legal form can vary; it can be organized as a state law trust, corporation, partnership, LLC, L.P., or segregated pool of financial assets. Mortgage loan receivables are contributed to a REMIC by the sponsor. The REMIC can then issue multiple classes of mortgage-backed securities against those receivables without incurring an entity-level tax. The taxable mortgage pool rules, discussed below, were created to make REMICs the only choice for implementing sequential pay mortgage securitizations. As such, if a REMIC is not used, the taxable mortgage pool rules will typically cause the PwC 6-17

270 Taxation securitization vehicle to be subject to tax, thereby reducing the amount of cash available for distribution to investors. An entity will be deemed a REMIC, regardless of its legal form, if it meets all of the following conditions: Elects to be treated as a REMIC. Has a calendar year-end. Satisfies the interests test, the assets test, and the arrangements test The interests test An entity satisfies the interests test when all of its interests are regular or residual. Regular interests are treated as debt instruments for tax purposes, regardless of how tax law (discussed above) would characterize them. Residual interests represent the equity interests of the REMIC. Conditions for regular and residual interests Regular interests must: Residual interests must: Be designated as a regular interest Be issued on the start-up day of the REMIC Be a single class of residual interest (pro-rata distribution) Be designated as a residual interest Have fixed terms Ensure that interest payments made prior to maturity are based on a fixed rate, a variable rate, or certain interest only instruments Be issued on the start-up day of the REMIC Not constitute a regular interest A REMIC can have multiple classes of regular interests. However, it can only have one class of residual interests, and all distributions on that class must be made pro rata to the residual interest holders. The 2004 Act, discussed further below, expanded the type of mortgages that could be placed into a REMIC to include home equity loans and reverse mortgages. Under the 2004 Act, an interest in a REMIC does not fail to qualify as a regular interest solely because the specified principal amount of such interest, or the amount of interest accrued on such interest, could be reduced as a result of the non-occurrence of one or more contingent payments on one or more reverse mortgages held by the REMIC provided that, on the start-up day for the REMIC, the REMIC sponsor reasonably believes that all principal and interest due under the interest will be paid upon or prior to the liquidation of the REMIC PwC

271 Taxation In addition, regular interests can be structured so that they are interest-only securities The assets test The assets test consists of two questions: Are the assets held by the entity considered qualified mortgages and permitted investments? If the entity holds assets other than qualified mortgages and permitted investments, do these other assets make up an insignificant portion of all of the assets? The assets test is satisfied when no more than a de minimis portion of the assets held by a REMIC are assets other than qualified mortgages and permitted investments. In other words, a substantial majority of the assets must be qualified mortgages and permitted investments. The entity must satisfy this test at all times, except for a de minimis amount and during the initial and final periods. The initial period is a threemonth period that starts on the start-up day. The final period is the liquidation period that begins on the date of adoption of the liquidation plan and ends after 90 days. In the following discussion, we discuss the meaning of qualified mortgages and permitted investments to determine what types of assets qualify an entity as a REMIC. Qualified mortgage A qualified mortgage can be defined as any one of the following: Any obligation that is principally secured by an interest in real property and transferred to the REMIC on or before the start-up day in exchange for regular or residual interests. An obligation principally secured by real property includes an increase in the principal amount under the original terms of an obligation, provided that the increase (i) is attributable to an advance made to the obligor pursuant to the original terms of the obligation, (ii) occurs after the start-up day of the REMIC, and (iii) is purchased by the REMIC pursuant to a fixed price contract in effect on the start-up day. An obligation that is purchased by the REMIC within three months of the start-up day, typically in accordance with a fixed-price contract created on the start-up day. Reverse mortgage loans and the periodic advances made to obligors on such loans. A regular interest in another REMIC that is transferred to the newly-created REMIC on the start-up day in exchange for a regular or residual interest. A qualified replacement mortgage. The 2004 Act, discussed further below, modified the definition so that each obligation transferred to (or purchased by) the REMIC will be treated as secured by an interest in real property if more than 50 percent of the obligations transferred to (or purchased PwC 6-19

272 Taxation by) the REMIC are originated by the United States, any state, or any political subdivision, agency, or instrumentality of the United States and are principally secured by an interest in real property (without regard to this statement). Real property is defined under the REMIC rules by reference to the REIT rules. 5 Under the applicable REIT rules, local law does not define what constitutes real property. Generally, real property means land, improvements to that land, and other inherently permanent structures. An interest in real property generally includes fee ownership, co-ownership, and leasehold interests. An obligation is principally secured in the following cases: The fair market value of the real estate securing property was at least 80 percent of the adjusted issue price at the time the obligation was originated or contributed to the REMIC. Substantially all the obligation proceeds were used to acquire, improve, or protect an interest in real property, which, as of the obligation date, is the only property securing the obligation. A qualified mortgage may be replaced during an initial three-month period. If an obligation in the asset pool is defective, this period is extended to two years. The question of whether a loan is a qualified mortgage is particularly relevant to commercial loans, since these borrowings can also be secured by equipment that might not meet the definition of real property. Similarly, if a loan has a high loan-tovalue ratio, it may not qualify as a mortgage if the value of the real property is less than 80 percent of the loan s adjusted issue price. Permitted investments Permitted investments in a REMIC include the following items, which are further defined below: Cash flow investments. Qualified reserve assets, which are any intangible property held as part of a qualified reserve fund (to ensure payment of REMIC expenses and compensate for defaults and delinquencies) and for investment purposes. Foreclosure property. Intangible investment property held as part of a reserve to provide a source of funds for the purchase of obligations as part of the modified definition of a qualified mortgage. 5 Treas. Reg G PwC

273 Taxation Cash flow investments are made with qualified mortgage payments for a temporary period (not exceeding 13 months) until the proceeds are distributed to the interest holders. For the purposes of the definition of qualified reserve assets, REMIC expenses would include qualified mortgage payments broadly defined to include the following: Payments of mortgage interest or principal. Payments under credit enhancement contracts. Proceeds from the disposition of a mortgage. Proceeds from the disposition of foreclosure property and cash flows from such property. Payments made by a prior mortgage owner or sponsor for breach of a customary mortgage warranty. Penalty payments for prepayment of a mortgage under the terms of a qualified mortgage. Foreclosure property includes real property that is acquired in connection with the default, or imminent default, of a qualified mortgage and generally held by a REMIC for no longer than two years from the date on which the property was acquired. Property is no longer deemed foreclosure property when any of the following conditions exist: The lease on the property provides for, or results in, non-qualifying rents. Construction is performed on the property, unless it began before the property was acquired by the REMIC. The property is used in a business (unless the trade or business is conducted through an independent contractor) and has been held by the REMIC for 90 days The arrangements test An entity satisfies the arrangements test when it makes reasonable arrangements or efforts to ensure both of the following conditions exist: Residual interests in the entity are not held by a disqualified organization, which could be a state or federal agency or an international organization that is exempt from taxation, including unrelated business income tax, under the IRC. Information is available to facilitate the imposition of the tax on transfers of residual interests on (1) disqualified organizations and (2) pass-through entities holding residual interests that are owned by disqualified organizations. PwC 6-21

274 Taxation Pass-through entities, such as trusts, LLCs, and partnerships may be subject to taxation if an interest in the pass-through entity is held by a disqualified organization. The required arrangements must remain in place throughout the life of the REMIC. They are not limited to transfers made in connection with the original distribution American Jobs Creation Act of 2004 (2004 Act) The 2004 Act expanded the REMIC rules by modifying the definitions of regular interests, qualified mortgages, and permitted investments so that certain types of real estate loans and loan pools can be transferred to, or purchased by, a REMIC. The intent was to allow for the securitization of home equity lines of credit and reverse mortgages, which are essentially revolving lines of credit secured by real estate. Although the 2004 Act allows the use of REMICs to finance home equity lines of credit (HELs), from a practical perspective, use of REMICs for financing HELs may be limited to pools with predictable future draws. The reason for this is that, although the 2004 Act allows for the REMIC to use a reserve to fund future draws, there is no provision that allows for the REMIC to hold anything other than cash and mortgages to fund the future draws. If a pool does not provide for predictable future draws that could be funded from a REMICs typical principal cash-flow from the mortgages, a large reserve of cash is required, which increases the sponsor s cost of funds. A provision allowing the REMIC to hold a letter of credit or other low cost supply of liquidity would have solved this problem Taxes imposed on the REMIC REMICs are not subject to entity-level tax in most circumstances. However, there are three entity-level taxes that could apply to REMICs: (1) 100 percent of net income derived from a prohibited transaction; (2) 100 percent tax on certain contributions made after the start-up day plus a three-month allowable period (a grace period); and (3) a tax at the highest corporate rate on certain income from foreclosure property. Most REMICs are structured and managed in a way that makes the application of such taxes rare. Prohibited transactions include the following: Receipt of income from non-qualified or non-permitted assets. Receipt of fees or other compensation for services rendered. Any disposition of a qualified mortgage other than a disposition that is: o o o A substitution of a qualified replacement mortgage for a qualified mortgage. Pursuant to the foreclosure, default, or imminent default of a qualified mortgage. Pursuant to bankruptcy or insolvency of the REMIC PwC

275 Taxation o o o Pursuant to a qualified liquidation. Necessary to prevent the default on a regular interest, where the threat of default resulted from a default of one or more qualified mortgages. Necessary to support a cleanup call. Realization of a gain that resulted from disposing of a cash flow investment other than a disposition pursuant to a qualified liquidation. A tax will not be imposed on a REMIC for cash contributions that meet the following conditions: Made within three months of the start-up day. Made to facilitate a cleanup call or qualified liquidation. Made as guarantee payments. Made to a qualified reserve fund by a residual interest holder. Allowed under the regulations. A REMIC may be subject to the highest marginal federal corporate income tax rate on income that would be considered net income from foreclosure property if the REMIC were a REIT. Income for this purpose excludes rents and gains from the sale of property that is not inventory Transferring assets to a REMIC When assets are transferred to a REMIC, the transferor (i.e., the sponsor of the REMIC) is deemed to receive both the regular and residual interests, with adjusted bases equal to the sum of the following: The aggregate adjusted bases of the transferred financial assets. Organizational expenses (e.g., legal and accounting fees) incurred in the creation of the REMIC. Such bases are allocated among the interests received in proportion to their respective fair market values (a measurement that may be similar to fair value under ASC 820 Fair Value Measurements, depending on the facts and circumstances). The REMIC has a basis in the transferred property equal to the fair market value of the property. Typically, the sponsor of a REMIC immediately sells all or most of the regular interest(s) received and recognizes a gain or loss on the sale that is equal to the difference between the cash received and the basis that was allocated to the sold regular interests. PwC 6-23

276 Taxation If the sponsor retains any regular interests, the built-in gain or loss on those interests (i.e., the difference between the assets bases, which has been allocated to the retained regular interest, and the financial assets fair market values) will be amortized over the weighted average life of the REMIC. Figure 6-2 Example of gain recognition upon the transfer of assets to a REMIC Taxpayer Y contributes financial assets with an aggregate adjusted tax basis of $80 to a REMIC. Two classes of regular interests (A and B) and one class of residual interest (R) are issued by the REMIC. A has a fair market value of $60, B has a fair market value of $40, and R has a fair market value of zero (a non-economic residual). The basis of each interest that Taxpayer Y receives in exchange for the financial assets contributed to the REMIC is determined by allocating the basis of all the contributed assets ($80) among the interests in accordance with their respective fair market values, as follows: A 80 60/100 = 48 B 80 40/100 = 32 R 0 Gain recognition is deferred until Y disposes of one or both regular interests. If Y sells A for $60 immediately after receiving such interest, $12 of gain (the $60 realized minus the $48 allocated basis) should be recognized. If Y retains B, the $8 deferred gain (the $40 issue price minus the $32 allocated basis) should be included in gross income, as though this amount were a market discount for the periods during which Y held the regular interest Taxation of regular and residual interest holders For tax purposes, regular interests are treated as debt instruments. The taxation of regular interest holders is discussed later in this Chapter (refer to TS 6.3). Residual interest holders are taxed on their allocable share of the daily portions of taxable income or net loss of a REMIC under the accrual method of accounting. Such income or loss is treated as ordinary. All or a portion of the taxable income of a REMIC is subject to special treatment under the excess inclusion rules, which mandate that the taxable income of a holder must be at least equal to its share of the excess inclusion of a REMIC for each quarter. In other words, even if a holder has a net operating loss, it must pay taxes on excess inclusion income. Definition of excess inclusion A holder s excess inclusion income for any calendar quarter is generally measured as the excess of the taxable income allocated to the residual interest over the income that would have accrued on the residual interest if it had yielded, from the time of its issuance, 120 percent of the long-term applicable federal rate (i.e., the rate that would have applied to the residual interest if it were a debt instrument). If the residual 6-24 PwC

277 Taxation interest initially had an insignificant value, then all taxable income would be excess inclusion income. Most residual interest holders generally are not permitted to use deductions or losses (including net operating loss carry forwards) to offset excess inclusion income. In other words, an interest holder s net taxable income cannot be reduced by losses to an amount that is less than the excess inclusion income. An example of this is a taxpayer that has $100 of losses from operations and $20 of excess inclusion income from a REMIC. The taxpayer has to pay taxes on the $20, even though it has losses from other sources. A residual interest holder must obtain appropriate information from the REMIC, its sponsor, or some other party to determine its share of the taxable income and excess inclusion income of a REMIC. This information is provided quarterly in Form 1066Q. Recognition of a loss A residual interest holder may recognize a loss from a REMIC only if the loss for any calendar quarter does not exceed the holder s adjusted basis in its interest as of the close of the quarter or time of disposition. A residual interest holder s adjusted basis is equal to the purchase price of the interest, increased by any taxable income that is reportable by the holder and decreased to a value of zero or more by (1) any cash distributions from the REMIC and (2) any loss that is reportable by the holder. Transfers to disqualified organizations In general, a tax is imposed on a person if he or she transfers a regular interest to a disqualified organization. This tax equals the product of the highest marginal federal corporate income tax rate times the present value of the future anticipated excess inclusion income on the interest. Certain transfers of a residual interest must be disregarded when tax collection from the transferee is unlikely. In such cases, the transferor is liable for the tax on income allocable to the residual interest. A transfer of non-economic residual interests to a U.S. person is disregarded if a significant purpose of the transfer is to impede the assessment or collection of tax. Similarly, a transfer of non-economic residual interests to a non-u.s. person will be disregarded and taxes will continue to be withheld on distributions, if the transfer allows the transferor to avoid the withholding tax on excess inclusions. Accordingly, a U.S. person cannot avoid taxes on excess inclusion income by transferring interests to a non-u.s. person Financial asset securitization investment trust (FASIT) The FASIT is a pass-through vehicle that was introduced by the Small Business Job Protection Act of The intent of a FASIT was to enable the securitization of a wide variety of debt obligations with short-term maturities, such as credit card receivables, home equity loans, and auto loans, in the same way that the REMIC facilitates mortgage securitizations. FASITs are similar to REMICs, except that FASITs could be used for non-mortgage debt instruments. The FASIT provisions were repealed by the 2004 Act because they proved to be unworkable in most instances. However, the repeal does not apply to FASITs in PwC 6-25

278 Taxation existence on October 22, 2004, the date on which the 2004 Act was passed. Therefore, regular interests issued by these entities prior to October 22, 2004, remain outstanding in accordance with their original terms. 6.3 How are the holders of debt instruments in securitizations taxed? A thorough discussion of securitization must include an examination of how the holders of debt instruments are taxed. This section applies to regular interest holders in a REMIC, which are generally taxed in the same manner as holders of debt instruments issued in other securitizations. A full analysis of the rules controlling taxation of debt obligations is beyond the scope of this publication, so this section simply outlines the governing principles Cash and accrual methods of accounting A taxpayer is generally required to utilize either the cash and disbursement method or the accrual method to account for interest on debt securities. The cash and disbursement method can be explained by the following: Interest is taken by the holder into gross income when it actually or constructively is received. Accrual method: Interest is included in gross income for a taxable year when all of the events have occurred that fix the right to receive the income and the amount of income can be determined with reasonable accuracy. Thus, interest income is economically accrued regardless of whether actual interest payments have been made. Prepayments of interest are included in gross income when actually received and deducted when actually paid. Interest income on debt securities can be classified into the following three general categories: Original issue discount. Market discount. Qualified stated interest (coupon interest that is subject to the rules of the cash and disbursement and accrual methods). In addition, qualified stated interest and original issue discount may be offset by a bond premium or an acquisition premium, respectively Original issue discount (OID) OID is the difference between the issue price of a debt instrument and its stated redemption price at maturity PwC

279 Taxation The OID rules recognize that the discount is the economic equivalent of interest on money, and should be subject to taxation in the same manner that currently paid interest is subject to taxation. OID rules require holders of debt instruments issued with OID to accrue the OID currently. In effect, this means subjecting all taxpayers to the accrual method of accounting, regardless of their accounting method for other purposes. A debt instrument s stated redemption price at maturity is defined as the sum of all payments provided by the debt instrument other than qualified stated interest. For this purpose, qualified stated interest is defined as stated interest that is unconditionally payable in cash or property (other than debt instruments of the issuer) at least annually at a single fixed rate. The holder of a debt instrument issued with OID is required to include in income the daily portion of the OID for each day the holder retains the security. The daily portion of the OID is calculated by dividing the increase in the debt instrument s adjusted issue price during each accrual period by the number of days in the accrual period. The accrual period is any length of time that is less than one year that ends on a scheduled principal and interest payment date. The debt instrument s adjusted issue price is its issue price increased by all prior daily accruals before the accrual period in question. The adjusted issue price is increased during an accrual period by an amount calculated as follows: [A]djusted issue price at the beginning of the accrual period multiplied by the debt instrument s yield to maturity (determined by compounding at the close of each accrual period and adjusted for the length of the accrual period) less the interest payable during the accrual period Floating rate notes that are issued with OID are governed by a special set of rules. In short, these rules convert floating rate notes into fixed rate notes to allow the OID to be accrued. Recognition of the floating rate coupon is not changed for this purpose. The OID rules also apply to regular debt instruments with set maturities. However, securities in securitizations are subject to prepayments, which are unknown. As a result, the OID on these instruments must be accounted for under the prepayment assumption catch-up (PAC) method of Section 1272(a)(6) of the IRC (i.e., the PAC method). The PAC method was designed to account for OID on obligations that have uncertain maturities, such as notes issued in securitizations. It uses a level yield approach that takes prepayment assumptions into account. Under Section 1272(a)(6) of the IRC, the portion of OID in an accrual period for debt instruments subject to the PAC method equals the following: [P]resent value of the remaining payments on a debt instrument at the close of the accrual period plus the principal payments received during the accrual period less the debt instrument s adjusted issue price at the beginning of the accrual period PwC 6-27

280 Taxation This amount is then allocated ratably to each day of the accrual period. The present value of the remaining payments is calculated with the yield to maturity and prepayment assumptions used at closing. The computation of OID for debt instruments in a securitization is a complex process that requires use of a financial model to calculate present value. Most taxpayers do not have the information or experience needed to make such calculations. Consequently, issuers are generally required to provide investors with information that allows the investors to calculate their monthly OID and interest accruals. For similar reasons, issuers are also required to provide investors with market discount factors that enable the investors to calculate market discount and potential premium amortization. Premium Premium is the excess of the amount payable on maturity over the basis of the debt instrument. Section 171 of the IRC generally allows the holder of a debt instrument purchased at a premium to amortize the premium from the date of purchase to maturity. Premium is amortized under the constant yield method. For taxable debt instruments, the amortized premium is applied as a direct offset to interest income and as a reduction of the debt instrument s basis. Thus, Section 171 is generally advantageous for taxpayers because it permits the premium to be amortized, thereby matching it to the interest received. For tax-exempt debt instruments, the annual amortization is simply a basis adjustment. If the premium is not amortized, it is allowed as a loss upon the sale or retirement of the instrument. This loss, and any loss on the sale or retirement of the debt instrument, is characterized as capital. The premium rules do not apply to debt instruments such as REMICs or other securitization debt to which the PAC method applies. Section 1272(a)(6) of the IRC does not discuss the treatment of premium instruments because it applies to instruments with OID. However, the Tax Reform Act of 1986 stipulates that premium can be amortized using the PAC method. Stripped bonds Section 1286 contains special rules that govern the taxation of stripped bonds and stripped coupons. A stripped bond is a bond that is issued with coupons for which there is a separation in ownership between the bond and any coupons that have not yet become due. A stripped coupon is a coupon that relates to a stripped bond. An example of a bond stripping transaction in a REMIC involves the transfer of receivables to a trust in exchange for IO strips (i.e., certificates representing rights to interest payments on the receivables) and PO strips (i.e., certificates representing rights to principal payments on the receivables) that can be sold to investors. The yields of IO and PO strips are very sensitive to changes in the rate of prepayments of the underlying receivables. In general, increases of prepayments reduce the yield on 6-28 PwC

281 Taxation IO strips and increase the yield on PO strips. Consequently, IO and PO strips issued in securitizations are governed by the rules of Section 1272(a)(6) discussed above. The net effect of the volatility of these securities is that the taxable income of the holder increases or decreases in tandem with the volatile yield Market discount Market discount is the excess of a bond s stated redemption price at maturity over the taxpayer s basis in the bond, immediately after acquisition. If a debt security has declined in value since issuance, a purchaser of the security will acquire it with a market discount. In contrast, a debt security that is originally issued at a discount to its stated redemption price at maturity is issued with OID. Although market discount is economically the same as OID, the rules governing its taxation differ from the OID rules. For example, a holder of a debt security issued with a market discount is not required to recognize amortization of the market discount on a current basis. A holder of a debt security may be subject to both market discount and OID rules. Thus, a bond issued with OID is considered to be issued with a market discount if it was acquired at a discount to the bond s adjusted issue price (i.e., issue price of the bond plus accrued OID). Accounting for market discount A holder of a debt security acquired with a market discount can record the discount in the following two ways: Under the first method, which is similar to a cash basis approach, the discount is recorded upon receipt of proceeds from the disposal of the bond or receipt of principal payments. Under the second method, a holder can elect to accrue market discount currently under the OID rules (i.e., the Section 1278 election, which permits matching the recognition of the OID to the interest cost on the related debt). If the election is made, it applies to all market discount bonds held by the taxpayer and the taxpayer is required to continue to use that method unless it receives consent from the IRS to change its method of accounting. If the holder of a note issued with a market discount incurred debt to acquire or finance the note, the holder cannot deduct interest payments on the related debt until the market discount is accrued. Accordingly, the deduction of interest payments on the debt cannot be deferred if the Section 1278 election is made. PwC 6-29

282 Taxation The U.S. Treasury has been authorized to issue regulations to determine the amount of accrued market discount on an obligation such as a REMIC regular interest for which principal is payable in installments. Until these regulations are issued, holders of such instruments may elect to accrue market discount in the same manner as any of the following: OID. Debt instruments that have OID in proportion to the accrual of OID. Debt instruments that have no OID, in proportion to payments of stated interest. The issuers of obligations subject to the PAC method are required to report information necessary to calculate accruals of market discount Acquisition premium An instrument has been purchased at an acquisition premium if a debt instrument with OID is purchased in the secondary market at a price that is less than the debt instrument s remaining stated redemption price, but greater than the debt instrument s adjusted issue price. The acquisition premium is amortized by applying a fraction (i.e., initial acquisition premium divided by the remaining unamortized OID as of the purchase date) to the amount of OID allocable to each accrual period. The acquisition premium amortization reduces the amount of OID that can be included in each accrual period. 6.4 What are Taxable Mortgage Pools? The Taxable Mortgage Pool (TMP) rules, which were enacted in conjunction with the REMIC rules, are designed to prevent income generated by a pool of real estate mortgages from escaping federal income taxation, if the pool is used to issue multiple class mortgage-backed securities. Utilizing a pool of real estate mortgages in this way makes REMICs the exclusive vehicle for issuing multiple classes of real estate mortgage-backed securities without entity-level tax. A TMP is an entity other than a REMIC, or a portion of an entity other than a REMIC, that satisfies the following three tests: Substantially all of the entity s assets must be debt obligations, and more than 50 percent of these obligations must be real estate mortgages or interests in those mortgages. The entity must be the obligor under debt obligations with different stated maturities. Under the regulations, debt obligations have two or more maturities if they have different stated maturities or if the holders of the obligations possess different rights related to accelerating or delaying the maturities of these obligations. Payments on these debt obligations must bear a relationship to payments on the debt obligations that the obligor holds as assets. An obligor s payments on debt 6-30 PwC

283 Taxation obligations bear a relationship to payments on debt obligations that it holds as assets if the following condition is met: The timing and amount of payments on the liability obligations are, in large part, determined by the timing and amount of payments (projected or otherwise) on the asset obligations. This relationship is best described as the relationship between payments coming into a securitization and the requirement that such payments be used to service the debt in a securitization. However, in certain instances this definition may be broader. Entities and portions of entities that issued debt on or after January 1, 1992, qualify as a TMP. They are treated as separate corporations that cannot be included in a consolidated return. Further, as TMP classification does not alter the taxation of a TMP as a corporation (with limited exceptions), the general rules governing corporations must be consulted to determine the proper tax treatment of TMPs and their owners. The TMP rules generally apply to entities or portions of entities that qualify for REMIC status but do not elect to be taxed as REMICs. These rules also apply to certain entities or portions of any entities that do not qualify for REMIC, such as trusts, corporations, partnerships, LLCs, etc. The TMP rules include an anti-avoidance provision that allows the IRS to convert transactions into TMPs if these transactions are entered to achieve the same economic effects as a TMP, but to avoid the TMP rules. Sponsors of securitizations should carefully consider the potential applicability of the TMP rules to assets they want to securitize, so that the BRE is not subject to an entitylevel tax. For example, franchise loans may not appear to be real estate mortgages, but these loans are typically secured by qualifying real estate. If the franchise loans meet the definition of a real estate mortgage or an interest connected to these mortgages, issuing debt with varying maturities will cause the TMP rules to apply if a REMIC election is not made. An entity must use the federal income tax basis of an asset in determining (1) whether substantially all its assets consist of debt obligations or interests and (2) whether more than 50 percent of those debt obligations or interests consist of real estate mortgages. The TMP regulations require that the determination of whether substantially all of an entity s assets are debt obligations be based on the relevant facts and circumstances, but they do not specifically indicate which facts or circumstances are relevant. However, if less than 80 percent of the entity s assets are debt obligations, the TMP rules do not need to be applied. This provides entities with a safe harbor. Real estate mortgages that are seriously impaired (e.g., a single-family residential real estate mortgage that is more than 89 days delinquent or a multi-family residential or commercial real estate mortgage that is more than 59 days delinquent) should not be treated as debt obligations. The tax basis of these assets must be determined by assuming that the entity is not a TMP. PwC 6-31

284 Taxation 6.5 How are servicing assets and servicing liabilities treated for tax purposes? ASC 860 does not distinguish between the following for accounting purposes, although these distinctions are important for tax purposes: Normal and excess servicing (to the extent that both normal and excess servicing are part of the contractually specified servicing fees). Purchased and originated servicing rights. Mortgage and non-mortgage servicing rights. Originators and sponsors of a securitization that transfer financial assets to an SPE usually retain the right and obligation to service the assets for a fee. The servicing contract generally stipulates that the servicer is entitled to: Receive an annual percentage of the outstanding principal balance on the loans to be serviced. Retain other income received in the course of servicing. Revenue Procedure provides a safe harbor to ensure that the amount the servicer is entitled to receive under a mortgage servicing contract does not exceed reasonable compensation for the services provided. This reasonable compensation can be as high as 25 basis points. There is no similar safe harbor provision for securitizations of non-mortgage assets. However, originators and sponsors of securitizations generally follow industry standards to determine reasonable servicing. Where compensation for servicing is considered reasonable, the tax sale of a loan and the servicing contract should be treated separately. However, if the servicing fee exceeds reasonable compensation, special tax rules apply. The excess amount, referred to as excess servicing, should be treated as a stripped interest right (stripped coupon) and the underlying loan should be treated as a stripped bond. The originator of the securitized loans that receives such excess servicing is deemed to retain an ownership interest in a portion of the interest payments on the underlying loans. Basis is allocated between the stripped bond and stripped coupons based on their fair market values. Consequently, gain or loss is recognized when the stripped bond is sold. Basis allocation prevents artificial losses upon the sale of the stripped items. The fair market value of a stripped bond is equal to the amount for which it is sold, while the fair market value of a stripped coupon is based on a fair value assessment. Following the tax sale, the bases of the stripped bond and stripped coupons are increased by the amount included in the owner s gross income. The holder is treated as having purchased, on the date of sale, the retained stripped bond and stripped coupons for an amount equal to the basis allocated to them PwC

285 Taxation Figure 6-3 Example of excess servicing An auto loan with principal of $100 and an interest rate of 12 percent is sold with a 2 percent servicing charge to a BRE. The BRE sponsors a securitization in which securities are backed by auto loans issued at a face value of $100 and a net interest rate of 10 percent. Assume that, based on industry standards, a reasonable fee for servicing this loan is equal to 1 percent of the principal balance on the loan. The amount by which the servicing fee exceeds a reasonable servicing fee (i.e., 1 percent = 2 percent minus 1 percent), is deemed to be excess servicing and is therefore treated as a stripped coupon. Assume that the fair market value of the stripped coupon is $3. Basis allocation is as follows: Basis allocated to sale of debt: $100 (basis of original debt) 100/103 = $97.09 Basis allocated to stripped coupon: $100 3/103 = $2.91 Gain = $100 (sale price) minus $97.09 (basis) = $ Chapter wrap-up The tax implications of structured finance transactions are far-reaching. For example, sale analysis under ASC 860 and under corresponding tax rules (of which there may be several) may shed light on only a small portion of the applicable tax issues and consequences. Therefore, sponsors and investors need to analyze the transactions from many different perspectives to assure there are no unfavorable or unanticipated tax effects. This document is not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. It is not intended to be tax advice or an opinion with respect to any specific transaction. Persons who are considering entering into a securitization should consult their tax advisor or PricewaterhouseCoopers LLP to determine the specific tax aspects of the transaction or whether to invest in such a transaction. PwC 6-33

286 Chapter 7: International considerations PwC 1

287 International considerations Structures commonly used within the U.S. to transact securitizations often differ from those used outside the U.S. as a result of tax, regulatory, and legal considerations. For example, in the U.S., securitizations often use a two-step structure. In contrast, securitizations in other countries may use a one-step structure by which a transferor sells to a securitization entity. In those jurisdictions, a transferee entity is commonly structured to meet the requirement for legal isolation. This Chapter is relevant to companies that report under U.S. GAAP and conduct transactions to transfer financial assets that involve foreign jurisdictions. It provides an overview of some of the legal and accounting matters that need to be considered when conducting these transactions. The accounting considerations have been limited to an overview of the differences between IFRS and U.S. GAAP as they relate to transfers of financial assets. Depending on the jurisdiction and the relevant financial reporting requirements, other GAAP may need to be considered. Key questions answered in this chapter Page in this publication How well do legal opinions prepared outside the U.S. meet the need for a legal opinion under ASC 860? How do IFRS and U.S. GAAP differ regarding derecognition of financial assets? How well do legal opinions prepared outside the U.S. meet the need for a legal opinion under ASC 860? Under U.S. GAAP, a legal analysis is required to support the conclusion that the transferred financial assets have been isolated from the transferor. (Refer to ASC through and to discussion in TS 2.2.4) Differences between the legal standards in the U.S. and other countries require special attention to determine if the isolation requirement is met. In this section, we discuss why it is important to evaluate legal opinions in foreign jurisdictions. Key questions to consider include the following: Does the legal opinion prepared outside the U.S. meet the requirements in ASC 860 in all areas for which a legal analysis is required? Specifically, does the legal opinion address the principles underlying the true sale and substantive consolidation requirements? Does the legal opinion cover all the relevant jurisdictions of the parties involved in the transfer of financial assets? 7-2 PwC

288 International considerations The need for a legal opinion is a concept that may be unfamiliar to many attorneys outside the U.S. because such an opinion is not generally needed to meet the requirements of non-u.s. accounting standards that provide guidance for transfers of financial assets (e.g., IFRS). In some cases, legal opinions for transactions outside the U.S. may be prepared at the request of rating agencies. However, modifications to the opinions are often necessary because for a legal opinion to meet the requirements in ASC 860 (e.g., requirement to consider involvement of consolidated affiliates of the transferor, refer to TS 2.2.3) it should go beyond the general requirements of the rating agencies. The specific language in ASC 860 is written with U.S. law in mind. The true sale and substantive consolidation opinions (refer to TS 2.2.4) may not be relevant legal concepts in other jurisdictions. For this reason, the opinion language used in other countries to demonstrate that the isolation requirements have been met will likely differ from the language used in the U.S. opinions, but the opinion language in other countries should still opine on the following: The assets have been irrevocably transferred The assets are legally isolated, even in the event of a bankruptcy The court would not recharacterize the transfer as a secured borrowing In the U.S., legal opinions are structured differently than in other countries. For example, opinions in foreign jurisdictions are not typically reasoned opinions, a common approach to writing opinions in the U.S. This can be attributed, at least in part, to different legal environments. The relevant law in most jurisdictions is a statutory civil law (rather than the common law that governs in the U.S.), and often relevant precedent is lacking in most jurisdictions. For example, in some countries (such as France), there are laws that specify a series of steps for a sale of financial assets to result in legal isolation of the transferred financial assets, which reduces the extent to which reasoned judgments are needed. It is important to verify that the opinions cover all of the relevant jurisdictions. An attorney will generally opine on the law of his/her expertise, typically the legal jurisdiction in which the transferor is located, and will explicitly assume that no other law is relevant. Clearly this single- or limited-jurisdiction opinion would not be adequate when the transferor has subsidiaries in multiple jurisdictions that are all transferring financial assets to a single transferee. The opinion would also prove inadequate if the legal documents governing the overall transaction were governed by yet another law. This typically occurs when some or all of the transferors are located in countries where corporate law is not well established or when the transferee is located in a tax-beneficial country. A limited-jurisdiction opinion is also inadequate when the underlying contract giving rise to the financial asset (e.g., a loan agreement between the transferor and its customer) is governed by another law. For example, consider an Italian bank with branches in Italy and Spain that are transferring loans governed by Italian or Spanish law to an entity based in the Channel Islands in a transaction governed by English law. The legal opinion on the transaction needs to address the law in Spain, Italy, and the PwC 7-3

289 International considerations Channel Islands. Additional implications will arise for companies in the European Union because European Union Law continues to develop. When the transferee is located in a different country than the transferor, a legal opinion prepared outside the U.S. often assumes that the transferee has been properly established under law. The verification of such an assumption might require a legal opinion prepared by an attorney from the jurisdiction in which the transferee was established. 7.2 How do IFRS and U.S. GAAP differ regarding derecognition of financial assets? Although U.S. GAAP and IFRS converge in some areas, the two are fundamentally different with respect to derecognition of financial assets. IAS 39 is the current authoritative guidance under IFRS. This guidance has been included unchanged in IFRS 9, which is effective for annual periods beginning on or after January 1, 2015, with early adoption permitted. The guidance under IFRS focuses on risk and rewards and to a lesser extent on control, while U.S. GAAP focuses on control (including legal sale). In practice, the fundamental differences are: Under U.S. GAAP, derecognition can be achieved in certain circumstances even if the transferor has significant continuing involvement with the financial assets, such as the retention of significant exposure to credit risk. Under IFRS, full derecognition generally cannot be achieved unless substantially all of the risks and rewards are transferred Scope The IFRS model does not permit many securitizations to qualify for full derecognition. Most transactions include some continuing involvement by the transferor that causes the transferor to retain substantial risks and rewards related to the transferred financial assets a situation that may preclude full derecognition under IAS 39 and IFRS 9, but not under ASC 860. Despite the requirements having been in place for a few years, implementation of some aspects of the IFRS derecognition model remain challenging in particular, interpreting the pass through criteria, applying the risks and rewards test, and applying continuing involvement accounting. The scope of the respective standards is very similar in that both, IFRS and U.S. GAAP, address financial assets and exclude sales of future revenues. There is no standard that specifically covers the sale of future revenues under IFRS. However, in practice those transactions are accounted for as borrowings. Future revenue transactions are addressed in U.S. GAAP in ASC 470. Also, the sale of interests in consolidated subsidiaries is not within the scope of either IFRS or U.S. GAAP derecognition models and is covered by IAS 27 and SIC 12 (for annual periods beginning on or after January 1, 2013, it will be covered by IFRS 10 which replaces the consolidation guidance of IAS 27 and SIC 12) and ASC 810, respectively. 7-4 PwC

290 International considerations One commonly encountered scope difference involves unguaranteed residual value related to a capital lease. Under IFRS, an unguaranteed residual value is treated as part of the lessor s financial asset and, therefore, its derecognition is subject to IAS 39 (or IFRS 9 once effective or early adopted). Under U.S. GAAP, an unguaranteed residual value is deemed an interest in the underlying asset (e.g., the equipment subject to the lease). As a result, the transfer of an unguaranteed residual value is subject to ASC 840 (i.e., the unguaranteed residual is recorded by the lessor as part of its investment in the capital lease) Application IAS 39 and IFRS 9 include a flowchart (Figure 7-1) that summarizes the appropriate methodology for applying the requirements of the standard for derecognition. Figure 7-1 IAS 39 flow chart 1 : Applying the Standard 1 Source: IAS 39, paragraph AG36, which is copyrighted material of the IFRS Foundation. Reprinted with permission of the IFRS Foundation. The same flow chart is included in IFRS 9 paragraph B PwC 7-5

291 International considerations Consolidation before derecognition Under IFRS, the transferor must first apply the consolidation guidance (IAS 27 and SIC 12 or IFRS 10 once effective or early adopted) and consolidate any and all subsidiaries or SPEs that it controls. Similarly, under U.S. GAAP, consolidation guidance in ASC 810 is applied before considering ASC 860. However, as discussed and illustrated later, consolidation of an issuing SPE does not preclude derecognition under IFRS, whereas the transfer likely would fail sale accounting under ASC 860 if an issuing SPE is consolidated by the transferor under U.S. GAAP. Consider, for example, the two-step U.S. securitization model (refer to TS 1.6 for an example of a two-step securitization model). Under IFRS, an entity would first apply IAS 27 and SIC 12 (or IFRS 10 once effective or early adopted) to determine whether both the bankruptcy remote entity (BRE) and the issuer SPE should be consolidated. For most securitizations, it is likely that both the BRE and the issuer SPE would be consolidated due to the level of risk retained by the transferor and its power over the entity. If that is the case, then IAS 39 (or IFRS 9 once effective or early adopted) would be applied to the transaction between the consolidated group as the transferor and the beneficial interest holders as the transferees Defining the asset The next step is to determine whether the analysis should be applied to a part of a financial asset (or part of a group of similar financial assets) or to the financial asset in its entirety (or a group of similar financial assets in their entirety). The derecognition requirements should be applied to a part of a financial asset (or part of a group of similar financial assets) only if the part being considered for derecognition meets one of the following three conditions: The part comprises only specifically identified cash flows from a financial asset (or a group of similar financial assets). The part comprises only a fully proportionate (pro rata) share of the cash flows from a financial asset (or a group of similar financial assets). The part comprises only a fully proportionate (pro rata) share of specifically identified cash flows from a financial asset (or a group of similar financial assets). The above criteria should be used to determine whether the derecognition model should be applied to the whole financial asset or to only a part of the financial asset. If none of the above criteria are met, the derecognition model is applied to the financial asset in its entirety (or to the entire group of similar financial assets). Therefore, the financial asset in a disproportionate transfer (e.g., transferor retains the first 10 of losses from an asset with a face amount of 100) can only be defined as the entire financial asset for purposes of applying the derecognition model. U.S. GAAP also requires consideration of certain specified criteria included in ASC A for transfers of portions of financial assets to be subject to the derecognition criteria. If a transfer of a portion of a financial asset does not meet the participating interest definition under U.S. GAAP, the entire financial asset must 7-6 PwC

292 International considerations continue to be recognized until such time as the transferor has transferred all of its interest and can meet the sale criteria. Compared to U.S. GAAP, IFRS has a broader definition of financial asset for which the derecognition criteria can be applied Is there a transfer? One of the conditions for derecognition under IAS 39 and IFRS 9 is that the financial asset (as defined in TS ) has been transferred. IAS 39 and IFRS 9 identify two ways in which a transfer can be achieved. An entity transfers a financial asset only if it either: transfers the contractual rights to receive the cash flows of the financial asset, or retains the contractual rights to receive the cash flows of the financial asset, but assumes a contractual obligation to pay the cash flows to one or more recipients, in what is often referred to as a pass-through arrangement. Regarding the first type of transfer, IAS 39 and IFRS 9 do not explain what is meant by the phrase transfers the contractual rights to receive the cash flows of the financial asset. A literal reading of the words would suggest an asset s legal sale, or a legal assignment of the rights to the cash flows from the asset. For example, an entity that has sold a financial asset (such as a legal sale of a bond) has transferred its rights to receive the cash flows from the asset. In this situation, the transferee has unconditional, currently exercisable rights to all the future cash flows. However, some types of financial asset (for example, a receivable or a portfolio of receivables) cannot be sold in the same way as other types (for example, a bond), but they can be transferred by means of a novation or an assignment. We believe that both novation and assignment will generally result in the transfer of contractual rights to receive the financial asset s cash flows. Any conditions or obligations placed upon the transferor should be considered and may impact this assessment. However, servicing the transferred assets after the transfer does not preclude this criterion from being satisfied. Regarding the second type of transfer, the pass-through test is met when a transferor retains the contractual rights to the cash flows, but assumes a contractual obligation to pass the cash flows on to one or more recipients in an arrangement under which the transferor: Has no obligation to pay to the recipients unless it collects equivalent amounts from the original financial asset. This generally means that note holders cannot be paid out of guarantees, reserve funds (unless funded by cash collected from the transferred financial asset), or other cash flows from the entity, such as swaps entered into separately with a consolidated issuing SPE. It also means that the entity must not be obligated to fund any cleanup call. Is prohibited by the terms of the transfer contract from selling or pledging the original financial asset other than as security to the eventual recipients. Thus, financial assets can be sold to third parties, such as on a cleanup call, so long as the funds are utilized to pay off the note holders. PwC 7-7

293 International considerations Has an obligation to remit any cash flows it collects on behalf of eventual recipients without material delay. In the meantime, it may reinvest such cash flows, only in cash and cash equivalents with interest in such investments passed on to the note holders. The pass-through test typically will apply to securitizations in which the issuing SPE is consolidated and to loan participations. Figure 7-2 In a securitization, the transferor may consolidate the transferee SPE pursuant to SIC 12 (or IFRS 10 once effective or early adopted). Since the contractual cash flows reside with the transferor (via the SPE), the pass-through criteria mentioned above must be evaluated. Many securitizations may not meet these pass-through criteria. A common form of securitization, the revolving facility, generally does not meet the last criterion and will therefore not achieve derecognition under IAS 39 and IFRS 9. Typically, a revolver uses the cash received on the original asset to purchase additional receivables for the facility during the revolving period; hence, the recipients do not receive the cash collected without material delay, and the cash collected is reinvested in assets other than cash and cash equivalents. On the other hand, providing credit enhancements via over-collateralization does not prevent the transfer from meeting the pass-through requirements. For example, a transferor sells 10,000 of receivables to a consolidated SPE for an up-front cash payment of 9,000 and a deferred payment of 1,000. The SPE issues notes of 9,000 to investors. The transferor will only receive the deferred payment of 1,000 if sufficient cash flows from the receivables remain after paying amounts due to investors. This provides credit enhancement to the note-holders in the form of over-collateralization that is, the transferor suffers the first loss on the transferred assets up to a specified amount. Provided that other pass-through requirements are met, the overcollateralization does not prevent the transfer from meeting the requirement for no obligation to pay the recipient unless it collects equivalent amount from the original asset. It is difficult to make a direct comparison of the IFRS transfer conditions with U.S. GAAP, as meeting these transfer conditions under IFRS only permits the transferor to move further down the flowchart to perform the risks and rewards test; whereas under U.S. GAAP, meeting the transfer conditions results in sale accounting. The examples in TS highlight the similarities and differences. 7-8 PwC