Guide to Accounting for Transfers and Servicing of Financial Assets

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1 Guide to Accounting for 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. This publication has been updated to reflect new and updated authoritative and interpretive guidance since the 2012 edition. 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publication is based on information available as of May 31, Accordingly, certain aspects of this publication may be superseded as new guidance or interpretations emerge.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. Portions of FASB Accounting Standards Codification, copyright by Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, are reproduced by permission.

3 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

4 Table of Contents Executive Summary... 1 Chapter 1: Introduction and Scope of Topic 860 Overview of ASC Key Questions Answered in This Chapter 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 Key Questions Answered in This Chapter 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 Table of Contents / 1

5 2.2.2 Transfer of a Financial Asset or Group of Financial Assets With Continuing Involvement by the Transferor Involvement of Consolidated Affiliates of the Transferor Legal Support for Determination of Isolation Applicability of Legal Opinions Received for Previous, Similar Transactions Use of an External Legal Opinion Analysis of a Legal Opinion Consideration of Transferor s Continuing Involvement and Arrangements or Agreements Made in Connection With a Transfer 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 Exchange or Pledge 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) Isolation of Transferred Financial Assets Transferee Right to Pledge or Exchange the Financial Assets Transferor Effective Control Chapter 3: Accounting for Sales-Type Transfers Key Questions Answered in This Chapter 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 Assets Obtained and Liabilities Incurred (Proceeds Received in the Transfer) Calculation of Gain or Loss on Sale / Table of Contents

6 3.2 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 Key Questions Answered in This Chapter When Should a Transfer Be Accounted for as a Secured Borrowing? Financial Assets That Are the Same or Substantially the Same Substantially the Agreed Terms Repurchase or Redemption Before Maturity at a Fixed or Determinable Price Entered Into at the Same Time as the Transfer What Is the General Accounting Model for Secured Borrowings? How Should Collateral Be Recognized? Cash Collateral Noncash Collateral What Is the Appropriate Accounting for a Repurchase Agreement? Accounting for Repurchase Agreements Accounting for Linked Repurchase Financing Transactions 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 Table of Contents / 3

7 4.7 Chapter Wrap-Up PwC s Questions and Interpretive Responses Chapter 5: Servicing of Financial Assets Key Questions Answered in This Chapter 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? 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 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 Key Questions Answered in This Chapter / Table of Contents

8 6.1 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? How Are Servicing Assets and Servicing Liabilities Treated for Tax Purposes? Chapter Wrap-Up Chapter 7: International Considerations Key Questions Answered in This Chapter 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 Table of Contents / 5

9 7.2.4 Developments Chapter 8: Effective Date, Transition, and Disclosures Key Questions Answered in This Chapter What Are the Effective Dates and Transition Provisions of the Most Recent Amendments to ASC 860? What Are the Disclosure Requirements of ASC 860? Disclosure Objectives and Aggregation of Disclosures Specific Disclosure Requirements Other Presentation Matters What About Some Disclosure Examples Consistent With the Requirements in ASC 860? Appendix A Technical References and Abbreviations... A - 1 B Glossary of Terms... B - 1 C Summary of Changes from 2012 Edition... C / Table of Contents

10 Executive Summary Executive Summary / 1

11 Executive Summary FASB ASC 860, Transfers and Servicing, has proven difficult to apply in practice. Acknowledging this, in 2009 the FASB amended ASC 860 to address practice issues highlighted most recently by events related to the economic downturn. The sweeping impact of this guidance and its amendments on securitizations and financial asset transfer activity is significant for financial companies, but it extends beyond the financial sector and highlights the need for all companies to gain a precise knowledge of its accounting implications. The table below summarizes the more significant changes made by the FASB in the more recent amendments to ASC 860 and compares them to the guidance applicable prior to the effective date of the amendments. Topic QSPEs Transfer of a portion of a financial asset Derecognition Criterion: Consideration of all arrangements Derecognition Criterion: Legal isolation Derecognition Criterion: Constraint ASC 860, as Amended The QSPE concept is eliminated. QSPEs will be subject to the consolidation model in ASC 810 for variable interest entities. As a result, many QSPEs will be consolidated by the transferors of financial assets to the entity. For the transfer of a portion of a financial asset to be eligible for sale accounting, that portion and the portion retained by the transferor must meet the definition of a participating interest. All arrangements in connection with the transfer need to be considered, including those entered into contemporaneously or in contemplation of the transfer. Clarifies the requirement that a transferred financial asset must be legally isolated from the transferor and its consolidated affiliates. The ability to look through the transferee to the beneficial interest holders to determine whether they have the ability to sell or pledge the assets is expanded to all transferees in securitization or asset-backed financing arrangements. ASC 860, Prior to Amendments Transferors of financial assets to entities that meet the criteria for QSPEs can achieve sale accounting even if the transferee does not have the right to sell or pledge those assets. All transfers of a portion of a financial asset are eligible for sale accounting. Silent on whether all relevant arrangements need to be considered, with exception of an initial transfer and a repurchase financing entered into contemporaneously. Requires that a transferred financial asset must be legally isolated from consolidated affiliates of the transferor, but was not specifically included in the legal isolation paragraph (ASC (a)). The transferee must be able to sell or pledge the assets in order for the transfer to be eligible for sale accounting. If the transferee is a QSPE, its beneficial interest holders must have that ability. (continued) 2 / Executive Summary

12 Topic Gain or loss calculation Transfers to a guaranteed mortgage securitization (GMS) ASC 860, as Amended Beneficial interests in the transferred financial asset(s), other than participating interests, obtained by the transferor are considered to be the proceeds of the sale with the carrying amount of the transferred financial asset in its entirety included for the purpose of calculating the gain or loss on sale. The guidance for calculating the gain or loss on a sale of a portion of a financial asset has not changed. Eliminates the exception allowing for classification of mortgage loans as ASC 320 securities or to recognize a servicing asset or servicing liability when transferring mortgage loans to a GMS in a transfer that does not meet the sale criteria. ASC 860, Prior to Amendments Beneficial interests in the transferred financial asset(s) obtained by the transferor are considered to be an interest retained in the transferred financial asset. The amount allocated to the portion sold (for the purpose of calculating the gain or loss on sale) and the beneficial interest obtained is determined by allocating the financial asset s carrying amount based on relative fair values. Allows a transferor to reclassify mortgage loans to ASC 320 securities and recognize a servicing asset or servicing liability in transfers of mortgage loans in a GMS transaction, even if the transfer does not meet the sale criteria. This Guide is intended to help issuers, deal makers, and accountants understand this ASC Topic and its amendments, apply the rules to deals, and understand the related accounting treatments. Securitization is notorious for its complexity especially in the areas of business, finance, and accounting. There is a great deal to know, and even seemingly minor details can make a difference in how a transaction is accounted for. It is not all about knowing the accounting rules, however; sound judgment is also necessary to make prudent and appropriate decisions. Transfers and/or securitization transactions subject to the requirements of ASC 860 generally include mortgage loans, mortgage servicing, trade receivables, credit card receivables, auto loans, loan participations, repurchase transactions, and securities lending, among other transaction types. Tasked with bridging the gap between the rules as written and the practical reality of transactions, companies have struggled to comply with the transfer guidance while continuing to structure their deals in ways that make market sense. As more companies undertake securitizations, both domestically and internationally, the opportunity for diversity in accounting practice expands. ASC 860 in its initial release represented a robust effort to match transactional reality with suitable accounting treatments. More recent amendments issued on this guidance represent further efforts to acknowledge industry practice while remedying some of the accounting problems that have come to light. The amendments will not solve all of the outstanding issues, but they increase clarity in key areas. This Guide is an introduction for newcomers to ASC 860, as amended, and its related guidance and an update for those experienced in accounting for these types of transactions. The opening Chapter introduces topics explored in later chapters in depth, ranging from broad issues, such as the challenges of implementation, to specific issues, such as participating interest accounting treatment. Executive Summary / 3

13 The Challenges of Application ASC 860, as amended, specifies narrow requirements that, if met, result in offbalance sheet treatment. The rules detailed by the guidance cannot, however, accommodate all of the different transfer and/or securitization structures that could potentially exist. For this reason, the key challenge for preparers in applying the guidance is to ensure that its intricate accounting rules are applied only to transactions that are clearly within its scope a task easier said than done. Transfer and/or securitization transactions rely on the underlying deal documents. To properly account for or audit a transfer and/or securitization, one must carefully assess all pertinent information and understand the complete transaction. The complexity of transfer and/or securitization transactions and corresponding accounting rules make it difficult both for accountants who prepare and those who audit financial statements to understand all of the elements that comprise a particular transaction. Because most transactions are unique, the accounting interpretation for one transaction can rarely be applied to another. As a consequence, the financial experts who created the transaction must play a significant role in applying the accounting rules to the transaction. One clause in a contract can disqualify a transaction from receiving a particular, desired accounting treatment. Auditors, in turn, must evaluate the structure and determine whether the accounting rules have been properly applied. To apply ASC 860 successfully, companies must overcome three key challenges: (1) understanding the complete transaction, (2) navigating the complexity of the rules, and (3) ensuring access to accounting and legal personnel qualified to address that complexity. Some companies may not have the sophistication to completely understand the structures and need assistance to apply the rules. The complexity of the guidance places these companies in danger of inappropriately interpreting and applying ASC 860. As the trend toward greater transparency in financial reporting increases, more companies are structuring their transfer and/or securitization transactions so that they appear on the balance sheet. Regardless of whether they seek on- or off-balance sheet treatment, however, many companies have responded to the difficulties of accounting for and reporting transfers and/or securitizations by increasing the time and resources dedicated to interpreting the finer details of the authoritative accounting guidance, seeking help from external advisors and standard setters, and expanding their systems for and controls over the transactions. Misapplication and Diversity in Practice Although intended to increase transparency and refine the requirements for offbalance sheet treatment, the complexities of the guidance have produced divergent interpretations among companies and auditors. The rules of ASC 860 that must be followed to achieve sale treatment are particularly challenging. Evaluating the sale criteria can be a complex and muddled undertaking. Sometimes a company with a structure that might qualify for sale treatment will add clauses on the advice of management or legal counsel. However, in so doing, the company might inadvertently change the transaction so that the structure no longer qualifies for sale treatment. Lacking full knowledge of the structure in its original and modified forms, companies sometimes mistakenly believe that a particular transaction still qualifies for sale treatment when, in fact, it does not. 4 / Executive Summary

14 To achieve sale accounting under ASC 860, transferors historically utilized a QSPE. A QSPE was deemed a passive vehicle that had little to no decision-making power. In the recent amendments to the guidance the QSPE concept was eliminated. These securitization entities are now subject to the consolidation model in ASC 810 for variable interest entities. As a result, many securitization entities will be consolidated by the transferors of financial assets to the entity. The amendments also added specific requirements that must be met for a transfer of a portion of an entire financial asset to meet sale accounting, which further complicates the evaluation of transfers in which less than full title and ownership is being transferred. Additionally, companies sometimes overlook the need to re-recognize the financial assets when the sale fails to continue to satisfy the requirements for sale accounting treatment. Other areas susceptible to misapplication include (1) failing to consider all arrangements entered into contemporaneously with, or in contemplation of, the transfer, when assessing whether a transaction meets the derecognition criteria and (2) failing to consider all forms of continuing involvement in the transferred financial assets by the transferor and its consolidated affiliates and agents. The Benefits of Derecognition From lottery winnings to record royalties, the increasing number of different asset types that can be securitized drives the exponential growth of the marketplace for securitizations. Participants attempt to securitize any and all assets which, in their view, qualify for securitization. Companies seek derecognition of financial assets for numerous reasons. Generally, the broad objective is to increase available capital or to obtain a discounted borrowing rate by legally isolating assets in certain vehicles, such as trusts. Derecognizing financial assets can provide companies with improved balance sheet ratios, increased return on equity, improved regulatory capital position, enhanced liquidity, the ability to convert receivables to cash, and additional funding resources. Business growth is often a key motivator in the decision to derecognize. If companies transfer assets to a trust or third party, they will receive proceeds which can then be used to expand business, pay down debt, or otherwise enhance the balance sheet. Securitization transactions also provide investors with certain benefits that are unavailable in the more traditional corporate security market. An essential feature of an institutional investor s diversified portfolio, structured transactions offer financial rewards associated with investments in different asset classes without direct ownership of the underlying assets. Other benefits of investing in such transactions include potentially improved returns, protection from bankruptcy of the transferor, and, in some cases, improved credit quality. Evaluating a Transaction for Derecognition When evaluating transactions for derecognition, companies should assess their structures well in advance of any deadlines and seek appropriately experienced resources. Because one sentence in a contract or the interplay of a few provisions can affect the accounting treatment, it is important to consult accountants and lawyers as early in the process as possible. Companies must consider the ways in which a transfer might be recharacterized and prevent the maximization of benefits to the investor in the asset. If the transaction involves the transfer of an interest or a portion of an entire financial asset, companies should allot sufficient time to evaluate and understand the structure and its evaluation under the participating interest requirements. In light of this, the Executive Summary / 5

15 evaluation process becomes exceedingly important. Companies must make certain that the appropriate resources are available to help when the transaction occurs. Accounting for beneficial interests in the transferred financial assets, an area of accounting with its own complex rules, generally relies on sophisticated evaluation techniques and cash-flow forecasting. When maneuvering the complexities associated with beneficial interests, companies should consider the implications of recourse and constraints sought by the transferor or transferee, whether to structure a transaction using a one- or two-step entity structure, and whether a true sale and a non-consolidation opinion are required to demonstrate legal isolation from the transferor and its consolidated affiliates in the financial statements being presented. Operational preparedness, internal controls, and risk management are other topics that should be systematically discussed. The complexity associated with transfers and/or securitization transactions also stems from the wide range of objectives that companies may have for derecognition. Those objectives may not be limited to the accounting but may also include tax objectives. In the U.S., securitization structures can qualify for tax deductions, but companies must navigate their way through all of the relevant tax rules to obtain optimum tax treatment. Derecognition in Other Legal Jurisdictions ASC 860 requires that transferred financial assets be isolated from a bankruptcy estate if the assets are to be accounted for as a sale rather than as a secured borrowing. From an accounting perspective, this isolation must be confirmed by a legal opinion. The task of obtaining such an opinion is further complicated by transactions that occur in other legal jurisdictions. A company evaluating a securitization transaction abroad is still required to demonstrate from a legal perspective that the assets have been isolated and that the transferor has surrendered effective control. Consequently, companies should consider whether the legal opinions they obtain cover the jurisdictions that govern the transfer and whether the lawyers consulted are qualified to offer legal advice in the governing jurisdiction. Depending on the number of jurisdictions and legal opinions involved, these formalities could significantly complicate the accounting for the transaction. When transfers of financial assets occur across borders, the assets are often subject to both IFRS and U.S. GAAP. The models for derecognition prescribed by IFRS and ASC 860 are fundamentally different. IFRS guidance for securitizations relies primarily on a risk and rewards model to determine whether derecognition is appropriate, while ASC 860 focuses on an effective control model that considers whether the transferor still effectively controls the financial assets. Under IFRS, full derecognition cannot be achieved unless substantially all of the risks and rewards are transferred. Under U.S. GAAP, derecognition can be achieved even if the transferor has significant ongoing involvement with the financial assets, such as considerable exposure to credit risk. Accordingly, companies must be familiar with the overlapping and conflicting rules under IFRS and U.S. GAAP. Foreign private issuers that develop, register, and sell securities to companies in the U.S. are tasked daily with reconciling these two conflicting models. Further, because each country may have its own set of laws for bankruptcy and true sales, first-time issuers may be unfamiliar with the process of appropriately applying the rules and may need to obtain legal opinions to satisfy isolation requirements under U.S. GAAP. 6 / Executive Summary

16 Internal Controls Companies are required to design and maintain internal controls that ensure the reliability and accuracy of their financial reporting. This means ensuring that companies have the correct resources in place to make appropriate decisions regarding accounting policy and financial reports. Processes must be properly defined, documented, and controlled with regard to the validity, accuracy, completeness, and security of transactional data. Key controls regarding securitizations include those related to the development and approval of assumptions used in the valuation models, the proper application of accounting principles, and the use of service organizations, specialists, and spreadsheets. Many companies continue to track securitization activities and evaluations in spreadsheets. The adequacy of spreadsheet controls can be critical to management s assessment of the effectiveness of the company s internal controls over financial reporting since increasing use of spreadsheet methodologies can increase data integrity risk and make companies vulnerable to control issues. Companies using spreadsheets may find it difficult to manage the authorization to change fields and formulas in the spreadsheet and to ensure that access to controls are limited to qualified personnel. Consequently, they may consider it preferable to migrate the information to an application that functions within a more formalized information-technology control environment. Controls are especially important because they can involve the monitoring of parties across the organization and interactions among financial reporting, legal, operations, and investor reporting. The investors involved in the actual securitization transaction want comfort that proper controls exist over the information reported to them monthly by issuers and that the information is appropriately distributed. Because investors require a certain level of information, the transferor, who typically remains the servicer, must maintain appropriate reporting functions to service investor needs on a monthly or quarterly basis, depending on the specific transaction, in accordance with Regulation AB. In keeping with Sarbanes-Oxley s goal of improved transparency in financial reporting, companies implementation plans for ASC 860 should emphasize clarity, consistency, and control. Convergence With IFRS In late 2009, the FASB finalized their project to amend and improve its requirements related to the derecognition of transfers of financial assets. The results of such improvements and amendments are incorporated into this updated Guide. In October 2010, the IASB issued amendments to IFRS 7, Disclosures Transfers of Financial Assets, which are effective for annual periods beginning on or after July The amendments broadly align derecognition disclosure requirements. The IASB also indicated that they would conduct a post-implementation review of the application of these amended requirements during At such point, the IASB would make a decision about the nature and scope of any further improvement and convergence efforts. As of the date of this publication, a decision is still pending from the IASB. The FASB also released an exposure draft in January 2013 to amend the accounting for transfers with repurchase agreements to repurchase assets and for repurchase financings in response to stakeholder concerns that repurchase agreements are generally viewed as financing transactions and should be accounted for as such. The Executive Summary / 7

17 FASB is in the process of redeliberating this exposure draft and it is expected that certain key aspects of the proposal may change. Conclusion The amendments to ASC 860 elicited strong reaction from market participants. The amendments came in response to perceived flaws in the accounting model governing transfers of financial assets, highlighted by events related to the economic downturn. The amendments to the guidance on transfers of financial assets were made in conjunction with amendments to the consolidation guidance. Together these changes aim to improve the visibility of off-balance sheet structures currently exempt from consolidation and address practice issues involving the accounting for transfers of financial assets as sales or secured borrowings. While this long-anticipated amendment has clarified some of the most contentious technical issues, it is yet to be seen whether the amendments will completely eradicate diversity in this area of accounting. The journey to consistency will surely be long and challenging. It will require the support, cooperation, and dedication of all concerned parties standard setters, companies, auditors, attorneys, and the entire financial community. At some point in the future, we expect that the FASB and the IASB will converge their respective guidance. But, given the inherent complexity of these transactions, even the achievement of that important milestone may not relieve management, auditors, and attorneys from the challenges of transfers and/or securitization accounting. 8 / Executive Summary

18 Chapter 1: Introduction and Scope of Topic 860 Introduction and Scope of Topic 860 / 1-1

19 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. The FASB also released an exposure draft in January 2013 to amend the accounting for transfers with repurchase agreements to repurchase assets and for repurchase financings in response to stakeholder concerns that repurchase agreements are generally viewed as financing transactions and should be accounted for as such. The FASB is in the process of redeliberating this exposure draft and it is expected that certain key aspects of the proposal may change. See TS 4.1 for further details of this exposure draft. 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. 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. 1-2 / Introduction and Scope of Topic 860

20 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 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. Introduction and Scope of Topic 860 / 1-3

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