Guide to Accounting for Transfers and Servicing of Financial Assets

Transcription

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publication is based on information available as of May 31, Accordingly, certain aspects of this publication may be superseded as new guidance or interpretations emerge.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

21 The following flowchart summarizes the basic accounting framework that should be utilized in determining the proper accounting for transfers of financial assets. Exhibit 1-1: Framework for Accounting for Transfers of Financial Assets* Does the transaction involve a transferee that is a consolidated affiliate of the transferor? See (TS 1) No Does the transaction involve financial asset(s)? See (TS 1) Yes No Yes Does the transaction meet the definition of a transfer? See (TS 1) Yes No Transaction is NOT subject to ASC 860 (Consider other GAAP such as ASC , ASC 840, ASC 972) Does the transfer meet any of the scope exceptions? See (TS 1) Yes No See TS 2 (Control Criteria) * For the purposes of this exhibit, 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). 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 ? 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 1-4 / Introduction and Scope of Topic 860

22 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: 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 860- Introduction and Scope of Topic 860 / 1-5

23 (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 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 evaluated as 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 1-6 / Introduction and Scope of Topic 860

24 many types of instruments and contracts that exist in today s market for which the determination is less clear. Exhibit 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 860. Exhibit 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 Notes and trade receivables Repurchase agreements, dollar rolls, and securities lending arrangements Lease residual values that are guaranteed at lease inception 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 costmethod 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. Notes and trade 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. 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. (continued) Introduction and Scope of Topic 860 / 1-7

25 Description Sales-type and direct-financing lease receivables Investment securities Analysis 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. Exhibit 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 860. Exhibit 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 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. (continued) 1-8 / Introduction and Scope of Topic 860

26 Description 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 Legal settlements-no contractual payment plan Non-performing loan previously written off Property taxes receivable Sale of future revenues Sales taxes receivable Servicing rights Shareholder note-classified in equity Securitized stranded utility costs Treasury stock Analysis 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. 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. Once a loan has been written off under GAAP, it is no longer a recognized financial asset. 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 contra-equity account. Thus, it is not a financial asset. (continued) Introduction and Scope of Topic 860 / 1-9

27 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 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 / Introduction and Scope of Topic 860

28 1.3.1 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. 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, sales-type and directfinancing 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 Certain receivable factoring arrangements Typical Financing-Type Transfers Repurchase or reverse repurchase agreements (e.g., treasuries and overnights) Securities lending arrangements Secured borrowings Pledges of collateral Bond swaps Introduction and Scope of Topic 860 / 1-11

29 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 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 is 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 / Introduction and Scope of Topic 860

30 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. 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. (continued) Introduction and Scope of Topic 860 / 1-13

31 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. 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 1-14 / Introduction and Scope of Topic 860

32 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 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 Introduction and Scope of Topic 860 / 1-15

33 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 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 (continued) 1-16 / Introduction and Scope of Topic 860

34 d. Contributions (for guidance on accounting for contributions, see Subtopic ) 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. 1.5 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? Introduction and Scope of Topic 860 / 1-17

35 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 1-6-1: 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 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 (continued) 1-18 / Introduction and Scope of Topic 860

36 financial assets and obtain a true sale in situations where the sponsor has continuing involvement in the transferred financial assets. Transfer Financial Assets Sponsor BRE Financing Agreement Obligor Recognized Financial Asset Cash* Cash* 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 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 Introduction and Scope of Topic 860 / 1-19

37 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 1-6-2: Commercial Paper Conduit (CP Conduit) A CP Conduit is an application of the concept of securitization that is commonly used for the funding of trade receivables or loans. The two-step structure described previously may be used for this type of transfer. Sponsors that want to liquidate their trade receivables transfer these assets to a BRE. The BRE then does one of two things: It either transfers the same trade receivables or loans to a trust, which then issues interests to a CP Conduit, or it transfers interests directly to the CP Conduit. At times, the CP Conduit is sponsored by a banking institution that also provides liquidity support to ensure timely redemption of the paper. Transfer Financial Assets Sponsor BRE Cash Financing Agreement Obligor Recognized Financial Asset Cash Transfer Financial Assets Periodic payments Periodic payments Servicer Cash * Transfer Financial Assets * CP Conduit (SPE) Administration, liquidity line and other credit enhancements Issuer (SPE) Sponsoring Bank CP periodic payments Cash Administration Fee Investors * 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. Certain of these CP Conduit securitization structures have been set up to transfer an undivided interest or a portion of the cash flows of a financial asset to the CP Conduit. Prior to the most recent 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. Under the concept of undivided interests, the tenant s rights to the cash flows generated from the entire financial assets were established on a pro rata or non-pro rata basis. A pro rata right would be, for example, the right to receive 50 percent of all cash flows. A non-pro rata right would be, for example, the right to 1-20 / Introduction and Scope of Topic 860

38 receive (1) cash flows relating to all the interest, referred to as an interest-only (IO) strip, or (2) cash flows relating to all of the principal, referred to as a principal-only (PO) strip. After the amendments to ASC 860, undivided interests no longer exist and were substituted with a new participating interest concept. As a result, transferors/ sponsors attempting to complete CP Conduit securitization transactions will need to evaluate these interests to determine if they meet the new participating interest rules. Due to the overcollateralization provided by the transferor/sponsor whereby the interest retained is subordinated to the interest transferred (transferor/sponsor covers first losses), it is expected that most of these structures will fail to meet the new participating interest criteria. As a result, these securitizations will 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. If consolidated, the transfer of financial assets between the transferor/sponsor and the issuer SPE will be eliminated in consolidation and thus the ultimate transaction with the third party investors will represent the issuance of debt from a consolidated standpoint. The CP Conduit will also need to be evaluated for consolidation, although it is expected that oftentimes the banking entities sponsoring these CP Conduits will be the likely consolidator, primarily as a result of their involvement in the design, the credit enhancements and liquidity facilities they offer the conduit, their administrator role and related fees, etc. Example 1-6-3: Factoring Arrangement for Trade Receivables Many companies transfer trade receivables in either traditional factoring arrangements or to bank-sponsored commercial paper conduits. Under traditional factoring arrangements, a transferor transfers entire trade receivables (or portions thereof) at a discount to a financial institution. For some of these transfers, the consideration is completely paid up front and for others there is partial cash consideration and a deferred payment feature ( holdback ) for which collection is contingent on the performance of the underlying trade receivables. As discussed in this chapter, the first step in evaluating transfers of trade receivables is to evaluate whether the transfer is subject to the participating interest rules of ASC 860. The determination of whether a transfer represents a transfer of a portion of the cash flows of the trade receivables (i.e., subject to the participating interest requirements), rather than a transfer of the trade receivable in its entirety, is based 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 become clear that a company has transferred the rights to the entire cash flows from its trade receivables to a financial institution. As consideration, a transferor may receive all cash upfront or could receive, for example, 90 percent of the proceeds upfront, with 10 percent ( holdback ) of the proceeds due when the trade receivable is collected from the customer. Under both scenarios, so long as the legal opinion and transaction documents clearly support the transfer of full title and interest in the receivables, the transfer will not be subject to the participating interest rules. (continued) Introduction and Scope of Topic 860 / 1-21

39 In assessing transfers of trade receivables using CP Conduits, the assessment of whether the participating interest requirements apply is based on the legal form of the second step of the transaction (i.e., transfer of an undivided ownership interest in the receivable from the BRE to the CP Conduit). This is because the BRE is generally a wholly-owned consolidated subsidiary of the transferor (under ASC 810). Understanding whether the legal transfer in the second step is that of the entire asset should be based on a review of the overall contractual arrangements governing the transaction. In many transactions, the underlying contracts specify that the legal transfer is of rights to the cash flows from the underlying pool of trade receivables in the form of an undivided ownership interest. Such undivided ownership interest would represent a portion of an asset and therefore be subject to the participating interest rules. In these structures, the transferor typically maintains exposure to first dollar credit losses, and because of this subordination, these transfers would typically fail the participating interest rules and would need to be accounted for as secured borrowings. CP Conduit structures continue to evolve. We have observed structures in practice that would appear to represent a legal transfer of the entire trade receivable. Under these alternative structures, the second-step of the transfer represents a transfer of the entire trade receivable in return for partial cash consideration and a note for the remainder of the purchase price, which is subordinated to the performance of the receivables transferred (the Deferred Purchase Price Structure (DPP)). In general, a legal opinion is not obtained for the second step because of the use of a BRE, and the fact that through a true sale opinion in the first step and a non-consolidation opinion the transaction taken as a whole would be viewed as legally isolating the assets. As a result, the legal analysis as to whether the second step of the transaction represents a transfer of the entire trade receivable becomes increasingly difficult. To determine whether the second-step of the transaction is or is not subject to the participating interest rules, the commercial and economic substance of the terms, transactions and arrangements should be evaluated. We believe that to reach a conclusion that the transfer is that of the entire receivable, the underlying transaction documents should address the following factors: Acknowledgment that the transfer between the BRE and CP Conduit is that of the entire financial asset (versus a portion of the financial asset). That is, full title to the pool of receivables is being transferred to the CP Conduit. Acknowledgment that the BRE acting as transferor on the transfer to the CP Conduit, is also a creditor of the CP Conduit with respect to the DPP or any other interest issued to the BRE (versus the BRE being a creditor to the trade receivable customer). Acknowledgment that the CP Conduit acting as transferee effectively becomes a creditor with respect to the obligor(s) (customer) of the underlying receivables (versus the BRE being a creditor to the trade receivable customer). Acknowledgment by all parties to the structure, that none of the assets obtained or liabilities incurred can be legally offset. That is, we would not expect the CP Conduit to legally offset the new receivables acquired against the obligation to the BRE as a result of the DPP. We would expect the legal documents underlying the transaction to be consistent with the four factors above. This would support the assertion that full title to and ownership of the trade receivables is being transferred to the CP Conduit in the second step and thus that the participating interest rules do not apply / Introduction and Scope of Topic 860

40 Example 1-6-4: 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 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. Credit Card Financing Agreement Obligor Sponsor Credit Card payments Recognized Financial Asset Cash * Transfer Financial Assets Servicer BRE Cash * Transfer Financial Assets Master Trust (SPE) Credit Card payments Securities ** Cash Securities ** Cash Issuance Trust 1 Issuance Trust 2 Securities ** Cash Securities ** Cash Investors Investors * 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. Introduction and Scope of Topic 860 / 1-23

41 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. Example 1-6-5: 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. Transferor/ Sponsor Cash Transfer Financial Assets (Debt Securities) Collateral Manager Management fee Management agreement Issuer (SPE) Tranche A Securities Cash Tranche B Securities Cash Tranche C Securities Cash Tranche A Investor Tranche B Investor Tranche C Investor 1-24 / Introduction and Scope of Topic 860

42 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. Example 1-6-6: 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. (continued) Introduction and Scope of Topic 860 / 1-25

43 Collateral Manager Management fee Management agreement Cash Premium Market Issuer (SPE) Counterparty Highly Rated Securities Credit Default Swap Tranche A Securities Cash Tranche B Securities Cash Tranche C Securities Cash Tranche A Investor Tranche B Investor Tranche C Investor 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 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 ) / Introduction and Scope of Topic 860

44 1.7.2 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: 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. (continued) Introduction and Scope of Topic 860 / 1-27

45 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. 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. (continued) 1-28 / Introduction and Scope of Topic 860

46 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). (continued) Introduction and Scope of Topic 860 / 1-29

47 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 broker-dealer 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. (continued) 1-30 / Introduction and Scope of Topic 860

48 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-be-announced 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 Interpretive 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, 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. (continued) Introduction and Scope of Topic 860 / 1-31

49 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 asset-backed 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 characteristics-presentation 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 Interpretive 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. 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 / Introduction and Scope of Topic 860

50 Question 1-4: Are VAT receivables considered financial assets that can be securitized in accordance with ASC 860? PwC Interpretive 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 startup 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 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 Interpretive 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 sales-type 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. Introduction and Scope of Topic 860 / 1-33

51 1.7.3 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 Interpretive 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. 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 Interpretive 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. (continued) 1-34 / Introduction and Scope of Topic 860

52 Before transferring the loan interest, Company X did not recognize the loan upon consolidation of the VIE, because the loan was eliminated as an intercompany 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 third-party 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 Interpretive Response: It depends. Certain structures exist where the holder of a partially government-guaranteed 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 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 (continued) Introduction and Scope of Topic 860 / 1-35

53 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 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 / Introduction and Scope of Topic 860

54 Question 1-9: 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 Interpretive Response: Transferors of trade receivables under factoring arrangements with holdbacks or 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 shortterm 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). Cash Flow Statement: Based on an analogy to an SEC speech given at the 2005 AICPA National Conference on Current SEC and PCAOB Developments, transferors have typically classified the cash inflows of the holdback or DPP as investing cash flows when collected. This resulted in a reduction of operating cash flows in the statement of cash flows and a general view by preparers that this classification did not properly reflecting the economic substance of the transaction. Even though the 2005 speech was not specific to this structure, in the speech the staff said that the cash flow classification for retained interests in securitizations should be driven by the method a company uses to account for such instruments. Because the holdback and DPP are not an instrument the transferor/sponsor generally plans to actively trade, and because they are now a receivable legally due from the financial institution or CP Conduit and not the obligor (customer), generally their nature and purpose was determined to be investing. However, we are aware that based on a recent SEC staff preclearance, transferors executing these transactions may make a policy election to classify collections on the holdback or DPP as operating or investing, if they do not already have an accounting policy that addresses this. The SEC staff communicated to the registrant that it would not object to operating cash flow treatment for the inflow from collection of the DPP subject to the following conditions: Separate line item Cash flows from the DPP should be stated on a separate line item within the operating section of the statement of cash flows (this is only required for Form 10-K and not for Form 10-Q filings). (continued) Introduction and Scope of Topic 860 / 1-37

55 Accounting policy disclosure Separate disclosure of its accounting policy (i.e., operating cash flow policy) and its basis for such policy should be provided (for both Form 10-K and 10-Q filings). Carefully evaluate interest rate risk It is important to note that in reaching their conclusion, the SEC staff carefully considered the registrant s interest rate risk exposure on its DPP. In the fact pattern considered, the registrant demonstrated that the interest rate risk associated with the DPP was de minimis, since the receivables transferred to the CP Conduit were 60-day receivables (i.e., short maturity) and impacted by the weighted average commercial paper rate of the entity (i.e., reset). The staff believed this was an important element in reaching their no objection conclusion Transfers Scoped Out of ASC 860 Question 1-10: Do the provisions of ASC 860 apply to not-for-profit organizations? PwC Interpretive Response: Yes. The scope of ASC 860 makes no distinction between a for-profit and a not-for-profit 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 Interpretive 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 criteria 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 / Introduction and Scope of Topic 860

56 Chapter 2: Control Criteria for Transfers of Financial Assets Control Criteria for Transfers of Financial Assets / 2-1

57 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) 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 should also be considered: Excerpt from ASC : 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 ] Excerpt from ASC A: 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. (continued) 2-2 / Control Criteria for Transfers of Financial Assets

58 Excerpt from ASC B: 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 c. Effective control The guidance above sets forth three broad criteria that must be met for control of the transferred financial assets to be passed to the transferee. In addition, 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 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, would prevent the transferor from derecognizing the transferred financial assets and would require that the transaction 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. Recent amendments to the guidance also make clear the importance of considering all continuing involvement of the transferor and all of its consolidated affiliates included in the financial statements being presented as part of the legal isolation evaluation (parent involvement shall not be considered when evaluating transfers between sister companies as support for the stand-alone financial statements of the subsidiaries). This was already mentioned in prior guidance, however, the importance of considering the transferor s consolidated affiliates was not apparent to some because it was not previously specified in ASC (a). In addition, the amendments require consideration of any arrangement or agreement made in connection with a transfer, even if it was not entered into at the time of the transfer. The remainder of this Chapter will discuss and provide perspective on the highlighted areas of the ASC 860 basic framework regarding control and the nuances involved in applying them. Control Criteria for Transfers of Financial Assets / 2-3

59 Exhibit 2-1: Framework for Accounting for Transfers of Financial Assets 1 Does the transaction involve a transferee that is a consolidated affiliate of the transferor? See (TS 1) Yes No Does the transaction involve financial asset(s)? See (TS1) No Yes Does the transaction meet the definition of a transfer? See (TS1) No Transaction is NOT subject to ASC 860 (Consider other GAAP such as ASC , ASC 840, ASC 972) Yes Does the transfer meet any of the scope exceptions? See (TS 1) Yes No Is the transfer eligible for sale accounting (i.e., involve a financial asset, group of financial assets, or a participating interest (see right flowchart) in an entire financial asset)? (TS 2) Yes Does the transfer meet all of the control criteria of ASC ? a. Have the financial assets been isolated from the transferor (and its consolidated affiliates) and its creditors? (40-5(a)) Portion Yes No If a transfer of a portion of a financial asset, does the interest transferred and the interest retained meet the participating interest definition in ASC A? All the following criteria must be met: a. Does it represent a pro rata ownership interest in an entire financial asset? (40-6A(a)) Yes b. Are all cash flows from the entire financial asset divided among the participating interest holders in proportion to their ownership share? (40-6A(b)) No No Yes Yes b. Does the transferee (or if a securitization/ asset-backed financing entity, each beneficial interest holder) have the right to pledge or exchange the transferred financial assets? (40-5(b)) No c. Do the rights of all participating interest holders have equal priority and none is subordinated? (40-6A(c)) Yes No Yes c. Has the transferor maintained effective control of the transferred assets? (40-5(c)) Yes d. Does any party have the right to pledge or exchange the entire financial asset without agreement by all participating interest holders? (40-6A(d)) No Yes No The portion is a participating interest. See TS 3 (Accounting for Sales-Type Transfers) See TS 4 (Accounting for Financing-Type Transfers) 1 For the purposes of this exhibit, 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. 2-4 / Control Criteria for Transfers of Financial Assets

60 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? 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? Paragraphs in ASC Page in This Publication 40-4A, 40-4B, 40-6A (a), 40-7 through (b), through (c), through 40-39, and 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. However, transfers of portions of financial assets do not result in the legal transfer of full title and ownership. As discussed in TS 1.3.2, prior to the recent amendments to ASC 860, these transfers were more commonly referred to as transfers of undivided interests or participations. An undivided interest was defined as: A partial legal or beneficial ownership of an asset as a tenant in common with others. The proportion owned may be pro rata, for example, the right to receive 50 percent of all cash flows from a security, or non-pro-rata, for example, the right to receive the interest from a security while another has the right to the principal. After the recent amendments to ASC 860, which are effective for all transfers completed on fiscal years beginning after November 15, 2009, a transfer of a portion of a financial asset needs to comply with the definition of a participating interest in order to be subject to the derecognition guidance in ASC A transfer of a portion that does not meet the participating interest definition must be accounted for as a secured borrowing until the transferor transfers all of its interest or the interest subsequently meets the participating interest guidance and can 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. Control Criteria for Transfers of Financial Assets / 2-5

61 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 considerations of the terms of the sale. Sales of financial assets directly to third parties with no continuing involvement by the transferor (e.g., credit enhancement, servicing responsibilities, or rights to residual cash flows from the assets) will generally be straightforward and qualify for sale treatment, 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 (i.e., whether it must be consolidated). 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. 2-6 / Control Criteria for Transfers of Financial Assets

62 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 & warranties. 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 simply transfers entire financial assets or group of entire financial assets to a third party 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 (i.e., credit enhancement), nor does it have 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 Chapter 3 (refer to TS 3)). If these transactions include the transfer of loans, they are often referred to as whole loan sales with servicing released. Exhibit 2-2 provides a visual depiction of a basic transfer without continuing involvement. Control Criteria for Transfers of Financial Assets / 2-7

63 Exhibit 2-2: Transfer With No Continuing Involvement Company A Financial Asset(s) Cash Company B 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 in the cash flows from the financial assets to third-party investors (these interests are often referred to as beneficial interests ). A trust may issue different classes of beneficial interests, whereby a senior class of beneficial interests would receive the cash flows generated from the financial assets of the trust before a more subordinate interest. This subordination of cash flows is a form of credit enhancement (structural), as any credit risk related to the financial assets in the trust will be pushed down to the lower classes of beneficial interests. The lowest interest class, typically referred to as the residual, receives any remaining cash flows generated by the financial assets of the trust after all other classes are paid their shares. 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. Obtaining sale accounting under ASC 860 is not based on whether the transferor has any continuing involvement in the transferred assets, but rather on whether control of the financial assets was ceded. The continuing involvement must be analyzed to determine whether the involvement affects the isolation of the assets from the transferor or otherwise provides the transferor with control of the transferred assets. 2-8 / Control Criteria for Transfers of Financial Assets

64 In evaluating the transferor s continuing involvement, all available evidence shall be considered, including, but not limited to, all of the following: 1. Explicit written arrangements 2. Communications between the transferor and the transferee or its beneficial interest holders 3. Unwritten arrangements customary in similar transfers. The nature and extent of support required to satisfy the assertion that a transferred financial asset has been isolated depends on the facts and circumstances of each transaction. All available evidence that either supports or raises questions about this assertion should be considered. Legal counsel is often sought, especially in situations where the transaction is complex or nonrecurring or if the rights of the parties are subject to interpretation. See TS below for a discussion of when a legal opinion is required Involvement of Consolidated Affiliates of the Transferor Recent amendments to ASC 860 clarified that the transferred financial assets must be isolated not only from the transferor, but also from its consolidated affiliates that are included in the financial statements being presented. A financial asset may or may not be isolated if a consolidated affiliate has continuing involvement in the transferred financial assets, such as providing servicing or credit enhancements. A consolidated affiliate is defined as: ASC : An entity whose assets and liabilities are included in the consolidated, combined, or other financial statements being presented. However, an entity that is designed to make remote the possibility that it would enter bankruptcy or other receivership (bankruptcy-remote entity) is not considered a consolidated affiliate for purposes of performing the isolation analysis. In addition and as discussed in TS 1.1, in transfers between entities under common control (i.e., Subsidiary A to Subsidiary B), the parent s involvement is ignored for purposes of the legal isolation analysis Legal Support for Determination of Isolation ASC 860 states that in order for transferred financial assets to be considered 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 the consideration of whether the transfer is a legal true sale, and in some circumstances whether the transferee would be substantively consolidated into the bankruptcy estate of the transferor (nonconsolidation opinions are discussed later in this Chapter). The determination of whether the transfer of financial assets constitutes a legal true sale is a legal determination rather than an accounting determination. A legal analysis under the laws of the applicable jurisdiction should be performed to verify that the transfer meets the legal isolation criterion. Control Criteria for Transfers of Financial Assets / 2-9

65 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 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 in the event of bankruptcy or other receivership regardless of how remote or probable bankruptcy or other receivership is at the date of transfer. That is, the requirement would not be satisfied simply because the likelihood of bankruptcy of the transferor is determined to be remote. Refer to TS 2.4 in this Chapter 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 transactions 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 truesale-at-law 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, 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. A transferor and its consolidated affiliates are not required to have limited or no recourse in the transferred financial asset in order for the transfer to be considered a legal true sale. However, the level of recourse is one of the many attributes of a transaction that lawyers consider in determining whether the transaction meets the isolation test. In some foreign jurisdictions, for instance, a transfer may be considered a legal true sale even if the transferor has full recourse to the assets transferred to the transferee. The regulations imposed by the legal jurisdiction in which the transaction is conducted generally dictate whether the financial assets are considered to be isolated. 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 the forms of continuing involvement when evaluating whether a true-sale-at-law exists. This analysis may be even more complex on transactions executed under foreign legal jurisdictions (refer to TS 7) / Control Criteria for Transfers of Financial Assets

66 Nonconsolidation Opinion A true-sale-at-law opinion provides support that the transferred financial assets have been legally isolated from the transferor and its consolidated affiliates. However, a true sale does not mean that the transferee will not be substantively consolidated into the bankruptcy estate of the transferor. If the transferred financial assets can be substantively consolidated into the bankruptcy estate of the transferor, then the financial assets are not considered isolated under ASC 860. Consequently, a nonconsolidation opinion may also be required to confirm that the transferee will not be substantively consolidated into the bankruptcy estate of the transferor. Since the concept of substantive consolidation does not exist in many foreign jurisdictions, such an opinion might not be required in such jurisdictions so long as the true sale opinion clearly reflects that the financial assets were isolated from the transferor and its consolidated affiliates. Substantive consolidation is a judicially created doctrine arising from the general equity powers granted to bankruptcy courts. Although no specific provision of the U.S. Bankruptcy Code expressly authorizes a court to order substantive consolidations, 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. Given that the power to order substantive consolidation derives from the jurisdiction of the bankruptcy court, the issue is determined on a case-by-case basis. The decision reflects the court s examination and a number of other items, which 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 the 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 would be unduly prejudiced. Substantive consolidation has been used with similar effect to extend the debtor s bankruptcy proceeding to include in the debtor s estate the assets of a related entity that is not a debtor. The court can only consolidate estates for certain claims (e.g., unsecured claims), not for all claims. While the matter can be addressed in various procedural contexts by litigation brought during the case, it is not inappropriate to propose substantive consolidation in a Chapter 11 plan. Generally, under the substantive consolidation doctrine, if a wholly owned SPE meets certain conditions, it would not be legally consolidated with its parent in a bankruptcy proceeding, even though it may be wholly owned and consolidated for financial reporting purposes. Such an entity is generally referred to as a bankruptcy remote Control Criteria for Transfers of Financial Assets / 2-11

67 entity ( BRE ). Generally, the following conditions must be achieved, at a minimum, for a BRE to be considered an entity that is legally separate from its parent. The BRE: Does not commingle its assets with those of its parent or related affiliates (the transferor). Maintains separate corporate and financial records from the transferor. Maintains separate corporate minutes from the transferor. Maintains separate bank accounts from the transferor. Observes corporate formalities. Has at least one independent director on its board of directors. Conducts its activities separate from those of the transferor. Pays its obligations with its own funds (i.e., it does not use the funds of its parent to satisfy its obligations). 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 or the involvement of 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. 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 / Control Criteria for Transfers of Financial Assets

68 The Exhibit 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. Exhibit 2-3: Framework for Determining the Extent of Legal Evidence Required to Support Legal Isolation Under the Topic 860 Is the transfer a routine transfer with NO continuing involvement? Yes No Does management have experience in other transfers with similar facts and circumstances under the same applicable laws and regulations? Yes Did management validate that all facts and circumstances are in fact similar, including all the assumptions made by the attorney in previous opinion? Yes No need to obtain a separate legal opinion for the current transfer. No In the transfer to an affiliate does it otherwise raise questions about the doctrine of substantive consolidation? Yes No A true sale opinion should be obtained to support isolation under ASC 860. The combination of a true sale opinion and a non-consolidation opinion may need to be obtained to support legal isolation under ASC 860. Generally, there is a rebuttable presumption that legal opinions will be obtained as supporting evidence for transfers of financial assets when the transfer includes some level of continuing involvement. We don t believe that a transfer of financial assets may be categorized as a routine transfer as discussed in ASC (B) (a) above, if the transferor retains some level of continuing involvement with the transferred assets. This presumption could be overcome only when management can assert that previous transfers with very similar facts and under the same legal jurisdictions have already obtained legal opinions and can therefore be used to leverage off the required analysis (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. See additional discussion in TS Other transactions involving SPEs (sponsored by the transferor) that hold securitized assets or in which the transferor retains recourse or some other forms of continuing involvement in the transferred financial assets (e.g., a right of substitution of accounts in a revolving-period securitization) are less clear. It can be difficult to determine Control Criteria for Transfers of Financial Assets / 2-13

69 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 satisfied is a legal opinion (i.e., satisfaction of the legal isolation criterion in ASC (a) is ultimately a legal matter, and management and auditors will rely on the opinion of a lawyer in evaluating satisfaction of this criterion). Since legal opinions are usually requested by rating agencies and other parties involved with these transactions, management and an auditor may be able to leverage from such existing opinions, 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 criteria have been met. For most one-step transactions in which the transferor maintains recourse or some other form of continuing involvement, it would be difficult to conclude that the assets are put presumptively beyond the reach of the transferor and its creditors in bankruptcy or receivership without a legal opinion. 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 truesale-at-law opinion should be received to demonstrate isolation. Additionally, nonconsolidation 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 ongoing involvement. A legal opinion is also needed for most two-step 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. The two-step transaction is designed to enhance the legal isolation of the structure through the combination of a true sale at law for the transfer to the BRE and a nonconsolidation opinion with respect to the BRE. This allows the structure to qualify for sale accounting and, at same time, make the assets attractive to investors in the second step by adding credit enhancements (two-step transactions are discussed in greater detail later in this Chapter). A legal opinion on these two-step securitization structures should consider the transaction taken as a whole, in order to provide persuasive evidence about the true sale nature of the transfer to the BRE as well as of the fact that the BRE would not be substantively consolidated into the bankruptcy estate of the transferor in the event of bankruptcy. A legal opinion should generally be obtained for the first transfer under a revolving structure. A periodic update to that opinion will be necessary to confirm that there have been no subsequent changes in relevant laws or applicable regulations that may affect the conclusions reached in the previous opinion. A new legal opinion for subsequent transfers under the structure may not be necessary unless there has been a change to the revolving structure or the relevant laws. In the case of a new securitization structure that is identical to a pre-existing securitization structure (and for which a legal opinion has been recently obtained), a new legal opinion may not be necessary. When the two structures are not identical, the differences should be identified. When assessing the conditions of paragraph ASC (a), the parties evaluating legal isolation should carefully consider all differences before they conclude that a legal analysis is not needed. As discussed 2-14 / Control Criteria for Transfers of Financial Assets

70 above, we also believe that the transferor will require that the legal assurance be updated periodically for the effects of changes in law or court decisions Applicability of Legal Opinions Received for Previous, Similar Transactions The receipt of a true-sale-at-law and nonconsolidation opinion 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 for a similar transaction 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 and a legal opinion was obtained may not require the receipt of a new legal opinion. For example, if the transferor previously obtained an opinion for a similar transaction with the same or similar parties under the same jurisdiction, 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 the legal specialist 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 assertion that the same facts and circumstances exist in a previous transfer of financial assets, enough evidence should be obtained to support the requirements that the legal isolation conditions have been met. This would include an analysis of whether the legal or regulatory framework governing the transaction has changed. Rollover Transactions 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 are rolling 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 confirm that there have been no Control Criteria for Transfers of Financial Assets / 2-15

71 subsequent changes in relevant laws or applicable regulations that may change the applicability of the previous opinion to such transfers. Changes in the transaction structure may require an updated legal opinion Use of an External Legal Opinion Although ASC 860 allows a transferor to reach a conclusion without consulting an attorney if it has experience with other transfers with the same fact patterns, we generally believe that it is inappropriate to rely on the opinion of a company s internal counsel to determine whether a transaction is a true sale unless the company s internal counsel is qualified as an expert in bankruptcy law and in all applicable jurisdictions. Professional judgment should be exercised in these circumstances (see relevant paragraphs in U.S. Auditing Standards AU Sections 336, Using the Work of a Specialist, and 337, Inquiry of a Client s Lawyer Concerning Litigation, Claims, and Assessments). Rather, a legal opinion should be received from a qualified external bankruptcy attorney. A legal opinion generally would include the lawyer s professional assessment of whether the transfer meets the legal definition of a true sale under the U.S. Bankruptcy Code and other applicable federal, state, or foreign jurisdiction regulatory requirements (refer to TS 7 for a discussion of international considerations). To assist auditors in their assessment of whether a legal opinion is adequate to meet the isolation criteria in paragraph ASC (a), the Audit Issues Task Force of the AICPA developed U.S. Auditing Standards AU Section 9336, Using the Work of a Specialist: Auditing Interpretations of Section 336, (AU 9336) which provides guidance on auditing issues surrounding the review and analysis of legal opinions, including issues arising from the implementation of ASC 860. As of the date of this publication, the AICPA has not yet updated AU 9336 to incorporate the recent amendments to ASC 860. We expect that the AICPA will issue updated guidance on lawyer s letters (e.g., legal opinions) in the near feature. In the meantime, the current auditing interpretation, The Use of Legal Interpretations as Evidential Matter to Support Management s Assertion That a Transfer of Financial Assets Has Met the Isolation Criteria in Paragraph 9(a) of Statement of Financial Accounting Standards No. 140 [AICPA Section AU ] is still in effect and should be considered when evaluating the legal isolation criterion under ASC 860, as amended. This interpretation provides guidance on auditing issues surrounding the review and analysis of legal opinions, and is also equally helpful in determining whether the legal opinion is adequate to meet the isolation criteria of ASC 860 and should therefore be considered by both management and auditors. Among other things, the guidance maintains that, when assessing the adequacy of a legal response, consideration should be given to the following: Whether the lawyer has experience in such matters: The lawyer should have knowledge of the U.S. Bankruptcy Code and other federal, state, or foreign laws, as applicable, as well as knowledge of the transaction. For transactions that may be affected by provisions of the Federal Deposit Insurance Act, one 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. Whether the legal opinion rendered applies the laws of the jurisdiction(s) that would govern the transfer(s) and bankruptcy proceedings: As laws vary from 2-16 / Control Criteria for Transfers of Financial Assets

72 jurisdiction to jurisdiction, a transaction that qualifies as a sale in one jurisdiction may not qualify as a sale in another. Whether the transferor and its auditor are 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 for the purpose of supporting management s assertion that the transferred assets have been isolated. Generally, if permission is not granted, the letter is considered an audit scope limitation. Alternatively, a separate reliance letter can be used to grant the auditor access to the legal opinion. For example, 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, which may or may not involve comparable facts. The company and its auditor should be alert to the possibility that the legal opinion may be based on incomplete or inaccurate facts and assumptions or that the lawyer may limit or qualify his opinion. Both instances could lead to a legal conclusion that would not demonstrate isolation of the transferred assets under ASC 860. For example, 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 an appropriate legal opinion. 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 does not provide persuasive evidence to support the entity s assertion that the transferred assets have been put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. Accordingly, mere receipt of a legal opinion stating that a transfer is a legal true sale and that the transferred financial assets would not be consolidated in the event of bankruptcy does not indicate that the transferred assets meet the isolation criterion. The company should be involved at an early stage in reviewing and agreeing to the extent and scope of assumptions to be used in the legal opinion, including seeking advice from its auditors on those assumptions Analysis of a Legal Opinion The transferor s management team is ultimately responsible for evaluating how much it can rely on the lawyer s opinion. Before reaching a conclusion that the transferred financial assets are isolated, management should develop procedures to review the form of the opinion, the facts and assumptions, and limitations and qualifications of a lawyer s opinion. Form of the Opinion For a legal opinion to be viewed as reasonable assurance that the assets have been isolated from the transferor and any of its consolidated affiliates and its creditors, the opinion, at a minimum, should indicate that the financial assets transferred 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. But even an appropriately worded would opinion may not satisfy the requirements of ASC 860 due to assumptions or qualifications that unduly limit the Control Criteria for Transfers of Financial Assets / 2-17

73 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. U.S. Auditing Standards AU 15, Audit Evidence, paragraph 6, states that to be appropriate, audit evidence must be both relevant and reliable in providing support for the conclusions on which the auditor s opinion is based. Additionally, conclusions about hypothetical transactions that do not contemplate all of the facts and circumstances or the provisions in the agreements of the transaction that is the subject of management s assertions generally would not provide persuasive evidence. It is also prudent to understand the qualifications of the attorney and the process followed by the legal firm to arrive at the opinion. Facts and Assumptions A lawyer may make a number of assumptions regarding the transaction to form a conclusion about whether a transfer of financial assets is a true legal sale. These assumptions, along with the lawyer s understanding of the facts of the transaction, are generally outlined in the lawyer s legal opinion. The validity of the facts and assumptions used by the lawyer in forming a conclusion must be evaluated by the transferor to determine whether the transferred financial assets are isolated. In certain cases, a lawyer s facts and assumptions may not reflect the specifics of the transaction. It is the transferor s responsibility to understand the facts and assumptions relied upon by the lawyer, to ensure that these facts and assumptions are consistent with its own understanding of the transaction, and to conclude whether the lawyer s legal opinion can be relied upon / Control Criteria for Transfers of Financial Assets

74 Example 2-1: Analysis of Legal Opinion Assumptions Example: 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 valid, it would not be appropriate to include the assumption in the legal letter that provides evidence of a true sale at law. Limitations and Qualifications: A lawyer may also place limitations or qualifications on its analysis of whether a transfer of financial assets is a true legal sale. One must determine whether such limitations or qualifications would affect the opinion rendered by the lawyer and, ultimately, whether the transferor is able to rely on the opinion to provide reasonable assurance that the assets have been isolated. Examples of phrases that a transferor would likely find in an acceptable true-saleat-law and nonconsolidation opinion: True-sale-at-law 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. (continued) Control Criteria for Transfers of Financial Assets / 2-19

75 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 i. 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, ii. the assets and payments thereunder are not property of the estate of the transferor under Bankruptcy Code Section 541, and iii. 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. 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 repudiation, reclamation, recovery, or recharacterization by the receiver or conservator appointed with respect to the Seller. Note: The transferor should include all of its consolidated affiliates. Nonconsolidation 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. 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 / Control Criteria for Transfers of Financial Assets

76 2.2.8 Consideration of Transferor s Continuing Involvement and Arrangements or Agreements Made in Connection With a Transfer ASC discusses the objective of the control guidance in ASC and states that such 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. The determination shall first consider whether the transferee would be consolidated by the transferor, it then considers the transferor s continuing involvement in the transferred financial assets, and finally; it requires the use of judgment in considering all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer, even if they were not entered into at the same time of the transfer. No specific guidance has been provided on how to determine whether the arrangements were entered into in contemplation of the transfer. Therefore, reporting entities must apply judgment and should establish their understanding of this term to help determine which arrangements need to be considered. ASC A provides additional guidance with respect to an initial transfer and a subsequent repurchase financing. The purpose of this implementation guidance is to illustrate the specific characteristics of this type of transaction and to prevent inappropriate analogy to other financing transactions that are outside the scope of the guidance beginning in ASC However, we believe the criteria discussed in paragraph ASC might be useful in determining whether separate transactions entered into by consolidated affiliates of the transferor should be considered agreements made contemporaneously with, or in contemplation of, the transfer, in applying the criteria in paragraph ASC Refer to TS for more details on transactions subject to the scope of ASC through With respect to considering all continuing involvement by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents, in a transfer between two subsidiaries of a common parent, the transferorsubsidiary shall not consider parent involvements with the transferred financial assets in applying the guidance in paragraph ASC However, the transferorsubsidiary as well as the parent should consider obtaining legal opinions to support the accounting of such transfers for purposes of the separate financial statements of each of the legal entities involved. In addition, if after the inter-company transfers the consolidated entity transfers the same financial assets to a third party, the continuing involvement of all the legal entities under the consolidated group should be considered as part of the evaluation of the criteria in ASC The analysis of legal isolation/nonconsolidation can be considerably more complicated when the transaction involves multiple legal jurisdictions. The following factors may influence this: The transferor and transferee are subject to different jurisdictions. The jurisdiction in which the transferred financial assets were originated. The location of other parties involved in the transactions. The jurisdiction noted in the contractual agreements between parties. Control Criteria for Transfers of Financial Assets / 2-21

77 The legal evidence for these types of transactions may require obtaining legal opinions from multiple law firms each with expertise in the relevant jurisdiction as well as to address the interaction amongst jurisdictions and which jurisdictions govern which elements of the transaction. Chapter 7 further discusses legal opinions in foreign jurisdictions. See Exhibit 2-4 and Exhibit 2-4(A) below for some examples of opinions that may need to be obtained by the different legal entities within a consolidated group. Exhibit 2-4: Example of Legal Opinions to Be Obtained by Legal Entities Under Common Control Involved in a Transfer When the Only Legal Jurisdiction Is U.S. Law. Legal Jurisdiction: United States 3 3 Subsidiary A Transfer Financial Assets 1 Ultimate Parent Company Parent Company SPE/Transferee Subsidiary B Interest Rate Swap Subsidiary A, as transferor, would need to obtain a legal isolation and nonconsolidation opinion to support the legal isolation criterion in ASC (a) in its stand-alone financial statements. Subsidiary A would also need to consider Subsidiary B in the nonconsolidation opinion to support the legal isolation criterion in its stand-alone financial statements. This is because of Subsidiary B s involvement with the SPE. The Parent and Ultimate Parent Company would each need to obtain a nonconsolidation opinion and a legal isolation opinion that considers the involvement of all of its consolidated affiliates (Subsidiary A and Subsidiary B) to support the characterization of the transfer as a sale in the consolidated financial statements of the Parent and those of the Ultimate Parent Company / Control Criteria for Transfers of Financial Assets

78 Exhibit 2-4(A): Examples of Legal Opinions to Be Obtained by Legal Entities Involved in a Transfer Between Entities Under Common Control When There Are Multiple Legal Jurisdictions Ultimate Parent Company Legal Jurisdiction: United States 3 3 Parent Company Legal Jurisdiction: Foreign Country Subsidiary A Transfer Financial Assets 1 SPE/Transferee Subsidiary B Interest Rate Swap Subsidiary A, as transferor, would need to obtain a legal isolation opinion and a nonconsolidation opinion (only to the extent that Foreign Country Law includes similar substantive consolidation principles as U.S. Law) to support the legal isolation criterion in ASC (a) in its stand-alone financial statements. Subsidiary A would also need to consider Subsidiary B in the nonconsolidation opinion (only to the extent that Foreign Country Law includes similar substantive consolidation principles as U.S. Law) to support the legal isolation criterion in its stand-alone financial statements. This is because of Subsidiary B s involvement with the SPE. The Parent and Ultimate Parent Company would each need to obtain a nonconsolidation opinion with respect to the SPE, as well as an opinion stating that a U.S. Court would not disregard the presiding court s characterization of the asset transfer as a sale or the substantive consolidation conclusion. Also, since the legal isolation opinion obtained by Subsidiary A did not consider the involvement from Subsidiary B, the Parent and Ultimate Parent may need to obtain an additional Foreign Country legal isolation opinion to support the assertion at the consolidated level. As shown in Exhibit 2-4 above, we believe that different legal opinions may be required when entering into transfers that involve members of a consolidated group and management of the separate legal entities is asserting that the legal isolation criterion in ASC (a) has been met for purposes of the separate financial statements of the legal entities involved in the transfer, as well as at the consolidated level. When this is the case, a company s management must assert, based on sufficient legal evidence, that the legal isolation and nonconsolidation conclusions reached at the stand-alone level would also be respected at the consolidated level. When dealing with multiple legal jurisdictions, in a fact pattern where the transferor/ subsidiary resides outside the U.S, but the parent or ultimate parent resides in the U.S., we believe that U.S. parent companies should seek legal advice and consider obtaining the opinions highlighted in Exhibit 2-4(A) above. If not a formal opinion, parent companies should, at a minimum, seek to obtain some sort of legal confirmation/letter supporting the conclusions reached at a stand-alone level by its foreign subsidiaries. At the consolidated level, the legal isolation opinion will need to consider the continuing involvement of all consolidated affiliates involved in the transfer and thus the opinion obtained to support the stand-alone legal isolation criterion may need to be updated to include other forms of continuing involvement and/or other arrangements entered into in contemplation of the transfer to the third party. Control Criteria for Transfers of Financial Assets / 2-23

79 Based on the example included in Exhibit 2-4(A) above, this would mean a legal isolation opinion 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 is all assuming that the SPE does not need to 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 A key motivation of a securitization transaction is to achieve a lower cost of funding. The credit risk in the securities issued to third parties directly affects the rate provided on the securities. A reduction in the credit risk to third-party beneficial interest holders can be accomplished by providing credit enhancement to the assets through a third-party guarantee, a subordination of the underlying asset s cash flows, or both. Therefore, to qualify for sale accounting, a securitization must be structured not only to achieve legal isolation, but also to make the ultimate securities or beneficial interests attractive to investors. To achieve both of these objectives, 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). In two-step securitization transactions, the key considerations in assessing isolation are whether: A true sale has occurred if the transferor has some amount of continuing involvement; and, The wholly owned subsidiary would be required to be consolidated into the parent if the parent were to enter 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. The subsequent transfer to the trust or other legal vehicle is often not a true sale at law, as credit or yield protection by the transferor is provided during this process. Consequently, in the event of BRE bankruptcy, the bankruptcy receiver could in theory reclaim the transferred financial assets. 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: It is intended to make it extremely difficult, even in bankruptcy, for the bankruptcy receiver to reclaim the transferred assets. The BRE has no other assets that can be substituted for the transferred financial assets. A key control in these transactions is to monitor and manage the BREs to ensure ongoing compliance with these conditions. In ASC , the FASB stated that it understands that 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. The fact that a true sale at law opinion is only issued for the first step places more weight on the analysis of the second step related to whether the second step transfer results in the transfer of an entire financial asset vs. a portion of a financial asset that would be subject to the participating interest definition. This is because there is no legal opinion validating whether the financial asset was legally sold in its entirety in the second step. Entities should focus on the legal form of the asset and what the asset conveys for purposes of determining whether an entire financial asset has been transferred in the second step, which will determine whether ASC A must be considered or not as part of the overall sale accounting evaluation / Control Criteria for Transfers of Financial Assets

80 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 the Transfers Guidance as well as to the guidance on Consolidation of Variable Interest Entities during September of 2010, 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 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 in the amended Transfers and Consolidation Guidance for derecognition (off balance sheet treatment), as well to those transfers that do not result in derecognition on the part of the sponsoring IDI. Scope of the final 2010 FDIC Safe Harbor 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 860, and the transfer qualifies for sale accounting under ASC 860 guidance). Securitizations completed after December 31, 2010, for which the IDI may not derecognize the transferred financial assets under the relevant ASC 860 and ASC 810 guidance 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 self-remedies, 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, Control Criteria for Transfers of Financial Assets / 2-25

81 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. A summary of key differences between the two safe harbor regimes, particularly with respect to the Conditions, are presented in Exhibit 2-5. Exhibit 2-5: Key Changes Related to FDIC Safe Harbor Rules Former FDIC Safe Harbor Rule Not clear whether Rule applied to GSEs and GNMA. Limited to securitizations/ participations meeting off-balance sheet treatment under GAAP. No safe harbor protection for on-balance sheet structures. Safe harbor protection contingent on meeting sale accounting criteria plus relatively perfunctory enforceability criteria (e.g., BoD approval, adequate consideration). Silent on whether it applied to unfunded or synthetic structures. No risk retention requirements. No differences between securitization types with respect to criteria that needed to be met. No specific due diligence reports required. May be repealed by the FDIC upon 90 days notice provided in the Federal Register, but any repeal shall not apply to any issuance made in accordance with this section before such repeal. Current FDIC Safe Harbor Rule Specifically excludes securitizations guaranteed by GSEs and GNMA from its scope. Applies to both on-balance sheet and off-balance sheet structures. Investors in on-balance sheet structures that meet applicable Conditions are entitled to par plus accrued interest if the securitization is repudiated and to exercise contractual remedies if FDIC is in monetary default. Required conditions consistent with proposed amendments to Regulation AB with respect to rules governing offering process, disclosure requirements and ongoing reporting requirements for securitizations. Conditions also extend to specific capital structure, disclosures, documentation and recordkeeping, compensation, origination and risk retention requirements. Specifically excludes unfunded or synthetic transactions from the Rule s scope. Risk retention requirement of 5 percent, until such time as regulations required under the Dodd-Frank Act are implemented, at which time auto-conform to the corresponding Dodd-Frank provisions on risk retention. Conditions impose more restrictive requirements on RMBS securitizations compared to other asset classes (e.g., establishment of reserve funds, limits capital structure to six tranches, no super senior leveraged tranches allowed, no external credit support allowed, and more extensive loan level disclosures). Requires sponsors to disclose a third party due diligence report on compliance with statutory and regulatory standards for origination of mortgage loans. May be repealed by the FDIC upon 30 days notice provided in the Federal Register, but any repeal shall not apply to any issuance made in accordance with this section before such repeal. The audit guidance in AU 9336 provides 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 2-26 / Control Criteria for Transfers of Financial Assets

82 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 wholly owned bankruptcy-remote entity 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. The AICPA has designated a task force that is currently evaluating the changes to both the Transfers Guidance and the Rule and assessing their implications for AU It is likely that the guidance currently found in AU 9336 will be updated and amended. Because AU 9336 may not incorporate some of the most current thinking on legal isolation issues, engagement teams working through complex transfer structures should consider consulting on these matters, particularly for transactions under the jurisdiction of the FDIC. 2.3 Does the Transferee Have the Right to Exchange or Pledge 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 rights in the transferred assets. Specifically: 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 in doing so, then the criterion is met. If it is determined that the transferee (or holder) is constrained by the transferor or an unaffiliated third party agent and that the constraint provides more than a trivial benefit to the transferor, sale treatment for the transfer would be precluded. Control Criteria for Transfers of Financial Assets / 2-27

83 The amendments to ASC 860 eliminated the QSPE concept. This concept was introduced by the FASB to permit derecognition of transferred financial assets in securitization transactions, provided that the securitization vehicle was considered a passive entity that met certain conditions. The conditions included the requirement that the entity only holds passive assets and that its activities were entirely specified in the legal documents and significantly limited. However, in practice these conditions proved difficult to apply because in reality few assets are passive with little or no decision making required. Consequently, the FASB elected to eliminate the QSPE concept from the accounting guidance, resulted in many of these securitization entities being consolidated by the transferor under the guidance in ASC 810. The amendments to the guidance also added a look through provision that permits an entity to consider the ability of the third-party beneficial interest holders to pledge or exchange their beneficial interest when the transferee entity s sole purpose is to engage in securitization or asset-backed financing activities. This ability to look through the transferee entity acknowledges the reality that often the transferee entity is constrained from selling or pledging the transferred financial assets in order to protect the interests of the beneficial interest holders. The notion of not having to apply this criterion to the transferee but to rather look through to the beneficial interest holders is expanded under the amendment to all entities that are engaged in securitization and asset-backed financing activities. As a result, more transfers of financial assets may meet this criterion for sale accounting. However, in many fact patterns the transferor may be required to consolidate the entity (which will likely be a VIE) under ASC 810. Exhibit 2-6 below displays a decision tree illustrating one approach to determining whether the conditions in paragraph ASC (b) are met. Exhibit 2-6: Ability of Transferee to Pledge or Exchange the Transferred Financial Assets Is the transferee (each third-party beneficial interest holder for SPE transfers) constrained from pledging or exchanging the transferred financial assets (beneficial interests)? Yes Yes Does the constraint provide more than a trivial benefit to the transferor? No Criterion ASC (b) is not met Result Criterion ASC (b) is met Do not apply sale accounting (i.e., secured borrowing) 2-28 / Control Criteria for Transfers of Financial Assets

84 The determination of whether the transferee has received the economic benefits of the transferred financial assets or whether the transferor has received more than a trivial benefit from the 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 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 within 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 regulation only allowing certain parties that are registered and qualified 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. Whether contingencies or conditions for call options would constrain the 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) would be satisfied because a conditional or contingent call does not entitle the transferor to repurchase the assets before their maturity (i.e., absent the occurrence of the contingent or conditional event before maturity). However, once the condition or contingency is met, the provisions of the call would need to be reanalyzed. In Control Criteria for Transfers of Financial Assets / 2-29

85 contrast, an unrestricted call generally precludes sale accounting (refer to TS 2.4 for more details on effective control considerations). The following conditions may be considered constraining and would preclude sale treatment: 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). Call option written by a transferee to the transferor on transferred assets not readily obtainable (i.e., this constrains a transferee because it might have to default if the call is exercised and if it had 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 can not be unreasonably withheld). On the other hand, economic constraints, such as a transferee (or holder) incurring a significant tax liability upon sale or further transfer 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 on 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 reasonable population of potential buyers). 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 a transfer (that contains such restrictions) from qualifying as a sale. All conditions should be considered collectively and should include consideration of all conditions that exist with either transferor, any of its consolidated affiliates in the financial statements being presented and its agents. Though they may not constrain the transferee (or holder) when considered individually, they may constrain the transferee (or holder) when considered collectively. Ultimately, the analysis of the impact of conditions imposed by the 2-30 / Control Criteria for Transfers of Financial Assets

86 transferor or by others should be specific to the facts and circumstances of the transaction. Prior to the recent amendments to ASC 860, to avoid failing the criterion in ASC (b), certain transfers were structured to consider a company s agent as the transferor rather than the company. This structure often arose if restrictive conditions in the transaction would provide a more-than-trivial benefit to the transferor or if the company had continuing involvement with the transferred financial assets (unlike the company s agent, which would have no further involvement). An example of this would be collateralized debt obligations (CDOs) or collateralized bond obligations (CBOs), 2 which contain a feature that places a limit on how much of the collateral the collateral manager can sell (e.g., no more than a specific percentage of the aggregate principal balance of the collateral annually). The amendments to ASC 860 include specific requirements to consider the continuing involvement of the transferor, its consolidated affiliates, and its agents. If the agent is acting on behalf of the transferor, then any transfer restrictions included in the transaction imposed either by the transferor directly or by its agent, would be considered a transferorimposed constraint. If a more-than-trivial benefit is attributed to such constraint, then the transferor may fail the criterion in ASC (b). If the collateral manager is determined to be an agent of the transferor, it raises a potential issue under ASC (b). Judgment is required to assess the significance of some conditions. Other 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 unaffiliated third party agent, 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. 2 A CBO is a type of CDO that is backed primarily by bonds. Control Criteria for Transfers of Financial Assets / 2-31

87 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 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 has debt covenants on 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. The transferor can be aware of the constraint, but if it has no continuing involvement with the transferred financial assets or does not benefit from the constraint, sale treatment is not precluded. As discussed above, economic constraints, such as the transferee incurring a significant tax liability upon sale or further transfer of the financial assets, are not considered to preclude sale treatment because this type of constraint is beyond the transferor s control / Control Criteria for Transfers of Financial Assets

88 2.4 Has the Transferor Given Up Effective Control of the Transferred Financial Assets? The third criterion that must be met for a transaction to qualify for sale accounting states that the transferor cannot 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). In evaluating the effective control criteria, the transferor must consider their 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. After the amendments to ASC 860, an entity shall not account for a transfer of an entire financial asset or a participating interest in an entire financial asset as a sale and partially as a secured borrowing. Control Criteria for Transfers of Financial Assets / 2-33

89 Exhibit 2-7 below summarizes how different physically settled options held by the transferor to reacquire an entire financial asset, group of financial assets, or participating interest generally would be viewed under paragraph ASC (b) and 40-5(c) as part of the evaluation of sale accounting. Exhibit 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-than-trivial benefit. For items below marked with an * however, if the call option is so far out of the money or for other reasons the transferor is unlikely to exercise the call when written, the transferor does not receive a more-than-trivial benefit and sale accounting is not precluded. 1. Unconditional attached call option at a fixed price on transfers of entire, groups of entire, or participating interests in entire financial assets*: On all transferred financial assets 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 On a portion of an individual transferred asset (e.g., if the remaining principal balance reaches 20 percent of the original balance) Conditional call option 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 to the transferor precludes sale accounting for the entire financial asset Yes, but reassess as an unconditional call option when the condition is resolved 2. Unconditional attached call option at a fixed price on transfers of groups of entire financial assets*: On a portion of a group of transferred assets and the transferor can choose the assets On a portion of a group of transferred assets and the transferor cannot choose the assets Yes, however, assets that are 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 loans, sale accounting is precluded only for the specified loans subject to the call, not the whole portfolio of loans) Yes, the ability to randomly remove assets is sufficiently limited so that the transferor cannot remove specific assets 3. Unconditional embedded call option at a fixed price on entire, groups of entire, or participating interests in entire financial assets*: Embedded by issuer of assets Yes, because it is the issuer that holds the call and not the transferor and the call does not provide the transferor with a more-than-trivial benefit Embedded in beneficial interests In effect this is an attached call (see guidance above) (continued) 2-34 / Control Criteria for Transfers of Financial Assets

90 Type of Option Eligible for Sale Accounting? 4. Unconditional freestanding call option at a fixed price on entire, groups of entire, or participating interests in entire financial assets*: On assets readily obtainable No, because the call s fixed price provides a more-than-trivial benefit On assets not readily obtainable 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 Conditional call option Yes, but reassess as an unconditional call option when the condition is resolved 5. Removal of accounts provision (ROAPs) on entire, groups of entire, or participating interests in entire financial assets*: This provision, which allows the transferor to reacquire the financial assets when an event occurs such as default, and clean-up call options, which enable 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, continue to be an exception to the rule and generally do not preclude sale accounting. Unconditional Analyze as if it is either an attached or freestanding unconditional call option Conditional (where the transferor does not have the unilateral right to exercise) Cleanup 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 included in the guidance 6. Call option at fair value on entire, groups of entire, or participating interests in entire financial assets: On assets readily obtainable Generally yes as it does not convey a morethan-trivial benefit to the transferor. However, if the transferor holds a residual interest in the securitized financial assets, the transferor would likely have a more-than-trivial benefit On assets not readily obtainable 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 third-party beneficial interests in the transferred assets. When assessing effective control, the transferor should only consider the involvement of an agent when such agent is acting on its 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 its fiduciary role in both the transferor s and transferee s behalf and states that only the investment manager s involvement when acting on the transferor s behalf should be considered. The criterion in ASC (c)(1) is intended to retain secured borrowing treatment for most repurchase agreements, securities lending, and dollar roll transactions (i.e., they would not qualify for sale treatment). In addition, a scope exception was made for qualifying cleanup call options (i.e., an option to purchase Control Criteria for Transfers of Financial Assets / 2-35

91 transferred financial assets when the amount of the outstanding assets falls to a level at which the cost servicing those assets becomes burdensome) 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 before maturity, it is considered to have effective control over the transferred financial assets and sale accounting would be precluded. The fact that the transferor will not exercise its right is irrelevant. The existence of the transferor s right to acquire those specific assets creates effective control, not the exercise of those rights. Agreements to repurchase or redeem the transferred financial assets prior to their maturity generally indicate that control has not passed. Transactions that contain such an agreement generally should be treated as secured borrowings. However, a transfer may qualify as a sale if the repurchase occurs at the maturity of the financial asset or if the transferee obtains all of the benefits of ownership as of the maturity date. The excerpts below introduces the guidance that must be met for a transfer to fail the condition in paragraph ASC (c) through an agreement of the type described in ASC (c)(1) and thus preclude sale accounting and result in accounting for the transfer 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 mortgagebacked 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 (continued) 2-36 / Control Criteria for Transfers of Financial Assets

92 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 Bond Market 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 Bond Market 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 them 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 : With respect to the condition in (a) in the preceding 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 reacquire securities that are identical to 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, generally do 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. During April 2011, the FASB issued amendments to the accounting requirements for repurchase agreements and similar arrangements that both entitle and obligate the transferor to repurchase or redeem a transferred financial asset before its maturity. ASU eliminates the transferor s ability criterion in ASC 860, which required the transferor to maintain at all times sufficient collateral in order to maintain effective control. As a result, the level of collateral in a repurchase agreement is now irrelevant for the purposes of assessing effective control. For further discussion on Accounting Standards Update noted above, refer to section Control Criteria for Transfers of Financial Assets / 2-37

93 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. In a borrowing, 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. As mentioned earlier, the criterion in ASC (c)(1) was specifically added to retain secured borrowing treatment for most repurchase agreements, securities lending, and mortgage trading transactions such as dollar rolls. ASC 860 contains guidelines for assessing whether the transferor has maintained effective control over the transferred financial assets through the agreement to repurchase (refer to TS 4.1 for a discussion of such transfer 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 rights to reacquire transferred financial 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. The incorporation of the notion of providing the transferor with a more-than-trivial benefit previously only existed in paragraph ASC (b) in assessing whether the transferee was constrained from selling or pledging the transferred financial asset. However, due to recent amendments to ASC 860 it is now included in the concept of whether the transferor is receiving a more than trivial benefit from an agreement which enables it to unilaterally cause the return of specific financial assets. ASC confirms that a call option on readily obtainable assets at fair value does not provide the transferor with a more-than-trivial benefit. 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-than-trivial benefit. However, if the call option is so far out of the money that the transferor is unlikely to exercise the call the transferor does not receive a more-than-trivial benefit and sale accounting is not precluded / Control Criteria for Transfers of Financial Assets

94 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 price the transferor pays in the repurchase, it has the ability to recoup its investment through the residual interest that it holds in the underlying financial assets. The guidance further discusses calls held by the transferor that may not result in the transferor obtaining effective control of the transferred financial assets: 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. 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 or whether the call becomes exercisable due to a specific provision in the agreement based on an unforeseeable future event outside of the transferor s control. If the call is not attached to specific assets but relates instead to similar assets that are readily obtainable in the marketplace, the transferor has not maintained effective control over the transferred financial assets and sale treatment may be obtained if the other sale criteria 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 transferor 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 (i.e., sale accounting would be precluded) 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 Control Criteria for Transfers of Financial Assets / 2-39

95 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, predefined 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 and 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 these 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 transferor is not thought to have effective control. 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 been met, the transferor must again recognize these assets, whether the ROAP is actually exercised or intended to be 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 of the financial assets and should account for the transfer as a sale. However, if the third party cancels its contract with Company B, Company A would regain effective control of the transferred financial assets and should recognize the assets at fair value at that time. Once the contingency has been met, Company A has the unilateral ability to remove the specific assets and is therefore deemed to have effective control. Cleanup Calls The right of the servicer or its affiliates, which may be the transferor, to invoke a cleanup call is generally not viewed as causing the servicer to maintain effective control over the assets transferred and, therefore, the transfer may be accounted for as a sale (provided the other sale requirements are met). 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 creates a burden for the servicer. The level at which servicing costs become burdensome is not specifically addressed by ASC 860. Practice has generally accepted a cleanup call of less than 10 percent of the total transferred financial assets as meeting this threshold, although specific facts and circumstances in a transaction could increase or decrease that threshold / Control Criteria for Transfers of Financial Assets

96 Parties other than the servicer or its affiliates cannot hold the option, because only the servicer is burdened when the amount of outstanding assets falls to a level at which the cost of servicing the assets become 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 (subsidiaries A and B) of the same parent company (Company A) are involved in a transfer. Subsidiary A transfers financial assets to SPE X, and Subsidiary B, a sister company of Subsidiary A, but not a consolidated affiliate in its standalone financial statements, obtains the servicing rights. In addition, Subsidiary A has the right to purchase all, but not less than all, of the outstanding interests at any time during the term when the aggregate outstanding balance falls below 10 percent. Subsidiary B has determined that servicing costs are burdensome when 10 percent of the assets remain outstanding. This cleanup call provision does not cause Company A to maintain effective control of the transferred financial assets in its consolidated financial statements. (Note: We have not addressed consolidation of SPE X by Company A nor its subsidiaries). Even though Subsidiary B is not a consolidated affiliate of Subsidiary A (i.e., the transferor and holder of the cleanup call), Subsidiary B is an affiliate. Under the cleanup call definition, if the holder of the cleanup call is an affiliate of the servicer (i.e., lower threshold than consolidated affiliate), then the call meets the definition of a cleanup call for purposes of the separate stand-alone financial statements of Subsidiary A. In the consolidated financial statements of Company A, the call option will 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 that exceeds a level at which the transferor-servicer concludes that its 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 entire financial assets or participating interest in entire financial assets transferred. For example, Company A, the servicer, transfers financial assets to Company B. Company A has the right to purchase all, but not less than all, of the outstanding interests at any time during the term when the aggregate outstanding balance falls below 20 percent of the facility s limit. Company A would record the entire financial assets or participating interest in entire financial assets subject to the transaction as a secured borrowing Ability of Transferee to Require the Transferor to Repurchase at a Favorable Price A transferor maintains effective control over the transferred financial asset as described in paragraph ASC (c)(3) 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 the transferred financial asset. Control Criteria for Transfers of Financial Assets / 2-41

97 The principle that the transferor maintains effective control because the price they could repurchase the transferred assets is so favorable to the transferee that it is probable such an option would be exercised at the date of transfer was a new example added in the recent amendments to ASC 860. This principle does not alter the underlying basis for evaluating whether the transferor has maintained effective control. It further supports the notion that all arrangements or agreements made with respect to the transferred financial assets must be reviewed to properly evaluate the substance of whether the control criteria have been met. Generally, the following conditions in isolation would not preclude sale treatment under paragraph ASC (c)(3): Put options written by the transferor to reacquire transferred assets (or beneficial interests from the transferee) at fair value. Call option deep out-of-the-money held by the transferor, if it is probable upon writing the option that it will not be exercised. Other Changes That Result in the Transferor Regaining Control of the 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 or the transferor regaining control of transferred financial assets previously recorded as a sale. At the time the transferor obtains effective control, the transferor is required to record the assets as a fair value purchase and recognize a liability for the same amount. The accounting for changes that result in the transferor regaining control of transferred financial assets is further discussed in ASC through (refer to TS 3.4 for further 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 applicable consolidation guidance. Whether the transferor exercises or intends to exercise its rights to reacquire transferred assets is irrelevant. The existence of the transferor s right to acquire those specific assets creates the effective control, not the exercise of those rights. For example, if the transferor has the right to repurchase the receivables at a fixed price in the event that the borrower defaults, the transferor would be able to recognize a sale (as long as the other sale requirements were met) at the onset of the transaction. However, once the borrower defaults, the transferor would need to recognize the asset and related liability, as it has the ability to obtain control of the asset even if it does not exercise it. Another example is a right of first refusal. The transferor can only exercise this right in the event that an independent party makes an offer first. However, once that happens, the call option becomes exercisable and, at that point, must be evaluated to determine if more than a trivial benefit to the transferor has been created. 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 impact the transferor s ability to control the financial asset / Control Criteria for Transfers of Financial Assets

98 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, whereas the transferor has effectively entered into a borrowing arrangement if it maintains control of the assets after the transfer. A transferor has relinquished control over the financial assets if the transfer meets three broad criteria: (1) the transferred financial assets are beyond the reach of the transferor, its consolidated affiliates or agents, and its creditors, (2) the transferee has the right to exchange or pledge the financial assets it received, and (3) the transferor, its consolidated affiliates or agents does not maintain effective control of the transferred financial assets or third party beneficial interests related to those transferred assets. In practice, compliance with all three criteria has proven to be difficult. For example, a complete legal analysis of the transaction, including indirect agreements between the transferor and beneficial interest holders, must be performed in order to determine whether the transferred financial assets are isolated from the transferor, its consolidated affiliates or agents, and its creditors. In addition, all contemporaneous arrangements or arrangements made in contemplation of the transfer must be evaluated as part of the determination as to whether control was surrendered. Lawyers often need to be involved in the process to determine whether the transaction meets the definition of a legal true sale, legal letters must be received and analyzed, and careful structuring of transactions must take place. 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; it does not matter whether the transferee is aware of the constraint. If the constraint provides a more-than-trivial benefit to the transferor, the transfer does not meet the criteria for sale accounting. 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 of the transferred financial assets or third party beneficial interest related to the transferred 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 be released. 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. Control Criteria for Transfers of Financial Assets / 2-43

99 2.6.1 Transferred Financial Assets (Entire, Groups of, or Participating Interests) 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 interestonly 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. (continued) 2-44 / Control Criteria for Transfers of Financial Assets

100 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. (continued) Control Criteria for Transfers of Financial Assets / 2-45

101 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 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 interestonly 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 thirdparty 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 / Control Criteria for Transfers of Financial Assets

102 Question 2-1: How should legal form be weighted against economic substance when applying the participating interest criteria in ASC A? PwC Interpretive 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 such that all the interest holders share cash proportionately but the company retains 5 percent of the cash flows that are subordinated to the transferred portion. In this fact pattern, the company would still need to recognize the entire financial asset until such time as it has transferred all of its interest and can meet the sale criteria. In contrast, consider a transaction where a company legally transfers the entire financial asset and guarantees up to 5 percent of the performance of the asset (i.e., guarantees the first 5 percent of losses on the asset). In this transaction, the company could be required to account for this transfer as a sale of the financial asset in its entirety with the guarantee accounted for as a liability. The only difference economically between these two transactions is that in the first transaction, the credit protection on the financial asset is funded, while in the second transaction it is not. For certain transactions, this distinction may not be trivial and therefore could open up the opportunity to structure the transaction 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, the 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. As an additional example, the new participating interest definition would preclude sale accounting by a transferor of an interest-only strip in an entire financial asset it owns. However, a transfer by an investor in an interest-only strip from an entire financial asset it does not own would still be eligible for sale accounting. Question 2-2: How would differences in rates 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 Interpretive Response: Transfers of loan participations in situations in which market interest rates have fluctuated after the loan s origination date are significantly impacted by the new participating interest definition, particularly, if the transferor and transferee intend to compensate for such differences by agreeing to a pass-through rate different than the loans underlying coupon rate. (continued) Control Criteria for Transfers of Financial Assets / 2-47

103 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 market rates for the loan are 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-onlystrip to compensate for the difference, it would also fail to meet the participating interest definition, but under ASC A(b). However, if the transferor/ transferee had agree to make up the difference in interest rates through higher or lower proceeds up-front, rather than by retaining a future right and/or obligation, the transfer would have likely met the conditions for participating interest treatment and would have been subject to the derecognition criteria. Question 2-3: What are some other common structures affected by the participating interest criteria in ASC A? PwC Interpretive Response: Transfers of receivables through a factoring or securitization arrangement in which the transferor retains a subordinated interest in a portion of the receivables, transfers of undivided interests in credit card portfolios, and many other transfers in which less than full title and ownership to the financial asset it s been legally transferred. The legal form of the agreement will play a critical role in whether the transaction is that of an entire financial asset vs. a portion of a financial asset and thus, to the extent possible, legal evidence should be obtained to support the fact that an entire financial asset was the subject of a transfer. Question 2-4: Do third-party guarantees impact the evaluation of a participating interest? PwC Interpretive 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 (other than standard representations or warranties, as defined in ASC A(c)). The guidance indicates that cash flows to a third-party guarantor would not preclude the transfer from meeting the participating interest definition. However, any guarantees or other obligations entered into by the transferor would most likely 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 premiums 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, once the timeframe of the recourse provision expires, the transfer should be reevaluated to determine if it meets the participating interest definition and it therefore becomes eligible for sale accounting / Control Criteria for Transfers of Financial Assets

104 Question 2-5: Should a transfer of a portion of a financial asset be reassessed after transaction date? PwC Interpretive Response: Yes. ASC establishes that some circumstances may result in a transferred portion of an entire financial asset no longer meeting the conditions of a participating interest. Also, even though ASC 860 do not specifically address subsequent reevaluations of whether a portion of an asset that initially failed to meet the participating interest definition subsequently becomes a participating interest, it does state 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 either a change in law, the passage of time, a modification to the transfer arrangement, or subsequent transfers of additional 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 salestype or direct-financing lease receivable if the entity only transfers an interest in the minimum lease payments, but not the residual value? PwC Interpretive 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 (emphasis added) residual value is not considered a financial asset subject to the guidance in ASC 860, a transfer of a portion of the minimum lease payments would not need to consider the unguaranteed residual value as part of the analysis of whether the minimum lease payments comply with the participating interest rules. However, if the transfer was that of a portion of the minimum lease payments along with a portion of a guaranteed (emphasis added) residual value, then the participating interest determination would need to consider whether the unit of account met 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 thirdparty 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 specifically states that cash flows to a third-party guarantor shall be excluded from the evaluation as to whether the participating interest definition is met (continued) Control Criteria for Transfers of Financial Assets / 2-49

105 ASC states that third party guaranteed residual value is part of the lessor s minimum lease payments Based on the guidance above, we would accept an interpretation that third-party guaranteed residual values need to be included or excluded from the participating interest evaluation in transfers of portions of sales-type or direct-financing lease receivables. We also believe it would not be appropriate for an entity to analogize to this specific fact pattern when evaluating other transactions and that once one of the two methods is selected by an entity (i.e., either including or excluding the guaranteed residual value from the participating interest evaluation), this policy should be consistently applied and disclosed as an accounting policy election. Question 2-7: How does an entity determines what is significantly above an amount that would fairly compensate a substitute service provider for purposes of ASC A(b)? PwC Interpretive Response: The FASB did not define what they meant by not significantly above an amount that would fairly compensate a substitute servicer nor did they provide any implementation guidance or bright lines as part of the recent amendments to the guidance. 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 taking on the servicing function of 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 of the agreement subject to evaluation that could explain the reasons why the servicer is entitled to a contractually specified servicing fee above and beyond what other servicers are receiving in the marketplace / Control Criteria for Transfers of Financial Assets

106 2.6.2 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. 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. (continued) Control Criteria for Transfers of Financial Assets / 2-51

107 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 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. (continued) 2-52 / Control Criteria for Transfers of Financial Assets

108 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 bankruptcy-remote 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. (continued) Control Criteria for Transfers of Financial Assets / 2-53

109 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. 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. (continued) 2-54 / Control Criteria for Transfers of Financial Assets

110 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 separate-entity 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. 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 (continued) Control Criteria for Transfers of Financial Assets / 2-55

111 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: Initial Transfer and Repurchase Financing This implementation guidance (including the following diagram) addresses the scope application guidance beginning in paragraph to an initial transfer and a subsequent repurchase financing. The purpose of this implementation guidance is to illustrate the characteristics of the transaction and to prevent an inappropriate analogy to other financing transactions that are outside the scope of the guidance beginning in paragraph Transfer of a Financial Asset a Cash Initial Transferor b Transfer of a Financial Asset (as collateral) Cash Initial Transferee Return of Financial Asset c Cash 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 beginning in paragraph : a. The initial transferor transfers a financial asset to the initial transferee in return for cash. (continued) 2-56 / Control Criteria for Transfers of Financial Assets

112 b. The initial transferee enters into a financing arrangement 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 financing arrangement, 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 beginning in paragraph However, the ability to net settle the transactions is a factor to consider in determining whether the two transactions meet all of the provisions in paragraphs through 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 is met? PwC Interpretive Response: We believe the guidance beginning in ASC is an excellent source when determining whether other arrangements or agreements were entered into contemporaneous with, or in contemplation of, the transfer. Specifically, we believe the following factors should be considered in making such determination: 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 analysis and ultimately considered in such legal opinions. Control Criteria for Transfers of Financial Assets / 2-57

113 Question 2-9: What does the term consolidated affiliate means in the context of evaluating all continuing involvement by the transferor? PwC Interpretive Response: Recent amendments to ASC 860 clarified that the legal isolation analysis must consider all of the continuing involvement by the transferor and any of its consolidated affiliates included in the financial statements being presented. For example, assume the transferor obtains a beneficial interest in the transferred financial assets and has a wholly owned subsidiary that is responsible for the servicing obligation. In addition, the ultimate parent company provides a limited recourse guarantee on the performance of 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 have 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. Based on the above, 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 (i.e., assuming a legal opinion can be obtained at that level), but account for the transfer as a secured borrowing in the parent s consolidated financial statements. There are many other scenarios in which the combination of a true sale opinion and non-consolidation opinion will need to be evaluated at different levels. Also, there might be legal jurisdiction issues that further complicate the analysis. 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 requirements of the legal entities involved in the transfer to determine the legal evidence 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 in which separate financial statements will be issued / Control Criteria for Transfers of Financial Assets

114 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 Interpretive 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, Derecognition 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 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. In addition, paragraph provides some considerations, including whether the contract or circumstances permit the transferor to revoke the transfer, 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 paragraph A) or otherwise isolated (see paragraph B), whether the transferor is affiliated with the transferee and consideration of other factors pertinent under applicable law. The Audit Issues Task Force Working Group of the AICPA issued an Auditing Interpretation (AU 9336) to assist auditors 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 included above). For entities that would be subject to FDIC receivership, refer to ASC A included above and TS Section for additional discussion related to such transactions. Question 2-11: Are legal opinions that restrict the use of the opinion to the client or to third parties other than the auditor considered acceptable audit evidence? PwC Interpretive Response: No. Given the importance of the legal opinion to the ASC 860 accounting model and the precision that attorneys use in drafting such opinions, an auditor should not use as evidence a legal opinion that he or she deems otherwise adequate if the letter does not expressly identify who can rely on those findings or if it restricts the use of the conclusions expressed therein to the client or to third parties other than the auditor. Ideally, the legal letter should specifically state that the auditor is permitted to rely on the conclusions expressed in the letter for the purpose of evaluating the company s assertions in the financial statements. (continued) Control Criteria for Transfers of Financial Assets / 2-59

115 Footnote 5 to U.S. Auditing Standards AU Section states: In some cases, the auditor may decide it is necessary to contact the specialist to determine that the specialist is aware that his or her work will be used for evaluating the assertions in the financial statements. Therefore, the auditor should request that the client obtain the attorney s written permission for the auditor to use the opinion in evaluating management s assertion that a transfer of financial assets meets the isolation criterion of ASC 860, if the letter does not expressly identify who can rely on those findings or if it restricts the use of the findings to the client or to third parties other than the auditors. If permission is not granted, the auditor cannot use the opinion as audit evidence. Question 2-12: How should a foreign subsidiary of a U.S. multinational company demonstrate that it has satisfied the criteria in paragraph (a) when a transfer transaction is executed in a foreign jurisdiction? PwC Interpretive Response: The approach to transfer transactions of foreign subsidiaries should be the same as those executed by U.S. companies. The isolation analysis should be based on bankruptcy or other applicable laws of the relevant country (or countries) when assessing whether legal isolation has been achieved. The legal principles may be dissimilar to the legal concepts of U.S. statutes. (Refer to TS 7 for a further discussion.) Question 2-13: 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 bankruptcy-remote? PwC Interpretive 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 / Control Criteria for Transfers of Financial Assets

116 2.6.3 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. (continued) Control Criteria for Transfers of Financial Assets / 2-61

117 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 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 2-14: How should the transferability limitation criterion in ASC (b) be applied to unconsolidated securitization entities now that the QSPE concept has been removed from the guidance? PwC Interpretive Response: Prior to the recent amendments to ASC 860, the guidance allowed an enterprise that transferred financial assets to a securitization vehicle that met the definition of a QSPE to derecognize the transferred assets when the transferee was constrained from pledging or exchanging the assets but the beneficial interest holders were not (provided that the transfer also satisfied the other conditions for sale accounting). Because the recent amendments to ASC 860 removed the concept of a QSPE, the FASB modified the requirement above to allow a transferor to look through the unconsolidated SPE if the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities. Accordingly, the transferor should look through such an unconsolidated SPE when evaluating whether there are any restrictions on the transferee s ability to pledge or exchange transferred assets and should instead focus on whether any third-party holder of the unconsolidated SPE s issued beneficial interests have the right to freely pledge or exchange. (continued) 2-62 / Control Criteria for Transfers of Financial Assets

118 This look through provision should not be construed to require that each transfer must have a third-party holder in order for the transaction to meet the criterion. 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 maintain a minimum level of the securities (i.e., precluded from pledging or exchanging) to still achieve sale accounting so long as the third-party holders, if any, could pledge or exchange the assets. We do not expect to see many instances in which 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. In addition to the discussion above, when evaluating whether derecognition accounting is met, an enterprise must consider whether the transferor and any of the consolidated affiliates included in the financial statements being presented have surrendered control of the asset. As a result of the modifications to ASC and ASC 860, the transferor may be required to consolidate many entities used in securitization and asset-backed financing transactions. Also, guaranteed mortgage securitizations, for example, in which the transferor obtains 100% of the securities issued by the unconsolidated SPE 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, in which case sale accounting may be precluded under the effective control criteria in ASC (c). Although ASC 860, as amended, expands on which entities the transferor is permitted to look through when evaluating transferability restrictions, if the transferee entity is consolidated by the transferor or if any of the other conditions for sale accounting are not met (i.e., legal isolation or effective control), derecognition would not be appropriate. Question 2-15: How does a lack of continuing involvement affect an entity s evaluation of the transferability limitation criterion in ASC (b)? PwC Interpretive Response: ASC 860 indicates that if the transferor has no continuing involvement with the transferred financial assets, the lack of continuing involvement would be a determinative factor in concluding that the transferor does not retain a more than trivial benefit from the imposed constraint. That is, the criterion in ASC (b) would be met even if the transferee is constrained in its ability to pledge or exchange the transferred financial assets. A transferor is still required to assess whether the transfer satisfies the other conditions for sale accounting. Control Criteria for Transfers of Financial Assets / 2-63

119 Question 2-16: How do restrictions on sale to several competitors, rather than a single competitor, impact the analysis under paragraph (b)? PwC Interpretive Response: If the provision only requires that financial assets not be sold to a single competitor, this would not violate the sale criteria of ASC 860, as long as there is a reasonable population of potential buyers for the transferred assets. Similarly, restrictions on sales to several competitors would not be problematic if a reasonable population of potential buyers for the transferred asset exists. Question 2-17: 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 Interpretive 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 are generally 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. For example, 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. A significant constraint would exist if the transferor was the only other willing buyer and sale to the transferor s competitor(s) was prohibited. Additionally, we believe that a restriction that exists for reasons apart from maintaining control of the transferred assets would not cause the transferor to unreasonably withhold its permission from the transferee to sell or pledge the transferred assets and would not constrain a transferee / Control Criteria for Transfers of Financial Assets

120 Question 2-18: 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 Interpretive Response: Yes to both questions. Sale treatment is precluded, until the sale restriction lapses. This restriction constrains the transferee from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor. Under this arrangement, the transferor benefits from knowing who has the asset and that the asset has not fallen into the hands of a competitor. The transferor has essentially maintained control over the transferred assets. 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 provide more than a trivial benefit to the transferor. 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 all other conditions for a sale are also met. If the transaction is expected to result in a loss, the loss, if probable and reasonably estimable, must be recognized at the date of transfer in accordance with ASC 450. Further, any gain on the transfer would be deferred until the sale occurs. ASC 860 requires that the transferee be able to obtain the economic benefits (i.e., the cash flows) of the transferred asset before sale accounting can occur. Those economic benefits can be obtained by the transferee when selling or pledging the assets. Restrictive conditions on the transferee s ability to sell or pledge would be deemed a constraint that precludes sale accounting Transferor 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 transferred financial assets before maturity (see paragraph (c)(1)): 1. Whether securities exchanged are substantially the same 2. Subparagraph superseded by Accounting Standards Update (continued) Control Criteria for Transfers of Financial Assets / 2-65

121 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 secured-borrowing accounting. The following are examples of whether securities exchanged are substantially the same as discussed in paragraph : 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 passthrough and pay-through securities, similar remaining weightedaverage 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 slowpay 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 singlefamily residential mortgages, to meet this characteristic. (continued) 2-66 / Control Criteria for Transfers of Financial Assets

122 Excerpt from ASC : Paragraph superseded by Accounting Standards Update Excerpt from ASC : Paragraph superseded by Accounting Standards Update Excerpt from ASC : Paragraph superseded by Accounting Standards Update 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-of-accounts 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 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. (continued) Control Criteria for Transfers of Financial Assets / 2-67

123 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-ofaccounts 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 morethan-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-than-trivial benefit to the transferor. 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: (continued) 2-68 / Control Criteria for Transfers of Financial Assets

124 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. (continued) Control Criteria for Transfers of Financial Assets / 2-69

125 e. If the third-party beneficial interests in a securitization entity pay off first (a so-called 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 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. in which the fair value of beneficial interests obtained by a transferor of financial assets that is not the servicer or an affiliate of the servicer is adversely affected by the amount of transferred financial assets declining to a low level. (continued) 2-70 / Control Criteria for Transfers of Financial Assets

126 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: 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. Control Criteria for Transfers of Financial Assets / 2-71

127 Question 2-19: Does the presence of an agent serving both the transferor and transferee cause a transfer to fail sale accounting under ASC (c)? PwC Interpretive Response: Generally no. Even though ASC 860 requires the transferor to consider all continuing involvement by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents to be continuing involvement by the transferor, when assessing effective control, the transferor only considers the involvements of an agent 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 shall not be considered in the transferor s evaluation of whether it has effective control over a transferred financial asset. 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 has a fiduciary responsibility to perform its duties in the best interests of the investors in the managed entities. 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. Question 2-20: Would the transfer of a pool of financial assets in which the transferor retains a call option that allows the transferor to repurchase the entire pool of receivables when it reaches a pre-specified level be an impediment to sale accounting under ASC (c)(2)? PwC Interpretive Response: It depends. If the call option does not meet the definition of a cleanup call, then sale accounting would be precluded for the entire group of transferred financial assets. Recent amendments to ASC 860 make it clear that a transfer of an entire financial asset or a participating interest in an entire financial asset shall not be accounted for partially as a sale and partially as a secured borrowing. In addition, 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: a. The unilateral ability to cause the holder to return specific financial assets b. A more than-trivial-benefit attributable to that ability. In the fact pattern discussed above, the transferor has the ability to repurchase from the group of transferred receivables any loans it chooses, up to some specified limit, which provides the transferor with the unilateral ability to cause the holder to return specific financial assets. If such an option also 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 / Control Criteria for Transfers of Financial Assets

128 Question 2-21: If a callable financial asset issued by Company A is acquired by Company B, can Company B obtain sale accounting treatment on a subsequent transfer of the financial asset with the embedded call option? PwC Interpretive Response: Yes. Sale accounting would not be precluded for Company B for the transfer of financial assets subject to calls embedded by Company A, the issuer of the financial instruments. Such an embedded call does not cause the transferor (Company B) to maintain effective control because the issuer (Company A), not the transferor, holds the call. If Company B holds a call option in the transferred financial assets that allows it to buy back the beneficial interests of a securitization entity at a fixed price, then Company B remains in effective control of the assets underlying those beneficial interests. Under these conditions, sale accounting would be precluded. Question 2-22: ASC 860 indicates that a cleanup call on transferred assets would not prohibit sale accounting. Under what conditions is a cleanup call not considered effective control over the assets? PwC Interpretive Response: A cleanup call is defined in ASC as An 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 level of costs of servicing that would be considered burdensome is not specified in the guidance. Current practice has generally accepted a level of 10 percent or less of the originally transferred financial assets. However, when the remaining assets are greater than 10 percent, a cleanup call provision may nonetheless qualify for sale treatment if it can be demonstrated that the servicing cost is deemed unduly burdensome in relation to the amount of assets to be called. Conversely, a cleanup call at a level lower than 10 percent might not result in servicing costs that are burdensome. 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. One of the primary requirements of a cleanup call is that the call must be held by the servicer or its affiliates (which may be the transferor) to achieve sale accounting. If a transferor-servicer sells the servicing rights and retains the call option, rerecognition of the financial assets subject to the call may be required. Control Criteria for Transfers of Financial Assets / 2-73

129 Question 2-23: A transferor transfers financial assets (e.g., loans that are not readily obtainable) and possesses a contingent forward-repurchase agreement under which it is obligated to repurchase the entire pool of transferred financial assets from whichever entity owns the financial assets at the time delinquencies rise above a specified percentage. Would the transferor maintain effective control over the transferred financial assets? PwC Interpretive Response: No. An obligation to repurchase is separately distinguished from a right to repurchase. An obligation based on third-party default is beyond a transferor s control. A right to acquire a financial asset is within a transferor s control. Furthermore, the transferee is not constrained as a result of the contingent forward contract as it can freely pledge or sell the financial assets. However, an obligation to repurchase could have an impact on the legal isolation analysis and might result in the transferred financial assets not being put beyond the reach of the transferor and its creditors. If the contingency requiring the repurchase is triggered, the transaction should be re-evaluated to determine if the transferor has regained effective control. Question 2-24: Would sale treatment be precluded in situations where the transferor retains an attached call option on financial assets that are not readily obtainable? PwC Interpretive Response: Sale treatment would be precluded. A transferor does not relinquish control when it is the holder of an attached call on specific financial assets that are not readily obtainable. 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 the financial assets. These contracts will likely constrain the transferee as it must be able to obtain the financial asset to comply with its obligations under the call or forward contract. 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 not readily obtainable financial assets: At the money ( ATM ) 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 ( ITM ) 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 ( OTM ) May not be a constraint if exercise is not probable 2-74 / Control Criteria for Transfers of Financial Assets

130 Question 2-25: Would a transfer of financial assets with an embedded call option written by the transferor of the financial assets violate the sale criteria if the assets are not readily obtainable? PwC Interpretive Response: Yes. An embedded call option, written by the transferor, results in the transferor maintaining effective control over the transferred financial assets if such a call provides the transferor with a more-than-trivial benefit. Since any holder of the assets would be required to return the assets to the transferor, the transferor has maintained effective control over the transferred assets. Paragraph (c)(2) should be applied if the transferor has a right to repurchase (i.e., holds a call option) the transferred financial assets, including options embedded in the financial assets. Paragraph (b) is not applicable to the constraint because the asset may be sold with the embedded option. If called, the ultimate holder of the financial asset must deliver it to the transferor. Question 2-26: Company A is in the construction business and had entered into a 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 that were payable by Company X in instalments over periods that ranged from several years to over a decade. Pursuant to 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 which 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 itself for such losses. Company A entered into a master purchase agreement (MPA) with Company Z regarding how Company A will sell, and Company Z will purchase, receivables from completed projects generated from the CSA between Company A and Company X. Company A does not obtain any interest in the transferred receivables or have servicing rights. Company Z has recourse back to Company A only if: a. Company A violates its general representations to Company Z with respect to the transferred financial assets, 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. 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 account receivable. However, the second condition is unrelated to the original contract and effectively grants the contracting enterprises right of offset with respect to its obligations to (from) Company A, including obligations arising from events that have not yet (and ultimately may not) occurred. Control Criteria for Transfers of Financial Assets / 2-75

131 Do product and service warranties result in effective control and thus preclude accounting for the transaction as a sale? PwC Interpretive Response: No. None of the conditions in the MPA results in Company A maintaining effective control over the receivable. For the criteria in paragraph (c) to be fulfilled, the transferor cannot maintain effective control over the transferred financial assets. In order to conclude that accounting for the transaction as a sale is appropriate, the criteria in paragraphs (a) and 40-5(b) should also be evaluated. The MPA s provisions do not violate the criteria in paragraph (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, which has purchased these receivables, would not be able to collect the entire amount due on these receivables from Company X. In that scenario, Company Z can put the receivables back to Company A. 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 itself regain control of the receivables. Repurchase of the receivables does not automatically result from Company A s default; multiple events that are outside of the control of Company A would have to occur in order for Company A to regain control of the asset. (i.e., Company A would have to default on its obligations to Company X. Company X then would have to act by withholding payments to Company Z. Then, Company Z would have to put the receivables back to Company A.) We believe that the existence of such multiple events which need to take place before Company A can regain control of the receivables effectively means that unilateral action on the part of Company A would not result in the Company getting control of the receivables. Regarding the CSA and MPA, Company A s obligations vis-à-vis the service warranty and other set-off provisions are like general representations and warranties with respect to the 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 / Control Criteria for Transfers of Financial Assets

132 Question 2-27: 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 criteria? PwC Interpretive Response: It depends. ASC 860 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. The guidance does not prohibit sale treatment for the transfer of financial assets with put options if the transferee is not restricted from selling or pledging the asset and the requirements of paragraph (a) (i.e., 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. In that case, the put option is likely to be exercised by the transferee, because the transferee is unlikely to sell the assets at market value if it can get a higher price from the transferor. Thus, the transferor will likely reacquire the transferred financial asset (refer to ASC D included above). Accordingly, in-the-money put contracts need to be evaluated to assess whether the transferee has an option or a constructive forward contract due to the beneficial economic terms. When the assets are not readily obtainable, the transferee is constrained as it cannot presumably 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 transferee, however, may be able to pledge the asset and satisfy (b). The economic benefit of the put to the transferee provides a constraint on what it can do with the asset as required by paragraph (b). When 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, however, and may result in a range of values. Freestanding rights to reacquire transferred assets that are readily obtainable presumptively do not constrain the transferee from exchanging or pledging them and thus do not preclude sale accounting under paragraph (b). These arrangements would include typical recourse provisions by which the transferor may be required under the agreement to substitute assets that have been prepaid or to repurchase assets that have defaulted. In these cases, the repurchase or substitution is outside the control of the transferor and is triggered by a specific recourse provision in the agreement. These arrangements need to be evaluated carefully to determine whether there is a constraint from the transferee s perspective and whether there is a more-than-trivial benefit derived from the transferor s perspective. Recourse in any form (e.g., puts or guarantees) must be carefully evaluated as part of the legal isolation analysis. Control Criteria for Transfers of Financial Assets / 2-77

133 Question 2-28: If the lead participant in a loan participation possesses a contingent call option on the portion of a loan participated out, assuming the transaction meets the definition of a participating interest, will the transfer of the loan under the participation agreement be treated as a sale? PwC Interpretive Response: Generally, no. The call option pertains to a specific transferred financial asset and does not provide to the transferor control over the loan. The conditions under which a transferor can regain control of the asset cannot be within the transferor s control. So, for example, sale accounting would not be disqualified if the transferor is allowed the right of first refusal on the occurrence of a bona fide offer to the transferee from a third party because the transferee is not constrained from pledging or exchanging the asset. Question 2-29: Are wash-sale transactions, in which a transferor both sells and repurchases the same or similar securities over a short period (generally days), treated as financings under ASC 860? PwC Interpretive Response: No. Wash-sale transactions that were not made contemporaneously with, or in contemplation of, the transfer and that do not involve a concurrent written contract that entitles and obligates the transferor to repurchase or redeem the transferred financial assets do not cause the transferor to maintain effective control over the transferred financial assets, even if the transaction occurs within a short period of time. Accordingly, the sale criteria in paragraph are satisfied in such a wash-sale transaction, and a sale of financial assets should be recorded. Considering the short-term nature of the separate sale and purchase transaction and considering the ASC 860 requirements to evaluate all arrangements entered into in contemplation of the 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 / Control Criteria for Transfers of Financial Assets

134 Question 2-30: Upon transfer of the assets, the transferor retains an option to repurchase the loans at par after 10 years of the original transfer day. The contractual terms for these loans range between 20 and 30 years. The transferor has determined that the likelihood of the option being exercised is remote. How is this option evaluated under ASC (c) to determine if sale has occurred? PwC Interpretive Response: The existence of such repurchase option will likely preclude sale treatment under ASC (c). Under ASC (c) (2), the transferor is considered to maintain effective control over the transferred financial asset if there is an agreement that provides the transferor the unilateral ability to cause the holder to return specific financial assets and provides more than a trivial-benefit to the transferor. Absent a prepayment of the loan by the borrower or another maturity event, this option will become exercisable by the transferor when the specified period expired (i.e., after 10 years). The guidance discussed similar passage of time options on amortizing asset(s) that provides the transferor the option to repurchase the asset or portfolio of assets after the original principal balance reaches a specified amount (for example, 20 or 30 percent of the original transferred balance). The guidance stated that sale accounting is precluded because the option allows the transferor to unilaterally cause the return of the individual asset or group of assets. We believe this option is similar to the options in this guidance and would likely preclude sale accounting due to the issuer/transferor s ability to repurchase the loan after certain time. Control Criteria for Transfers of Financial Assets / 2-79

135 Chapter 3: Accounting for Sales-Type Transfers Accounting for Sales-Type Transfers / 3-1

136 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 / Accounting for Sales-Type Transfers

137 Exhibit 3-1: Framework for Accounting for Transfers of Financial Assets 1 Does the transaction involve a transferee that is a consolidated affiliate of the transferor? (TS 1) Yes No Does the transaction involve financial asset(s)? (TS 1) No Yes Does the transaction meet the definition of a transfer? (TS 1) No Transaction is NOT subject to ASC 860 (Consider other GAAP such as ASC , ASC 840, ASC 972) Yes Does the transfer meet any of the scope exceptions? (TS 1) Yes No Is the transfer eligible for sale accounting (i.e., involve a financial asset, group of financial assets, or a participating interest (see right flowchart) in an entire financial asset)? (TS 2) Yes Does the transfer meet all of the control criteria of ASC ? a. Have the financial assets been isolated from the transferor (and its consolidated affiliates) and its creditors? (40-5(a)) Portion Yes No If a transfer of a portion of a financial asset, does the interest transferred and the interest retained meet the participating interest definition in ASC A? All the following criteria must be met: a. Does it represent a pro rata ownership interest in an entire financial asset? (40-6A(a)) Yes b. Are all cash flows from the entire financial asset divided among the participating interest holders in proportion to their ownership share? (40-6A(b)) No No Yes Yes b. Does the transferee (or if a securitization/ asset-backed financing entity, each beneficial interest holder) have the right to pledge or exchange the transferred financial assets? (40-5(b)) No c. Do the rights of all participating interest holders have equal priority and none is subordinated? (40-6A(c)) Yes No Yes c. Has the transferor maintained effective control of the transferred assets? (40-5(c)) Yes d. Does any party have the right to pledge or exchange the entire financial asset without agreement by all participating interest holders? (40-6A(d)) No Yes No The portion is a participating interest. See TS 3 (Accounting for Sales-Type Transfers) See TS 4 (Accounting for Financing-Type Transfers) 1 For the purposes of this exhibit, 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. Accounting for Sales-Type Transfers / 3-3

138 Key Questions Answered in This Chapter 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 re-recognition of financial assets previously sold? How should a transferee account for transfers of financial assets? Paragraphs in ASC Page in This Publication 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: 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: (continued) 3-4 / Accounting for Sales-Type Transfers

139 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 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. Accounting for Sales-Type Transfers / 3-5

140 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: 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 interestrate 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 ). 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 / Accounting for Sales-Type Transfers

141 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 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). Accounting for Sales-Type Transfers / 3-7

142 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. 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. 3-8 / Accounting for Sales-Type Transfers

143 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. 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. Accounting for Sales-Type Transfers / 3-9

144 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. 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 fixed-rate 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) / Accounting for Sales-Type Transfers

145 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 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 Accounting for Sales-Type Transfers / 3-11

146 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. 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 / Accounting for Sales-Type Transfers

147 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 $ 100 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 (continued) Accounting for Sales-Type Transfers / 3-13

148 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. 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 110 Servicing asset 75 retained Servicing asset 75 Net proceeds $ 990 (continued) 3-14 / Accounting for Sales-Type Transfers

149 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 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. Accounting for Sales-Type Transfers / 3-15

150 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. 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: 3-16 / Accounting for Sales-Type Transfers

151 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 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 Accounting for Sales-Type Transfers / 3-17

152 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 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 / Accounting for Sales-Type Transfers

153 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: 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. Accounting for Sales-Type Transfers / 3-19

154 3.3.1 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 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 / Accounting for Sales-Type Transfers

155 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. Exhibit 3-2 lists examples of financial assets that are subject to prepayment risk. Exhibit 3-2: Examples of Financial Assets Subject to Prepayment Risk Asset-backed securities High-rate debt instruments Purchased interest-only strips Interest-only strips obtained as proceeds of a sale Mortgage-backed securities CMOs 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 3. Accounting for Sales-Type Transfers / 3-21

156 3.3.2 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 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 / Accounting for Sales-Type Transfers

157 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. 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 Accounting for Sales-Type Transfers / 3-23

158 Exhibit 3-4: Decision Tree for Determining Whether a Beneficial Interest (BI) is Within the Scope of ASC Is the holder of the BI required to consolidate the issuer? Yes No Is the BI a debt security or required to be accounted for like one pursuant to ASC ? Yes Is the purchase of the BI within the scope of ASC ? No Yes No Does the securitization involve financial assets that have contractual cash flows (for example, loans, receivables, debt securities, etc.)? No Yes Are the BIs of such high credit quality that the possibility of credit loss is remote (e.g., (1) BIs that are guaranteed by the U.S. government, its agencies, or other creditworthy guarantors and (2) loans or securities that are sufficiently collateralized)? Are the BIs not able to be contractually prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment? Yes No The BI is within the scope of ASC Not in the scope of ASC Follow the GAAP that applies to that investment; consolidate as appropriate. 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-thantemporary impairment. If a change in the cash-flow estimates has not resulted in an 3-24 / Accounting for Sales-Type Transfers

159 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 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 Accounting for Sales-Type Transfers / 3-25

160 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 non-credit 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 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 / Accounting for Sales-Type Transfers

161 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. 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. Accounting for Sales-Type Transfers / 3-27

162 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 NPV at 15% Original estimate $ 20 $ 20 $ 20 $ 20 $ 220 $300 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. 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-than-temporary impairment should be recognized (refer to Exhibit 4-4 above for further analysis). Refer to the decision tree below for additional information on determining whether impairment recognition is necessary / Accounting for Sales-Type Transfers

163 Exhibit 3-5: Decision Tree for Determining Whether Impairment Recognition Is Necessary Is the fair value less than the reference amount? Yes No Has the prior cash flow estimate changed adversely? Yes Has the prior cash flow estimate changed in a manner that is either adverse or favorable? No Impairment charge for credit loss is required. Does the Company intend to sell or is it more likely than not that it will be required to sell before recovery (see ASC 320)? Yes No No impairment is recognized: yield adjustment is recognized prospectively. Impairment charge for both non-credit and credit loss is required. Yes or No 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 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. Accounting for Sales-Type Transfers / 3-29

164 3.4 How Should a Transferor Account for the Re-Recognition 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) 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 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 3-30 / Accounting for Sales-Type Transfers

165 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. Exhibit 3-6: Accounting for Re-Recognition Events How should a transferor s beneficial interest be accounted for upon re-recognition 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 loan-loss 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 re-recognized under paragraph ? After a paragraph event, should the transferor account for its beneficial interest in the original transaction separately from the re-recognized financial assets? Re-Recognition Upon Transfer Under ROAP or Other Contingent Call 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. Yes, unless a subsequent event results in the transferor reclaiming those assets under a ROAP (or consolidation of the securitization entity). Example 3-2 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. Accounting for Sales-Type Transfers / 3-31

166 Example 3-2: 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 100 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 $ / Accounting for Sales-Type Transfers

167 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. 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. Accounting for Sales-Type Transfers / 3-33

168 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 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 paidthrough, 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 / Accounting for Sales-Type Transfers

169 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: 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 (continued) Accounting for Sales-Type Transfers / 3-35

170 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 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 x 9/10) $ 990 One-tenth participating interest that continues to be held by the transferor ($1,100 x 1/10) 110 (continued) 3-36 / Accounting for Sales-Type Transfers

171 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 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. (continued) Accounting for Sales-Type Transfers / 3-37

172 Carrying Amounts Minimum lease payments $ 540 Unearned income related to minimum lease payments 370 Gross investment in minimum lease payments 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 $ 19 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 (continued) 3-38 / Accounting for Sales-Type Transfers

173 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. 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 (continued) Accounting for Sales-Type Transfers / 3-39

174 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-for-sale security. 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 / Accounting for Sales-Type Transfers

175 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: 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. (continued) Accounting for Sales-Type Transfers / 3-41

176 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 separate-entity 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. 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 Interpretive 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 / Accounting for Sales-Type Transfers

177 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 Interpretive 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 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. Options Embedded in Transferred Securities Excerpt from ASC : 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. (continued) Accounting for Sales-Type Transfers / 3-43

178 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 460. 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. (continued) 3-44 / Accounting for Sales-Type Transfers

179 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 (continued) Accounting for Sales-Type Transfers / 3-45

180 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. (continued) 3-46 / Accounting for Sales-Type Transfers

181 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. (continued) Accounting for Sales-Type Transfers / 3-47

182 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. (continued) 3-48 / Accounting for Sales-Type Transfers

183 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. 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 availablefor-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.) (continued) Accounting for Sales-Type Transfers / 3-49

184 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 heldto-maturity classification is acceptable if the conditions specified for a held-to-maturity classification in paragraphs (c) and (a) have been met. 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 available-for-sale or trading under ASC 320. Does that requirement result in those financial assets being included in the scope of ASC 320? PwC Interpretive 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 / Accounting for Sales-Type Transfers

185 3.7.4 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. 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 Interpretive 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. Accounting for Sales-Type Transfers / 3-51

186 Question 3-5: Can the accounting for transferred financial assets that previously satisfied the ASC 860 criteria for sale accounting be reversed? PwC Interpretive 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 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 / Accounting for Sales-Type Transfers

187 Chapter 4: Accounting for Financing-Type Transfers Accounting for Financing-Type Transfers / 4-1

188 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 Chapter 2, a transfer of financial assets qualifies for sale accounting if the transferor of the financial assets relinquishes control of the assets. If the transferor does not relinquish control of the financial assets, the transfer is accounted for as a type of financing arrangement referred to as a secured borrowing. The rationale behind this is that if control of the transferred financial assets remains with the transferor, its consolidated affiliates in the financial statements being presented, or its agents, the transaction is more akin to a financing arrangement, with the transferor borrowing cash and granting the lender a security interest in the financial assets to serve as collateral for its obligation. The lender may be permitted to sell or repledge (i.e., transfer) this collateral, which is held under a pledge. The lender may or may not have recourse against the transferor s other assets. Besides typical securitizations and other secured transfers that do not meet the control criteria for sale accounting in paragraph ASC (i.e., failed sales), other financial asset transfers have been structured to ensure they are accounted for as secured borrowings. In such cases, the transferor transfers securities in exchange for cash and agrees to reacquire the securities at a future date. The commitment to repurchase the financial assets serves an important function: it enables transferors, such as financial institutions, to obtain and/or use funds based on the value of the collateral used to secure the transactions, while maintaining control over the collateral. Such arrangements are prevalent in today s marketplace. Three types of these secured borrowing transactions include: Repurchase agreements. The debtor transfers 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 debtor enters into an agreement to repurchase the same security from the borrower at a future date. Dollar rolls. The debtor transfers a MBS to an entity that acts as secured party (the MBS serve as collateral) in exchange for cash. At the same time, the debtor enters into an agreement to repurchase a similar but not identical MBS from the borrower 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. Generally, secured borrowings result in the transferor recognizing the cash it received from the borrowing and an obligation to return the cash in the future. A detailed analysis of the facts and circumstances of the agreement must be performed in order to determine the correct accounting for any 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 application of that accounting model to repurchase agreements, securities lending, and dollar rolls. 4-2 / Accounting for Financing-Type Transfers

189 Exhibit 4-1: Framework for Accounting for Transfers of Financial Assets 1 Does the transaction involve a transferee that is a consolidated affiliate of the transferor? (TS 1) Yes No Does the transaction involve financial asset(s)? (TS 1) No Yes Does the transaction meet the definition of a transfer? (TS 1) No Transaction is NOT subject to ASC 860 (Consider other GAAP such as ASC , ASC 840, ASC 972) Yes Does the transfer meet any of the scope exceptions? (TS 1) Yes No Is the transfer eligible for sale accounting (i.e., involve a financial asset, group of financial assets, or a participating interest (see right flowchart) in an entire financial asset)? (TS 2) Yes Does the transfer meet all of the control criteria of ASC ? a. Have the financial assets been isolated from the transferor (and its consolidated affiliates) and its creditors? (40-5(a)) Portion Yes No If a transfer of a portion of a financial asset, does the interest transferred and the interest retained meet the participating interest definition in ASC A? All the following criteria must be met: a. Does it represent a pro rata ownership interest in an entire financial asset? (40-6A(a)) Yes b. Are all cash flows from the entire financial asset divided among the participating interest holders in proportion to their ownership share? (40-6A(b)) No No Yes Yes b. Does the transferee (or if a securitization/ asset-backed financing entity, each beneficial interest holder) have the right to pledge or exchange the transferred financial assets? (40-5(b)) No c. Do the rights of all participating interest holders have equal priority and none is subordinated? (40-6A(c)) Yes No Yes c. Has the transferor maintained effective control of the transferred assets? (40-5(c)) Yes d. Does any party have the right to pledge or exchange the entire financial asset without agreement by all participating interest holders? (40-6A(d)) No Yes No The portion is a participating interest. See TS 3 (Accounting for Sales-Type Transfers) See TS 4 (Accounting for Financing-Type Transfers) 1 For the purposes of this exhibit, 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. Accounting for Financing-Type Transfers / 4-3

190 Key Questions Answered in This Chapter Paragraph in ASC 860 Page in this Publication When should a transfer be accounted for as a secured borrowing? What is the general accounting model for secured borrowings? How should collateral be recognized? and What is the appropriate accounting for a repurchase agreement? What is the appropriate accounting for a dollar roll? What is the appropriate accounting for a securities lending transaction? , through When Should a Transfer Be Accounted for as a Secured Borrowing? A transfer should either be accounted for as a sale or, if the transfer fails to meet the criteria for sale accounting, as a secured borrowing. The criteria used to determine whether a transfer should be treated as a sale are described in ASC and 40-5 (refer to TS 2). These criteria also apply when determining the proper accounting for secured borrowings, including repurchase agreements, dollar rolls, and securities lending transactions. ASC 860 provides applicable guidance for transfers that fail to meet the sale criteria. 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 before their maturity, (2) an agreement that provides the transferor with both the ability to unilaterally cause the holder to return specific financial assets and a more-than-trivial-benefit (other than through a clean up call), 4-4 / Accounting for Financing-Type Transfers

191 or (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. ASC 860 provides further guidance, clarifying 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: a. The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred b. Subparagraph superseded by Accounting Standards Update c. The agreement is to repurchase or redeem them before maturity, at a fixed or determinable price. d. The agreement is entered into contemporaneously with, or in contemplation of, the transfer. If the conditions above for maintaining effective control are met, the transfer transaction should be accounted for as a secured borrowing. However, if any of the conditions are not met (assuming that the other sale criteria in ASC have been satisfied), the transfer transaction should be accounted for as a sale by the transferor and a purchase by the transferee. Some repurchase agreements may be required to be accounted for as a derivative instrument under ASC 815 (refer to TS 4.4.2). On April 29, 2011, the FASB issued ASU , which eliminated the requirement for entities to consider whether a transferor has the ability to repurchase the financial assets in a repurchase agreement. Specifically, the amendments in this ASU removed from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. See also TS for additional discussions. The FASB also released an exposure draft in January 2013 to amend the accounting for transfers with forward 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 Accounting for Financing-Type Transfers / 4-5

192 for as such. As a result, the exposure draft proposes the following changes to the effective control model: Identifies when certain transactions, such as repurchase agreements, should be viewed as secured borrowings as opposed to sale, Clarifies the characteristics for a financial asset to qualify as substantially the same, Eliminates the current model for repurchase financings which will require the initial transfer and repurchase agreement to be evaluated separately, Includes additional disclosures depending on if the transaction is treated as a sale or a secured borrowing. The FASB is in the process of redeliberating this exposure draft and it is expected that certain key aspects of the proposal may change Financial Assets That Are the Same or Substantially the Same The financial assets (typically securities) to be repurchased or redeemed must be the same or substantially the same as those transferred. ASC 860 clarifies when the securities are considered substantially the same. Excerpt from ASC (a): 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 MBS market have established parameters for what is considered acceptable delivery. These specific standards are defined by the Bond Market Association and can be found in Uniform Practices for the Clearance and Settlement of MBS and Other Related Securities, which is published by the Bond Market Association. See paragraph for implementation guidance related to these conditions. 4-6 / Accounting for Financing-Type Transfers

193 The determination of whether a security is substantially the same should be based on the economics of the terms of the securities. Therefore, the criteria in ASC (a) is satisfied, as long as the security to be repurchased or redeemed in a secured borrowing (1) has the same obligor as the transferred security; (2) is the same type (i.e., common stock, preferred stock, bond) as the transferred security; (3) has the same maturity as the transferred security; (4) has an identical interest rate, if the transferred security is a debt security; (5) is backed by collateral of a similar asset type to that which backs the transferred security (if the transferred security is backed by collateral); and (6) has the same unpaid principal balance as the transferred security. As discussed in TS 4.1, the FASB issued an exposure draft to amend the accounting for repurchase agreements. This proposal also includes clarification to the characteristics to qualify as substantially the same. This clarification reinforces the need for a full analysis of the criteria rather than broad based assumptions Substantially the Agreed Terms ASU : Reconsideration of Effective Control for Repurchase Agreements removed from the assessment of effective control the criterion relating to the transferor s ability to repurchase or redeem the transferred financial asset at all times on substantially the agreed terms, as previously discussed in ASC (b). As a result, the update also eliminates the requirement to demonstrate that the transferor possesses adequate collateral. The guidance is effective for first interim or annual periods beginning on or after December 15, The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. The elimination of this criterion was a result of the FASB s undertake of the repurchase agreements project in the aftermath of the recent credit crisis. Some constituents questioned whether the ability to repurchase or redeem financial assets, and the related collateral maintenance guidance in ASC 860, were relevant to the entity s assessment of effective control over transferred financial assets in repurchase arrangements. The FASB ultimately determined that an assessment of effective control should focus on a transferor s contractual rights and obligations with respect to transferred financial assets and not on whether the transferor has the practical ability to exercise those rights or honor those obligations. Under the amended guidance, a transferor maintains effective control over transferred financial assets (and thus accounts for the transfer as a secured borrowing) if there is an agreement that both entitles and obligates the transferor to repurchase the financial assets before maturity and all of the other conditions described in ASC are met. The elimination of the transferor s ability criterion from the effective control assessment simplifies the accounting for repos and similar arrangements. It also could result in some arrangements that have been typically accounted for as sales being accounted for as secured borrowings. Moreover, the amendments will make it easier to compare financial statements by ensuring that repos with similar features are accounted for consistently, regardless of the different collateral requirements in different jurisdictions Repurchase or Redemption Before Maturity at a Fixed or Determinable Price The agreement to repurchase or redeem the transferred financial assets must occur before the maturity of the transferred financial assets at a fixed or determinable price. Accounting for Financing-Type Transfers / 4-7

194 This condition is not met when the term of the repurchase agreement extends to the maturity date of the transferred financial asset or when the repurchase price for the transferred financial asset is not explicitly stated or determinable based on the terms of the contract. An agreement that allows the repurchase of the security at its maturity date does not result in the transferor maintaining effective control of the financial assets. A repurchase agreement at maturity therefore fails the criterion in ASC (c), as the transferor surrenders control of the assets because its right to repurchase the financial assets occurs only at the time the assets matured or expired. If the transfer transaction fails the criterion in ASC (c) the transaction should be treated as a sale under ASC 860, assuming the other sale criteria of ASC have been met Entered Into at the Same Time as the Transfer If the transferor enters into an agreement to repurchase or redeem the financial assets at, a time other than the same time that it transfers the financial assets, the effective control over those financial assets may be maintained by the transferor. The contractual right or obligation to repurchase the transferred financial assets is not solely dependent upon entering into such agreement concurrently with the initial transfer. If the agreement was entered into contemporaneous with, or in contemplation of, the transfer (even if they were not entered into at the time of the transfer) the transaction could meet the criterion in paragraph (d) and the transferor would effectively maintain control over the transferred financial assets at the time of transfer (refer to TS for more details on linked transactions). 4.2 What Is the General Accounting Model for Secured Borrowings? When a transfer of financial assets does not meet the sale criteria in ASC , the transfer must be accounted for as a secured borrowing. Generally, accounting for a secured borrowing requires the transferor to perform the following activities: Recognize any cash received on the transfer as an asset. Record the obligation to return the cash as a liability. Continue to apply the appropriate GAAP for the financial asset. Apply the collateral provisions of ASC 860 (discussed later in this Chapter) to the financial assets transferred (i.e., account for the transferred assets as the pledge of collateral on the borrowing arrangement). If the transferee is a VIE, the accounting may be different. ASC 810 requires that a VIE be analyzed under its provisions to determine who, if anyone, is its primary beneficiary and thus is responsible for consolidating it. In many situations, the transferor may be the primary beneficiary of the VIE transferee. If the VIE is consolidated by the transferor, the entries for the secured borrowing would be negated in consolidation (i.e., any of the transferor s obligations would be considered assets of the transferee, etc.). 4.3 How Should Collateral Be Recognized? ASC 860 requires the lender (transferor) in a securities lending transaction or secured party (transferee) in a repurchase agreement, when these are to be accounted for as secured borrowing transactions to evaluate whether the assets received as collateral 4-8 / Accounting for Financing-Type Transfers

195 should be reflected on its balance sheet. Collateral can either be cash or noncash (e.g., securities). The following illustration shows a typical transfer of securities as collateral by a secured party from a debtor to a third party. Exhibit 4-2: Transfer of Collateral by a Secured Party Debtor (Transferor) Securities Cash Secured Party (Transferee) Securities Cash Third Party 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 shall 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 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, a securities lending or repurchase agreement transaction does not satisfy the sale criteria and is accounted for as a secured borrowing. Accounting by Both Transferor and Transferee In addition, in securities lending and repurchase agreement transactions accounted for as secured borrowings, the transferor and transferee should generally (absent an EOD) continue to recognize the financial assets (i.e., securities) subject to the transfer. However, if the other party 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 either party defaults, the financial assets should be derecognized and recognized as assets by the other party. Accounting for Financing-Type Transfers / 4-9

196 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.) 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. Therefore, the following key accounting results occur when the guidance from ASC (above) is implemented in transactions involving collateral: Securities or other noncash financial asset received by the transferee as collateral should continue to be recognized on the transferor s balance sheet if the transferee has the right to sell or repledge the collateral. When the transferee sells the noncash collateral, it should recognize any proceeds it receives from the transaction and record a liability for its obligation to return the collateral. Prior to the sale, the pledged asset should not be recognized on the transferee s balance sheet unless the transferor defaulted under the loan 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) / Accounting for Financing-Type Transfers

197 If none of the provisions of ASC are met, the transferor should recognize the collateral as an asset, and the transferee should not recognize the pledged asset. The following chart provides a decision tree with three key considerations for evaluating who should recognize collateral. Exhibit 4-3: Example Decision Tree for Collateral Recognition Transferee (secured party) and transferor (debtor) must evaluate criteria in ASC 860 relating to control over collateral for financial assets in their possession or pledged. (There are three separate and distinct considerations) Consideration 1: No separate accounting for collateral by secured party or debtor (assets remain on books of debtor) No Does the secured party have the right by contract or custom to sell or repledge the collateral? (ASC (a)) Yes No separate accounting for collateral by secured party (the debtor is required to reclassify the collateral pledged) Consideration 2: No change to accounting in consideration 1 (collateral pledged remains on books of debtor) No Has the secured party sold collateral pledged by the debtor? (ASC (b)) Yes Secured party must recognize proceeds from sale and obligation to return collateral Consideration 3: No change to accounting for collateral (collateral pledged remains on books of debtor) No Has the debtor defaulted, and thus is no longer entitled to redeem the collateral? (ASC (c)) Yes Debtor shall derecognize pledged asset and secured party will recognize collateral as its own asset Accounting for Financing-Type Transfers / 4-11

198 4.4 What Is the Appropriate Accounting for a Repurchase Agreement? Repurchase agreements (often referred to as repos ) are transactions by which the transferor (or lender of securities) transfers a financial asset (usually a security) to a transferee (or borrower of securities) 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, certificates of deposit, or treasury bills. The transferee, who is often a dealer financing its trading inventory, will pay a lower rate than it would on a collateralized bank loan. Parties to repo transactions are referred to in a variety of ways. The following chart presents the terms that are commonly used to identify these entities. Exhibit 4-4: The Parties in Repos Transferor Lender of securities Borrower of cash Repo party Securities Cash Transferee Borrower of securities Lender of cash Reverse repo counterparty 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, one week, several weeks, a month, or even 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 borrower of securities) or transferor (or lender of securities) at anytime, 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 the loan is repaid to the transferee, thus providing security to the transferee in the EOD by the transferor / Accounting for Financing-Type Transfers

199 4.4.1 Accounting for Repurchase Agreements Consistent with the ASC 860 model, the accounting for repos depends on whether the agreement qualifies for sale accounting under ASC Most repos are accounted for as secured borrowing transactions, as the transferor maintains effective control over the securities, as described in paragraph ASC (thereby, failing the criterion for sale accounting under paragraph ASC (c)). Specifically, repos that are accounted for as secured borrowing transactions generally include an agreement to return or repurchase the transferred securities and have the following characteristics: The term of the repo generally does not extend past the maturity date of the transferred securities. The securities to be returned are the same or substantially the same as the ones that were originally transferred. The transferor in a repo transaction with the characteristics described above should recognize any cash received, record the obligation to repurchase the security in the future, and determine how to account for the transferred financial assets by applying the collateral provisions in paragraph ASC Repo transactions, however, may not always be secured borrowing transactions. Certain agreements result in the transferor not maintaining effective control of the transferred financial assets. In this case, the repo may have to be accounted for as a sale transaction with a forward purchase contract, as long as all of the criteria in paragraph ASC are met. The forward purchase contract 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. Accounting for Financing-Type Transfers / 4-13

200 Exhibit 4-5: Accounting for Standard Repurchase Transactions Are all criteria in paragraph ASC met? No Yes Repo accounted for as a financing Record cash received and related repo obligation Repo accounted for as a sale of securities and a forward commitment to repurchase Yes Is the transferee permitted to pledge or sell the securities collateral? No Derecognize asset(s), record proceeds and recognize gain/loss. Also, recognize forward purchase commitment Transferor reclassifies the securities collateral as securities pledged to creditors Transferor does not reclassify the securities collateral because it has not surrendered control of the collateral 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 later in this Chapter). In effect, the securities received are accounted for as if they were cash (i.e., to be 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. In order for the transferor to maintain effective control of the financial asset through an agreement to repurchase or redeem any transferred security, the security to be repurchased or redeemed must be substantially the same as the transferred security. Because the securities 4-14 / Accounting for Financing-Type Transfers

201 sold and repurchased can be similar but not identical, a careful analysis of the transaction is necessary to determine whether the transferor has maintained effective control of 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. When a repo expires at the maturity date of the transferred financial assets, the transferor no longer maintains control of the transferred security through its agreement to repurchase the asset because the repurchase of the instrument did not take place before the time at which the security matured or expired. The guidance clarifies that transfers with agreements to repurchase at maturity should be accounted for by the transferor as a sale of financial assets and a forward repurchase commitment (i.e., apply sale accounting to the repo transaction), as long as all of the requirements established in ASC are also met. 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 (or borrower of securities) 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 arrangement, accounted for as a secured borrowing. Example 4-1: Standard Repo Accounted for as a Secured Borrowing Transferee (or Borrower of Securities) 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 collateral is $5, based on an approximate 5 percent annual rate for 35 days. Company B receives a fee 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. (continued) Accounting for Financing-Type Transfers / 4-15

202 Company A Transferor (Lender of securities) Company B Transferee (Borrower of securities) 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 To record transfer of cash to the securities lender Securities pledged to Company B 1,000 Company B is not required to recognize Securities 1,000 the security on its balance sheet. An To reclassify pledged security that the obligation to return the pledged security secured party has the right to sell or repledge is only recorded when Company B sells Money market instrument 980 the security or Company A defaults. The security held as collateral is disclosed. 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 (rebate) 4 To record results of short term cash investment To record receipt of cash on conclusion of reverse repo transaction Securities 1,000 Securities pledged to Company B 1,000 To reclassify security no longer pledged Obligation under repo agreements 980 Interest expense (rebate) 4 Cash 984 To record repayment of repo principal plus interest [Note: Interest income and expense should be recorded on the accrual basis of accounting throughout the term.] Example 4-2: Standard Repo Accounted for as a Secured Borrowing Transferee (Borrower of Securities) 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 collateral is $5, based on an approximate 5 percent annual rate for 35 days. Company D receives a fee 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. (continued) 4-16 / Accounting for Financing-Type Transfers

203 Company C Transferor (Lender of securities) Company D Transferee (Borrower of securities) 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 Securities 1,000 To reclassify pledged security that the secured party has the right to sell or repledge The transferor reclassifies the security to securities pledged which reflects the economics retained by the transferor of the security. This is not deemed to be a receivable. To record transfer of cash to the securities lender Company D is not required to recognize the security on its balance sheet. An obligation to return the pledged security is only recorded when Company D sells the security or Company C defaults. The security held as collateral is disclosed. Money market instrument 980 Cash 980 Cash 980 Obligations under repo agreements 980 To record investment of cash collateral To record the repledge of colalteral The on pledge of collateral will need to be disclosed. Money market investment 980 Cash 980 To record investment of cash collateral 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 investment Securities 1,000 Securities pledged to Company D 1,000 To reclassify security no longer pledged To record results of short term cash investment Obligations under repo agreements 980 Cash 980 To record return of repledge security and cash collateral Obligation under repo Cash 984 agreements 980 Interest expense (rebate) 4 Reverse repo agreements 980 Cash 984 Interest income (rebate) 4 To record repayment of repo principal plus interest To record the receipt of cash collateral and interest on the repo agreement Accounting for Financing-Type Transfers / 4-17

204 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 thirdparty 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 collateral is $5, based on a 5 percent annual rate for 35 days. Company F receives a fee 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 (Lender of securities) Company F Transferee (Borrower of securities) 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 To record transfer of cash to the securities lender The transferor does not reclassify the securities as transferee does not have the right to sell or repledge. The amount of securities pledged will need to be disclosed. This example contrasts securities transfers in which the transferee can sell/repledge the collateral. Under a triparty agreement, the transferee does not have access to the security The same accounting will occur when the transferee holds securities that cannot be sold or repledged as further described in ASC 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 (rebate) 4 To record results of short term cash investment To record the receipt of cash collateral and interest on the repo agreement Obligation under repo agreements 980 Interest expense (rebate) 4 Cash 984 To record the repayment of repo principal Accounting for Linked Repurchase Financing Transactions The FASB amended ASC 860 in 2008 to provide guidance, beginning in ASC , in determining whether an initial transfer of a financial asset and a repurchase financing should be considered linked for the purposes of assessing whether sale accounting is appropriate. Unless the initial transfer and the repurchase 4-18 / Accounting for Financing-Type Transfers

205 financing meet all of the criteria in paragraph , the transactions shall be considered linked. The linked transaction should then be evaluated to determine whether it meets the requirements for sale accounting under paragraph If the linked transaction does not meet the requirements for sale accounting, the linked transaction shall be accounted for based on the economics of the combined transactions, which generally represent a forward contract that may be subject to derivative accounting under ASC 815. The repurchase financing guidance was effective for fiscal years beginning after November 15, 2008, and must be applied prospectively to repurchase financings related to initial transfers that were executed on or after the date of adoption. Early adoption was not permitted. The scope of the repurchase financing guidance applies to repurchase financings that relate to previously transferred financial assets between the same counterparties (or consolidated affiliates of either counterparty), that are entered into contemporaneously with or in contemplation of the initial transfer. Repurchase financings that could be subject to the guidance are those described in: Excerpt from ASC : Government securities dealers, banks, other financial institutions, and corporate investors commonly use repurchase agreements to obtain or use short-term funds. Excerpt from ASC : Repurchase agreements can be effected in a variety of ways. Some repurchase agreements are similar to securities lending transactions in that the transferee has the right to sell or repledge the securities to a third party during the term of the repurchase agreement. In other repurchase agreements, the transferee does not have the right to sell or repledge the securities during the term of the repurchase agreement. For example, in a tri-party repurchase agreement, the transferor transfers securities to an independent third-party custodian that holds the securities during the term of the repurchase agreement. Excerpt from ASC : Many repurchase agreements are for short terms, often overnight, or have indefinite terms that allow either party to terminate the arrangement on short notice. However, other repurchase agreements are for longer terms, sometimes until the maturity of the transferred financial asset. Some repurchase agreements call for repurchase of securities that need not be identical to the securities transferred. Per ASC a transferor and transferee should not account for a transfer of a financial asset and a related repurchase financing separately unless (1) the two transactions have a valid and distinct business or economic purpose for being entered into separately, and (2) the repurchase financing does not cause the initial transferor to regain control over the financial asset. These requirements are met if all of the criteria of paragraph are met at the inception. A repurchase financing is entered into in contemplation of the initial transfer (rather than contemporaneously with it) if both transactions are considered together at the execution of the initial transfer. When a significant amount of time separates the two Accounting for Financing-Type Transfers / 4-19

206 transactions, it becomes easier to support that there is a valid and distinct business purpose for entering into the two transactions separately. ASC provides certain criteria, that if met, will result in the initial transfer and repurchase financing considered to have been entered into in contemplation of each other and as a result shall be considered linked for accounting purposes. Excerpt from ASC : A repurchase financing is entered into in contemplation of the initial transfer if both transactions are considered together at the execution of the initial transfer. An initial transfer of a financial asset and repurchase financing that are entered into contemporaneously with, or in contemplation of, one another shall be considered linked unless all of the following criteria are met at the inception of the transaction: a. The initial transfer and the repurchase financing are not contractually contingent on one another. Even if no contractual relationship exists, the pricing and performance of either the initial transfer or the repurchase financing shall not be dependent on the terms and execution of the other transaction. b. The repurchase financing provides the initial transferor with recourse to the initial transferee upon default. That recourse shall expose the initial transferor to the credit risk of the initial transferee, or its affiliates, and not solely to the market risk of the transferred financial asset. The initial transferee s agreement to repurchase the previously transferred financial asset (or substantially the same asset) is for a fixed price and not fair value. c. The financial asset subject to the initial transfer and repurchase financing is readily obtainable in the marketplace. In addition, the initial transfer of a financial asset and the repurchase financing are executed at market rates. This criterion shall not be circumvented by embedding off-market terms in a separate transaction contemplated with the initial transfer or the repurchase financing. d. The financial asset and repurchase agreement are not coterminous (the maturity of the repurchase financing shall be before the maturity of the financial asset). For guidance on determining whether the repurchase agreement is before the maturity of the asset, see paragraph Companies must apply judgment and should establish their understanding of the term in contemplation of to help determine which transactions will be subject to the repurchase financing guidance beginning in ASC If companies choose not to establish their own definition of in contemplation of, there is a presumption that all initial transfers and repurchase financing transactions between the same counterparties are within the scope of the guidance. We believe that the company s definition should be reasonable, defensible, and consistent with the spirit and intent of the guidance / Accounting for Financing-Type Transfers

207 The following diagram is included in ASC A and summarizes three elements that typically comprise transactions that fall within the scope of the repurchase financing guidance. Transfer of a Financial Asset a Cash Initial Transferor b Transfer of a Financial Asset (as collateral) Cash Initial Transferee Return of Financial Asset c Cash a. An initial transfer: The initial transferor transfers a financial asset to the initial transferee in return for cash.* b. The execution of a repurchase financing: The initial transferee enters into a repurchase financing arrangement 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 financing arrangement, the initial transferee is obligated to repurchase the financial asset (or substantially the same financial asset) at a fixed price within a prescribed period of time. c. The settlement of the repurchase financing: 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. * Whether or not the parties agree to net settle steps (a) and (b) does not affect whether the transactions are within the scope of the guidance. However, the ability to net settle the transactions is a factor to consider in determining whether the two transactions meet all the provisions in paragraphs ASC through In considering the requirements of paragraph ASC (b), the initial transferor s exposure to the credit risk of the initial transferee is unrelated to the initial transferee s overall credit or credit rating. Rather, it is intended to ensure that the transferor is at risk for the full fixed price under the repurchase agreement without that risk being limited to the value of the underlying asset transferred. This recourse could be satisfied by other assets of the transferee. If the transferor s recourse in the EOD by the initial transferee were limited just to selling the financial asset, the initial transferor is exposed to the risk of subsequent changes in fair value, and therefore effectively maintains control over the transferred financial asset. An agreement that requires full collateral to be provided against the fixed price, whereby a decline in the value of the collateral requires the provision of additional collateral to cover the decline, would appear to satisfy this requirement. Accounting for Financing-Type Transfers / 4-21

208 To comply with the requirements in paragraph ASC (c), the initial exposure draft proposed that the financial assets be Level 1 assets as defined in ASC 820, Fair Value Measurements and Disclosures. Several comment letters, including our own, felt that this definition was too restrictive and instead proposed that the financial assets be readily obtainable a term already used in ASC 860. In our view, the use of the term readily obtainable in the marketplace, as included in the final version of paragraph ASC (c), means that the initial transferor can return the same or similar financial assets and is not constrained in any manner from selling or pledging the initially transferred financial assets. In situations where the transferred financial asset is unique or not readily obtainable, the initial transferor effectively constrains itself from pledging or selling the asset by agreeing to a repurchase provision. Similarly, if the initial transferee were the only party that held the type of assets that the initial transferor had to return to the initial transferee, the financial assets initially transferred would not be readily obtainable. Examples of financial assets that are readily obtainable in the marketplace include treasury notes/ bonds and agency MBS, including TBA securities. An example of a financial asset that is not readily obtainable is a specific commercial loan. In considering the requirements of paragraph ASC (d), the implementation guidance included in ASC elaborates on this concept. It states in part that, A transferor s agreement to repurchase a transferred asset would not be considered a repurchase or redemption before maturity if, because of the timing of the redemption, the transferor would be unable to sell the asset before maturity (that is, the period until maturity is so short that the typical settlement is a net cash payment). If the transactions meet all of the aforementioned criteria, the initial transfer should be accounted for separately from the repurchase financing and the repurchase financing should be analyzed as a repurchase agreement under ASC 860. If the transactions do not meet all of the aforementioned criteria, the initial transfer and repurchase financing should be evaluated as a linked transaction to determine whether sale accounting under ASC 860 is appropriate. If the linked transaction does not meet the requirements for sale accounting, the linked transaction should be accounted for based on the economics of the combined transactions, which generally represents a forward contract. ASC 815 should be used to evaluate whether the forward contract should be accounted for as a derivative. Other accounting literature may also need to be considered. Determining whether the resulting forward contract is a derivative will likely depend on whether it meets the net settlement requirement under ASC 815. The forward contract may also be eligible for hedge accounting under ASC ( Allin-One Hedges ). If the forward contract is not a derivative, the guidance contained in ASC may be applicable if the financial asset is a security that will be accounted for under ASC 320, Accounting for Certain Investments in Debt and Equity Securities / Accounting for Financing-Type Transfers

209 Example 4-4: Accounting Treatment for a Linked Transaction in the Event of a Failed Sale, Assuming That the Resulting Forward Contract Meets the Definition of a Derivative Under ASC 815 (Note that other scenarios could exist) Company A (initial transferor) transfers a security with a fair value of $1,000 to Company B (initial transferee) in exchange for $990 in cash. The security is not readily obtainable in the marketplace. Company B then transfers the same security to Company A and agrees to repurchase the security in 35 days for $990. The fair value of the security increases to $1,020 during the course of the 35-day period. The initial transfer and repurchase agreement are net-settled. The fair value of the forward contract is determined by both parties to be $9 at inception and $30 at maturity. The change in fair value includes a financing fee of $8 based on an 8-percent annual rate for 35 days. The typical rate for such a transaction is 4 percent. Although Company A may sell or repledge the security, it does not do so during the transaction. For purposes of this example, assume that the legal right of offset exists. Both Company A and B conclude that the repurchase financing transaction was entered into in contemplation of the initial transfer. Both companies also conclude that the two transactions must be linked because (1) the security is not readily obtainable in the marketplace, and (2) the two transactions were not executed at market rates (since the forward was executed at a rate that differed from the current market rate for the securities involved). After linking the two transactions, both companies conclude that sale accounting is not appropriate for the initial transfer of the security and that the resulting forward contract meets the definition of a derivative under ASC 815. (continued) Accounting for Financing-Type Transfers / 4-23

210 The following journal entries illustrate the appropriate accounting treatment for this arrangement for each company: Company A Initial transferor of securities and provider of financing Company B Initial transferee of securities and recipient of financing At inception: At inception: Asset/expense/equity Forward purchase $9 depending on nature of derivative transaction $9 Forward sale derivative $9 Liability/income/equity depending on nature of transaction $9 To record the fair value of derivative contract at inception (no exchange of cash due to net settlement) To record the fair value of derivative contract at inception (no exchange of cash due to net settlement) At maturity of repurchase agreement: At maturity of repurchase agreement: Securities 20 Unrealized gain on securities 20 To record fair value change on the securities Loss on derivative 21 Forward purchase derivative 21 Forward sale derivative 21 Gain on forward derivative 21 To record fair value change on forward contract To record fair value change on derivative contract Cash 990 Securities 1,020 Forward sale derivative 30 Forward purchase derivative 30 Securities 1,020 Cash 990 To record cash receipt on settlement of forward sale, and to derecognize the security To record cash payment on settlement of forward purchase, and to recognize the security purchased 4-24 / Accounting for Financing-Type Transfers

211 The following decision tree provides an overview of the process that should be followed to determine whether the initial transfer of a financial asset and a repurchase financing should be linked or accounted for separately: Decision Tree Was the repurchase financing entered into contemporaneously with the initial transfer? (ASC ) No Yes Was the repurchase financing entered into in contemplation of the initial transfer? (ASC ) Yes Are the initial transfer and the repurchase financing contractually contingent on one another? (Paragraph 44(a)) No No Yes If no contractual relationship exists, does the pricing and performance of either the initial transfer or the repurchase financing depend on the terms and execution of the other transaction? (Paragraph 44(a)) No No Does the repurchase financial provide the initial transferor with recourse that exposes the initial transferor to the credit risk of the initial transferee, or its affiliates, and not solely to the market risk of the transferred financial asset, upon default? (Paragraph 44(b)) Yes No Is the initial transferee s agreement to repurchase the previously transferred financial asset (or substantially the same asset) for a fixed price and not fair value? (Paragraph 44(b)) Yes No Is the financial asset subject to the initial transfer and the repurchase financing readily obtainable in the marketplace? (Paragraph 44(c)) Yes No Are the initial transfer and repurchase financing executed at market rates? (Paragraph 44(c)) Yes Yes Are there embedded off-market terms in a separate transaction contemplated with the initial transfer or the repurchase financing? (Paragraph 44(c)) No Yes Are the financial asset and repurchase agreement coterminous (i.e., the maturity of the repurchase financing is not before the maturity of the financial asset)? (Paragraph 44(d)) No The initial transfer and repurchase financing shall be considered linked. The initial transfer and repurchase financing shall be accounted for separately. Accounting for Financing-Type Transfers / 4-25

212 As discussed in TS 4.1, the FASB issued a proposal on the accounting for repurchase agreements and repurchase financings. The proposed amendment eliminates the current model for repurchase financings. As such, this amendment will require that the initial transfer and repurchase agreement be evaluated separately under the sale accounting criteria. 4.5 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. Three federally sponsored credit agencies the FHLMC, the FNMA, and the GNMA and many private companies purchase mortgages to create MBSs. The MBS market consists of dealers who finance their securities inventory and take trading positions in the cash and forward markets (i.e., when issued securities). A special type of repo, known as the dollar roll, has evolved in this market. Dollar rolls are agreements where the lender transfers an MBS to a borrower in exchange for cash. At the same time, the lender enters into an agreement to repurchase a similar but not identical MBS at a future date. The 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: GNMA Rolls: The term GNMA rolls has been used broadly to refer to a variety of transactions involving MBS, 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 on types 1, 2 and 3 are all subject to the guidance in ASC 860. Type 4 dollar rolls, in which the transferor rolls out a TBA security would not be subject to ASC 860, since the TBA security is not a recognized financial asset at the time of the transaction. These type 4 dollar roll transactions need to be accounted for under the 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 / Accounting for Financing-Type Transfers

213 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, the key provision for determining the accounting for dollar rolls is the guidance in ASC (c), which requires the transferor to give up effective control of the financial assets before it can account for the transaction as a sale. ASC further explains that, in order for the transferor to maintain effective control of the asset through an agreement to repurchase or redeem any transferred security, the security to be repurchased or redeemed must be substantially the same as the transferred security. Because the securities sold and 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 maintained effective control of the financial assets. Although most yield maintenance dollar rolls are accounted for as sales, some fixed coupon dollar rolls are accounted for as secured borrowings. Dollar roll contracts, however, should be reviewed to determine whether the transferor has maintained effective control of the transferred assets under ASC (c), including whether any security to be repurchased is substantially the same as the transferred security. 4.6 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. 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. In the United States, equity transactions must settle in three days. If a dealer sells a security that it does not own, the dealer must borrow the security temporarily to enable settlement of the transaction. Securities loaned are generally treated as sales under bankruptcy and tax laws. Accounting for Financing-Type Transfers / 4-27

214 4.6.1 Accounting for Securities Lending Consistent with the guidance for secured borrowings, the proper accounting for a securities lending transaction is predicated on whether the transaction meets the criteria in ASC for sale accounting. ASC provides further guidance regarding the accounting for securities lending transactions. Excerpt from ASC : Paragraphs through provide background on securities lending transactions. If the conditions in paragraph are met, a securities lending transaction shall 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. Excerpt from ASC : 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. Excerpt from ASC : 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, a securities lending transaction does not satisfy the sale conditions and is accounted for as a loan of securities by the transferor to the transferee. The guidance above reiterates that securities loaned should be accounted for as a sale if they meet the criteria in ASC If the securities lending agreement meets the requirements for sale accounting, the lender should derecognize the transferred securities, the collateral (regardless of whether it is in the form of cash or other securities, but provided that the lender can sell or repledge the collateral) should be recognized as an asset, and a forward repurchase commitment should be recognized. Depending on the economics of the transaction, a gain or loss may also have to be recorded. Letters of credit are not considered proceeds and should only be disclosed. However, in practice, securities lending transactions are generally designed to ensure that the transactions are not recorded as sales for GAAP or tax purposes. In addition to the criteria outlined in ASC , ASC provides guidance on the treatment of securities lending transactions as secured borrowings / Accounting for Financing-Type Transfers

215 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. Therefore, if a securities lending arrangement results in the transferor maintaining effective control of the transferred financial assets (as described in ASC ), it should be accounted for as a secured borrowing. When applying the principles of ASC 860 to account for securities lending transactions as secured borrowings, the following should be considered: 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. 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 (or any investments made with that cash) should be recognized as an asset by the lender, as long as it 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 cash or collateral. The examples below illustrate the accounting approaches for the following three different securities lending transactions: (1) a securities lending transaction that is treated as a secured borrowing, where the securities lender (i.e., the transferor) receives cash as collateral and the borrower of securities sells the securities upon receipt, later buying similar securities to return to the securities borrower, (2) a securities lending transaction that is treated as a secured borrowing, where the securities lender receives treasury securities as collateral and the securities borrower does not sell the securities, and (3) a securities lending transaction that is treated as a secured borrowing, where the securities lender receives treasury securities as collateral and the borrower of securities sells the securities upon receipt, later buying similar securities to return to the securities lender. Accounting for Financing-Type Transfers / 4-29

216 Example 4-5: 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; a third party). 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 for 35 days, and $4, based on an annual rate of 4 percent for 35 days. 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 qualifies for secured borrowing treatment. The following journal entries show the accounting treatment for this arrangement. Company A Transferor (Lender of stock) Company B Transferee (Borrower of stock Lender of Cash) At inception: At inception: Cash $1,020 Receivable under securities loan agreements $1,020 Payable under securities Cash $1,020 loan agreements $1,020 To record the receipt of cash in exchange for securities collateral To record transfer of cash to the securities lender Securities pledged to Cash 1,000 Company B 1,000 Securities 1,000 Obligation to return borrowed 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 To record investment of cash collateral To record sale of borrowed security to third party and obligation At conclusion: At conclusion: Cash 1,025 Cash 1,024 Interest income 5 Receivable under securities loan agreements 1,020 Money market instrument 1,020 Interest income (rebate) 4 To record results of short term investment To record the receipt of cash collateral and rebate interest Securities 1,000 Obligation to return borrowed securities 1,000 Securities pledged to Cash 1,000 Company B 1,000 To reclassify security no longer pledged To record the repurchase of security borrowed and redelivery of security to lender Payable under securities loan agreements 1,020 Interest expense 4 Cash 1,024 To record repayment of cash collateral plus interest 4-30 / Accounting for Financing-Type Transfers

217 Example 4-6: 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; a third party). 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 transferred. However, Company F does pay a fee of $1 to Company E, based on an annual rate of 1 percent for 35 days. 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 for Security X Company F Transferee of Security X (The Lender) (The Borrower) At inception: At inception: Securities (Y) $1,020 Company F is not required to recognize Payable under securities the borrowed Security X on its balance loan agreements $1,020 sheet. The obligation to return the pledged To record the receipt of Security Y in lieu of Security X is only recorded if Security X is cash collateral that the transferor can sell or sold or Company E defaults. The security pledge held as collateral is disclosed. Cash or securities collateral that the transferor is able to sell or repledge is considered the amount borrowed under a secured borrowing. 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 No entry or disclosure is required by Company F for the transfer of Security Y as it is not deemed to be collateral. At conclusion: At conclusion: Securities (X) 1,010 Security lending fee 1 Securities pledged to Cash 1 Company F 1,010 To reclassify Security X no longer pledged To record fee 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 lending Security X to transferee Accounting for Financing-Type Transfers / 4-31

218 Example 4-7: 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; a third party). 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 transferred. However, Company D pays a fee of $1 to Company C, based on an annual rate of 1 percent for 35 days. Company C agrees to repurchase Security S in 35 days. 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 for Security S (The Lender) Company D Transferee for Security S (The Borrower) At inception: At inception: Securities (T) $1,020 Receivable from broker $1,010 Payable under securities Short position (S) $1,010 loan agreements $1,020 To record the receipt of Security T in lieu of cash collateral that the transferor can sell or repledge Securities (S) pledged to Company D 1,010 Securities (S) 1,010 To reclassify pledged/loaned Securities (S) that the secured party has the right to sell or repledge To record short sale of Security S on trade date Securities (S) 1,010 Obligation to return borrowed securities 1,010 To record borrowed Security S and the resulting obligation when it is delivered 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 or disclosure 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 To repurchase short security Payable under securities loan Obligation to return agreements 1,020 securities 1,010 Securities (T) 1,020 Securities (S) 1,010 To record repayment/redelivery of Security T To record delivery of securities to Company C Cash 1 Security lending fee 1 Security lending fee 1 Cash 1 To record fee for lending Security S to the transferee To record fee to lender of Security S 4-32 / Accounting for Financing-Type Transfers

219 4.7 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 or derecognition of the assets by the transferor. ASC provides criteria that must be met in order for sale accounting to be appropriate. If the criteria in ASC are not met, the transaction must be accounted for as a secured borrowing. Transactions that are accounted for as secured borrowings can take many different forms. These forms can range from sale transactions that fail sale accounting requirements (i.e., failed sales ), to certain transfer transactions that act as borrowing arrangements structured to achieve financing accounting treatment (e.g., repos, dollar rolls, and securities lending arrangements). As many of the standard secured borrowing arrangements contain agreements to repurchase or redeem the transferred financial assets at a future date, a determination of whether the transferor maintains effective control of the assets must be performed in order to conclude whether the criteria for sale accounting in ASC (c) have been met. If the transferor maintains effective control of 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. An initial transfer with a related repurchase financing might need to be considered a linked transaction if there was no valid business or economic purpose for entering into the transactions separately and the repurchase financing causes the transferor to retain effective control. These transactions may need to be accounted for as derivative instruments (forward contracts) under ASC 815. 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. However, if the transferee in the borrowing arrangement is a VIE, the accounting may differ because certain VIEs may require consolidation by the transferor (if it is determined that the transferor is the primary beneficiary). The general principle is clear: If the transferor maintains effective control of the financial assets through an agreement to repurchase or redeem the transferred assets in the future, the transaction should be accounted for as a secured borrowing. If not, it should be accounted for as a sale. However, with many nuances in structured transactions, each transaction should be reviewed carefully. In light of the proposal released by the FASB in January 2013 on repurchase agreements and repurchase financings, the accounting for these transactions may change. The FASB is in the process of redeliberating this exposure draft and it is expected that certain key aspects of the proposal may change. 4.8 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. Accounting for Financing-Type Transfers / 4-33

220 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 Interpretive 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 to many repurchase agreement, dollar-roll, securities lending, and similar transactions in which cash is obtained in exchange for financial assets with an obligation for an opposite exchange later, as well as to many other transactions. 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: What is the proper classification by the transferor of securities loaned or transferred under a repurchase agreement accounted for as a secured borrowing if the transferee is permitted to sell or repledge those securities? PwC Interpretive Response: ASC provides guidance on collateral accounting issues. ASC (a) indicates that pledged financial assets should be reclassified in the statement of financial position separately from other assets not so encumbered. However, it does not specify the classification or the terminology to be used to describe those assets. ASC illustrates possible classifications and terminology. Question 4-3: Company A participates in a securities lending program with a financial institution whereby the financial institution borrows securities from Company A s portfolio of investments and posts collateral to Company A for the borrowing. The collateral provided is a unit in a cash collateral pool that the financial institution manages. Are the units received by Company A in the cash collateral pool a cash transaction for purposes of the statement of cash flow? PwC Interpretive Response: It depends. Determining whether the units received in the cash collateral pool is a cash flow transaction versus a noncash transaction depends on whether the units received can be considered a cash equivalent as defined in the Master Glossary to the FASB Codification. A cash equivalent is a short-term, highly liquid investment that is both readily convertible to known amounts of cash and so near maturity that there is insignificant risk of changes in value because of changes in interest rates. If Company A determines that the units are cash equivalents, the transaction should be presented in the financing section of the statement of cash flows since the units received are considered a borrowing. If it is determined that the units do not meet the definition of a cash equivalent, the receipt of the collateral is a noncash transaction and should be disclosed as a noncash financing activity in the financial statement footnotes / Accounting for Financing-Type Transfers

221 Question 4-4: What is the appropriate classification of liabilities incurred in connection with securities borrowing and resale agreement transactions? PwC Interpretive Response: ASC does not specify classification or terminology to be used to describe liabilities incurred by either the secured party or debtor in securities borrowing or resale transactions. However, those liabilities should be separately classified. ASC illustrates possible classifications and terminology. Question 4-5: How should a transferor measure transferred collateral that must be reclassified (for example, as securities pledged to creditors)? PwC Interpretive 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 follow the same measurement principles as before 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, while debt securities reclassified from the held-to-maturity category to securities pledged to creditors should continue to be measured at amortized cost. Question 4-6: 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 Interpretive Response: No. ASC 860 generally does not address subsequent measurement of transferred financial assets or the obligation to return transferred collateral. The liability to return the 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 the obligations incurred in short sales should be reported as liabilities and adjusted to fair value through the income statement at each reporting date. Accounting for Financing-Type Transfers / 4-35

222 Question 4-7: 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 Interpretive 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 very likely that at least some transfers end up being accounted for 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 4-8: Are most standard repo transactions treated as financings under ASC 860? PwC Interpretive Response: Generally, yes. In most standard repo transactions, the following conditions will prevail: 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. Securityfor-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 4-9: Standard U.S. dollar (USD) repurchase agreements have typically been accounted for as financing arrangements. Does ASC 860 change the accounting for USD repos (and for similar arrangements)? PwC Interpretive Response: No, most repo agreements include a concurrent written agreement to repurchase the same, or substantially the same security and therefore are treated as financings under ASC / Accounting for Financing-Type Transfers

223 Question 4-10: Prior to ASC 860, certain repos were accounted for as secured borrowings in those arrangements where the financial assets to be repurchased were not identical to the transferred asset, but were nonetheless substantially the same (e.g., dollar rolls). Are these types of transactions accounted for as secured borrowings under ASC 860? PwC Interpretive Response: In many cases, they will be accounted for as secured borrowings under ASC 860. ASC 860 incorporates the guidance in ASC , which helps to define a substantially the same repurchased asset. Specifically, in a fixed coupon dollar-roll agreement, the securities repurchased have the same stated interest rate as and maturities similar to the securities sold. They are also generally priced to result in substantially the same yield. Thus, these arrangements may be treated as financings under ASC 860. However, in a yield maintenance agreement, the securities repurchased may have a different stated interest rate than that of the securities sold, and therefore they are usually priced to result in different yields. As such, these agreements will generally continue to be treated as sales under ASC 860 because the securities repurchased are not substantially the same as those sold. Each dollar-roll transaction must be analyzed to determine the proper accounting treatment. Question 4-11: For a repo or securities lending contract that meets the collateral recognition provisions, the transferor/debtor must reclassify the pledged assets as a separate receivable on the balance sheet (e.g., securities receivable from the broker). At what value should the receivable initially be recorded, and how should it subsequently be measured? PwC Interpretive Response: ASC 860 offers no guidance regarding the initial accounting for and subsequent measurement of receivables created by the reclassification of pledged assets. We believe that such receivables should be recorded and measured at fair value if the pledged assets themselves are carried at fair value. Otherwise, the receivable should be initially recorded and subsequently measured at amortized cost, and then periodically evaluated for impairment. Question 4-12: 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? PwC Interpretive 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. Adjustments to the collateral s carrying value should also apply to the entity s obligation to return that collateral. Accounting for Financing-Type Transfers / 4-37

224 Question 4-13: Are forward contracts (or rollovers of forward contracts) that were not initiated with a simultaneously physically settled transaction subject to ASC 860? PwC Interpretive 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 4-14: 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 Interpretive 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 pursuant to a transfer of financial assets. Question 4-15: 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 end-of-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 Interpretive Response: Irrespective of whether the clearing corporation steps into the shoes of the trade counterparty (e.g., 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 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 4-16: 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 Interpretive Response: The broker should not recognize the collateral on its books because it does not effectively control the collateral / Accounting for Financing-Type Transfers

225 Question 4-17: To the extent that, for balance sheet reporting purposes under ASC 860, repos and similar transactions that were previously accounted for as financings are now treated as purchases and sales (and vice versa), should the income statement classification of earnings also change? PwC Interpretive Response: ASC 860 does not address income statement classification for such transactions (i.e., whether interest income on certain financing transactions should now be treated as gains and losses on sales). We believe that the earnings from such transactions should be reported based on the accounting for the transaction. Accordingly, interest income should be reported when a transaction is accounted for as a financing; gains and losses should be reported when a transaction is accounted for as a sale. Question 4-18: Can a dealer net an obligation to return collateral against a receivable? PwC Interpretive Response: For an offset to occur, all of the criteria of ASC must be met, including that the reporting party intends to set off. In most circumstances, these conditions will not be met. Additionally, the offsetting of collateral against an asset falls outside the scope of ASC Under certain conditions, the offset of those amounts recognized as payables under repos and those amounts recognized as receivables under reverse repos is permitted. If, however, the debtor in a reverse-repo or securities lending transaction were to default, the secured party should (1) close out the transaction by netting its investment (in the reverse repos), and (2) recognize the collateral as its asset. Question 4-19: 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 Interpretive 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 returned. Accordingly, under ASC 860, 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. Accounting for Financing-Type Transfers / 4-39

226 Question 4-20: 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 Interpretive Response: Broker-dealers and other parties to secured borrowings and similar arrangements must establish systems in order 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. Identification of information for sales transactions that had previously been treated as financings. Identification of contemporaneous initial transfers with related repurchase agreements / Accounting for Financing-Type Transfers

227 Chapter 5: Servicing of Financial Assets Servicing of Financial Assets / 5-1

228 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, presentation and disclosure of, 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 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? 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? Are there standards that servicers of financial assets are required to follow? Paragraphs in ASC , and Page in This Publication and N/A 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 5-2 / Servicing of Financial Assets

229 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 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 mortgagebacked securities, forward contracts, Treasury and Eurodollar futures contracts, and options on futures contracts. 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. Servicing of Financial Assets / 5-3

230 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). 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. (continued) 5-4 / Servicing of Financial Assets

231 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. 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. Servicing of Financial Assets / 5-5

232 5.2.2 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: 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 5-6 / Servicing of Financial Assets

233 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 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 Servicing of Financial Assets / 5-7

234 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 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. 5-8 / Servicing of Financial Assets

235 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 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. Servicing of Financial Assets / 5-9

236 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 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 5-10 / Servicing of Financial Assets

237 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 principalto-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-to-model 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. 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. Servicing of Financial Assets / 5-11

238 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 arrangement with the agencies and it is specifically related to the servicing function (refer to TS for more details). However, for nonagency 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 5-12 / Servicing of Financial Assets

239 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). 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 Servicing of Financial Assets / 5-13

240 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; 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 / Servicing of Financial Assets

241 Inappropriate use of assumptions when estimating servicing income, including retention benefits, deferred tax benefits, captive reinsurance premiums, and crosssell 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. 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. Servicing of Financial Assets / 5-15

242 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. 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. Exhibit 5-1 below demonstrates the application of the amortization requirement. Exhibit 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: (continued) 5-16 / Servicing of Financial Assets

243 Year Servicing Asset Carrying Value A = A (Initial Value) C 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 B = F/G C = A (Initial Value) x 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 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. Servicing of Financial Assets / 5-17

244 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. Exhibit 6-2 demonstrates the application of the impairment requirement when applying the amortization method for subsequent measurement. Exhibit 5-2: Analysis of Measurement of Servicing Assets Risk characteristics of underlying financial assets Stratum A Stratum B Stratum C Stratum D Stratum E Total WAC 8.633% WAC 9.002% WAC % WAC % WAC 9.792% N/A WAM WAM WAM WAM WAM N/A years years years years years Type Residential Size 100m 500m Geographic West * Type Residential Size 100m 500m Geographic East * Commercial Real Estate* Size 500m 5mm Geographic U.S. Commercial and Type All other * Industrial* Size 500m 5mm Size 227m Geographic U.S. Geographic U.S. 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. 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 / Servicing of Financial Assets

245 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. Servicing of Financial Assets / 5-19

246 Exhibit 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) 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 b No servicing asset is recorded as the servicer determines that it is just adequately compensated (i.e., no fair value). Because no contractual servicing fee is specified, a servicing liability is recorded. (continued) 5-20 / Servicing of Financial Assets

247 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 Servicing asset or servicing liability is initially recorded at fair value Servicing asset is subject to ASC impairment testing (Amortization Method only) Servicing asset may be subject to regulatory capital limitation for certain financial institutions Scenario 1 Scenario 2 Scenario 3 Scenario 4 X X X X X 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 Servicing of Financial Assets / 5-21

248 5.2.9 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? Servicing assets should be recorded separately from servicing liabilities in the statement of financial position; they cannot be presented on a net basis. Further, ASC requires an entity to report recognized servicing assets and servicing liabilities that are measured subsequently using the fair value measurement method in a manner that separates those carrying amounts from the carrying amounts for separately recognized servicing assets and servicing liabilities that are subsequently measured using the amortization method / Servicing of Financial Assets

249 Excerpt from ASC : An entity shall report recognized servicing assets and servicing liabilities that are subsequently measured using the fair value measurement method in a manner that separates those carrying amounts on the face of the statement of financial position from the carrying amounts for separately recognized servicing assets and servicing liabilities that are subsequently measured using the amortization method. Excerpt from ASC : To accomplish that separate reporting, an entity may do either of the following: a. Display separate line items for the amounts that are subsequently measured using the fair value measurement method and amounts that are subsequently measured using the amortization method b. Present the aggregate of those amounts that are subsequently measured at fair value and those amounts that are subsequently measured using the amortization method (see paragraphs through 35-11) and disclose parenthetically the amount that is subsequently measured at fair value that is included in the aggregate amount. ASC 860 requires different disclosures for servicing assets and servicing liabilities subsequently measured using the amortization method and those measured at fair value. ASC lists the disclosure requirements for servicing assets and servicing liabilities. (Refer to TS 8.2 of this Guide for further discussion of the disclosures required by ASC 860.) 5.4 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 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 Servicing of Financial Assets / 5-23

250 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 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 / Servicing of Financial Assets

251 5.4.3 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. 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. Servicing of Financial Assets / 5-25

252 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. 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 / Servicing of Financial Assets

253 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 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 asset-backed 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. Servicing of Financial Assets / 5-27

254 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, 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 / Servicing of Financial Assets

255 5.7.1 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 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. (continued) Servicing of Financial Assets / 5-29

256 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. 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 / Servicing of Financial Assets

257 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 Interpretive 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 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 Interpretive 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 Interpretive 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. Servicing of Financial Assets / 5-31

258 Question 5-4: What unit of account should be considererd when applying the MSR derecognition guidance in ASC ? PwC Interpretive 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 / Servicing of Financial Assets

259 Chapter 6: Taxation Taxation / 6-1

260 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 How is a securitization transaction determined to be a sale or a secured borrowing for tax purposes? Page in This Publication 6-2 What tax entities should be used in a securitization? 6-10 How are the holders of debt instruments in securitizations taxed? 6-20 What are Taxable Mortgage Pools? 6-24 How are servicing assets and servicing liabilities treated for tax purposes? 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. 6-2 / Taxation

261 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). 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. Taxation / 6-3

262 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 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 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). 6-4 / Taxation

263 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 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 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). Taxation / 6-5

264 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 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. 6-6 / Taxation

265 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 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 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. Taxation / 6-7

266 Application of the Rules to Securitizations Typical Classification Rationale Junior classes of securities 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. Senior classes of security 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 re-characterized 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 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. 6-8 / Taxation

267 6.1.3 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 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: 60/110 x 100 = Consequently, the sponsor would have a gain of $5.46 on the sale of the Class A security to the investors. Taxation / 6-9

268 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 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 / Taxation

269 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 Exhibit 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. Exhibit 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 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. (continued) Taxation / 6-11

270 Grantor Trust Two criteria for qualification: Distinguishing Characteristics Tax Treatment Asset Type Fixed investment trust 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.) 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.) Types of Interests Certificates of beneficial interest in underlying financial assets, referred to as pass-through certificates Pass-through certificates may include: Stripped pass-through certificates Senior and subordinated pass-through certificates Debt obligations of partnership General partnership interests Limited partnership interests Other Limitations 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) Unincorporated entities must be able to elect or default to partnership classification under the check-the-box rules Publicly Traded Partnership (PTP) rules may result in partnership being treated as an association taxable as a corporation for federal tax purposes (continued) 6-12 / Taxation

271 Partnership (continued) Distinguishing Characteristics Tax Treatment Asset Type 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 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 Foreign eligible entities default to a classification based on whether any member has unlimited liability 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 Types of Interests Other Limitations Tax allocations must be in compliance with IRC tax provisions and regulations N/A Must have at least 100 shareholders, meet an ownership diversification test, and distribute substantially all of its income annually (continued) Taxation / 6-13

272 REMIC Legal form is generally a trust or segregated pool of assets, but can be also corporation or partnership, Distinguishing Characteristics Tax Treatment Asset Type Requirements: Must make REMIC election All interests must be regular or residual interests One class of residual interests Must have calendar tax year 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 entity-level tax Issuance of multiple class mortgage-backed 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: Taxed in same manner as holder of a debt instrument Must use accrual method of accounting for income recognition 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: Is transferred to or purchased by the REMIC on or before the start-up day, or Within the three-month period beginning on the start-up day 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: Cash flow investment Qualified reserve assets Foreclosure property Types of Interests Regular Interest: Issued on the start-up day with fixed terms Designated as a regular interest 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: Issued on the start-up day Designated as a residual interest Any interest in REMIC other than a regular interest One class only Distributions must be pro-rata Other Limitations Cannot vary the composition of mortgage assets Special rules for income from residual interests: Subject to the full statutory withholding rate for certain non-u.s. persons 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) (continued) 6-14 / Taxation

273 REMIC (continued) Distinguishing Characteristics Tax Treatment Asset Type Excess inclusion concept: Residual interest holder: Minimum taxable income for residual holder 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 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 Taxed on all net income of the REMIC not taken into account by holders of regular interests Recognizes taxable income/net loss daily, generally determined under accrual method Character ordinary income/loss Excess inclusion income generally cannot be offset by net operating losses Excess inclusion is unrelated business taxable income for taxexempt investors Indefinite carry-forward of losses 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 Withholding tax applicable for certain non-u.s. persons Types of Interests Other Limitations (continued) Taxation / 6-15

274 Corporation Entity level tax Distinguishing Characteristics Tax Treatment Asset Type Typically parent/subsidiary 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.) 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 Typically used for auto loans, credit card receivables and other non mortgage receivables 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 Types of Interests Generally debt Minimal equity Debt of sponsor, not trust Other Limitations If not part of a consolidated group, implications of double taxation (i.e., entity and investor levels) 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) 6-16 / Taxation

275 6.2.1 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 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: Be designated as a regular interest Be issued on the start-up day of the REMIC 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 Residual Interests Must: Be a single class of residual interest (prorata distribution) Be designated as a residual interest 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 Taxation / 6-17

276 reasonably believes that all principal and interest due under the interest will be paid upon or prior to the liquidation of the REMIC. 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 three-month 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 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) / Taxation

277 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. 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. 5 Treas. Reg G-2. Taxation / 6-19

278 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. 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 / Taxation

279 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: 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. 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. Taxation / 6-21

280 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. 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. Exhibit 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 x 60/100 = 48 B 80 x 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

281 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 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 Taxation / 6-23

282 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 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) / Taxation

283 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. 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 Taxation / 6-25

284 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 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 / Taxation

285 6.3.3 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. 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. Taxation / 6-27

286 6.3.4 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 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 / Taxation

287 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 entity-level 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. 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 Taxation / 6-29

288 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. Exhibit 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) x 100/103 = $97.09 Basis allocated to stripped coupon: $100 x 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 / Taxation

289 Chapter 7: International Considerations International Considerations / 7-1

290 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 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? Page in This Publication 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? 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. 7-2 / International Considerations

291 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 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, International Considerations / 7-3

292 7.2.1 Scope 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. 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. 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 (Exhibit 7-1) that summarizes the appropriate methodology for applying the requirements of the standard for derecognition. 7-4 / International Considerations

293 Exhibit 7-1: IAS 39 Flow Chart 1 : Applying the Standard Consolidate all subsidiaries (including any SPE) [Paragraph 15] Determine whether the derecognition principles below are applied to a part or all of an asset (or group of similar assets) [Paragraph 16] Have the rights to the cash flows from the asset expired? [Paragraph 17 (a)] Sponsor Yes Derecognize the asset No Has the entity transferred its rights to receive the cash flows from the asset? [Paragraph 18(a)] Sponsor No Yes Has the entity assumed an obligation to pay the cash flows from the asset that meets the conditions in paragraph 19? Sponsor [Paragraph 18 (B)] No Continue to recognize the assets Yes Has the entity transferred substantially all risks and rewards? Sponsor [Paragraph 20 (a)] Yes Derecognize the asset No Has the entity retained substantially all risks and rewards? [Paragraph 20 (b)] Yes Continue to recognize the assets No Sponsor Has the entity retained control of the asset? [Paragraph 20 (c)] No Derecognize the asset Yes Sponsor Continue to recognise the asset to the extent of the entity s continuing involvement 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 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 International Considerations / 7-5

294 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 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. 7-6 / International Considerations

295 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. 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. International Considerations / 7-7

296 Exhibit 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. Transferor/Entity Sale Transferor/Entity SPE Note Holders* Assets Swap Counterparty *eventual recipient Many securitizations may not meet these pass-through criteria. A common form of securitization, the revolving facility, generally does Investors 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 Have all the Risks and Rewards Been Substantially Transferred? Once it is determined that there is a transfer, an entity must determine the extent to which it retains the risks and rewards of ownership of the financial asset. IAS 39 and 7-8 / International Considerations

297 IFRS 9 require the entity to evaluate the extent of the transfer of risks and rewards by comparing its exposure to the variability of the transferred financial assets net cash flows, both before and after the transfer. Examples of the various risks and rewards that will need to be considered include: interest rate risk, credit risk, foreign exchange risk, equity price risk, late-payment risk and pre-payment risk, depending on the particular asset that is being considered for derecognition. In the case of short-term trade receivables, the main risks to consider are likely to be credit risk and late payment risk and perhaps foreign currency risk if they have been transacted in a foreign currency. In the case of mortgages, the key risks to consider are likely to be interest rate risk, credit risk, and in the case of fixed rate mortgages, in particular, pre-payment risk. If an entity s exposure does not change significantly, substantially all of the risks and rewards of ownership are retained; consequently, derecognition would not be appropriate. A liability equal to the consideration received would be recorded (in effect a financing transaction). Alternatively, if substantially all of the risks and rewards are transferred, the entity will derecognize the financial asset transferred and recognize separately any asset or liability created through any rights and obligations retained in the transfer (e.g., servicing assets or liabilities). IAS 39 and IFRS 9 do not define substantially all and therefore judgment must be used to perform these evaluations. Examples of when an entity has transferred substantially all the risks and rewards of ownership are: An unconditional sale of a financial asset for a single fixed cash sum; A sale of a financial asset together with an option to repurchase the financial asset at its fair value at the time of repurchase. In this situation, the entity is no longer exposed to any value risk (potential for gain or exposure to loss) on the transferred financial asset, which is borne by the transferee. The ability for the transferor to buy the asset back at its fair value at the date of repurchase is, in terms of risks and rewards, no different from buying a new financial asset; and A sale of a financial asset together with a put or call option that is deeply out of the money (that is, an option that is so far out of the money that it is highly unlikely to go into the money before expiry). In this situation, the transferor has no substantial risks and rewards because there is no real possibility that the call or put option will be exercised. Examples of when an entity has retained substantially all the risks and rewards of ownership are: A sale and repurchase transaction where the repurchase price is a fixed price or the sale price plus a lender s return (for example, a repo or securities lending agreement); A sale of a financial asset together with a total return swap that transfers the market risk exposure back to the entity; and A sale of a financial asset together with a deep in-the-money put or call option (that is, an option that is so far in the money that it is highly unlikely to go out of the money before expiry). International Considerations / 7-9

298 In order to meet sale accounting under U.S. GAAP, ASC 860 does not specifically look to whether the transferor retains risks and rewards in the transferred financial assets. However, under U.S. GAAP, the legal opinion may consider the level of recourse provided to the transferee by the transferor in the sale Accounting Treatment Based on Risks and Rewards and Control Analyses If there is a transfer (i.e., contractual rights to the cash flows from the asset have been transferred to the transferee or the pass-through criteria have been met), the possible outcomes from the risks and rewards and controls tests are illustrated in Exhibit 7-3. Exhibit 7-3: Accounting Treatment Based on Risks and Rewards and Control Analyses Risk and Rewards Transferred substantially all Transferred some Retained substantially all Do not control assets Control assets Full derecognition Full derecognition Continuing involvement No derecognition Full Derecognition (off Balance Sheet) An entity that derecognizes a financial asset in its entirety includes the difference between the carrying amount of the asset and the consideration received (including any cumulative gain or loss that had been recognized directly in equity) in the income statement. An entity that derecognizes only a part of a larger financial asset (e.g., a proportion, specified cash flows or a proportion of specified cash flows) allocates the previous carrying amount of the financial asset between the part that continues to be recognized and the part that is derecognized based on relative fair values at the date of transfer. The difference between the carrying amount allocated to the part derecognized and the consideration received (including any cumulative gain or loss relating to the part derecognized that had previously been recognized in equity) is included in the gain or loss on derecognition. No Derecognition (on Balance Sheet) A transaction is accounted for as a collateralized borrowing if the transfer does not satisfy the conditions for derecognition. The entity recognizes a financial liability for the 7-10 / International Considerations

299 consideration received for the transferred asset. If the transferee has the right to sell or repledge the asset, it is presented separately in the balance sheet (for example, as a loaned asset, pledged security or repurchased receivable). In subsequent periods, the entity recognizes income relating to the transferred assets and any expense incurred on the financial liability. Where a derivative forms part of the transaction and precludes the asset from being derecognized, the derivative is not accounted for separately, as this would result in the derivative being accounted for twice. Control and Continuing Involvement When an entity has neither retained nor transferred substantially all of the risks and rewards of ownership, control of the transferred asset must be considered; this is addressed in TS Has Control Over the Financial Assets Been Retained? When the entity has neither retained nor transferred substantially all of the risks and rewards of ownership, IAS 39 and IFRS 9 require the transferor to evaluate whether it has retained control of the financial asset. If the entity does not control the financial asset, the financial asset is derecognized and the entity reports the assets and liabilities it creates in the transfer. If the entity controls the financial asset, it reports its continuing involvement in the financial asset. The transfer of control by the transferor occurs if the transferee has the practical ability to sell the transferred financial asset to a third party (paragraph 23 of IAS 39, paragraph of IFRS 9). The emphasis is on what the transferee can do in practice and whether it is able, unilaterally, to sell the financial asset without imposing additional restrictions on the transfer. Any restrictions imposed on the transferee may restrict its practical ability to sell the financial assets, and control may be retained by the transferor. The fact that the transferee is unlikely to sell the transferred financial asset does not, by itself, mean that the transferor has retained control of the transferred financial asset. However, a put option or guarantee may constrain the transferee from selling the transferred financial asset because the transferee would, in practice, not sell the transferred financial asset to a third party without attaching a similar option or other restrictive conditions. Under these circumstances, the transferor has retained control of the transferred financial asset. Here are two examples that illustrate the different meaning of control under IFRS and U.S. GAAP. Put option on a transferred asset with no active market: Consider an entity that transfers a 10 percent interest in a private company in exchange for cash. Assume further that the transferee holds an out-of-the money put option on the shares (that is not sufficiently out of the money to conclude that the transferor has transferred substantially all of the risks and rewards of ownership) and there is no active market for the shares sold to the transferee. Under U.S. GAAP, the put option generally does not constrain the transferee, unless it is sufficiently deepin-the-money when it is written such that it is probable the transferee will exercise it. Under IFRS, the transferee is deemed not to have the practical ability to sell its shares in the market since it would rather hold the assets so that it can put the asset back to the transferor and realize the benefits of the put option when the value declines. In this case, U.S. GAAP would view control to have transferred to the transferee while IFRS would not. International Considerations / 7-11

300 Call option on a transferred asset with no active market: Consider an entity that transfers a 10 percent interest in a private company in exchange for cash. Assume further that the transferor holds an out-of-the money call option on the shares (that is not sufficiently out of the money to conclude that the transferor has transferred substantially all of the risks and rewards of ownership) and there is no active market for the shares sold to the transferee. In effect, the transferee does not have the practical ability to sell its shares in the market (without imposing a similar call option). Rather it needs to hold the assets so that it can deliver them to the transferor in settlement of the call. In this case, under both IFRS and U.S. GAAP, control has not transferred to the transferee. Under the IFRS model, if control is not retained, an entity derecognizes the financial asset (i.e., full derecognition) as described above. However, if control is retained, the entity applies the continuing involvement accounting described in TS To emphasize, control is the primary driver for the derecognition conclusion under U.S. GAAP, whereas under IFRS, control dictates whether to fully derecognize a financial asset or to account for the transaction under continuing involvement after the risks and rewards test is applied Continuing Involvement Accounting When the entity has some risk and rewards in the transferred financial asset and retains control over the transferred financial asset, the entity must continue to recognize the transferred financial asset to the extent of its continuing involvement exposure to changes in the value of the transferred financial asset. The continuing involvement is measured as the maximum amount of consideration received that the entity could be required to repay (in the case of a guarantee) or the amount of the transferred financial asset that the entity may repurchase (in the case of a repurchase option). There is no concept of continuing involvement accounting in U.S. GAAP; instead, if a transaction qualifies for derecognition, the transferor must recognize any retained ongoing liability at fair value (i.e., a financial components approach). The fair value of a guarantee would reflect the likelihood of payment or repurchase, rather than the maximum possible payment. Paragraph 30 of IAS 39 and paragraph of IFRS 9 describe the measurement of various types of continuing involvement. When recording the continuing involvement under a guarantee of the financial asset, it is incorrect to assume that the recorded asset will be small. IFRS requires that the full amount an entity could be required to pay under the guarantee be recorded, up to a maximum amount of the financial asset transferred. As a result, the value of the continuing involvement may require an asset to be recorded at the same value as the financial asset transferred, effectively resulting in no derecognition. For example, where a guarantee causes the continuing involvement, the asset recognised at the date of transfer is measured at the lower of the carrying amount of the financial asset and the maximum amount of the consideration received in the transfer that the entity could be required to repay (the guaranteed amount). As the net amount of the financial asset and associated liability represents the fair value of the guarantee, the associated liability is the balancing number. The liability is initially measured at the guarantee amount plus the fair value of the guarantee (which is normally the consideration received for the guarantee). Exhibit 7-4 below explains this visually / International Considerations

301 Exhibit 7-4: Illustration of Continuing Involvement Accounting Guarantee first x% of credit losses Balance Sheet Asset Lower of carrying amount and maximum payment (guaranteed amount) Liability Guaranteed amount + fair value of guarantee Net balance sheet position is the fair value of the guarantee If the continuing involvement is in the form of a residual interest (e.g., a subordinated beneficial interest in the transferred assets), the entity allocates the previous carrying amount of the financial asset between the part it continues to recognize under continuing involvement, and the part it no longer recognizes on the basis of the relative fair values of those parts on the date of the transfer. Gain or loss is recognized on the difference between the carrying amount allocated to the part that is no longer recognized and the consideration received for the part no longer recognized (including any gain or loss recognized in OCI). In addition to the part retained, the entity continues to recognize its continuing involvement in the asset and the associated liability. The manner in which the above guidance is applied to continuing involvement in a part of a financial asset is illustrated in paragraph AG52 of IAS 39 and paragraph B of IFRS 9. Although that example is not presented here, the application illustrated in that example is best understood by reference to a securitization transaction given below. (Note: the example is simplified; the continuing involvement accounting will depend on facts and circumstances.) Entity A enters into a securitization transaction in which it transfers a pool of receivables amounting to $1,000, but retains a subordinated interest of $100 in that pool. The terms of the securitization arrangements show that the transaction is to be accounted for using the continuing involvement approach (which, inter alia, requires that the buyer assume significant risks and rewards). Under the continuing involvement approach, the seller typically recognizes an asset of $200 and a liability of $100. This gives a net asset of $100 which might be expected as it represents the retained subordinated interest of $100. However, the gross numbers can be confusing to understand. Paragraph AG52 of IAS 39 and paragraph B analyse the transaction as comprising: A retention of a non-subordinated 10 percent interest in the transferred assets; and The subordination of that interest that is equivalent to the seller providing a credit guarantee. Both these elements result in continuing involvement and both need to be accounted for. The first element (the retention of a non-subordinated 10 percent interest) results International Considerations / 7-13

302 in a continuing involvement asset of $100. In addition, the second element (the subordination of that interest which is equivalent to the seller providing a guarantee of the first $100 of losses) also results in a continuing involvement asset of $100, and a liability of $100 (being the maximum amount the entity may have to pay by losing the $100 asset recognized for the first element). Therefore, the seller will recognize a total continuing involvement asset of $200 and a liability of $100. Measuring a financial asset in the above manner may not be in accordance with the general measurement rules for financial assets, but is necessary to ensure that the accounting properly reflects the transferor s continuing involvement in the asset. Under U.S. GAAP, there is no allocation of carrying value to determine gain or loss nor do transferors recognize continuing involvement as illustrated above under IFRS; once a transfer is determined to be a sale, the gain or loss is determined based on the fair value of the consideration received and obligations assumed Servicing Assets and Liabilities If an entity transfers a financial asset that qualifies for derecognition and retains the right to service it for a fee, it recognizes either a servicing asset or a servicing liability for the servicing contract that is initially measured at fair value. A liability for the servicing obligation is recognized if the fee to be received is not expected to compensate the entity adequately for performing the servicing. An asset is recognized for the servicing contract if the fee to be received is expected to be more than adequate compensation for the servicing. Adequate compensation is determined by benchmarking what a normal market servicer would earn for providing the servicing. Subsequently, servicing assets or liabilities are amortized ratably over the service period. There is much more guidance on accounting for servicing rights under U.S. GAAP as described in Chapter 5. In contrast to the approach under IFRS, an entity that records servicing rights under U.S. GAAP shall subsequently measure each class of servicing assets or liabilities using either the amortization or the fair value method. The latter approach relieves the burden of employing hedge accounting to mitigate income statement volatility where servicing rights are hedged. Under IFRS, servicing rights are considered nonfinancial assets, so they may be hedged only for foreign currency risk or for the entire change in fair value Summary of Differences Between U.S. GAAP and IFRS Key differences between IFRS and U.S. GAAP regarding derecognition of financial assets is summarized as follows: 7-14 / International Considerations

303 Overall approach Control SPEs Continuing involvement accounting Servicing rights IFRS IFRS is based on an evaluation of the transfer of risks and rewards of ownership of an asset. Only if that test is not conclusive is there then an evaluation of the transfer of control. Legal isolation of the assets from the transferor is not specifically required. The evaluation of control in IFRS is based on whether the transferee has the practical ability to sell the asset unilaterally without additional restrictions. Control is a secondary criteria when the risk and rewards evaluation is not conclusive. The control criteria dictates whether to fully derecognize the transferred asset or to account for the transaction under continuing involvement accounting. An entity first consolidates all subsidiaries in accordance with IAS 27 and SIC 12 (or IFRS 10 once effective or early adopted); it then applies the derecognition principles in IAS 39 (or IFRS 9 once effective or early adopted) to the resulting consolidated group. If an asset is transferred to an SPE where the transferor is required to consolidate the SPE, partial derecognition may be achieved if the pass-through and risks and rewards conditions are met. There is a concept of continuing involvement, which may result in partial derecognition, where the amount of the asset that continues to be recognized is mirrored by a gross liability, resulting in a net position equivalent to the continuing involvement (e.g., guarantee, put option, call option, etc.). Subsequent to initial recognition, servicing assets or liabilities are amortized ratably over the service period. Servicing rights are considered nonfinancial assets, so they may be hedged for foreign currency risk or for the entire change in fair value. U.S. GAAP U.S. GAAP applies a controlbased approach and does not specifically look to risks and rewards. Legal isolation is a significant consideration. Control is generally based on what the transferor can do, with fewer restrictions on what the transferee can do. Whether the transferor has control of the transferred asset is the primary criteria in determining whether the asset should be derecognized. Like IFRS, consolidation is considered before derecognition. However, unlike IFRS, once an issuing SPE is required to be consolidated, derecognition is not possible under U.S. GAAP since ASC 860 does not apply to transfers in which the transferee is considered a consolidated affiliate of the transferor, as defined in the standard. There is no concept of continuing involvement under U.S. GAAP. If sale accounting is achieved, the entire financial asset is derecognized and any rights and obligations assumed are recorded at fair value. Each class of servicing assets or liabilities is subsequently measured using either the amortization or the fair value method. There is more flexibility in designating hedged risks; however, the need for hedge accounting is mitigated by electing the fair value method. International Considerations / 7-15

304 Below are two examples that highlight the differences between IFRS and U.S. GAAP: Factoring with risk retention: Assume the transferor transfers short-term receivables to a factor and provides overcollaterization to absorb substantially all of the credit losses on the receivables. U.S. GAAP: if legal isolation can be achieved, this transfer would qualify as a sale transaction and the receivables will be derecognized. IFRS: although there is a transfer of the contractual rights, substantially all the risk and rewards of the receivables have been retained by the transferor; therefore, the receivables will not qualify for derecognition and the transaction will be accounted for as a secured borrowing. Securitization into a consolidated SPE that is not a BRE (i.e., issuing SPE is consolidated): Assume the transferor transfers loans into an issuing SPE and retains a portion of the subordinated beneficial interest; all of the senior and some of the subordinated beneficial interests are sold to an unrelated investor. U.S. GAAP: the SPE to which the loans are transferred is likely to be consolidated by the transferor due to the retention of the subordinated interest; therefore, the loans remain on the transferor s consolidated balance sheet and the notes issued out of the SPE will be recorded as borrowings. IFRS: although the SPE is likely to be consolidated by the transferor, provided that the arrangement meets the pass-through criteria, the loans may qualify for partial derecognition depending on the extent of the risks and rewards retained by the transferor through its subordinated beneficial interest Developments As discussed in the Executive Summary of this Guide, the FASB and IASB reassessed their convergence strategy in 2010 with respect to derecognition of financial assets. The boards agreed that their near-term priority was on increasing the transparency and comparability of their standards by improving and aligning the disclosure requirements in IFRSs and U.S. GAAP for financial assets transferred to another entity. As a result, in October 2010, the IASB issued amendments to IFRS 7 which are effective for annual periods beginning on or after July These amendments broadly align the derecognition disclosure requirements regarding the nature and extent of a transferor s continuing involvement resulting from transfers of financial assets / International Considerations

305 Chapter 8: Effective Date, Transition, and Disclosures Effective Date, Transition, and Disclosures / 8-1

306 This Chapter provides the effective dates and related transition provisions of the most recent amendments to ASC 860, and the disclosure requirements of ASC 860. The most recent amendments incorporated in ASU remove from the assessment of effective control for repurchase agreements the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in default by the transferee. Refer to Chapter 4 (TS 4.1.2) for further information on the amendment. The disclosure requirements of ASC 860 are substantial and thus preparers should carefully review such requirements to ensure completeness and accuracy of their footnotes. Key Questions Answered in this Chapter Paragraph in ASC 860 Page in this Publication What are the effective dates and transition provisions of the most recent amendments to ASC 860? What are the disclosure requirements of ASC 860? 10-50, 20-50, and What about some disclosure examples consistent with the requirements in ASC 860? N/A What Are the Effective Dates and Transition Provisions of the Most Recent Amendments to ASC 860? The most recent amendments to ASC 860, issued in ASU are effective prospectively for new transactions and modifications to existing transactions that occur in the first interim or annual period beginning on or after December 15, Therefore, for example, a calendar year-end company would apply the guidance to new transactions and modifications to existing transactions that occur on or after January 1, Early adoption is not permitted. 8.2 What Are the Disclosure Requirements of ASC 860? The guidance in ASC 860 provides four broad disclosure objectives to guide preparers in determining what disclosures are necessary. The objectives are to provide users of the financial statements with an understanding of: 1. The transferor s continuing involvement with transferred financial assets. 2. The nature of any restrictions on the assets reported in the transferor s statement of financial position that relate to a transferred financial asset, including the carrying amount of those assets. 3. How servicing assets and servicing liabilities are reported by the transferor. 4. How a transfer of financial assets affects the transferor s statement of financial position, earnings, and cash flows Disclosure Objectives and Aggregation of Disclosures ASC 860 provides further discussion on the four objectives and the aggregation of certain disclosures. It states: 8-2 / Effective Date, Transition, and Disclosures

307 Excerpt from ASC : The objectives in the preceding paragraph apply regardless of whether this Topic requires specific disclosures. The specific disclosures required by this Topic are minimum requirements, and an entity may need to supplement the required disclosures depending on any of the following: a. The facts and circumstances of a transfer b. The nature of an entity s continuing involvement with the transferred financial assets c. The effect of an entity s continuing involvement on the transferor s financial position, financial performance, and cash flows. Disclosures required for a particular form of continuing involvement shall be considered when determining whether the disclosure objectives of this Topic have been met. Excerpt from ASC A: Disclosures required by this Topic may be reported in the aggregate for similar transfers if separate reporting of each transfer would not provide more useful information to financial statement users. A transferor shall both: a. Disclose how similar transfers are aggregated b. Distinguish between transfers that are accounted for as secured borrowings and transfers that are accounted for as sales. Excerpt from ASC : In determining whether to aggregate the disclosures for multiple transfers, the reporting entity shall consider quantitative and qualitative information about the characteristics of the transferred financial assets, including all of the following: a. The nature of the transferor s continuing involvement b. The types of financial assets transferred c. Risks related to the transferred financial assets to which the transferor continues to be exposed after the transfer and the change in the transferor s risk profile as a result of the transfer d. The guidance in paragraph (for risks and uncertainties) and paragraphs through 55-2 (for concentrations involving loan product terms). (continued) Effective Date, Transition, and Disclosures / 8-3

308 Excerpt from ASC : The disclosures shall be presented in a manner that clearly and fully explains to financial statement users the transferor s risk exposure related to the transferred financial assets and any restrictions on the assets of the entity. An entity shall determine, in light of the facts and circumstances, how much detail it must provide to satisfy disclosure requirements of this Topic and how it aggregates information for assets with different risk characteristics. The entity shall strike a balance between obscuring important information as a result of too much aggregation and excessive detail that may not assist financial statement users to understand the entity s financial position. For example, an entity shall not obscure important information by including it with a large amount of insignificant detail. Similarly, an entity shall not disclose information that is so aggregated that it obscures important differences between the different types of involvement or associated risks. Excerpt from ASC : To apply the disclosures required in this Topic, a public entity shall consider all involvements by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents to be involvements by the transferor. Aggregation of the disclosures for multiple transfers is allowed if separate reporting of each transfer would not provide financial statement users with decision useful information. However, at a minimum, disclosures should distinguish between transfers that are accounted for as sales and those that are accounted for as secured borrowings, and between transfers to SPEs accounted for as sales versus all other transfers that are accounted for as sales. The method used to aggregate the disclosures also needs to be disclosed. If disclosures are already required by other Topics for a particular form of the transferor s continuing involvement, then the preparer is required to cross-reference to those other disclosures to provide financial statement users with an understanding of the risks retained in transfers accounted for as sales. Further, companies can omit certain disclosures if those disclosures are not required by other Topics and would not provide meaningful information. Different users prefer different levels of information. Although certain users may naturally prefer the most disaggregated level of information available, others may find that same level of information unwieldy and excessive. In deciding whether to disclose disaggregated or aggregated information, companies should use judgment to determine the information that will be most useful to financial statement users and achieve the disclosure objectives Specific Disclosure Requirements The specific disclosure requirements are organized by those required for: (1) collateral; (2) in-substance defeasance of debt; (3) all servicing assets and liabilities; (4) servicing assets and liabilities subsequently measured at fair value; (5) servicing assets and liabilities subsequently amortized; (6) transfers accounted for as sales in securitization and asset-backed financing arrangements when the transferor has continuing 8-4 / Effective Date, Transition, and Disclosures

309 involvement with the transferred financial assets; and (7) transfers of financial assets accounted for as secured borrowings. The following table summarizes the specific required disclosures. ASC Reference ASC : Financial Assets Securitized Required Disclosure For each income statement presented: Characteristics of the transfer (including: a description of the transferor s continuing involvement with the transferred financial assets, the nature and initial fair value of the assets obtained as proceeds and the liabilities incurred in the transfer, and the gain or loss from sale) For initial fair value measurements of assets obtained and liabilities incurred in the transfer: Level in the fair value hierarchy in Topic 820 in which the fair value measurements fall in their entirety Key inputs and assumptions used in measuring fair value (e.g., discount rates, expected prepayments including the expected weighted-average life of prepayable financial assets, anticipated credit losses including expected static pool losses) Valuation techniques used to measure fair value Cash flows between a transferor and transferee (including proceeds from new transfers, proceeds from collections reinvested in revolving-period transfers, purchases of previously transferred financial assets, servicing fees, and cash flows received on interests that continue to be held by the transferor) For each statement of financial position presented: Qualitative and quantitative information about the transferor s continuing involvement with transferred financial assets that provides financial statement users with sufficient information to assess the reasons for the continuing involvement and the risks (including, but not limited to credit risk, interest rate risk, and other risks) the transferor continues to be exposed after the transfer and the extent that the transferor s risk profile has changed as a result of the transfer, including all of the following: Total amount of principal outstanding, the amount that has been derecognized as a result of the transfer and the amount that continues to be recorded in the statement of financial position Terms of arrangements that could require the transferor to provide financial support (for example, liquidity arrangements and obligations to purchase assets) to the transferee or its beneficial interest holders, including a description of any events or circumstances that could expose the transferor to loss and the amount of maximum exposure to loss If the transferor has provided financial or other support that it was not previously contractually required to provide to the transferee or its beneficial interest holders, or if the transferor has assisted the transferee or its beneficial interest holders in obtaining support, the type and amount of support and the primary reasons for providing the support An entity is also encouraged to provide information about any liquidity arrangements, guarantees, and/or other commitments provided by third parties related to the transferred financial assets (continued) Effective Date, Transition, and Disclosures / 8-5

310 ASC Reference ASC : Sales of Loans and Trade Receivables ASC : Collateral Required Disclosure Accounting policies for subsequently measuring assets or liabilities that relate to continuing involvement with the transferred financial assets Key inputs and assumptions used in measuring the fair value of assets or liabilities that relate to the transferor s continuing involvement (e.g., discount rates, expected prepayments including the expected weighted-average life of prepayable financial assets, anticipated credit losses including expected static pool losses). If an entity has aggregated transfers, it may disclose the range of assumptions For the transferor s interests in the transferred financial assets, a sensitivity analysis or stress test showing the hypothetical effect on the fair value of those interests (including any servicing assets or servicing liabilities) of two or more unfavorable variations from expected levels and a description of the objectives, methodology, and limitations of the sensitivity analysis or stress test Information about the asset quality of transferred financial assets and any other assets that it manages together with them (separated between assets that have been derecognized and assets that continue to be recognized), including, but not limited to delinquencies at the end of the period and credit losses, net of recoveries, during the period. See Example 8-5 below for an illustration of this disclosure requirement. The aggregate amount of gains or losses on sales of loans or trade receivables (including adjustments to record loans held for sale at the lower of cost or fair value) shall be presented separately in the financial statements or disclosed in the notes to financial statements. See Topic 310 for a full discussion of disclosure requirements for loans and trade receivables. The following disclosures are required for collateral: Policy for requiring collateral or other security if repurchase agreements or securities lending transactions have been entered into As of the date of the latest statement of financial position presented, both of the following: Carrying amount and classification of assets pledged as collateral that are not reclassified and separately reported in the statement of financial position Associated liabilities Disclosure above should include qualitative information about the relationship between those assets and associated liabilities If the company holds collateral that it is permitted to sell or repledge, it shall disclose all of the following: The fair value of the collateral as of each statement of financial position presented The fair value as of the date of each statement of financial position presented of the portion sold or repledged Information about the sources and uses of that collateral See Example 8-2 for an illustration of the accounting policy disclosure requirement. (continued) 8-6 / Effective Date, Transition, and Disclosures

311 ASC Reference ASC : Repurchase Agreements and Securities Lending ASC : All Servicing Assets and Servicing Liabilities ASC : Servicing Assets and Servicing Liabilities Measured at Fair Value ASC : Servicing Assets and Servicing Liabilities Measured at Amortized Cost Required Disclosure Effective January 1, 2013, reporting entities shall disclose the information that is required by paragraphs through 50-6 that are either offset in accordance with Section or subject to an enforceable master netting arrangement or similar agreement for the following: Recognized repurchase agreements and reverse sale and repurchase agreements and recognized securities borrowing and securities lending transactions. For all servicing assets and servicing liabilities, all of the following shall be disclosed: Management s basis for determining its classes of servicing assets and liabilities Description of the risks inherent in servicing assets and liabilities and the instruments used to mitigate the income statement effect of changes in fair value Amount of contractually specified servicing fees, late fees, and ancillary fees earned for each period, including where each amount is reported in the income statement Quantitative and qualitative information about assumptions used to estimate the fair value (e.g., discount rates, anticipated credit losses, prepayment speeds) Quantitative information about instruments used to manage the risks inherent in servicing assets and servicing liabilities, including the fair value of those instruments at the start and end of the period is encouraged but not required. If provided, an entity is also encouraged, but not required, to disclose quantitative and qualitative information about the assumptions used to estimate the fair value of those instruments. Section provides guidance on disclosures of accounting policies. For servicing assets and servicing liabilities subsequently measured at fair value, both of the following shall be disclosed: The activity in the balance of each class of servicing assets and liabilities (including a description of where changes in fair value are reported in the income statement for each period) including: The beginning and ending balances Additions (purchases of servicing assets, assumptions of servicing liabilities, and recognition of servicing obligations that result from transfers of financial assets) Disposals Changes in fair value during the period from: Changes in valuation inputs or assumptions Other changes in fair value and a description of those changes Other changes that affect the balance and a description of those changes See Example 8-3 below for an illustration of this disclosure requirement. For servicing assets and servicing liabilities subsequently measured under the amortization method, all of the following shall be disclosed: The activity in the balance of each class of servicing assets and liabilities (including a description of where changes in the carrying amount are reported in the income statement for each period) including: The beginning and ending balances (continued) Effective Date, Transition, and Disclosures / 8-7

312 ASC Reference ASC : Subsequent Measurement at Fair Value is Elected Other Presentation Matters Required Disclosure Additions (purchases of servicing assets, assumptions of servicing liabilities, and recognition of servicing obligations that result from transfers of financial assets) Disposals Amortization Valuation allowance to adjust carrying value of servicing assets Other-than-temporary impairments Other changes that affect the balance and a description of those changes The fair value for each class of recognized servicing assets and servicing liabilities at the beginning and end of the period The predominant risk characteristics of the underlying financial assets used to stratify recognized servicing assets for purposes of measuring impairment. If the predominant risk characteristics are changed, that fact and the reasons for those changes shall be included in the disclosures For each period for which results of operations are presented, the activity by class in any valuation allowance for impairment of recognized servicing assets, including: The beginning and ending balances Aggregate additions charged and recoveries credited to operations Aggregate write-downs charged against the allowance See Example 8-3 below for an illustration of this disclosure requirement. If an entity (whether public or nonpublic) elects under paragraph (d) to subsequently measure a class of servicing assets and servicing liabilities at fair value at the beginning of the fiscal year, the amount of the cumulative-effect adjustment to retained earnings shall be separately disclosed. For secured borrowing transactions, if the secured party (transferee) has the right by contract or custom to sell or repledge the collateral, then the obligor (transferor) shall 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. Liabilities incurred by either the secured party or obligor in securities borrowing or resale transactions shall be separately classified. ASC 860 does not specify the classification or the terminology to be used to describe the following: Pledged assets reclassified by the transferor of securities loaned or transferred under a repurchase agreement accounted for as a secured borrowing if the transferee is permitted to sell or repledge those securities Liabilities incurred by either the secured party or obligor in securities borrowing or resale transactions. Refer to Chapter 4 (TS 4) for some examples of possible classification and terminology for these financing-type transfers. Servicing assets are to be reported separately from servicing liabilities on the statement of financial position. Netting is not permitted. Paragraph / Effective Date, Transition, and Disclosures

313 further requires an entity to report recognized servicing assets and servicing liabilities that are subsequently measured using the fair value measurement method in a manner that separates those carrying amounts from the carrying amounts for separately recognized servicing assets and servicing liabilities that are subsequently measured using the amortization method. Further information on the presentation of servicing rights can be found in Chapter 5 (refer to TS 5.3). 8.3 What About Some Disclosure Examples Consistent With the Requirements in ASC 860? The following provides illustrative examples of the disclosure requirements of ASC 860. These examples are written in general terms and need to be tailored to reflect an entity s particular facts and circumstances. In addition, companies shall also consider the disclosure objectives of the guidance when determining the extent and appropriateness of their disclosures. Example 8-1: Summary of Significant Accounting Policies Application of FASB Accounting Standards Codification Topic 860 Under ASC 860, Transfers and Servicing (ASC 860), the Company applies a controloriented, financial-components approach to financial-asset-transfer transactions of entire financial assets, group of entire financial assets, or participating interests in entire financial assets whereby it: 1. Recognizes the financial assets it controls and the liabilities it has incurred, and 2. Derecognizes financial assets when control has been surrendered. Under ASC , control is considered to have been surrendered only if: i. The transferred financial assets have been isolated from the transferor (including the transferor s consolidated affiliates in the financial statements being presented) and its creditors, even in bankruptcy or other receivership (for multiple step transfers, a bankruptcy-remote entity is not considered a consolidated affiliate for purposes of performing the legal isolation analysis) ii. 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 thirdparty holder of its beneficial interests) has the right to pledge or exchange the transferred financial assets (or beneficial interests) it received, and iii. The transferor, its consolidated affiliates in the financial statements being presented, or its agents do not maintain effective control over the transferred financial assets through an agreement that both entitles and obligates it to repurchase or redeem those assets prior to maturity, through an agreement, other than clean up call, that provides the transferor with the unilateral ability to cause the holder to return specific financial assets and a more-than-trivial benefit attributable to that ability, or, an agreement that permits the transferee to require the transferor to repurchase the transferred financial assets at a price that is so favourable to the transferee that it is probable that the transferee will require repurchase. If any of these conditions are not met, the Company accounts for the transfer as a secured borrowing. (continued) Effective Date, Transition, and Disclosures / 8-9

314 The accounting for non-cash collateral received in secured-borrowing transactions depends on whether the Company takes control of the collateral and on the rights and obligations that result from the collateral arrangement, as defined in ASC If the Company controls the collateral, it is required to recognize the collateral as its asset and initially measure it at fair value and will also recognize a liability for its obligation to return the collateral, as required by ASC If the Company does not control the non-cash collateral, it is not recognized, but it will be disclosed. When the Company is the debtor in a secured-borrowing transaction, and the creditor has taken control of the assets that the Company pledged as collateral, the Company is required to reclassify the assets to a receivable, which is reported separately from other unencumbered assets. When repurchase and reverse-repurchase transactions satisfy the sale criteria of ASC , the Company accounts for the transactions as sales and forward-repurchase commitments or as purchases and forward-resale agreements, respectively. If the control criteria in ASC are not met, the repurchase or reverse-repurchase transactions are accounted for as financings, which are subject to the collateralrecognition provisions for secured borrowings. Example 8-2: Policy for Requiring Collateral or Other Security for Repurchase, Securities Lending, and Similar Arrangements Securities purchased under agreements to resell and securities sold under agreements to repurchase generally qualify as financing transactions under ASC , and are carried at the amounts at which the securities subsequently will be resold or reacquired as specified in the respective agreements. Such amounts include accrued interest. Reverse-repurchase and repurchase agreements are presented in the accompanying statement of financial position where net presentation is consistent with the guidance in ASC , Right of Set-Off Conditions. It is the Company s policy to take possession of securities purchased under agreements to resell. The Company monitors the fair value of the underlying securities as compared to the related receivable, including accrued interest, and requests additional collateral as necessary. The Company s agreements with third parties specify their rights to request additional collateral. All collateral is held by the Company or a custodian. Securities borrowed and securities loaned transactions generally qualify as financing transactions under ASC , and are carried at the amounts of cash advanced and received, respectively. The Company measures the fair value of the securities borrowed and loaned against the cash collateral on a daily basis. Additional cash collateral is obtained as necessary to ensure such transactions are adequately collateralized. The Company s agreements with third parties specify their rights to request additional collateral. All collateral is held by the Company or a custodian. In reverse-repurchase and securities-borrowed transactions where the securities received qualify for collateral recognition under ASC 860, the securities are recorded at fair value, along with an obligation to return them. Under repurchase and securities-lending arrangements, the collateral received (generally cash) is recorded on the Company s statement of financial position, along with the related obligation to reacquire the securities. In situations where the Company has relinquished control of securities transferred in a repurchase or securities-lending arrangement, it derecognizes the securities and records a receivable from the counterparty. (continued) 8-10 / Effective Date, Transition, and Disclosures

315 In instances in which any of the transactions discussed in the preceding paragraphs are accounted for as purchases and/or sales, the Company recognizes the financial assets purchased or derecognizes the financial assets sold, and accounts for the forward sale or purchase commitment at fair value. The forward sale or purchase commitments are generally treated as derivative instruments. The Company s policy is to disclose these transactions that meet the conditions for sale accounting, including the basis for treating them as purchases and/or sales, the nature of the transfers and the business purpose of such transfers. Example 8-3: Accounting Policy Disclosure of Servicing Assets and Liabilities Summary of Significant Accounting Policies In accordance with ASC , the Company records a separate servicing asset or servicing liability representing the right or obligation to service third-party loans (or other financial assets that are being serviced). Servicing assets and servicing liabilities are initially recorded at their fair value as a component of the sale proceeds. The fair value of the servicing assets and liabilities is initially calculated from market quotes, where available. Alternatively, the fair value is based on an analysis of discounted cash flows that incorporates estimates of (1) market servicing costs, (2) market-based estimates of ancillary servicing revenue, (3) market-based prepayment rates, and (4) market profit margins. Servicing assets and servicing liabilities are subsequently measured at either fair value or amortized in proportion to, and over the period of, estimated net servicing income. The entity elects one of those methods on a class basis. A class is determined based on (1) the availability of market inputs used in determining the fair value of servicing assets and servicing liabilities, and/or (2) our method for managing the risks of servicing assets and servicing liabilities. For servicing assets and servicing liabilities that are amortized in proportion to, and over the period of, estimated net servicing income, the impairment of those servicing assets or increases in fair values of servicing liabilities (above carrying values) are evaluated through an assessment of the fair value of those assets and liabilities via a disaggregated, discounted cash-flow method under which the assets and liabilities are disaggregated into various strata, based on predominant risk characteristics. The net carrying value of each stratum is compared to its discounted estimated future net cash flows to determine whether adjustments should be made to carrying values or amortization schedules. Impairment of a servicing asset is recognized through a valuation allowance and a charge to current-period earnings if it is considered to be temporary or through a direct write-down of the asset and a charge to current-period earnings if it is considered other than temporary. An increase in the fair value of a servicing liability above its carrying value is recognized through an increase in the liability and a charge to current-period earnings. The predominant risk characteristics of the underlying loans that are used to stratify the servicing assets and liabilities for measurement purposes generally include the (1) loan origination date, (2) loan rate, (3) loan type and size, (4) loan maturity date, and (5) geographic location. The rate of prepayment of loans serviced is the most significant estimate involved in the measurement process. Estimates of prepayment rates are based on market participant s expectations of future prepayment rates, reflecting the company s historical rate of loan repayments if consistent with market participant assumptions, industry trends, and other considerations. Actual prepayment rates differ from those projected by management due to changes in a variety of economic factors, (continued) Effective Date, Transition, and Disclosures / 8-11

316 including prevailing interest rates and the availability of alternative financing sources to borrowers. If actual prepayments of the loans being serviced were to occur more quickly than projected, the carrying value of servicing assets might have to be written down through a charge to earnings (or in the case of a servicing liability, a credit to earnings) in the current period. If actual prepayments of the loans being serviced were to occur more slowly than had been projected, the carrying value of servicing assets could increase, and servicing income would exceed previously projected amounts (or in the case of a servicing liability, a charge to earnings). Accordingly, the servicing assets actually realized, or the servicing liabilities actually incurred, could differ from the amounts initially recorded. Changes in the balances of servicing assets and servicing liabilities subsequently measured using the fair value measurement method for the year ended December 31, 2012, are recorded as follows: Class 1 Servicing Assets Servicing Liabilities Fair value as of January 1, 2012 $XXXXX $XXXXX Additions: Purchases of servicing assets XXXXX XXXXX Assumption of servicing obligations XXXXX XXXXX Servicing obligations that result from transfers of financial assets XXXXX XXXXX Subtractions: Disposals (XXXXX) (XXXXX) Changes in fair value: Due to change in valuation inputs or assumptions used in the valuation model XX/(XX) XX/(XX) Other changes in value XX/(XX) XX/(XX) Other changes that affect the balance XX/(XX) XX/(XX) Fair value as of December 31, 2012 $XXXXX $XXXXX 8-12 / Effective Date, Transition, and Disclosures Class 2 Servicing Assets Servicing Liabilities Fair value as of January 1, 2012 $XXXXX $XXXXX Additions: Purchases of servicing assets XXXXX XXXXX Assumption of servicing obligations XXXXX XXXXX Servicing obligations that result from transfers of financial assets XXXXX XXXXX Subtractions: Disposals (XXXXX) (XXXXX) Changes in fair value: Due to change in valuation inputs or XX/(XX) XX/(XX) assumptions used in the valuation model Other changes in value XX/(XX) XX/(XX) Other changes that affect the balance XX/(XX) XX/(XX) Fair value as of December 31, 2012 $XXXXX $XXXXX (continued)

317 Changes in the balances of servicing assets and servicing liabilities subsequently measured using the amortization method for the year ended December 31, 2012, are as follows: Class 3 Servicing Assets Servicing Liabilities Carrying Amount as of January 1, 2012 $XXXXX $XXXXX Additions: Purchases of servicing assets XXXXX XXXXX Assumption of servicing obligations XXXXX XXXXX Servicing obligations that result from transfers of financial assets XXXXX XXXXX Subtractions: Disposals (XXXXX) (XXXXX) Amortization (XXXXX) (XXXXX) ) Application of valuation allowance to adjust carrying values of servicing assets XX/(XX) XX/(XX) Other-than-temporary impairments (XXXXX) (XXXXX) Other changes that affect the balance XX/(XX) XX/(XX) Carrying amount before valuation allowance XXXXX XXXXX Valuation allowance for servicing assets: Beginning balance XXXXX N/A Provision/recoveries XX/(XX) N/A Other-than-temporary impairments (XXXXX) N/A Sales and disposals (XXXXX) N/A Ending balance XX/(XX) N/A Carrying amount as of December 31, 2012 $XXXXX $XXXXX Fair value as of January 1, 2012 XXXXX XXXXX Fair value as of December 31, 2012 XXXXX XXXXX (continued) Effective Date, Transition, and Disclosures / 8-13

318 Servicing Assets Class 4 Servicing Liabilities Carrying Amount as of January 1, 2012 $XXXXX $XXXXX Additions: Purchases of servicing assets XXXXX XXXXX Assumption of servicing obligations XXXXX XXXXX Servicing obligations that result from transfers of financial assets XXXXX XXXXX Subtractions: Disposals (XXXXX) (XXXXX) Amortization (XXXXX) (XXXXX) Application of valuation allowance to adjust carrying values of servicing assets XX/(XX) XX/(XX) Other-than-temporary impairments (XXXXX) (XXXXX) Other changes that affect the balance XX/(XX) XX/(XX) Carrying amount before valuation allowance XXXXX XXXXX Valuation allowance for servicing assets: Beginning balance XXXXX N/A Provision/recoveries XX/(XX) N/A Other-than-temporary impairments (XXXXX) N/A Sales and disposals (XXXXX) N/A Ending balance XX/(XX) N/A Carrying amount as of December 31, 2012 $XXXXX $XXXXX Fair value as of January 1, 2012 XXXXX XXXXX Fair value as of December 31, 2012 XXXXX XXXXX Example 8-4: Disclosures for Participating Interests That Continue to Be Held by the Transferor in Transfers of Portions of Entire Financial Assets Summary of Accounting Policies Loan Participations When the Company sells portions of commercial and construction development loans, it retains a participating interest in the entire financial asset subject to the transfer. The Company may also obtain servicing assets or assume servicing liabilities for the participating interest sold that are initially measured at fair value. Gains or losses on the sale of the receivables depend, in part, on both (a) the allocation of the previous carrying amount of the entire financial asset between the participating interest sold and the participating interest that continues to be held by the transferor based on their relative fair value at the date of transfer and (b) the proceeds received. To obtain fair values, quoted market prices are used if available. However, quotes are generally not available for participating interests that continue to be held by the transferor, so the Company generally allocates the total loan fair value to both the participating interest sold and retained in a systematic and rational manner. Participating interests in commercial and construction development loans that continue to be held by the transferor are generally included in the Company s (continued) 8-14 / Effective Date, Transition, and Disclosures

319 loans and receivables portfolio and are accounted for at amortized cost, net of an allowance for loan losses. Note Y Loan Participation Sales During 20X2 and 20X1, the Company sold participations on commercial and construction development loans in transactions negotiated with other financial institutions. In all those transactions, the Company obtained servicing responsibilities and retained participating interests. The Company receives annual servicing fees approximating 1.5 percent (for commercial loans) and 2 percent (for construction development loans) of the outstanding balance and rights to future principal and interest payments on the pro-rata ownership interest retained (after deduction of servicing fee) in the entire financial asset. The financial institutions have no recourse for failure of debtors to pay when due. The interests that continue to be held by the Company have the same priority to the financial institution s interests. Their value and ultimate collectability is subject to the same credit, prepayment, and interest rate risk they were subject to prior to the transfer. In 20X2, the Company recognized pretax gains of $10.3 million on participation sales of commercial loans and $5.2 million on participation sales of construction development loans. In 20X1, the Company recognized pretax gains of $6.9 and $5.0 million on participation sales of commercial and construction development loans, respectively. Example 8-5: Disclosures for Beneficial Interests Obtained by the Transferor in Transfers of entire Financial Assets or Groups of entire Financial Assets Summary of Accounting Policies Receivable Sales When the Company sells receivables in securitizations of automobile loans, credit card loans, and residential mortgage loans, it may obtain interest-only strips, one or more subordinated tranches, and in some cases a cash reserve account, all of which are beneficial interests obtained by the transferor in the securitized receivables that are initially measured at their fair value. The Company may also obtain servicing assets or assume servicing liabilities that are also initially measured at fair value. Gains or losses on the sale of the receivables depend, in part, on both (a) the net non-cash proceeds received or paid and (b) the cash proceeds received. To obtain fair values, quoted market prices are used if available. However, quotes are generally not available for beneficial interests that are obtained by the transferor, so the Company generally estimates fair value based on the present value of expected future cash flows, which are calculated using management s best estimates of the key assumptions credit losses, prepayment speeds, forward yield curves, and discount rates commensurate with the risks involved. Refer to Note X for more details on the Company s fair value estimates on servicing assets and servicing liabilities. Note Y Sales of Receivables During 20X2 and 20X1, the Company sold automobile loans, residential mortgage loans, and credit card loans in securitization transactions. In all those securitizations, the Company obtained servicing responsibilities and subordinated beneficial interests. The Company receives annual servicing fees approximating 0.5 percent (for mortgage loans), 2 percent (for credit card loans), and 1.5 percent (for automobile loans) of the outstanding balance and rights to future cash flows arising after the investors in the securitization trust have received the return for which they contracted. The investors and the securitization trusts have no recourse to the Company s other assets for failure of debtors to pay when due. The beneficial (continued) Effective Date, Transition, and Disclosures / 8-15

320 interests obtained by the Company are subordinate to investor s interests. Their value is subject to credit, prepayment, and interest rate risks on the transferred financial assets. In 20X2, the Company recognized pretax gains of $22.3 million on the securitization of the automobile loans, $30.2 million on the securitization of credit card loans, and $25.6 million on the securitization of residential mortgage loans. In 20X1, the Company recognized pretax gains of $16.9, $21.4, and $15.0 million on the securitization of the automobile loans, credit card loans, and residential mortgage loans, respectively. Key economic assumptions used in measuring the beneficial interests at the date of securitization resulting from securitizations completed during the year were as follows (rates* per annum): 20X2 Automobile Credit Card Residential Mortgage Loans Loans Loans Fixed-Rate Adjustable** Prepayment Speed 1.00% 15.00% 10.00% 8.00% Weighted-average life (in years) Expected credit losses % 6.10% 1.25% 1.30% Residual cash flows discounted at % 12.00% 10.00% 8.50% Variable returns to transferees Forward Eurodollar yield curve plus contractual spread over LIBOR ranging from 30 to 80 basis points Not applicable 20X1 Automobile Credit Card Residential Mortgage Loans Loans Loans Fixed-Rate Adjustable** Prepayment Speed 1.00% 12.85% 8.00% 6.00% Weighted-average life (in years) Expected credit losses % 5.30% 1.25% 2.10% Residual cash flows discounted at % 13.00% 11.75% 11.00% Variable returns to transferees Forward Eurodollar yield curve plus contractual spread over LIBOR ranging from 30 to 80 basis points Not applicable * Weighted-average rates for securitizations entered into during the period for securitizations of loans with similar characteristics. ** Rates for these loans are adjusted based on an index (for most loans, the 1-year Treasury note rate plus 2.75 percent). Contract terms vary, but for most loans, the rate is adjusted every 12 months by no more than 2 percent. At December 31, 20X2, key economic assumptions and the sensitivity of the current fair value of residual cash flows to immediate 10 percent and 20 percent adverse changes in those assumptions are as follows ($ in millions): (continued) 8-16 / Effective Date, Transition, and Disclosures

321 Automobile Loans Credit Card Loans Residential Mortgage Loans Fixed-Rate Adjustable Carrying amount/fair value of beneficial interests obtained by the transferor $15.6 $21.25 $12.0 $13.3 Weighted-average life (in years) Prepayment speed assumption (annual rate) 1.3% 15.0% 11.5% 9.3% Impact on fair value of 10% adverse changes $0.3 $1.6 $3.3 $2.6 Impact on fair value of 20% adverse changes $0.7 $3.0 $7.8 $6.0 Expected credit losses (annual rate) 3.0% 6.1% 0.9% 1.8% Impact on fair value of 10% adverse changes $4.2 $3.2 $1.1 $1.2 Impact on fair value of 20% adverse changes $8.4 $6.5 $2.2 $3.0 Residual cash flows discount rate (annual) 14.0% 14.0% 12.0% 9.0% Impact on fair value of 10% adverse changes $1.0 $0.1 $0.6 $0.5 Impact on fair value of 20% adverse changes $1.8 $0.1 $0.9 $0.9 Interest rates on variable and adjustable contracts Forward Eurodollar yield curve plus contracted spread Impact on fair value of 10% adverse changes $1.5 $4.0 $0.4 $1.5 Impact on fair value of 20% adverse changes $2.5 $8.1 $0.7 $3.8 These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10 percent variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the beneficial interests obtained by the transferor is calculated without changing any other assumption; in reality, changes in one assumption may result in changes to another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the sensitivities. (continued) Effective Date, Transition, and Disclosures / 8-17

322 The actual and expected static pool credit losses used in measuring the fair value of the beneficial interests obtained by the transferor are as follows: Automobile Loans Securitized in Actual and Projected Credit Losses (%) as of: 20X2 20X1 20X0 December 31, 20X December 31, 20X December 31, 20X0 4.5 Note: Static pool losses are calculated by summing the actual and projected future credit losses and dividing them by the original balance of each pool of assets. The amount shown here for each year is a weighted average for all securitizations during the period. The table below summarizes certain cash flows received from and paid to securitization trusts ($ in millions): Year Ended December 31 20X2 20X1 Proceeds from new securitizations $1,413 $971 Proceeds from collections reinvested in previous credit card securitizations 3,150 2,565 Servicing fees received Other cash flows received on beneficial interests obtained by the transferor* Purchases of delinquent or foreclosed assets (45) (25) Servicing advances (102) (73) Repayments of servicing advances * This amount represents total cash flows received from beneficial interests obtained by the transferor other than servicing fees. Other cash flows include, for example, all cash flows from interest-only strips and cash above the minimum required level in cash collateral accounts. (continued) 8-18 / Effective Date, Transition, and Disclosures

323 The following illustration presents quantitative information about delinquencies, net credit losses, components of securitized financial assets, and other assets managed together with them ($ in millions): Total Principal Amount of Loans Principal Amount of Loans 60 Days or More Past Due* December 31 Type of Loan 20X2 20X1 20X2 20X1 Automobile loans $ 830 $ 488 $42.3 $26.8 Residential mortgage loans (fixed-rate) Residential mortgage loans (adjustable) Credit card loans Total loans managed or securitized*** 2,156 1, Less: Loans securitized**** 1, Loans held for sale or securitization Loans held in portfolio $ 652 $ 465 Average Balance Net Credit Losses** During the Year Type of Loan 20X2 20X1 20X2 20X1 Automobile loans $ 720 $ 370 $21.6 $12.6 Residential mortgage loans (fixed-rate) Residential mortgage loans (adjustable) Credit card loans Total loans managed or securitized*** 2,060 1,240 $49.4 $36.8 Less: Loans securitized**** 1, Loans held for sale or securitization 17 9 Loans held in portfolio $ 675 $ 479 * ** *** Loans 60 days or more past due are based on end of period total loans. Net credit losses are charge-offs and are based on total loans outstanding. Owned and securitized loans are customer loans, credit card loans, mortgage loans, auto loans, and other loans, as applicable, in which the transferor retains a subordinate beneficial interest or retains any risk of loss (for example, 10 percent recourse). **** Represents the principal amount of the loan. Interest-only strips (or other beneficial interests obtained by a transferor) and servicing assets and servicing liabilities held for securitized assets are excluded. Effective Date, Transition, and Disclosures / 8-19

324 Appendix A: Technical References and Abbreviations Technical References and Abbreviations / A - 1

325 Appendix A: Technical References and Abbreviations The following table should be used as a reference for the abbreviations utilized throughout the Guide: Abbreviation ASC 210 ASC 250 ASC 310 ASC 320 ASC 325 ASC 360 ASC 450 ASC 460 ASC 470 ASC 810 ASC 815 ASC 820 ASC 825 ASC 840 ACS 860 ASC 942 ASC 946 ASC 958 IAS 27 IAS 39 SIC 12 AU 336 AU 9336 AU 337 Technical References Accounting Standards Codification Topic 210, Balance Sheet Accounting Standards Codification Topic 250, Accounting Changes and Error Corrections Accounting Standards Codification Topic 310, Receivables Accounting Standards Codification Topic 320, Investments Debt and Equity Securities Accounting Standards Codification Topic 325, Investments Other Accounting Standards Codification Topic 360, Property, Plant, and Equipment Accounting Standards Codification Topic 450, Contingencies Accounting Standards Codification Topic 460, Guarantees Accounting Standards Codification Topic 470, Debt Accounting Standards Codification Topic 810, Consolidation Accounting Standards Codification Topic 815, Derivatives and Hedging Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures Accounting Standards Codification Topic 825, Financial Instruments Accounting Standards Codification Topic 840, Leases Accounting Standards Codification Topic 860, Transfers and Services Accounting Standards Codification Topic 942, Financial Services Depository and Lending Accounting Standards Codification Topic 946, Financial Services Investment Companies Accounting Standards Codification Topic 958, Not-for-Profit Entities International Accounting Standard IAS 27, Consolidated and Separate Financial Statements International Accounting Standard IAS 39, Financial Instruments: Recognition and Measurement Standing Interpretations Committee Interpretation SIC-12, Consolidation Special Purpose Entities AU Section 336, Using the Work of a Specialist AU Section 9336, Using the Work of a Specialist: Auditing Interpretations of Section 336 AU Section 337, Inquiry of a Client s Lawyer Concerning Litigation, Claims, and Assessments Abbreviation ABS AFS AICPA AIR ASC Other References Asset-Backed Securities Available-For-Sale American Institute of Certified Public Accountants Accrued Interest Receivable Accounting Standards Codification A - 2 / Technical References and Abbreviations

326 Abbreviation ASU ATM BIH BRE CBO CDO CDS CMO CP CPDI CPR CSA DFL DRD EOD FAS FASB FASIT FDIC FHLMC FMV FNMA GAAP GMS GNMA HELOCs IAS IASB IFRS IO IRC IRS ITM MBS MPA OCC OCI OID OTM PAC PO Accounting Standards Update At The Money Beneficial Interest Holder Bankruptcy-Remote Entity Collateralized Bond Obligation Collateralized Debt Obligation Credit Default Swap Collateralized Mortgage Obligation Commercial Paper Contingent Payment Debt Instrument Constant Prepayment Rate Construction and Sale Agreement Direct-Financing Lease Dividends Received Deduction Event of Default Other References Financial Accounting Standards (superseded by FASB Accounting Standards Codification ASC ) Financial Accounting Standards Board Financial Asset Securitization Investment Trust Federal Deposit Insurance Corporation Federal Home Loan Mortgage Corporation Fair Market Value Federal National Mortgage Association Generally Accepted Accounting Principles Guaranteed Mortgage Securitization Government National Mortgage Association Home Equity Loans and Lines of Credit International Accounting Standards International Accounting Standards Board International Financial Reporting Standards Interest-Only Strip Internal Revenue Code Internal Revenue Service In The Money Mortgage-Backed Securities Master Purchase Agreement Office of the Comptroller of the Currency Other Comprehensive Income Original Issue Discount Out of The Money Prepayment Assumption Catch-up Principal-Only Strip Technical References and Abbreviations / A - 3

327 Abbreviation PPE PSA PTP QSPE REIT REMIC ROAP SEC SPE STL TBA TMP USAP USD VA VAT VIE WAC WAM Other References Property, Plant & Equipment Public Securities Administration Publicly Traded Partnership Qualifying Special Purpose Entity Real Estate Investment Trust Real Estate Mortgage Investment Conduit Removal of Accounts Provision Securities and Exchange Commission Special Purpose Entity Sales-Type Lease To-Be-Announced Taxable Mortgage Pool Uniform Single Attestation Program for Mortgage Bankers United States Dollar Department of Veterans Affairs Value Added Tax Variable Interest Entity Weighted Average Coupon Weighted Average Maturity A - 4 / Technical References and Abbreviations

328 Appendix B: Glossary of Terms Glossary of Terms / B - 1

329 Adequate Compensation Affiliate Agent Attached Call Option Bankruptcy-Remote Entity Beneficial Interests 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. A party that, directly or indirectly through one or more intermediaries, controls, is controlled by, or is under common control with an entity. A party that acts for and on behalf of another party. For example, a third-party intermediary is an agent of the transferor if it acts on behalf of the transferor. A call option held by the transferor of a financial asset that becomes part of and is traded with the underlying instrument. Rather than being an obligation of the transferee, an attached call option is traded with and diminishes the value of the underlying instrument transferred subject to that call option. An entity that is designed to make remote the possibility that it would enter bankruptcy or other receivership. Rights to receive all or portions of specified cash inflows received by a trust or other entity, including, but not limited to, all of the following: a. Senior and subordinated shares of interest, principal, or other cash inflows to be passedthrough or paid-through. b. Premiums due to guarantors. c. Commercial paper obligations. d. Residual interests, whether in the form of debt or equity. Benefits of Servicing Cleanup Call Option Revenues from contractually specified servicing fees, late charges, and other ancillary sources, including float. An 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. B - 2 / Glossary of Terms

330 Collateral Consolidated Affiliate Contractually Specified Servicing Fees Continuing Involvement Derecognize Derivative Financial Instrument Dollar-Roll Repurchase Agreement Personal or real property in which a security interest has been given. An entity whose assets and liabilities are included in the consolidated, combined, or other financial statements being presented. All amounts that, per contract, are due to the servicer in exchange for servicing the financial asset and would no longer be received by a servicer if the beneficial owners of the serviced assets (or their trustees or agents) were to exercise their actual or potential authority under the contract to shift the servicing to another servicer. Depending on the servicing contract, those fees may include some or all of the difference between the interest rate collectible on the financial asset being serviced and the rate to be paid to the beneficial owners of those financial assets. Any involvement with the transferred financial assets that permits the transferor to receive cash flows or other benefits that arise from the transferred financial assets or that obligates the transferor to provide additional cash flows or other assets to any party related to the transfer. Remove previously recognized assets or liabilities from the statement of financial position. A derivative instrument that is a financial instrument. An agreement to sell and repurchase similar but not identical securities. The securities sold and repurchased are usually of the same issuer. Dollar rolls differ from regular repurchase agreements in that the securities sold and repurchased have all of the following characteristics: a. They are represented by different certificates. b. They are collateralized by different but similar mortgage pools (for example, conforming single-family residential mortgages). c. They generally have different principal amounts. Fixed coupon and yield maintenance dollar agreements comprise the most common agreement variations. In a fixed coupon agreement, the seller and buyer agree that delivery will be made with securities having the same stated interest rate as the interest rate stated on the securities sold. In a yield maintenance agreement, the parties agree that delivery will be made with securities that will provide the seller a yield that is specified in the agreement. Glossary of Terms / B - 3

331 Embedded Call Option Equitable Right of Redemption Financial Asset Financial Instrument A call option held by the issuer of a financial instrument that is part of and trades with the underlying instrument. For example, a bond may allow the issuer to call it by posting a public notice well before its stated maturity that asks the current holder to submit it for early redemption and provides that interest ceases to accrue on the bond after the early redemption date. Rather than being an obligation of the initial purchaser of the bond, an embedded call option trades with and diminishes the value of the underlying bond. The right of a property owner who has defaulted on a secured obligation to recover the securing property before its sale by paying the amounts due and any appropriate fees and charges. Other creditors of or a receiver for the property owner also may be able to exercise that right. After a transfer of a financial asset, a right of redemption may allow the transferor to buy back the transferred 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. Cash, evidence of an ownership interest in an entity, or a contract that both: a. Imposes on one entity a contractual obligation either: 1. To deliver cash or another financial instrument to a second entity. 2. To exchange other financial instruments on potentially unfavorable terms with the second entity. B - 4 / Glossary of Terms

332 Financial Instrument (continued) b. Conveys to that second entity a contractual right either: 1. To receive cash or another financial instrument from the first entity. 2. To exchange other financial instruments on potentially favorable terms with the first entity. The use of the term financial instrument in this definition is recursive (because the term financial instrument is included in it), though it is not circular. The definition requires a chain of contractual obligations that ends with the delivery of cash or an ownership interest in an entity. Any number of obligations to deliver financial instruments can be links in a chain that qualifies a particular contract as a financial instrument. Contractual rights and contractual obligations encompass both those that are conditioned on the occurrence of a specified event and those that are not. All contractual rights (contractual obligations) that are financial instruments meet the definition of asset (liability) set forth in FASB Concepts Statement No. 6, Elements of Financial Statements, although some may not be recognized as assets (liabilities) in financial statements that is, they may be off-balance-sheet because they fail to meet some other criterion for recognition. For some financial instruments, the right is held by or the obligation is due from (or the obligation is owed to or by) a group of entities rather than a single entity. Financial Liability Freestanding Call Option A contract that imposes on one entity an obligation to do either of the following: a. Deliver cash or another financial instrument to a second entity. b. Exchange other financial instruments on potentially unfavorable terms with the second entity. A call option that is neither embedded in nor attached to an asset subject to that call option. Glossary of Terms / B - 5

333 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. Interest-Only Strip Loan Origination Fees A contractual right to receive some or all of the interest due on a bond, mortgage loan, collateralized mortgage obligation, or other interest-bearing financial asset. Origination fees consist of all of the following: a. Fees that are being charged to the borrower as prepaid interest or to reduce the loan s nominal interest rate, such as interest buy-downs (explicit yield adjustments). b. Fees to reimburse the lender for origination activities. c. Other fees charged to the borrower that relate directly to making the loan (for example, fees that are paid to the lender as compensation for granting a complex loan or agreeing to lend quickly). d. Fees that are not conditional on a loan being granted by the lender that receives the fee but are, in substance, implicit yield adjustments because a loan is granted at rates or terms that would not have otherwise been considered absent the fee (for example, certain syndication fees addressed in paragraph ). B - 6 / Glossary of Terms

334 Loan Origination Fees (continued) Loan Participation Loan Syndication Participating Interest Protection Provisions Proceeds Recourse e. Fees charged to the borrower in connection with the process of originating, refinancing, or restructuring a loan. This term includes, but is not limited to, points, management, arrangement, placement, application, underwriting, and other fees pursuant to a lending or leasing transaction and also includes syndication and participation fees to the extent they are associated with the portion of the loan retained by the lender. A transaction in which a single lender makes a large loan to a borrower and subsequently transfers undivided interests in the loan to groups of banks or other entities. A transaction in which several lenders share in lending to a single borrower. Each lender loans a specific amount to the borrower and has the right to repayment from the borrower. It is common for groups of lenders to jointly fund those loans when the amount borrowed is greater than any one lender is willing to lend. Paragraph ASC A defines the term participating interest. Provisions in some contracts to sell or transfer mortgage servicing rights that could affect the amount ultimately paid to the transferor. For example, the transferor may agree to adjust the sales price for loan prepayments, defaults, or foreclosures that occur within a specified period of time. Cash, beneficial interests, servicing assets, derivative instruments, or other assets that are obtained in a transfer of financial assets, less any liabilities incurred. The right of a transferee of receivables to receive payment from the transferor of those receivables for any of the following: a. Failure of debtors to pay when due. b. The effects of prepayments. c. Adjustments resulting from defects in the eligibility of the transferred receivables. Remote The chance of the future event or events occurring is slight. Glossary of Terms / B - 7

335 Repurchase Agreement Repurchase Financing Revolving-Period Securitizations Securitization Security Interest Seller Set-off Right Standard Representations and Warranties Servicing Asset An agreement under which the transferor (repo party) transfers a security to a transferee (repo counterparty or reverse party) in exchange for cash and concurrently agrees to reacquire that security at a future date for an amount equal to the cash exchanged plus a stipulated interest factor. Instead of cash, other securities or letters of credit sometimes are exchanged. Some repurchase agreements call for repurchase of securities that need not be identical to the securities transferred. A repurchase agreement that relates to a previously transferred financial asset between the same counterparties (or consolidated affiliates of either counterparty) that is entered into contemporaneously with, or in contemplation of, the initial transfer. Securitizations in which receivables are transferred at the inception and also periodically (daily or monthly) thereafter for a defined period (commonly three to eight years), referred to as the revolving period. During the revolving period, the specialpurpose entity uses most of the cash collections to purchase additional receivables from the transferor on prearranged terms. The process by which financial assets are transformed into securities. A form of interest in property that provides that upon default of the obligation for which the security interest is given, the property may be sold in order to satisfy that obligation. A transferor that relinquishes control over financial assets by transferring them to a transferee in exchange for consideration. A common law right of a party that is both a debtor and a creditor to the same counterparty to reduce its obligation to that counterparty if that counterparty fails to pay its obligation. Representations and warranties that assert the financial asset being transferred is what it is purported to be at the transfer date. A contract to service financial assets under which the estimated future revenues from contractually specified servicing fees, late charges, and other ancillary revenues are expected to more than adequately compensate the servicer for performing the servicing. A servicing contract is either (a) undertaken in conjunction with selling or securitizing the financial assets being serviced or (b) purchased or assumed separately. B - 8 / Glossary of Terms

336 Servicing Liability Trade Receivables Transfer A contract to service financial assets under which the estimated future revenues from contractually specified servicing fees, late charges, and other ancillary revenues are not expected to adequately compensate the servicer for performing the servicing. Trade receivables are financial assets that represent a contractual right to receive cash or another financial instrument and are amounts owed by customers, prepayments to suppliers and other similar non-financial claims. Many companies transfer trade receivables in either traditional factoring arrangements or to banksponsored commercial paper conduits. 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. Transferee Transferor Transferred Financial Assets Unilateral Ability An entity that receives a financial asset, an interest in a financial asset, or a group of financial assets from a transferor. An entity that transfers a financial asset, a portion of a financial asset, or a group of financial assets that it controls to another entity. Any of the following: An entire financial asset. A group of entire financial assets. A participating interest in an entire financial asset. A capacity for action not dependent on the actions (or failure to act) of any other party. Glossary of Terms / B - 9

337 Appendix C: Summary of Changes from 2012 Edition Summary of Changes from 2012 Edition / C - 1

338 Appendix C: Summary of Changes from 2012 Edition The 2013 edition of the PricewaterhouseCoopers (PwC), Guide to Accounting for Transfers and Servicing of Financial Assets, has been updated as of May 31, 2013 to include additional authoritative and interpretive guidance not included in the 2012 edition. This appendix includes a summary of the noteworthy revisions to this guide. Noteworthy Revisions Chapter 2: Control Criteria for Transfers of Financial Assets Section was updated for reference to AU 15 Audit Evidence. Chapter 4: Accounting for Financing-Type Transfers Section 4.1 was updated for the recent FASB exposure draft issued in January 2013 related to accounting for transfers with forward repurchase agreements to repurchase assets and for repurchase financings. Chapter 5: Servicing of Financial Assets Section 5.7 was updated with Question 5-3 related to bifurcating a servicing fee and Question 5-4 related to the unit of account for derecognition of MSRs. Chapter 8: Effective Date, Transition and Disclosure Section was updated for disclosure requirements under ASC related to offsetting. C - 2 / Summary of Changes from 2012 Edition

339 How PwC Can Help ASC 860 represents a transfer of financial assets derecognition model that is applicable to a wide array of entities. In addition, the ASC 860 Topic also provides accounting guidance with respect to accounting for servicing rights and transfers of such rights. ASC 860 is a principles-based standard that bases derecognition of financial assets transferred on whether the transferor and its consolidated affiliates in the financial statements being presented have surrendered control over such assets. Our transfers and servicing consultants and Assurance professionals frequently advise companies regarding interpretation and application of the accounting rules under ASC 860 and related matters, including: Determining whether an asset subject to a transfer meets the definition of a financial asset; Determining whether a financial asset subject to a transfer should be considered an entire financial asset or a portion of a financial asset; Identifying consolidated affiliates of the transferor; Determining whether the transfer of a portion of a financial asset meets the participating interest rules and the sale criteria; Determining whether the transfer of an entire financial asset meets the conditions for sale accounting; Initial accounting for transfers that meet sale as well as for those that fail sale and subsequent accounting; and Identifying appropriate disclosure items. Our professionals bring value to businesses by understanding and resolving their complex business issues. There will be many such issues related to the accounting for transfers of financial assets under ASC 860. If you have any questions or comments, please contact your PricewaterhouseCoopers partner. About PricewaterhouseCoopers PwC United States helps organizations and individuals create the value they re looking for. We re a member of the PwC network of firms in 158 countries with more than 180,000 people. We re committed to delivering quality in assurance, tax and advisory services. Tell us what matters to you and find out more by visiting us at

340 Acknowledgments Our first edition of the guide published in 2007 and subsequent updates represented the efforts and ideas of many individuals within PwC, including members of PwC s National Professional Services Group and various subject matter experts. Primary contributors to the 2013 edition include Frederick Currie, Christopher Gerdau, Marie Kling, Mary Perrotta, Mike Yenchek, Lynn Chin, Adam Davis, and Jonathan Odom. We are grateful to many others whose key contributions enhanced the quality and depth of this guide.