By David Thrope, partner at Ernst & Young
Accounting changes effective for fiscal years beginning after Nov. 15, 2009 (the effective date) will significantly impact many securitization transferors, servicers, guarantors and, in some cases, investors. The changes will make it difficult to derecognize financial assets and avoid securitization vehicle consolidation. Some of the changes apply to entities created before the effective date, resulting in a cumulative effect adjustment to effective date retained earnings.
This article is a high-level summary of the accounting (not disclosure) changes; it does not address many aspects of securitization accounting that remain unchanged. Accordingly, research and/or professional consultation should be performed and/or obtained before accounting for, or preparing, financial statement disclosures for, an actual or proposed transaction.
Derecognition
Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, (FAS 140) applies to pre-effective date transfers. Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets -- an amendment of FAS 140, (FAS 166) applies to post-effective date transfers.
In a change from FAS 140, there can only be a FAS 166 sale (i.e., derecognition) for transfers of (1) an entire financial asset, (2) groups of entire financial assets or (3) a "participating interest" in an entire financial asset. Participating interests must have: (a) equal, proportionate allocations and priority of underlying asset principal and interest to all participating interest holders; (b) no recourse to, or subordination by, any participating interest holder (other than standard representations and warranties); and (c) no participating interest holder right to pledge or exchange the entire underlying financial asset unless all participating interest holders agree.
Although differing in some details, FAS 140 and FAS 166 both provide that financial asset transfers should be accounted for as sales (as opposed to secured borrowings) only if the following requirements are met:
In contrast to FAS 140, FAS 166 requires transferors to initially account for all interests obtained from transfers of an entire financial asset or groups of entire financial assets accounted for as a sale at fair value. FAS 166 provides that the portion of an entire financial asset retained after the transfer of a participating interest accounted for as a sale is carried at allocated cost, based on the relative fair value of the sold and retained portions. Under FAS 140, all retained interests resulting from sales are initially carried at allocated cost.
Consolidation
Interpretation No. 46(R) Consolidation of Variable Interest Entities, (FIN 46(R)) applies to most securitization vehicles until the effective date. Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R), (FAS 167) applies to most securitization vehicles on the effective date. As FAS 166 eliminates the QSPE concept, QSPEs are not exempt from FAS 167 consolidation as they were, in most cases, under FIN 46(R).
FAS 167 indicates a variable interest entity is an entity (1) whose at-risk equity is insufficient to absorb entity "expected loss," (2) whose at-risk equity holders as a group do not have the power to direct the activities that most significantly impact the entity's economic performance, (3) whose at-risk equity holders as a group do not receive entity losses and benefits or (4) for which substantially all entity activities involve, or are conducted on behalf of, an entity investor and its related parties where the investor (not including related parties) has disproportionately fewer votes than its economic interest. In contrast to FIN 46(R), these determinations are made without considering equity holder rights to replace a non-equity holding decision-maker, unless the rights are exercisable, without barriers, by a single party (including its related parties and de facto agents). Under FAS 167, criteria (2) above is not met if the entity's non-equity holding decision-maker cannot be replaced by the entity's equity.
FIN 46(R) and FAS 167 require VIEs to be consolidated by their primary beneficiary. In a significant change from FIN 46(R), the primary beneficiary under FAS 167 is the party (if any) who holds VIE variable interests that (1) provides it with power to direct the activities of the VIE that most significantly impact VIE economic performance and (2) has the right to receive VIE benefit or loss that could potentially be significant to the VIE. Variable interests are contractual, ownership or other pecuniary VIE interests that vary with changes in VIE net assets. There is no primary beneficiary under FAS 167 if power is shared by unrelated parties. If different parties have the same power over portions of VIE assets, the primary beneficiary is the party, if any, with power over the majority of VIE assets. In evaluating power, the ability to replace a decision-maker is not relevant to the determination of who has power, unless the right is exercisable, without barriers, by a single party (including its related parties and de facto agents); in that case, the party with "kick-out" rights has power.
Fees to VIE decision-makers and other service providers are not variable interests under FAS 167 if: (1) the fee is commensurate with the related effort; (2) substantially all of the fee is at or above the level of seniority of VIE operating liabilities (e.g., trade payables); (3) the provider (including related parties and de facto agents but not employees) does not hold other variable interests that absorb more than insignificant VIE expected loss or residual return; (4) the related arrangement has terms that are customary to similar third-party arrangements and (5) the fees are insignificant to anticipated VIE economic performance and are expected to absorb insignificant variability in anticipated VIE performance.
Both FIN 46(R) and FAS 167 provide that an entity's VIE status should be reconsidered upon a change in its equity at risk, when entity activities change or when new entity activities result in changes in entity risks or rewards. FAS 167 also requires reconsideration of VIE status if equity holders lose the ability to control the entity. In an important change from FIN 46(R), FAS 167 requires reconsideration of a VIE's primary beneficiaries each time a variable interest holder issues financial statements (e.g., quarterly for public companies).
David Thrope is a partner in the New York Financial Services Office of Ernst & Young.
The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young.