FASB Wrestles With ‘Sold’ vs. ‘Transferred’

When accounting rulemakers say they want to get back to basics on good financial reporting, they mean it: The rules will soon contain new directives on how to define “sold.”

The concept would seem straightforward enough: Party A gives an asset to Party B, who gives money to Party A in exchange. Sold.

Well, not so in modern accounting.

Garmong

“We thought we all understood what ‘sold’ meant,” says Sydney Garmong, a partner at the auditing firm Crowe Chizek. “We don’t even use the term ‘sold’ any more. We use the term ‘transferred.’”

That’s because assets are routinely transferred often among entities without a clear-cut view for investors of whether control over a given asset has transferred as well—not to mention the potential gains or losses arising from the asset. The assets end up parked in “special purpose entities” that don’t appear on the balance sheet, so they’re out of investors’ view.

That complexity contributed to the current credit crisis. Financial engineering has led to complex securitizations, or the repackaging of various financial assets such as loans into new financial instruments. They are transferred under complex contracts spelling out who has control, who will benefit from any gains, and who will suffer from any losses.

Now the Financial Accounting Standards Board is toiling on two chunks of accounting literature to try to make it easier for investors to sort out who owns what. Financial Accounting Standard No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and Financial Interpretation No. 46(R), Consolidation of Variable Interest Entities, contain the bulk of guidance currently under scrutiny and certain revision.

Stacey

“The changes they’re going to make are going to be pretty dramatic to reflect the current credit crisis,” says Carol Stacey, vice president at the SEC Institute and a former top accountant at the Securities and Exchange Commission. “We’re going to get more transparency around this issue.”

Securitizations have become increasingly complex in recent years as packagers found investors more willing to pay premium prices when the risk was sufficiently diffused. “There are not a lot of parties who individually want to acquire these types of assets, mainly loans and mortgages,” Stacey says. “They’ll say, ‘No. If I wanted to be a lender, I’d be a bank.’ But if banks pool them all and get a certain amount of credit enhancement so investors are somewhat protected, investors can be comforted that when

they buy them they aren’t buying the entire risk.”

140 PROPOSALS

Below is an excerpt of a FASB meeting handout pertaining to FAS 140, Transfers and Servicing of Financial Assets.

The staff proposes that the transition and effective date for the proposed Exposure Draft to Statement 140 should be as follows (subject to drafting):

Public Entities

X1. For public entities, this Statement shall be effective for fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for new transfers of financial assets occurring after fiscal years beginning after November 15, 2008.

X2. Transfers completed in periods prior to fiscal years beginning after November 15, 2008, and transfers of financial assets after the effective date that are required by commitments made before the effective date to transferees or beneficial interest holders other than the transferor, its affiliates, or its agents shall continue to be accounted for under the previous accounting standards for transfers of financial assets that applied when the transferor made or committed to those transfers.

X3. Except as provided in paragraph X4, a special-purpose entity (SPE) that was a qualifying SPE prior to fiscal years beginning after November 15, 2008, shall continue to be considered a qualifying SPE if it maintains its qualifying status under previous accounting standards, does not issue new beneficial interests after the effective date, and does not receive financial assets it was not committed to receive (through a commitment to transferees or beneficial interest holders unrelated to the transferor). Otherwise, the formerly qualifying SPE and assets transferred to it shall be subject to consolidation standards and guidance and to all the provisions of Statement 140, as amended by this Statement.

X4. Existing transfers completed in periods prior to fiscal years beginning after November 15, 2008, and transfers of assets after the effective date required by commitments made before that date shall apply the guidance in this Statement prospectively in financial statements issued for fiscal years beginning after November 15, 2009, and interim periods within those fiscal years. On adoption of this Statement for existing qualifying SPEs, the qualifying SPE is not exempt from consolidation guidance as previously provided in paragraph 46 of Statement 140.

X5. Earlier application of this Statement is prohibited.

Non-public Entities

X6. For non-public entities, this Statement shall be effective for financial statements issued for fiscal years beginning after November 15, 2009. This Statement shall be applied prospectively as of the beginning of the fiscal year in which this Statement is initially applied. Transfers completed in periods prior to fiscal years beginning after November 15, 2009, and transfers of financial assets completed after the effective date that are required by commitments made before the effective date to transferees or beneficial interest holders other than the transferor, its affiliates, or its agents shall continue to be accounted for under the previous accounting standards for transfers of financial assets that applied when the transferor made or committed to those transfers. On adoption of this Statement for existing qualifying SPEs, the qualifying SPE is not exempt from consolidation guidance as previously provided in paragraph 46 of Statement 140.

X7. Earlier application of this Statement is permitted for non-public entities consistent with the transition and effective date guidance provided for public entities provided that the reporting entity has not yet issued financial statements for that fiscal year.

Source

Handouts From the FASB Meeting on FAS 140, FIN 46R (June 11, 2008).

FASB has already determined it will eliminate the concept of a “qualified” special purpose entity from FAS 140. QSPEs are entities that would qualify automatically to house off-balance-sheet securitizations if they meet some bright-line tests that would suggest the assets under management essentially belonged to someone else.

FASB finally saw how QSPEs have been abused when the banking community flew into action—under banking regulators’ and the SEC’s approval—to work out troubled loans held in QSPEs. The act suggests that control over the assets hadn’t really transferred, further suggesting they belonged on the banks’ balance sheets.

Some banks attracted even more scrutiny when they started making cash infusions into securitizations held in QSPEs, according to Charles Mulford, accounting professor at Georgia Institute of Technology. “The issue was we don’t have a contractual obligation, but somehow our name is associated with this,” he says. “I don’t have a contractual obligation to bail this thing out, but if I don’t, word will get out that this fund has failed and it’s mine—that's demonstrating you have some interest in it, some obligation to it, and it should be consolidated to the balance sheet.”

In revising FAS 140 to eliminate the QSPE, the Board also plans to map out a series of required disclosures to help investors understand the economics behind securitizations—such as whether an entity like a bank still has continuing involvement with a securitization transaction and any terms that require or compel providing financial support to the securitization, among others.

In more recent deliberations, FASB has focused on how under FIN 46R an entity should regard a special-purpose entity as something it still owns and, therefore, should reflect in its financial statements—or is something that someone else essentially owns, and therefore can be kept off the balance sheet. Discussions have centered on defining ownership: who controls the asset, who benefits if it performs well, and who suffers if it performs poorly.

Ciesielski

“The hard part is who sold an asset,” says Jack Ciesielski, owner of advisory firm R.G. Associates. “FASB could take a hard line and say once you’ve packaged these things off, if you don’t have any continuing involvement, ever, it’s a sale. That would be clean, but I don’t think anyone would go for that.”

Wording in the new rules will be critical to determining when something belongs on the balance sheet. “I believe there could potentially be some significance to very key phraseology that will help you think more broadly about what the implications are and where the residual risks may lie,” FASB member Tom Linsmeier said in a recent meeting to discuss FIN 46R revisions.

Linsmeier

As FASB works to sort out whether an asset transfer should be treated as “sold,” it not only will lead to new disclosures, but also new determinations around whether a securitization or a sale of an asset has occurred, Stacey says. If not, the alternative treatment for accounting purposes is direct financing.

“The cash you receive ends up being a liability,” she says. “That may happen where it didn’t before.”

FASB is still working to determine effective dates for the various changes it plans to enact. While it generally wants new accounting and disclosures in place for the coming fiscal year, it acknowledges that may be difficult to do all in one step, given existing securitization structures and the transition that will be involved.