Chapter 3 — Accounting for Transfers of Financial Assets

3.2 Meaning of the Term “Participating Interest”

3.2.1 General

ASC 860-10

Meaning of the Term Participating Interest

40-6A A participating interest has all of the following characteristics:

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.
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:
  1. They are not subordinate to the proportionate cash flows of the participating interest.
  2. 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.
The priority of cash flows has all of the following characteristics:
1. The rights of each participating interest holder (including the transferor in its role as a participating interest holder) have the same priority.
2. No participating interest holder’s interest is subordinated to the interest of another participating interest holder.
3. The priority does not change in the event of bankruptcy or other receivership of the transferor, the original debtor, or any other participating interest holder.
4. Participating interest holders have no recourse to the transferor (or its consolidated affiliates included in the financial statements being presented or its agents) or to each other, other than any of the following:
  1. Standard representations and warranties
  2. Ongoing contractual obligations to service the entire financial asset and administer the transfer contract
  3. 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.
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 paragraphs 860-10-55-17I through 55-17N.

Circumstances That Result in a Transferor Regaining Control of Financial Assets Previously Sold

40-41 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 (see paragraph 860-10-40-6A) or the transferor’s regaining control of transferred financial assets after a transfer that was previously accounted for as a sale, because one or more of the conditions in paragraph 860-10-40-5 are no longer met. See the related guidance beginning in paragraph 860-20-25-8.

Application of the Term Participating Interest

55-17I Paragraph 860-10-40-6A(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:

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.
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.
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 860-10-40-6A(c)).

55-17J Given the conditions in paragraph 860-10-40-6A(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:

Loan origination fees paid by the borrower to the transferor
Fees necessary to arrange and complete the transfer paid by the transferee to the transferor
Fees for servicing the financial asset.

55-17K The transfer of a portion of an entire financial asset may result in a gain or loss on the transfer if the contractual interest rate on the entire financial asset differs from the market rate at the time of transfer. Paragraph 860-10-40-6A(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 interest-only strip to the transferor from the transferee. An interest-only strip would result in a disproportionate division of cash flows of the financial asset among the participating interest holders and would preclude the portion from meeting the definition of a participating interest.

55-17L Paragraph 860-10-40-6A(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.

55-17M Paragraph 860-10-40-6A(c) addresses recourse in a participating interest. Recourse in the form of an independent third-party guarantee shall be excluded from the evaluation of whether the participating interest definition is met. Similarly, cash flows allocated to a third-party guarantor for the guarantee fee shall be excluded from the determination of whether the cash flows are divided proportionately among the participating interest holders.

55-17N Examples of standard representations and warranties (as used in paragraph 860-10-40-6A(c)) include representations and warranties about any of the following:

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.
The quality, accuracy, and delivery of documentation relating to the transfer and the underlying financial asset
The accuracy of the transferor’s representations in relation to the underlying financial asset.

ASC 860-10 contains several conditions that must be met for transfers of portions of entire financial assets to be eligible for sale accounting. Because of the requirements for participating interests, many financing transactions are accounted for as secured borrowings. For example, many traditional bank-sponsored trade receivable programs fail to meet the conditions for sale accounting because they involve transfers of portions of receivables while retaining a subordinated interest, which is a prohibited form of recourse.5 However, if entire receivables are transferred, the transferor may obtain a subordinated interest and meet the conditions for sale accounting. Thus, the application of the guidance on participating interests depends on the form, and not necessarily the substance, of the transfer.

Table 3-2 summarizes the requirements under which an interest in an entire financial asset meets the definition of a participating interest. (Note that these conditions must be met throughout the entire term of the arrangement. If an entity knows as of the transfer date that a transferred portion of an entire financial asset will not meet all the conditions of a participating interest in the future, it may not account for the transfer as a sale of a participating interest.) If an entity transfers a portion of an entire financial asset that does not meet the definition of a participating interest, the transfer must be accounted for as a secured borrowing unless all portions of the entire financial asset have been transferred (see ASC 860-10-40-4E). If the portion transferred meets the definition of a participating interest, sale accounting is appropriate if the transferee is not consolidated by the transferor and all the conditions in ASC 860-10-40-5 are met. Examples 3-5, 3-6, 3-7, and 3-12 illustrate the guidance on participating interests.

SEC Considerations

The SEC staff interprets literally the conditions that need to be met for a participating interest to exist in an entire financial asset. As a result, transfers of portions of entire financial assets that contain unique terms and features are often considered not to meet the definition of transferred participating interests.

Table 3-2

Requirement in ASC 860-10-40-6A	Discussion
a. “From the date of the transfer, [the interest] represents a proportionate (pro rata) ownership interest in an entire financial asset.”	The percentage ownership held by the transferor, its consolidated affiliates, and its agents may vary over time while the entire financial asset remains outstanding provided that the portions held meet the characteristics of a participating interest. 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. That is, at all times after the date of the transfer, any interest held by any party must meet the definition of a participating interest.
b. “From the date of the transfer, all cash flows received from the entire financial asset [(i.e., principal and interest cash flows)] 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 (i.e., principal only, interest only, or excess interest) is prohibited except for the following: Services performed — Cash flows allocated as compensation for servicing activities are not included in the evaluation provided that they are not subordinate to the proportionate cash flows of the interest and are not significantly above an amount that would fairly compensate a substitute servicer, which includes the profit that would be demanded in the marketplace. Therefore, an interest holder that is the servicer can have rights to cash flows for servicing fees before distribution of cash flows to interest holders. However, embedding an IO strip into servicing fees would be inconsistent with ASC 860-10-40-6A(b). In addition to servicing fees, cash flows for services performed include loan origination fees paid by the borrower to the transferor and fees to arrange and complete the transfer that are paid by the transferee to the transferor. Proceeds from sale — When a transferor sells an interest in an entire financial asset (e.g., a loan receivable), to meet the definition of a participating interest, the interest transferred must contain the same stated rate as the interest rate on the entire financial asset (after taking into account any servicing fees that meet the conditions in ASC 860-10-40-6A(b)(1) or guarantee fees as discussed in ASC 860-10-55-17M) even if market interest rates have changed since origination of the asset. If the transferred interest contains the then-market rate of interest, the definition of a participating interest will not be met. When an entire financial asset contains a stated interest rate that differs from the then-current market rate because of changes in market interest rates since origination, the difference between the market interest rate and the contractual interest rate on the portion of the entire financial asset transferred will represent a gain or loss to the transferor on disposition. That is, to meet the definition of a participating interest, the interest in the entire financial asset must be sold at a premium (i.e., a gain) or at a discount (i.e., a loss) when the stated interest rate differs from the then-current market interest rate. Any proceeds received by the transferor upon transfer of an interest in an entire financial asset, including any gain or loss on transfer because of changes in market interest rates, are not included in the evaluation of ASC 860-10-40-6A(b) provided that the proceeds do not include the receipt of an ownership interest in the entire financial asset that results in the transferor’s receiving disproportionate cash flows in the future. That is, any gain may be paid up front as a premium, but the transferor cannot receive an IO strip as proceeds (or receive the gain through higher than market servicing fees) because the future cash flows on the entire financial asset would not be shared proportionately.6 Third-party guarantee fees — Certain cash flows paid to a third-party guarantor are excluded from the evaluation of ASC 860-10-40-6A(b). See further discussion below. If cash flows other than those discussed above are not allocated proportionately, transferred portions of entire financial assets do not meet the definition of participating interests. A transferred portion of an entire financial asset that contains any provision that would result in a disproportionate allocation of cash flows upon the occurrence of a specified condition or event does not meet the definition of a participating interest regardless of the likelihood of the occurrence of the condition or event that would result in disproportionate cash flows.
c. “The rights of each participating interest holder (including the transferor in its role as a participating interest holder) have the same priority,” and “[n]o participating interest holder’s interest is subordinated to the interest of another participating interest holder.” Further, “[t]he priority does not change in the event of bankruptcy or other receivership of the transferor, the original debtor, or any other participating interest holder.” Moreover, “[p]articipating 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 . . . [s]tandard representations and warranties[, o]ngoing contractual obligation to service the entire financial asset and administer the transfer contract[, and c]ontractual obligations to share in . . . set-off benefits. . . . 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.”	To meet the definition of a participating interest, the rights of each interest holder (including the transferor, its consolidated affiliates, and its agents) must have the same priority throughout the entire life of the entire financial asset. If any interest holder does not have the same rights as all other interest holders upon the occurrence of a specified condition or event, the transferred interest does not meet the definition of a participating interest regardless of the likelihood that such a condition or event would occur. Recourse Provisions Interest holders can have no recourse to (1) the transferor, its consolidated affiliates, or its agents or (2) other interest holders, besides: Standard representations and warranties made by the transferor (see ASC 860-10-55-17N). Ongoing contractual obligations of the party designated to service the entire financial asset and administer the interests in the entire financial asset. Contractual obligations to share in any set-off benefits received by any interest holder. A provision that could require the transferor to make a payment to an interest holder if the entire financial asset is prepaid within a defined time frame would fail to meet this criterion. However, once the provision expires, transferred interests may meet the definition of participating interests. Third-Party Guarantees A third-party guarantee does not represent recourse under ASC 860-10-40-6A(c) even if the guarantee is related only to interests held by parties other than the transferor. Third-party guarantees on some, but not all, participating interests and third-party guarantees on only portions of losses do not affect whether interests in an entire financial asset are participating interests, because these guarantees are considered a separate unit of account.7 However, if one interest holder provides a guarantee to another interest holder, the interests in an entire financial asset are not participating interests unless the guarantee (1) does not involve the transferor, its consolidated affiliates, or its agents and (2) was entered into between interest holders after the transfer date. Cash flows allocated to a third party for guarantee fees are excluded from the determination of whether cash flows on the entire financial asset are divided proportionately among interest holders if the guarantee is related to all interest holders. If a guarantee pertains to only certain interests in an entire financial asset, interests in the entire financial asset can meet the definition of a participating interest only if the guarantee fees (1) are not senior to other cash flows on the entire financial asset and (2) are paid through a reduction of the pro rata cash flows owed to the guaranteed interest holders.
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.”	While no party can have the right to pledge or exchange the entire financial asset, if any third-party interest holder is constrained from pledging or exchanging its interest, sale accounting would be precluded because the condition in ASC 860-10-40-5(b) would not be met.
A set-off right is not an impediment to meeting the definition of a participating interest.	See Section 3.3.1.4.4 for further discussion of set-off rights.

ASC 860-10-40-41 states that 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.” Furthermore, ASC 860-10-55-17L states, in part, that when an interest holder’s recourse to the transferor expires, the “transferred portion shall be reevaluated to determine if it meets the participating interest definition.” On the basis of this guidance, entities should continually assess whether portions of an entire financial asset are participating interests.

Transferred interests in portions of entire financial assets that are initially accounted for as secured borrowings may subsequently meet the definition of participating interests. For example, when recourse to a transferor or priority rights of an interest holder expire as a result of either the passage of time or a modification to the transfer arrangement, the transferor should reassess its conclusion about the participating interest. Previously transferred participating interests may also no longer meet the definition of a participating interest. The following are examples of scenarios in which a previously transferred portion of an entire financial asset no longer meets the definition of a participating interest:

An entity transfers an interest in an advance on a line of credit that meets the definition of a participating interest. Upon a subsequent drawdown by the borrower, the previous advance loses its identity. The interest rate on the line of credit changes as a result of the subsequent drawdown; accordingly, the originally transferred interest no longer meets the definition of a participating interest.
An entity transfers an interest in an entire financial asset that meets the definition of a participating interest. Later, the entity transfers another interest in the same financial asset that does not meet the definition of a participating interest because the cash flows of the interest are not proportionate. As a result, the originally transferred interest no longer meets the definition of a participating interest.

If an entity has previously accounted for a transfer of a participating interest in an entire financial asset as a sale, and changes in circumstances cause the transferred interest to no longer meet the definition of a participating interest, the entity must rerecognize the previously sold interest and apply secured borrowing accounting (see Example 3-5 and Section 4.3 for more information). However, in accordance with ASC 860-10-40-4E, if an entity transfers an entire financial asset in portions that do not individually meet the definition of a participating interest, but all portions of the entire financial asset have been transferred, sale accounting is appropriate if all of the conditions in ASC 860-10-40-5 are met. See Q&As 3-5 and 3-21, and Example 3-12.

3.2.2 Interpretive Guidance

3.2.2.1 Transition to ASU 2009-16

Q&A 3-1 Transfers of Additional Interests in Entire Financial Assets After Adoption of ASU 2009-16

Before adoption of ASU 2009-16 (which reflects the guidance issued in FASB Statement 166), the financial components approach permitted entities to achieve sale accounting for transfers of undivided interests in entire financial assets even if those interests were not proportionate ownership interests. After adoption of ASU 2009-16, sale accounting may be achieved only for transfers of participating interests in entire financial assets. ASU 2009-16 applies only prospectively to transfers that occur after adoption. Assume that, after adopting ASU 2009-16, an entity transfers an interest in an entire financial asset and that the entity had previously sold an interest in that same asset that was accounted for as a sale.

Question

Should the entity apply the definition of participating interest to the transfer that occurs after adoption of ASU 2009-16?

Answer

Yes. If an entity accounted for a transfer of an undivided interest in an entire financial asset as a sale before adoption of ASU 2009-16, in the absence of modifications to the terms of the transfer, it can continue to apply sale accounting to that transfer after adopting ASU 2009-16. This is appropriate even if the previously transferred interest would not meet the definition of a participating interest. However, if an entity transfers another interest in the same entire financial asset after adopting ASU 2009-16, the definition of participating interest must be applied to that transfer. If the interest transferred in the entire financial asset before adoption of ASU 2009-16 does not meet the definition of a participating interest, the interest transferred after the adoption date of ASU 2009-16 cannot meet the definition of a participating interest because all holders of interests in the entire financial asset do not hold a participating interest. As a result, the transfer that occurs after adoption of ASU 2009-16 must be accounted for as a secured borrowing. As stated above, the entity can continue to account for the transferred portion of the entire financial asset that occurred before adoption of ASU 2009-16 as a sale. This conclusion is based on informal discussions with the FASB staff. The FASB staff does not believe that an entity can apply the definition of participating interest on the basis of the remaining “unsold portions” of an entire financial asset as of the adoption date of ASU 2009-16.

Q&A 3-2 Transfers of Interests in Entire Financial Assets That Were Purchased Before Adoption of ASU 2009-16

Question

How should an entity account for a transfer of an interest in an entire financial asset that was purchased before adoption of ASU 2009-16?

Answer

On the basis of informal discussions with the FASB staff, we understand that the asset purchased by the entity is used to determine the unit of account. If the transfer that occurred before adoption of ASU 2009-16 was accounted for as a sale by the transferor, the transferee would be considered to have purchased an entire financial asset. This is the case even if that previously transferred interest would not meet the definition of a participating interest.8 Therefore, if, after adoption of ASU 2009-16, an entity transfers an interest in an undivided interest that was purchased before adoption of ASU 2009-16, and that interest meets the definition of a participating interest, which would be determined solely on the basis of the terms of the undivided interest, the entity may account for that transfer as a sale if all the conditions in ASC 860-10-40-5 are met. This is appropriate because the interest transferred after adoption of ASU 2009-16 is considered to convey an entire financial asset to its holder as determined on the basis of GAAP before adoption of ASU 2009-16.

In summary, an entity that purchased an interest in an entire financial asset before the adoption of ASU 2009-16 could account for the following transfers as sales after the adoption of ASU 2009-16 provided that all the conditions in ASC 860-10-40-5 are met:

A transfer of the entire interest purchased before adoption of ASU 2009-16 to an unconsolidated entity (i.e., a transfer of an entire financial asset).
A transfer of a portion of the interest purchased before adoption of ASU 2009-16 to an unconsolidated entity if that portion meets the definition of a participating interest, as determined only on the basis of the terms of the previously purchased interest (i.e., a transfer of a participating interest).

The above conclusion is consistent with the guidance in ASC 860-10-55-17G.

3.2.2.2 Scope of Guidance on Participating Interest

Q&A 3-3 Direct-Financing and Sales-Type Lease Assets (Before Adoption of ASC 842)

Question

For entities that had not adopted ASC 842 as of the date of a transfer, what components of direct-financing and sales-type lease assets are financial assets subject to the guidance on participating interest?

Answer

Direct-financing and sales-type receivables secured by leased equipment consist of two components: minimum lease payments and residual values. 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 guaranteed or unguaranteed. ASC 860-10-55-6 states that “[r]esidual values meet the definition of financial assets to the extent that they are guaranteed at the inception of the lease.” Therefore, the following components of direct-financing and sales-type lease receivables are financial assets subject to the guidance on participating interest:

Minimum lease payments.
Residual values guaranteed by the lessee at inception of the lease.

The following components of direct-financing and sales-type lease receivables are not financial assets and therefore are not subject to the guidance on participating interest since these transfers are outside the scope of ASC 860-10:

Unguaranteed residual values.
Residual values guaranteed by the lessee after inception of the lease.

If the residual value of a direct-financing or sales-type lease receivable is guaranteed by a third party after lease inception, that guarantee is not considered a financial asset and therefore is not subject to the guidance on participating interest. If the residual value of a direct-financing or sales-type lease receivable is guaranteed by a third party at inception of the lease, on the basis of informal discussions with the FASB staff, an entity may reasonably interpret ASC 860-10 in accordance with either of the following views:

View A — Only transfers of minimum lease payments need to meet the definition of a participating interest. Third-party guarantees do not affect the application of the definition of a participating interest in accordance with ASC 860-10-55-17M.
View B — ASC 840-10-25-7 states:

For a lessor, minimum lease payments comprise the payments described in paragraphs 840-10-25-5 through 25-6 for a lessee plus any guarantee of the residual value or of rental payments beyond the lease term by a third party unrelated to either the lessee or the lessor, provided the third party is financially capable of discharging the obligations that may arise from the guarantee.

Since this paragraph indicates that minimum lease payments include any guarantee of the residual value by a third party, the financial asset for a direct-financing or sales-type lease includes any third-party guarantee of the residual value at the inception of the lease.

The view selected by an entity should be applied consistently and disclosed as an accounting policy. We understand that the FASB staff does not believe it would be appropriate to analogize to the views on this issue when evaluating other transactions.

The table below summarizes the financial asset components of direct-financing and sales-type leases before an entity’s adoption of ASC 842.

Table 3-3

Nature of Lease	Financial Asset Components	Discussion
Unguaranteed residual value at inception of lease	Only the minimum lease payments are financial assets. The unguaranteed residual value is not a financial asset and therefore is not subject to ASC 860-10.	The minimum lease payments represent the entire financial asset. If a portion of the minimum lease payments is transferred, and that portion meets the definition of a participating interest, the transfer is eligible for sale accounting. This view has been informally discussed with the FASB staff. Entities that transfer interests in minimum lease payments that meet the definition of a participating interest and achieve sale accounting must allocate the gross investment in the lease receivable between the minimum lease payments and residual value on the transfer date to calculate the gain or loss on sale. A transfer of a residual value not guaranteed at inception is not subject to ASC 860-10.
Residual value guaranteed by lessee at inception of lease	The minimum lease payments and the guaranteed residual value are viewed as a single unit of account that is a financial asset. This conclusion does not change if the residual value guarantee is included in a separate contract rather than in the lease agreement.	The minimum lease payments and the guaranteed residual value represent the entire financial asset. If a portion of the minimum lease payments and guaranteed residual value are transferred, and that portion meets the definition of a participating interest, the transfer is eligible for sale accounting. A transfer of all or only a portion of the minimum lease payments (i.e., no portion of the guaranteed residual value is transferred) must be accounted for as a secured borrowing because the transfer involves a portion of an entire financial asset that does not meet the definition of a participating interest. To meet the definition of a participating interest, the guaranteed residual value must be transferred.
Residual value guaranteed by a third party at inception of lease	Either of the following two views may be applied as an accounting policy election: View A — The minimum lease payments are an individual unit of account (i.e., the guaranteed residual value is excluded on the basis that it is a separate unit of account in accordance with ASC 860-10-55-17M). View B — The minimum lease payments and the guaranteed residual value constitute a single unit of account. The acceptability of these two views has been informally discussed with the FASB staff.	Under View A, if a portion of the minimum lease payments is transferred without a transfer of the third-party guarantee, and the interest transferred meets the definition of a participating interest (determined on the basis of only the total minimum lease payments), the transfer is eligible for sale accounting. Under View B, if a portion of the minimum lease payments and the third-party guarantee are transferred, and the portion of the total gross investment in the lease transferred meets the definition of a participating interest, the transfer is eligible for sale accounting.
Residual value guaranteed by lessee or a third party after inception of lease	Only the minimum lease payments are financial assets. A residual value that is guaranteed after the inception of the lease is not a financial asset and therefore is not subject to ASC 860-10.	The minimum lease payments represent the entire financial asset. If a portion of the minimum lease payments is transferred, and that portion meets the definition of a participating interest, the transfer is eligible for sale accounting. A transfer of a residual value not guaranteed at inception is not subject to ASC 860-10.

Q&A 3-4 Direct-Financing or Sales-Type Lease Assets (After Adoption of ASC 842)

Question

For entities that have adopted ASC 842, what components of direct-financing and sales-type lease assets are financial assets subject to the guidance on participating interests?

Answer

Lease receivables from direct-financing and sales-type leases consist of two components: the right to receive lease payments and guaranteed residual values. Residual values represent the lessor’s estimate of the salvage value of the underlying asset at the end of the lease term and may be guaranteed or unguaranteed. ASC 860-10-55-6 states that “[r]esidual values meet the definition of financial assets to the extent that they are guaranteed at the commencement of the lease.” Therefore, the following components of direct-financing and sales-type lease receivables are financial assets subject to the guidance on participating interests:

Rights to receive lease payments.
Residual values guaranteed by the lessee at commencement of the lease.

The following components of direct-financing and sales-type lease receivables are not financial assets and therefore are not subject to the guidance on participating interests since these transfers are outside the scope of ASC 860-10:

Unguaranteed residual values.
Residual values guaranteed by the lessee after commencement of the lease.

If the residual value of a direct-financing or sales-type lease receivable is guaranteed by a third party after commencement of the lease, that guarantee is not considered a financial asset and therefore is not subject to the guidance on participating interests. If the residual value of a direct-financing or sales-type lease receivable is guaranteed by a third party at commencement of the lease, the residual value guarantee may be excluded from the determination of whether a portion of the lease receivable meets the definition of a participating interest. This is consistent with the definition of lease payments in ASC 842-10-30-5 and the guidance in ASC 860-10-55-17M on third-party guarantees. An entity would not, however, be precluded from transferring a proportionate (pro rata) interest in the entire investment in lease receivables (i.e., including the third-party guarantee) since a third-party guarantee at commencement of a lease is a financial asset within the scope of ASC 860-10.

The table below summarizes the financial asset components of direct-financing and sales-type leases after an entity’s adoption of ASC 842.

Table 3-4

Nature of Lease	Financial Asset Components	Discussion
Unguaranteed residual value at commencement of lease	Only the lease payments are financial assets. The unguaranteed residual value is not a financial asset and therefore is not subject to ASC 860-10.	The lease payments represent the entire financial asset. If a portion of the lease payments is transferred and that portion meets the definition of a participating interest, the transfer is eligible for sale accounting. Entities that transfer interests in lease payments that meet the definition of a participating interest and achieve sale accounting must allocate the investment in the lease receivable between the lease payments and residual value as of the transfer date to calculate the gain or loss on sale. A transfer of a residual value not guaranteed at lease commencement is not subject to ASC 860-10.
Residual value guaranteed by lessee at commencement of lease	The lease payments and the guaranteed residual value are viewed as a single unit of account that is a financial asset. This conclusion does not change if the residual value guarantee is included in a separate contract rather than in the lease agreement.	The lease payments and the guaranteed residual value represent the entire financial asset. If a portion of the lease payments and guaranteed residual value is transferred and that portion meets the definition of a participating interest, the transfer is eligible for sale accounting. A transfer of all or only a portion of the lease payments (i.e., no portion of the guaranteed residual value is transferred) must be accounted for as a secured borrowing because the transfer involves a portion of an entire financial asset that does not meet the definition of a participating interest. To meet the definition of a participating interest, the guaranteed residual value must be transferred.
Residual value guaranteed by a third party at commencement of lease	The guaranteed residual value may be excluded on the basis that it is a separate unit of account in accordance with ASC 860-10-55-17M.	If a portion of the lease payments is transferred without a transfer of the third-party guarantee, and the portion transferred meets the definition of a participating interest (determined on the basis of only the lease payments), the transfer is eligible for sale accounting. In addition, if a portion of the lease payments and third-party guarantee is transferred, and the portion of the investment in the lease (including the third-party guarantee) meets the definition of a participating interest, the transfer is eligible for sale accounting.
Residual value guaranteed by lessee or third party after commencement of lease	Only the lease payments are financial assets. A residual value that is guaranteed after commencement of the lease is not a financial asset and therefore is not subject to ASC 860-10.	The lease payments represent the entire financial asset. If a portion of the lease payments is transferred and that portion meets the definition of a participating interest, the transfer is eligible for sale accounting. A transfer of a residual value not guaranteed at commencement of the lease is not subject to ASC 860-10.

Q&A 3-5 Transfer of a 100 Percent Interest in an Entire Financial Asset in Stages

Entity A originates a commercial loan receivable. After origination, on a single date, A transfers interests in the commercial loan receivable to third parties as follows:

25 percent proportionate interest to Entity B.
35 percent proportionate interest to Entity C.
40 percent proportionate interest to Entity D.

In conjunction with these transfers, A enters into an agreement that obligates it to absorb the first 10 percent of principal losses on the commercial loan receivable. Entity A continues to service the commercial loan receivable for an annual servicing fee equal to 0.5 percent of the loans’ outstanding principal amount.

Question

Are the transferred interests in the commercial loan subject to the guidance on participating interests?

Answer

No. ASC 860-10-40-4E states, in part, that “if the transferor transfers an entire financial asset in portions that do not individually meet the participating interest definition, [ASC 860-10-40-5] shall be applied to the entire financial asset once all portions have been transferred.” In accordance with this guidance, although the transfer is completed in portions, A has transferred the entire financial asset. Therefore, the definition of participating interest does not apply. Although A has entered into a recourse agreement in conjunction with the transfer, that obligation does not affect the conclusion that an entire financial asset has been transferred. The recourse obligation is not considered a component of or an interest in the entire financial asset, since it is not contractually part of the transferred asset (i.e., it is an agreement between A and the transferees that does not involve the borrower of the commercial loan). The fact that A continues to service the mortgage loan receivable also does not result in the requirement to apply the definition of participating interest. Entities commonly transfer entire financial assets and retain servicing without applying the definition of participating interest.

Economically, the above transaction is similar to a transfer of 90 percent of the credit risk in the commercial loan receivable and retention of 10 percent of that risk. However, the applicability of the definition of participating interest depends on the form of the transfer. Although A would have been required to apply secured borrowing accounting if it applied the definition of participating interest, since the guidance on participating interests does not apply, A may account for the above transfer as a sale if the conditions in ASC 860-10-40-5 are met. We have informally discussed the accounting for this transaction with the FASB staff.

Q&A 3-6 Transfer of an Interest in an Entire Financial Asset by a Consolidated Transferee

An entity transfers a loan receivable to a securitization entity that it consolidates under ASC 810-10. The securitization entity (the transferee) transfers a proportionate interest in the loan to a third party.

Question

Does the guidance on participating interests apply to the transfer by the securitization entity?

Answer

Yes. If the interest in the entire loan receivable that is transferred by the securitization entity to a third party meets the definition of a participating interest and the conditions in ASC 860-10-40-5 are met, the securitization entity can reflect a sale of an interest in the loan receivable. As a result, in its consolidated financial statements, the entity may also reflect a sale of an interest in the loan receivable even though the transfer of the entire loan receivable to the securitization entity does not achieve sale accounting since the securitization entity is consolidated under ASC 810-10.

Q&A 3-7 Reacquisition of a Previously Sold Interest in an Entire Financial Asset

On March 1, 20X1, Entity B originates a large commercial mortgage loan. On June 1, 20X1, B transfers an 80 percent senior interest in the commercial loan to Entity C, a third party. This transfer is accounted for as a secured borrowing because the transferred interest is not a participating interest. On October 1, 20X1, B transfers its 20 percent subordinated interest in the commercial loan to Entity D, a third party. Because all portions in the entire commercial mortgage loan receivable have been transferred as of October 1, 20X2, and the transfer meets the conditions in ASC 860-10-40-5, B accounts for this transfer as a sale of the entire commercial mortgage loan.

In 20X2, B purchases the subordinated interest from D.

Question

Should the guidance on participating interests be applied when B purchases the subordinated interest?

Answer

Yes. ASC 860-10-40-41 states, in part, that 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 (see paragraph 860-10-40-6A).” ASC 860-20-25-9 indicates that the transferor should account for such a change in the same manner as a purchase of such transferred financial asset from the former transferee(s). ASC 860-10-40-4 notes that the objective of sale accounting “is to determine whether a transferor and its consolidated affiliates included in the financial statements being presented have surrendered control over transferred financial assets.” That paragraph states that certain arrangements involving transferred financial assets must be considered even if they were not entered into at the time of transfer. In accordance with this guidance, B should apply the guidance on participating interests as of the date it purchases the subordinated interest in the commercial loan. Because B owns a disproportionate interest in the entire commercial loan, that interest is not a participating interest. Therefore, B must rerecognize the entire commercial loan receivable and recognize a liability for the 80 percent senior interest owned by C. See Section 4.3 for further discussion of the accounting when a transferor regains control of a financial asset previously considered sold.

The same conclusion would apply if B had purchased less than all of the subordinated interest or any portion of the senior interest in the commercial loan receivable. This is the result of the “stickiness” aspect of the sale accounting guidance in ASC 860-10.

Q&A 3-8 Transfer of an Interest in an Entire Financial Asset for Which a Participating Interest Has Been Previously Sold

Question

What is the impact on the accounting for a previously sold participating interest if the transferor transfers another interest in the entire financial asset that is not a participating interest?

Answer

The second transfer must be accounted for as a secured borrowing because the transferred interest does not meet the definition of a participating interest. In addition, the second transfer causes the previous transfer to no longer meet the definition of a participating interest because ASC 860-10-40-6A(a) requires that all interests in an entire financial asset meet the definition of a participating interest. As a result, the transferor should rerecognize the originally transferred interest as if it had purchased this interest from the original transferee. See Section 4.3 for more information.

See Q&A 3-1 if the original transfer occurred before the adoption of ASU 2009-16.

Q&A 3-9 GNMA Securitizations

GNMA MBSs are securities backed by residential mortgage loans that are mainly insured or guaranteed by the U.S. Federal Housing Authority (FHA) or U.S. Department of Veteran Affairs (VA) . Unlike substantially all other securitization transactions in the United States, the issuance of a GNMA MBS is not completed through a trust or other legal entity. Rather, approved issuers pool eligible mortgage loans, assign rights to the loans to the GNMA through a pool custodian, and issue GNMA MBSs. GNMA MBSs are commonly traded as securities in secondary markets. The GNMA MBS transaction is the only type of securitization vehicle in the United States that is designed by a U.S. government agency.

Legally, GNMA MBSs represent undivided interests in mortgage pools. GNMA MBSs are often referred to as “pass-though” certificates because the principal and interest on the underlying mortgage loans are passed through to investors. The interest rate on the securities is lower than the interest rate on the underlying loans because a portion of the coupon on the underlying mortgage loans is used to pay servicing and guarantee fees. Although the FHA and VA insure or guarantee principal and interest payments on the underlying mortgage loans, those guarantees are less than 100 percent of all principal and interest payments. For example, the FHA guarantees 100 percent of the principal payments and a portion of interest payments, and the VA guarantees up to 50 percent of principal payments.

The issuer of GNMA MBSs, which is generally also the servicer of the underlying mortgage loans and the MBSs, has the following continuing involvement in these securitization transactions:

Investor in MBSs (the significance of such investments varies).
Servicer.
Obligation to advance cash shortfalls of principal and interest.
Default ROAP.
Standard representations and warranties.

If an issuer of GNMA MBSs was required to apply the guidance on participating interests, these transfers would be accounted for as secured borrowings because the issuer is required to advance unpaid principal and interest amounts to MBS investors on a nonrecourse basis and the FHA and VA do not guarantee 100 percent of principal and interest on the underlying mortgage loans.9 This represents a form of recourse that is not permitted under ASC 860-10-40-6A(c)(4).10 As a result, a transferor could not achieve sale accounting and these securitization transactions would not allow for the recharacterization of the mortgage loans as securities.

Question

Must issuers (transferors) of mortgage loans in GNMA MBS transactions apply the definition of participating interest to those transfers?

Answer

No. In February 2010, in response to a preclearance submission by the Mortgage Bankers Association, the staff of the SEC’s Office of the Chief Accountant indicated that it would not object to the following accounting conclusions:

GNMA MBSs are created through transfers of eligible mortgage loans (i.e., entire financial assets) to “virtual” entities.
These “virtual” entities are VIEs.
The issuer (transferor) is not the primary beneficiary and therefore does not have to consolidate these VIEs because it does not meet the power criterion in ASC 810-10-25-38A(a).

As a result of these conclusions, issuers (transferors) of mortgage loans in GNMA securitization transactions can account for such transfers as sales if the conditions in ASC 860-10-40-5 are met.

In reaching its conclusions, the staff of the SEC’s Office of the Chief Accountant indicated the following:

The conclusion only applies to GNMA I and II MBS transactions.
The conclusion only applies to the issuer of the securities.
Replication of the conclusion by analogy to other types of transactions would not be appropriate since the conclusions were based, in part, on the unique structure by the U.S. government for these types of transactions.
No views were provided on the sale accounting conditions in ASC 860-10.

Q&A 3-10 Transfers of Interests in Equity Securities

Question

Can a transfer of a portion of an equity security meet the definition of a participating interest?

Answer

No. The definition of a participating interest focuses on the pass-through of contractual cash flows. Equity securities do not have contractual cash flows. Therefore, if an entity transfers a portion of an ownership interest in an equity security, it must account for the transfer as a secured borrowing.

3.2.2.3 Transfers of Interests in Entire Financial Assets at Other Than Fair Value

Q&A 3-11 Transfers of Interests in Entire Financial Assets at Other Than Fair Value

Question

For a transfer of a portion of an entire financial asset to meet the definition of a participating interest, must the sale price be at fair value?

Answer

Yes. For a transferred portion of an entire financial asset to meet the definition of a participating interest, the price paid by the transferee should represent fair value as of the transfer date. When a portion of an entire financial asset is transferred at or close to the origination date of the financial asset, if any initial fees that may be included in the sale price (see ASC 860-10-55-17J) are ignored, the price paid by the transferee may equal or closely approximate the principal amount of the interest sold because the fair value and principal amount are the same or not significantly different. However, when a portion of an entire financial asset is sold at a later date, there are often “built-in gains” or “built-in losses” when the principal amount and fair value of the transferred interest are compared. These gains or losses occur because of changes in market conditions (e.g., interest rates, prepayment rates, credit spreads) between the origination date of the financial asset and the date an interest in that financial asset is transferred to a third party. In these situations, if any initial fees that may be included in the sale price (see ASC 860-10-55-17J) are ignored, the purchase price of an interest with a “built-in gain” should be at a premium to the interest’s principal amount and the purchase price of an interest with a “built-in loss” should be at a discount to the interest’s principal amount. Such premiums (discounts) will result in the recognition of gains (loss) by the transferor if the transferred interest meets the conditions for sale accounting. This is acceptable, as discussed in ASC 860-10-55-17K.

If the price paid by the transferee does not equal or approximate fair value, or if the price paid equals fair value because the interest rate on the transferred interest differs from the interest rate on the entire financial asset to take into account a “built-in gain” or a “built-in loss,” the interest transferred is not a participating interest because it does not represent a proportionate interest in the cash flows of the entire financial asset. A sale of an interest at other than fair value is similar to a sale of an interest at fair value and then an immediate cash flow exchange between the transferor and transferee that benefits one party to the detriment of the other.

If an entity has previously sold an interest in an entire financial asset that is a participating interest and later transfers an additional interest for an amount that is not fair value, both the original and subsequently transferred interest will not meet the definition of a participating interest (see also Q&A 3-8). See Section 4.3 for discussion of the accounting when a transferor regains control over previously sold participating interests.

3.2.2.4 Transfers of Interests in Entire Financial Assets Accompanied by Put or Call Options

Q&A 3-12 Transfers of Interests in Entire Financial Assets Accompanied by a Put Option

An entity transfers a proportionate interest in an entire financial asset to a third party. In conjunction with the transfer, the entity writes a put option that permits the transferee to put its interest back to the transferor at a fixed amount (i.e., the unpaid principal amount plus unpaid accrued interest).

Question

Does the transfer meet the definition of a participating interest?

Answer

No. The definition of a participating interest focuses on the pass-through of all contractual cash flows received on an entire financial asset. If the transferee can put its interest back to the transferor at a fixed price, the transferred interest is not a participating interest. First, the cash flows on the entire financial asset may be considered, in substance, not to be proportionately shared between the interest holders and thus not to meet the condition in ASC 860-10-40-6A(b). In addition, a put option represents a form of recourse to the transferor that causes the transferee to have a priority to cash flows over the transferee; thus, the condition in ASC 860-10-40-6A(c) would not be met.

For example, assume that Entity E transfers a 40 percent interest in a loan receivable that has a principal amount of $1 million. The transferee can put its interest back to E for $400,000. If the obligor of the loan receivable had a credit concern that resulted in its ability to only repay $500,000 of the principal amount, the transferee would not be required to absorb any of the cash flow shortfalls on the loan receivable. Rather, it could put its interest back to E for $400,000 and not incur any principal loss. As a result, E would only receive $100,000 of the principal amount on a $1 million loan for which it owns a 60 percent interest. Therefore, the transferred interest is not a participating interest.

The conclusion above would not change if the transferee could only exercise the put option if the obligor on the entire loan receivable was not in default or otherwise not experiencing any credit concerns. This is because the obligor could default after the date the put option is exercised and the same issues described above with respect to disproportionate cash flows and recourse would exist.

Q&A 3-13 Transfers of Interests in Entire Financial Assets Accompanied by a Call Option

Question

Can a transfer of a portion of an entire financial asset meet the definition of a participating interest if the transferor retains an option to repurchase the transferred interest?

Answer

Generally, no. A call option held by a transferor on a transferred portion of an entire financial asset would not change the contractual ownership percentage of the parties and would generally not represent a form of recourse or otherwise entitle an interest holder to a right to receive cash from the transferred financial asset before the transferor has such a right. However, an entity should consider whether a call option results in a disproportionate allocation of contractual cash flows under ASC 860-10-40-6A(b). The following are two examples of the evaluation of a call option on a transferred interest in an entire financial asset:

Default call option — An entity transfers an interest in an entire financial asset that otherwise meets the definition of a participating interest. In conjunction with the transfer, the entity obtains a call option that allows it to repurchase the transferred interest at the unpaid principal amount plus unpaid accrued interest in the event of a default by the borrower of the entire financial asset. The transferor is under no obligation to exercise the call option, and exercise of the option is uncertain because the purchase price would exceed fair value. The call option has a nominal fair value as of the date of the transfer. The purpose of the call option is to allow the transferor to make unilateral “workout” or credit mitigation decisions (see also Q&A 3-24). In this circumstance, the transferred interest does not meet the definition of a participating interest because exercise of the call option results in a disproportionate allocation of cash flows from the entire financial asset. However, if the exercise price of the call option was fair value, we believe that such a contingently exercisable option would not preclude the transferred interest from meeting the definition of a participating interest (although the transferor would have to rerecognize the transferred interest once the call option becomes exercisable [see Section 4.3]). Other contingently exercisable call options on interests in entire financial assets that have an exercise price that equals the fair value on the repurchase date may also not preclude such transferred interests from meeting the definition of participating interests.
Cleanup call option — An entity transfers an interest in a group of entire financial assets that otherwise meets the definition of a participating interest. In conjunction with the transfer, the entity obtains an option that allows it to purchase the remaining financial assets when 10 percent or less of the principal amount of those financial assets remains outstanding. The purchase price is the unpaid principal amount plus unpaid accrued interest. We believe that the FASB only allowed for cleanup call options as an exception to the application of ASC 860-10-40-5(c). We do not believe that there is a similar exception in the evaluation of whether a transferred interest is a participating interest. Rather, such a cleanup call option would preclude a transferred interest from being a participating interest. There are several reasons for this, including that a cleanup call option may cause interest holders to receive a different amount of cash flows on the underlying financial assets than they would have otherwise received, resulting in a disproportionate sharing of cash flows. For example, the financial assets repurchased would have accrued additional interest after the date the cleanup call option is exercised.

We acknowledge the difficulty in reconciling this view to the view above that a default call option with a fair value exercise price does not preclude a transferred interest from meeting the definition of a participating interest; however, we believe that an option exercisable only upon default by the underlying obligor would not be reasonably expected to prevent interest holders from receiving the contractual cash flows that they would have otherwise been entitled to when the exercise price of the option is fair value.

3.2.2.5 Transfers of Interests With Recourse

Q&A 3-14 Limited Recourse Provisions

Question

Can limited recourse provisions provided by a transferor prevent a transfer of an interest in an entire financial asset from meeting the definition of a participating interest?

Answer

Yes. In certain transfers, a transferor provides recourse to the transferee for a limited period after the transfer. For example, a transferor may be required to reimburse the transferee if the financial asset for which an interest is transferred defaults or is prepaid within 90 days after the transfer. This type of recourse provision is not a standard representation and warranty; therefore, it prevents the transferred interest from meeting the definition of a participating interest. However, once the recourse provision expires, the transferor should reevaluate whether the transferred interest meets the definition of a participating interest (see Section 3.2.1). In accordance with ASC 860-10-55-17M, recourse in the form of an independent third-party guarantee is excluded from the evaluation of whether the definition of participating interest is met. Similarly, cash flows allocated to a third-party guarantor (e.g., premiums or fees) are excluded from the determination of whether the cash flows are divided proportionately among the participating interest holders.

3.2.2.6 Transfers of Interests in Entire Financial Assets With Servicing Rights Retained

Q&A 3-15 Meaning of “Amount That Would Fairly Compensate a Substitute Service Provider”

ASC 860-10-40-6A(b)(1)(ii) indicates that cash flows allocated as compensation for servicing are not included in the evaluation of whether an interest is a participating interest if 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.”

Question

What is the meaning of “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”?

Answer

This phrase means adequate compensation, which is defined in ASC 860-50-20 (see Section 6.3.2). Therefore, to exclude cash flows from the determination of whether an interest in an entire financial asset meets the definition of a participating interest, the servicing fees may not significantly exceed adequate compensation. In determining whether servicing fees significantly exceed adequate compensation, an entity must use judgment and take into account the type of financial asset being serviced, the inherent risks in the serviced financial asset (which will affect the degree of servicing necessary), the availability and reliability of market inputs to determine adequate compensation, and the types of fees included in the servicing fees.

Because servicing fees can exceed adequate compensation and qualify for the exception in ASC 860-10-40-6A(b)(1)(ii), an entity may recognize a servicing asset upon a sale of an interest in an entire financial asset to an unconsolidated entity that meets the definition of a participating interest.

Q&A 3-16 Below-Market or No Servicing Fees

Question

Can a portion of an entire financial asset meet the definition of a participating interest if the transferor does not receive any fees for servicing activities?

Answer

Yes. The only requirements in ASC 860-10-40-6A(b)(1) are that any servicing fees not be subordinate or “significantly above an amount that would fairly compensate a substitute service provider” (see also Q&A 3-15). There is no requirement that the transferor receive, from the cash flows on the related financial asset, fees for servicing the entire financial asset or any transferred interests in the asset. In fact, it is common in the marketplace for there to be no servicing fees involved in transferred interests that meet the definition of participating interests. If the transferor is entitled to servicing fees, they may also be “below market” provided that they are not subordinated.

However, if there is no servicing fee or the fee is below adequate compensation, and the transferred interest in an entire financial asset has a “built-in loss,” an entity should consider whether the “built-in loss” is being paid for through a below-market or zero servicing fee (i.e., the discount on the purchase price is less than the difference between the fair value and principal amount of the interest transferred). In these situations, the adjustment of the servicing fee may preclude the transferred interests from being participating interests. See also Q&A 3-11.

Q&A 3-17 Incentive Servicing Fees

Question

If servicing fees payable to the transferor include variable incentive amounts, may transferred interests in an entire financial asset meet the definition of participating interests?

Answer

Generally, no. The incorporation of a variable incentive fee is inseparable from the inclusion of an embedded IO strip in a servicing fee arrangement, which is inconsistent with ASC 860-10-40-6A(b).

Q&A 3-18 Seniority of Servicing Fees

Question

If servicing fees payable to a transferor of an interest in an entire financial asset are not senior in the prioritization of cash flows received on the entire financial asset, can the transferred interests meet the definition of a participating interest?

Answer

Yes. ASC 860-10-40-6A(b)(1)(i) only requires that servicing fees not be subordinated to the distribution of cash flows from the entire financial asset to its interest holders. Therefore, cash flows payable to the transferor for servicing may either be senior to, or pari passu with, the distribution of cash flows from the entire financial asset. If, however, the transferee is required to make the transferor whole for servicing fees because no or inadequate cash flows are received from the entire financial asset (i.e., because of defaults), the transferred interests would not meet the definition of a participating interest.

Q&A 3-19 Servicer Advances

Question

Can a portion of an entire financial asset meet the definition of a participating interest if the transferor, as servicer, advances principal and interest to interest holders before such amounts are received?

Answer

No. ASC 860-10-40-6A(c) states that one of the requirements of a participating interest is that “no participating interest holder is entitled to receive cash before any other participating interest holder under its contractual rights as a participating interest holder.” In addition, ASC 860-10-40-6A(b) indicates that the cash flows that each interest holder (including the transferor) is entitled to must be those that are proportionately allocated from the cash flows on the entire financial asset.

Q&A 3-20 Servicer Remittances

Question

For the definition of a participating interest to be met, is the servicer of interests in an entire financial asset required to remit the cash flows received from the entire financial asset to third-party interest holders within a specific period?

Answer

No. ASC 860-10-40-6A(c) states, in part, that “[i]f 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.” ASC 860-10 does not provide specific guidance on the period within which the servicer has to remit cash received from the entire financial asset to third-party interest holders. Provided that the transferor, as servicer, remits the cash flows to third-party investors within a period that is consistent with market practice, the temporary holding of such cash by the transferor would not preclude the transferred interests from being participating interests. In practice, the period within which the transferor holds cash received would generally not exceed 30 days.

Q&A 3-21 Transfers of All Portions in an Entire Financial Asset When Servicing Is Retained

ASC 860-10-40-4E states, in part, that “if the transferor transfers an entire financial asset in portions that do not individually meet the participating interest definition, the following paragraph [ASC 860-10-40-5] shall be applied to the entire financial asset once all portions have been transferred.”

Question

Has an entity transferred all portions of an entire financial asset if it sells 100 percent of the ownership interests in the entire financial asset to various third parties but continues to service the asset?

Answer

Yes. It is appropriate to consider that all portions have been sold even if the transferor continues to service the financial asset. In practice, entities commonly sell entire financial assets and retain the rights to service the sold assets.

3.2.2.7 Interest Payments on Transferred Interests in Entire Financial Assets

Q&A 3-22 Interest Rates on Transferred Interests

Question

Can a portion of an entire financial asset meet the definition of a participating interest if the interest rate on such a transferred interest differs from the contractual interest rate on the entire financial asset?

Answer

No. For the definition of a participating interest to be met, ASC 860-10-40-6A(b) requires that all contractual cash flows, including interest cash flows, from an entire financial asset be divided among all interest holders in proportion to their share of ownership in the entire financial asset. Differences between the contractual interest rate on an entire financial asset and the market rate of interest on that asset as of the transfer date will result in the selling of interests at premiums or discounts to their stated principal amounts. Sales at premiums or discounts to reflect the fair value of the interests transferred, which will result in gains or losses on sale if the transferor achieves sale accounting, do not preclude transferred interests from being participating interests. However, embedding those premiums or discounts into the yield on transferred interests precludes those interests from being participating interests. The stated rate on an interest in an entire financial asset can differ from the stated rate on the entire financial asset only if the difference is due to servicing fees that meet the conditions in ASC 860-10-40-6A(b)(1) or guarantee fees as discussed in ASC 860-10-55-17M. See also Table 3-2 and Q&A 3-11.

Q&A 3-23 Accrued Interest as of the Date an Interest in an Entire Financial Asset Is Transferred

Entity F originates a commercial mortgage loan receivable. Shortly after origination, F transfers a proportionate interest in the commercial mortgage loan to a third party. As of the transfer date, less than 30 days’ interest has accrued on the loan but is not yet payable by the borrower.

Question

Is F required to transfer the accrued interest receivable for the transferred interest to meet the definition of a participating interest?

Answer

No. On the basis of discussions with the FASB staff, we believe that, although ASC 860-10-40-6A(b) literally seems to require entities to transfer the accrued interest, if the loan is performing and the accrued interest will be paid within a short period (i.e., a month or less), a transfer of an interest in the loan that excludes such accrued interest can meet the definition of a participating interest. This conclusion is appropriate since, once the accrued interest is paid, the remaining transferred interest will meet the definition of a participating interest. If, however, a loan for which an interest is transferred is not a performing asset (e.g., the borrower is delinquent and recovery of all contractual cash flows is not reasonably assured), a transfer of an interest in the loan must include any accrued and unpaid interest to meet the definition of a participating interest.

3.2.2.8 Rights of Holders of Interests in Entire Financial Assets

Q&A 3-24 Rights of Interest Holders

In discussing the priority of cash flows, ASC 860-10-40-6A(c)(1) states, in part, that “[t]he rights of each participating interest holder (including the transferor in its role as a participating interest holder) have the same priority.”

Question

For the definition of a participating interest to be met, do all interest holders need to agree before a servicer may take an action that affects the entire financial asset or transferred interests in the entire asset?

Answer

It depends. The servicer may unilaterally take an action related to the entire financial asset only if this action is administrative in nature (i.e., the action could not affect the future cash flows on the entire financial asset). However, to meet the condition in ASC 860-10-40-6A(c)(1), which requires that each interest holder have the same rights, risks, and benefits of the cash flows of the entire financial asset in proportion to its ownership interests, interest holders must agree before the servicer can take any other action. Such actions include:

Changes to the terms of the entire financial asset even if those changes are limited to those that would not materially adversely affect the interest holders in the entire financial asset.11
Modifying the terms of the entire financial asset as part of a “work-out” or credit-mitigation activity.
Foreclosing on, or selling, the collateral securing the entire financial asset.
Allowing a substitution of collateral securing the entire financial asset.
Selling or pledging the entire financial asset even if such a sale is only allowed upon default by the obligor of the entire financial asset.12

Judgment should be applied if there is a predefined set of actions the servicer can take without the agreement of third-party interest holders.

Although approval of interest holders (including the transferor, its consolidated affiliates, and its agents) is needed for a servicer to take an action that could affect the cash flows on the entire financial asset, unanimous consent of all interest holders is not always needed. ASC 860-10-40-6A(d) states that to be a participating interest, each interest holder must agree to pledge or exchange the entire financial asset. However, for other actions, it is reasonable to conclude that the definition of a participating interest is met as long as (1) each interest holder has the same right to influence a decision of the servicer (e.g., the right to vote in proportion to its ownership percentage) and (2) no action can be taken by decision of a single interest holder (even if that interest holder is not the transferor, its consolidated affiliates, or its agent). We believe that if these two conditions are met, each interest holder has the same rights and the condition in ASC 860-10-40-6A(c)(1) is met.

For example, when there are multiple interest holders and no individual holder owns 50 percent or more of the entire financial asset (if the transferor, its consolidated affiliates, and its agents collectively are considered as a single interest holder), majority approval by all interest holders is sufficient for the servicer to take an action. However, if there is only one third-party interest holder, regardless of that holder’s ownership percentage, consent of that interest holder is required for the servicer to take any action that could affect the future cash flows on the entire financial asset. If a single interest holder (which would include the transferor, its consolidated affiliates, and its agents in the aggregate) controls the majority of the entire financial asset, it would be necessary for at least one other interest holder to consent for the servicer to take an action that could affect the future cash flows on the entire financial asset. Otherwise, a single interest holder would be considered to have a senior right because the voting or consent right of other interest holders would be nonsubstantive.

All interest holders must have the right to consent to any change to the contractual terms of the interests in the entire financial asset, unless such a change is administerial. In addition, all interest holders must unanimously consent to any change that would affect the proportionate ownership interests in the entire financial asset or the proportionate rights of each interest holder to the cash flows received from the entire financial asset. Unanimous consent of all interest holders would generally also be required for other changes to the contractual terms of the interests. Note that entities cannot circumvent the requirement in ASC 860-10-40-6A(c)(1) by “pre-setting” modifications or changes that the transferor can make without consent.

Q&A 3-25 Rights of Third-Party Interest Holders to Require Transferor to Sell Its Interest

Entity G transfers interests in a loan receivable to three independent third parties and retains an interest in the loan receivable. The terms of the transfer specify that if the transferor becomes insolvent, the third-party investors may purchase the transferor’s interest at a fixed price.

Question

Do the transferred interests meet the definition of a participating interest?

Answer

No. The potential purchase of the transferor’s interest at a fixed price will result in a disproportionate allocation of cash flows after that interest is purchased. Such an allocation would not comply with the requirement related to proportionate cash flows in ASC 860-10-40-6A(b). If, however, the purchase price was fair value as of the purchase date, it would be acceptable to consider this a protective provision that does not cause the transferred interests not to meet the definition of participating interests.

3.2.2.9 Specific Transaction Structures

Q&A 3-26 Transfers of Interests in SBA Loans

A Small Business Act (SBA) Section 7(a) loan includes a guarantee of up to 85 percent of the principal amount by the Small Business Administration, which is a U.S. government agency. The guarantee is contractually attached to the SBA loan; therefore, investors in SBA loans consider the loans and the embedded guarantee as a single unit of account. Entities that originate SBA loans often transfer the guaranteed portion to third parties and retain the unguaranteed portion of such loans.

Question

Can a transfer of only the guaranteed portion of an SBA Section 7(a) loan meet the definition of a participating interest?

Answer

Yes. An interest in an entire financial asset does not meet the definition of a participating interest if there is a prioritization of cash flows, including when an interest holder has recourse to the transferor (see ASC 860-10-40-6A(c)). However, ASC 860-10-55-17M states, in part, that “[r]ecourse in the form of an independent third-party guarantee shall be excluded from the evaluation of whether the participating interest definition is met.” Paragraph A21 of the Basis for Conclusions of FASB Statement 166 discusses this exception:13

Respondents to the 2008 Exposure Draft asked the Board to clarify whether a third-party guarantee received by a transferor that is passed on to other interest holders would affect the determination of whether a transferred portion of a financial asset meets the definition of a participating interest. Some respondents noted that in certain transfers the transferor retains the unguaranteed portion but transfers a portion along with a guarantee provided by a third party to those interest holders. The Board decided that third-party guarantees should not affect whether the participating interest definition is met. The Board reasoned that an independent third-party guarantee is an arrangement in which a third-party guarantor would assume a participating interest in the event of default that does not result in recourse to the transferor or to other participating interest holders. As a result, the Board concluded that third-party guarantees should be excluded from the evaluation of whether the participating interest definition is met.

Thus, a transfer of only the guaranteed portion of an SBA Section 7(a) loan does not, itself, preclude a transferred interest from meeting the definition of a participating interest. The fact that an investor in such loans would consider the guarantee to be an embedded feature (i.e., the loan, including the Small Business Administration’s guarantee, represents a single unit of account) does not affect this conclusion. Neither ASC 860-10-55-17M nor the basis for the FASB’s conclusion requires that third-party guarantees be separate units of account (i.e., freestanding financial instruments) for them to be excluded from the determination of whether an interest in an entire financial asset is a participating interest.14 The Small Business Administration’s guarantee does not cause the transferee to have recourse to the transferor. Thus, in applying the definition of participating interest, the transferor of only a guaranteed portion of an SBA Section 7(a) loan can account for the transfer as a sale provided that the transferee is not consolidated by the transferor and the conditions in ASC 860-10-40-5 are met. Similarly, we believe that the definition of a participating interest could also be met if the entity transferred only the unguaranteed portion of an SBA Section 7(a) loan.

Although a transfer of only the guaranteed or unguaranteed portion of an SBA Section 7(a) loan will not, itself, prevent a transferred interest from meeting the definition of a participating interest, there are additional matters for an entity to consider in determining whether a transferred portion of an SBA Section 7(a) loan meets the definition of a participating interest, including the following:

All portions of the entire financial asset (i.e., transferred and retained) must contain the same interest rate. If a transferred guaranteed portion of a loan contains a lower fixed rate than the unguaranteed portion, or the transferred guaranteed portion contains a fixed rate and the unguaranteed portion contains a variable rate, the transferred interest will not meet the definition of a participating interest. An entity may, however, transfer a guaranteed portion at a premium to the principal amount (or transfer the unguaranteed portion at a discount to the principal amount); accordingly, the fair value of the transferred interest would be reflected and the definition of a participating interest would still be met. See also Q&A 3-11.
Sales of SBA Section 7(a) loans generally occur in the marketplace on the basis of a standard servicing fee of 1 percent of the principal amount. If a transferee pays a higher servicing fee in exchange for paying a lower premium to purchase the guaranteed portion (or pays a lower servicing fee in exchange for paying a lower discount to purchase the unguaranteed portion), the transferred interest will not meet the definition of a participating interest. Although ASC 860-10-40-6A(b)(1) permits an entity to exclude servicing fees from the evaluation of the proportionality of cash flows if certain conditions are met, a sale of an interest in an SBA Section 7(a) loan with a servicing fee above or below the standard fee in market transactions results in a purchase price greater or less than fair value. If the purchase price differs from fair value, the proportionate cash flow requirement in ASC 860-10-40-6A(b)(1) is not met. See also Q&As 3-11 and 3-16.
Other recourse provided to the transferee by the transferor would preclude a transferred interest in an SBA Section 7(a) loan from meeting the definition of a participating interest (see ASC 860-10-40-6A(c)(4)). Such recourse could include:
- A provision that requires the transferor to return any premium paid by the transferee on a guaranteed interest in an SBA Section 7(a) loan if the borrower (1) prepays the loan within 90 days or (2) fails to make the first three monthly minimum payments on the loan and is in default on the loan within 275 days. (Note that the interest transferred may meet the definition of a participating interest once these provisions lapse.)
- The transferor provides additional guarantees of principal or interest beyond the amounts guaranteed by the Small Business Administration on the loans.
In some situations, the transferor may agree to advance amounts to the transferee before they are received. Such amounts could include advances of principal and interest payments on the loans or amounts receivable from the Small Business Administration’s guarantee. These provisions may prevent the transferred interest from meeting the definition of a participating interest even if the transferor believes that the amounts advanced will be received from the Small Business Administration. See also Q&A 3-19.
The transferor may be entitled to repurchase transferred interests in SBA Section 7(a) loans upon the consent of the transferee or Small Business Administration.15 Call options held by the transferor on transferred interests, or put options held by the transferee, generally prevent the transferred portion from meeting the definition of a participating interest. See also Q&As 3-12 and 3-13. However, rights of the Small Business Administration to purchase SBA Section 7(a) loans that are in default would generally not preclude transferred interests from meeting the definition of participating interests.

Q&A 3-27 Transfers of Interests in Reverse Mortgage Loan Receivables

Question

Can interests in reverse mortgage loan receivables that are transferred into GNMA pools meet the definition of participating interests?

Answer

No. In a preclearance submission with the SEC’s Office of the Chief Accountant, a conclusion was reached that interests in reverse mortgages did not meet the definition of participating interests in ASC 860-10-40-6A for the following reasons:

The transferor (servicer) is obligated to pay third-party interest holders any interest that accrues between the date of a prepayment by the obligor of the reverse mortgage loan and the date of payment of interest to third-party interest holders. The transferor (servicer) is not contractually entitled to recover all such amounts.
If the loan goes into foreclosure, the transferor (servicer) is obligated to pay interest to the third-party interest holders up to the foreclosure date and must repurchase the loan receivable at the unpaid principal amount, plus unpaid accrued interest. The transferor (servicer) is not contractually entitled to recover all such amounts.

Q&A 3-28 A/B Note Structures

An entity originates a large commercial real estate loan with a borrower. One of the loan agreement provisions states that the lender can modify the loan, without the borrower’s consent, so that it becomes an “A” tranche that has seniority in rights to cash flows and a “B” tranche that is junior in rights to cash flows. The entire loan is a single legal agreement and is secured by the same real estate. If the loan is separated into A and B tranches, the real estate serves as collateral for both tranches. The borrower is indifferent about whether the lender creates an A and B tranche because it will continue to make one payment of principal and interest in accordance with the terms of the loan.

Question

Does the fact that the legal agreement for the loan allows the lender to create A and B tranches mean that if the separate tranches are created, a transfer of either of them constitutes a transfer of an entire financial asset?

Answer

No. As discussed in Section 3.1.2.1, the unit of account is determined on the basis of (1) the legal form of the transferred asset and (2) what the transferred asset conveys to its holder. In this type of arrangement, given both the legal form of the loan and what it conveys to the creditor before separation and transfer, there is only one unit of account. Therefore, if the lender creates an A and B tranche and transfers less than 100 percent of all portions of the loan, the transfer must be accounted for as a secured borrowing because the definition of participating interest applies to the transfer and the individual tranches do not represent proportionate interests. This conclusion is evident on the basis that the same collateral secures the entire loan and the borrower is indifferent to the lender’s separation of the loan into two tranches.

Q&A 3-29 LIFO and FIFO Participations

In a “LIFO participation,” an originating bank advances funds to a borrower until it reaches its legal lending limit for that borrower. After that limit has been exceeded, the originating bank sells the remaining interests in loans funded to a third-party participating bank. In accordance with the transfer agreement, the participating bank receives all principal and interest payments from the borrower on the larger loan, which is a single legal agreement, before any amounts are retained by the originating bank. A “FIFO participation” is similar, but the cash flows received from the borrower are allocated in reverse order. That is, the originating bank receives all principal and interest payments from the borrower on the larger loan before any amounts are received by the participating bank. In both LIFO and FIFO participations, in the event of a default by the borrower, the originating bank and participating bank share losses on a pro rata basis.

Question

Do LIFO or FIFO participations meet the definition of participating interests?

Answer

No. The cash flows received on the larger loan are not allocated proportionately to the originating bank and participating bank on the basis of their respective ownership percentages. Therefore, the condition in ASC 860-10-40-6A(b) is not met. The fact that losses upon default by the borrower are shared ratably does not cause these transferred interests to represent participating interests.

Q&A 3-30 Transfers of Portions of Interests Received as Proceeds From Sales of Financial Assets

Question

Can an entity transfer a portion of an interest that is received as proceeds from a sale of financial assets and meet the definition of a participating interest?

Answer

Yes. For example, if an entity receives an IO strip as proceeds in a sale of an entire financial asset, the IO strip received is an entire financial asset (i.e., under ASC 860-20, the IO strip is not considered a retained interest in assets sold). Therefore, an entity could transfer an interest in the IO strip and meet the definition of a participating interest. However, this conclusion is appropriate only if the financial asset for which the interest is being transferred represents an entire financial asset. For example, an entity cannot create an IO strip from a recognized entire financial asset and conclude that the transfer of the IO strip, or any portion thereof, is a participating interest. Under ASC 860-10, the unit of account depends on the legal form of the asset and what the asset conveys to its holder before the transfer (see Section 3.1.2).

Q&A 3-31 Transfers of Interests in Entire Financial Assets That Represent Receivables From a Transferor Upon a Failed Sale

Question

Can a transfer of a portion of an interest in a receivable from a transferor that was recognized as a result of a failed sale of an asset owned by the transferor meet the definition of a participating interest?

Answer

Yes. For example, assume that Entity H transfers a portfolio of mortgage loans to Entity J and that the transfer must be accounted for as a secured borrowing. As a result, in lieu of recognizing the transferred mortgage loans, J recognizes a receivable from H. Entity J could transfer an interest in this receivable and meet the definition of a participating interest provided that J determines that the receivable from H represents an entire financial asset.

Footnotes

See Section 3.6.3.2 for further discussion of transfers of trade receivables.

Whether the gain or loss is paid up front or through an IO strip will affect whether a transferred interest is a participating interest and, therefore, whether sale accounting is appropriate. For example, assume that an entity originates a loan of $1,000 with a contractual coupon of 8 percent and subsequently sells a 50 percent interest in that loan in a declining interest rate environment in which market rates for the loan are 6 percent. If the transferor retains a 2 percent IO strip representing the gain on the sale (i.e., transferees receive a 6 percent coupon), the participating interest requirements are not met and sale accounting is not appropriate. However, if the premium representing the gain is paid up front (i.e., transferees receive an 8 percent coupon as part of their interest), sale accounting may be appropriate.

The FASB’s conclusion is based on its belief that a third-party guarantee is a separate arrangement in which the guarantor will assume ownership of the participating interest in the event of default (i.e., upon default, the third-party guarantee no longer exists since the guarantor assumes ownership of the participating interest and the rights and obligations of the other participating interest holders do not change).

Before adoption of ASU 2009-16, entities could achieve sale accounting for transfers of undivided interests in entire financial assets that did not represent proportionate (pro rata) interests in entire financial assets.

The GNMA only guarantees certain payments if the issuer defaults on its obligations to make sure payments.

There may be other reasons why these transfers would not meet the definition of a participating interest.

An entity must use judgment in assessing such changes since the evaluation of what constitutes a material change is subjective.

If a transferor has a right to sell an entire financial asset for which an interest has been sold upon default by the obligor, such a right would preclude the transferred interest from meeting the definition of a participating interest. For example, the transferor may have the unilateral right to sell a loan in lieu of performing “work-out” activities in the event of the borrower’s default. Such a right would preclude accounting for any transferred interest as a participating interest (see ASC 860-10-40-6A(d)). It would not be appropriate to ignore such a right on the basis that it was “pre-approved” by the interest holder as of the date of the acquisition of the interest in the entire loan receivable. The guidance on default ROAPs that applies to the evaluation of ASC 860-10-40-5(b) is not relevant to the determination of the unit of account for a transfer of financial assets.

We understand that SBA Section 7(a) loans were identified by the respondents discussed in paragraph A21 of FASB Statement 166.

This conclusion has been discussed informally with the FASB staff.

If the transferor has the unilateral ability to repurchase transferred portions of SBA Section 7(a) loans, the condition in ASC 860-10-40-5(c) would not be met.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.