3.7 Examples Illustrating the Application of ASC 860-10

Entity A transfers a portfolio of mortgage loan receivables. A consolidated subsidiary of A writes an at-the-money put option on the transferred financial assets. The put option, which is negotiated as part of the transfer, represents a form of recourse to the transferee. The pricing of the sale of loans is based on the put option.

The put option is entered into in conjunction with the transfer. Therefore, A should consider the option in evaluating the sale accounting conditions in ASC 860-10-40-5. Although the put option is written by a consolidated affiliate of A, it must be considered in the evaluation of whether the transfer meets the conditions for sale accounting. See also Example 3-19.

On March 1, 20X1, Entity B transfers mortgage loans to Entity C, a third party. The transfer meets the conditions for sale accounting. On July 30, 20X2, C decides to exit the mortgage loan business. As part of this decision, C enters into a forward contract to sell the previously purchased mortgage loans to B.

The forward contract between B and C is entered into separately and apart from the original transfer of the mortgage loans, as demonstrated by the time that has lapsed between the agreements and the reason C is selling the mortgage loans back to B. As a result, B is not considered to have regained control over previously sold mortgage loans as of the date it enters into the forward contract. Rather, the transfer should be accounted for as a sale or secured borrowing, depending on its terms, at settlement of the forward contract.

Note that when an unconditional obligation to purchase previously sold financial assets occurs as a result of terms and conditions related to the original sale, the seller-transferor is considered to have regained control over those assets and must recognize them before the actual purchase date. That guidance does not apply to this example because the previously transferred mortgage loans are subsequently purchased in connection with an agreement that is unrelated to the original sale agreement. See Section 4.3 for further discussion of the accounting in situations in which a transferor regains control over previously sold financial assets.

Entity H originates a $10 million, five-year, 7 percent nonprepayable commercial loan and acquires a guarantee of 75 percent of the principal and interest on the loan. In return for the guarantee, H pays the third-party guarantor an up-front fee of 5 percent of the principal amount of the loan (i.e., $500,000). The guarantee is contractually attached to the loan (i.e., it is transferred with any sale of the loan). Entity H charges the borrower additional origination fees that equal 1 percent of the principal amount of the loan (i.e., $100,000).

Assume the following:

• There have been no changes in market conditions between the origination date of the commercial loan and the date H transfers an interest in this loan (i.e., no changes in interest rates or credit spreads that, if the guarantee is ignored, would make the fair value of the commercial loan differ from its principal amount).
• Entity H does not charge any servicing fee for transferring an interest in the commercial loan.
• Entity H provides no recourse to any transferee that acquires an interest in the commercial loan.
• The stated interest rate on any transferred portion in the commercial loan is 7 percent.

Since the guarantee is provided by a third party, in accordance with ASC 860-10-55-17M, H could enter into any of the following transfers and meet the definition of a participating interest:

• Transfer 1 — A sale of the entire guaranteed portion at a purchase price of $8,075,000 (i.e., the $7.5 million principal amount, plus the $500,000 guarantee fee paid by H, plus $75,000 of the total origination fees) or a sale of any specified percentage of the guaranteed portion ranging from 1 percent to 100 percent at a purchase price of $107,666.67 per 1 percent interest of the total loan purchased ($107,666.67 = $8,075,000 ÷ 75).
• Transfer 2 — A sale of the entire guaranteed portion at a purchase price of $8 million (i.e., the $7.5 million principal amount, plus the $500,000 guarantee fee paid by H) or a sale of any specified percentage of the guaranteed portion ranging from 1 percent to 100 percent at a purchase price of $106,666.67 per 1 percent interest of the total loan purchased ($106,666.67 = $8,000,000 ÷ 75). Note that H is not required to “pass through” any portion of the origination fees received from the borrower.
• Transfer 3 — A sale of the entire unguaranteed portion at a purchase price of $2,525,000 (i.e., the $2.5 million principal amount plus $25,000 of the total origination fees) or a sale of any specified percentage of the unguaranteed portion ranging from 1 percent to 100 percent at a purchase price of $101,000 per 1 percent interest of the total loan purchased ($101,000 = $2,525,000 ÷ 25).
• Transfer 4 — A sale of the entire unguaranteed portion at a purchase price of $2,500,000 (i.e., the principal amount) or a sale of any specified percentage of the unguaranteed portion ranging from 1 percent to 100 percent at a purchase price of $100,000 per 1 percent interest of the total loan purchased ($100,000 = $2,500,000 ÷ 25). Note that H is not required to “pass through” any portion of the origination fees received from the borrower.
• Transfer 5 — Any combination of the above transfers of guaranteed and unguaranteed portions that do not exceed the total principal amount of the commercial loan.

Had the guarantee fee been payable over time, H could have transferred all or any specified percentage of the guaranteed portion at its principal amount, with a contractual per annum interest rate of 5.667 percent.65  However, H could not reduce the total contractual interest on any transferred guaranteed portion of the commercial loan by more than the amount of the guarantee fee payable.

An accounts receivable securitization is structured so that the transferor first transfers its trade receivables to a BRSPE, which it consolidates for financial reporting purposes. The BRSPE then issues two classes of participation certificates. The senior class of participation certificates is sold to a third party (such as a multiseller CP conduit), and the junior certificates are retained by the entity. Under ASC 860-10, the entity will have to account for this transfer as a secured borrowing given that the transferred senior interests are not participating interests because they contain priority rights to, and do not share proportionately in, the cash flows associated with the transferred receivables.

Entity P directly wholly owns Q and R and indirectly wholly owns S through Q.

Entity Q transfers mortgage loans receivables to a BRSPE that transfers those receivables to a securitization entity. In return, Q receives cash and a subordinated beneficial interest in the mortgage loans. Entity S, a wholly owned consolidated subsidiary of Q, services the transferred mortgage loans. Entity R provides a guarantee on the repayment of principal and interest on the transferred mortgage loans. Entity Q pays R a fee that fairly compensates R for providing the guarantee.

In P’s consolidated financial statements, all involvement of Q, R, and S must be considered in the determination of whether the transferred mortgage loans meet the legal isolation condition in ASC 860-10-40-5(a). In Q’s stand-alone consolidated financial statements, only the involvement of Q and S must be considered in the determination of whether the transferred mortgage loans meet the legal isolation condition in ASC 860-10-40-5(a). This is because the objective in this evaluation is only to determine whether the mortgage loans have been legally isolated from Q. It may be possible to reach a conclusion that the legal isolation condition is met for Q but not for P.

Entity T owns one million shares of ABC stock and accounts for them at fair value under ASC 321. Entity T enters into an agreement to sell its investment in ABC stock to a third party. At the time of the sale, T also enters into a net-cash-settled total return swap agreement with the transferee, which effectively transfers to T all of the risks and rewards of owning shares of ABC stock. If the transfer meets all the conditions in ASC 860-10-40-5 (i.e., the transferred ABC stock has been isolated from T, the transferee has the right to pledge or exchange the ABC stock, and T does not maintain effective control of the ABC stock through, for example, a physically settled forward purchase or call option), T should derecognize the ABC stock upon the transfer. Note, however, that if the transfer is subject to bankruptcy laws in the United States, it is unlikely that T would be able to obtain appropriate evidence that the transferred assets have been legally isolated because of the total return swap. That is, an attorney is unlikely to issue an appropriate true sale opinion when the transferor has retained all or substantially all of the risks and rewards of ownership of the assets transferred.

Entity V transfers fixed-rate whole mortgage loan receivables to a third party in return for cash and a pass-through interest in the transferred mortgage loans. Entity V continues to service the transferred mortgage loans. The pass-through interest gives V the right to all interest coupons on the transferred mortgage loans that exceed LIBOR plus 200 basis points. The pass-through interest represents a freestanding financial instrument (i.e., it is not attached to the mortgage loan receivables). There are no explicit limitations on the transferee’s ability to pledge or exchange the transferred mortgage loans.

Assume that V (1) obtains a true sale opinion that provides sufficient evidence that it has transferred entire mortgage loans and they are legally isolated and (2) has no rights or obligations to repurchase the transferred mortgage loans. Although the conditions in ASC 860-10-40-5 (a) and (c) are met, to qualify for sale accounting, the transferee must have the ability to pledge or exchange the mortgage loans. While there are no explicit limitations on the transferee’s ability to pledge or exchange the transferred mortgage loans, an entity must consider whether the obligation to pay V amounts due on the pass-through interest constrains the transferee’s ability to pledge or exchange the mortgage loans. The pass-through interest on the transferred mortgage loans represents a freestanding, net-cash-settled derivative instrument between V and the transferee. Since the transferee can freely sell the mortgage loans and retain its obligation on the pass-through interest, it would not appear that the pass-through interest constrains the transferee under ASC 860-10-40-5(b). This conclusion is based on the fact that V is not able to repurchase the transferred mortgage loans. Note that if the pass-through obligation must be transferred with the mortgage loans upon a pledge or exchange of those loans by the transferee to a third party (i.e., it is attached to the transferred mortgage loans), the transfer would represent the transfer of an interest in an entire financial asset that does not meet the definition of a participating interest; therefore, sale accounting would be precluded regardless of whether the condition in ASC 860-10-40-5(b) was met.

Entity W originates unsecured personal loans and often finances such originations by securitizing the loans. In 20X3, W transfers some of these loans to a third party. The terms of the transfer stipulate that, without W’s consent, the transferee can only sell such loans into securitization transactions involving other personal loans originated by W. Only personal loans originated by W are included in such securitizations.

Although various securitization trusts contain loans originated by W, access to such transactions is limited. Therefore, the transferee’s ability to only obtain the economic benefits of the purchased loans through securitization transactions with other personal loans originated by W is a constraint that precludes the transfer from meeting the condition in ASC 860-10-40-5(b). This constraint provides a more than trivial benefit to W because it allows W to always know who owns these loans.

Entity X transfers $100 million of loan receivables to Entity Y in return for $35 million in cash and a $65 million note payable, due in five years, that contains market terms. Entity Y has pledged the loan receivables as collateral on the $65 million note payable to X. Assume the following four scenarios related to Y’s ability to pledge or exchange the loan receivables:

• Scenario 1 — Entity Y is free to sell any of the loan receivables at any time but must use the first $65 million in proceeds to repay the note payable to X. There is no prepayment penalty if Y repays the loan.
• Scenario 2 — Entity Y can only sell the loan receivables if it first substitutes collateral on the note payable. Any investment-grade securities or performing loan receivables may be substituted as collateral. Entity X must consent to the collateral substitution, which may not be unreasonably withheld.
• Scenario 3 — Entity Y can only sell the loan receivables if it first substitutes collateral on the note payable. Entity X must consent to any collateral substitution, which may be withheld at X’s discretion.
• Scenario 4 — Entity Y can only sell the loan receivables after it first pays off the note payable.

In Scenario 1, Y is not constrained from pledging or exchanging the loan receivables because it can sell them at any time and the requirement to repay the note payable with the proceeds does not impede Y’s ability to sell the loans. The fact that Y cannot pledge the loan receivables because they are already pledged as collateral on the note payable is irrelevant because the condition in ASC 860-10-40-5(b) can be met if a transferee can only sell transferred financial assets. (Note that a constraint would exist if either (1) the note payable was originally entered into at favorable terms to Y or (2) there was an other-than-insignificant prepayment penalty on the note payable.)

In Scenario 2, Y is not constrained from pledging or exchanging the loan receivables because it can pledge or sell the loans provided that it substitutes collateral. The parameters associated with the eligible collateral are sufficiently broad (i.e., such collateral would be readily obtainable), and X cannot unreasonably withhold its consent on the collateral substitution.

In Scenario 3, Y is constrained from pledging or exchanging the loan receivables because it can only sell the loans if it substitutes collateral; however, X can prohibit such collateral substitution for any reason. Therefore, X effectively can prevent Y from pledging or exchanging the loan receivables. Since this constraint was imposed by X, as transferor, it provides a more than trivial benefit (i.e., it allows X to always know who holds the loan receivables); therefore, sale accounting is precluded since the condition in ASC 860-10-40-5(b) is not met.

In Scenario 4, Y is constrained from pledging or exchanging the loan receivables because it must repay the note payable before it can pledge or exchange the loan receivables. Given the significance of the amount required to be repaid before the loan receivables can be pledged or exchanged, this represents a constraint. Since this constraint was imposed by X, as transferor, it provides a more than trivial benefit (i.e., it allows X to always know who holds the loan receivables); therefore, sale accounting is precluded since the condition in ASC 860-10-40-5(b) is not met.

Entity A enters into an agreement to sell $225 million of FHA-insured residential mortgage loan receivables on a servicing-retained basis to a third party. The transferred mortgage loans were purchased from GNMA securitization trusts once they became delinquent. Entity A transfers these mortgage loan receivables along with an additional guarantee that protects the transferee for the 3 percent difference between the contractual principal and interest amounts due on the loans and the 97 percent guarantee that the FHA provides on such principal and interest amounts.

As servicer, A must comply with the servicing guidelines of HUD, which regulates FHA residential mortgage loans. These guidelines require A to provide temporary repayment plans once loans are delinquent. If a borrower complies with the repayment plan and certain other conditions are met regarding the delinquency status of the loan (e.g., the loan is at least three months past due and is not in foreclosure), the borrower must be offered a permanent loan modification. Such modifications would occur before a borrower is legally in default on its mortgage loan. As part of the sale agreement, A acquires an option to purchase any transferred mortgage loan that is modified in accordance with the HUD servicing requirements (the repurchase option) and also agrees to repurchase any transferred mortgage loan if the FHA insurance proceeds are not received by the 90th day after a foreclosure sale date (the mandatory repurchase). Because these loans are FHA-insured, this mandatory repurchase does not expose A to any additional loss since it already guarantees the 3 percent of principal and interest payments not insured by the FHA. The repurchase only serves to accelerate repayment of the contractual principal and interest payments to the transferee. It is unlikely that there will be any significant amounts of such repurchases because FHA insurance proceeds are generally received within 90 days after a foreclosure sale date.

Further assume the following:

• The transfer meets the legal isolation condition in ASC 860-10-40-5(a). (Note that the additional guarantee of A was considered in this analysis.)
• The transferee can freely pledge or exchange the transferred mortgage loan receivables.
• None of the transferred mortgage loans qualified for a modification as of the transfer date.

This transfer is not within the scope of SAB Topic 5.V (see Section 2.4.4.3). Provided that the repurchase option and mandatory repurchase features do not result in the failure to meet the condition in ASC 860-10-40-5(c), this transfer would qualify as a sale as of the transfer date. The repurchase features are evaluated below.

The transferred mortgage loans were delinquent as of the transfer date; however, none of them qualified for a modification as of this date. Since all the transferred mortgage loans were delinquent as of the transfer date, it is reasonable to expect that modifications will occur (i.e., some borrowers will meet all the conditions for a permanent modification). As a result, A will be able to repurchase those loans. Nevertheless, as of the transfer date, A does not have the unilateral ability to reclaim any specific mortgage loan transferred and it is not certain that any specific transferred mortgage loan will be modified. Thus, it is appropriate to consider this repurchase option to be a contingent call option as long as the conditions that must be met before a modification are considered substantive. On the basis of the facts, those conditions are substantive. Before a loan modification occurs, all of the following must happen:

• The borrower must comply with the terms of the temporary repayment plan. Not all borrowers will comply.
• Other conditions must be met regarding the delinquency status of the loan (e.g., the loan is at least three months past due and is not in foreclosure). These conditions will not be met in all cases.
• The borrower must accept the loan modification. Some borrowers may not accept the modification terms.

Since these conditions are substantive and A does not control their occurrence, the repurchase option does not cause A to maintain effective control under ASC 860-10-40-5(c). Entity A is not required to determine the likelihood that each individual loan will become subject to modification since the conditions leading up to such modification are substantive and not within A’s control.

This requirement to repurchase transferred mortgage loans is contingent on both a foreclosure sale and the fact that the FHA insurance proceeds are not received within 90 days of the foreclosure sale date. Since substantive contingencies outside A’s control must occur before A is obligated to repurchase transferred mortgage loans under this feature, this provision also does not cause A to maintain effective control under ASC 860-10-40-5(c).

In summary, A may account for the transferred mortgage loan receivables as a sale as of the transfer date. After the transfer date, A would apply the guidance in ASC 860-10 on regaining control over previously sold assets upon the occurrence of either a modification or the conditions leading to A’s required repurchase of transferred mortgage loans. See Section 4.3.

Entity B transfers prepayable loan receivables to a third party. In conjunction with the transfer, B obtains an option that allows it to repurchase any of the transferred loans on any date beginning five years after the transfer date. Entity B expects that a significant number of the transferred loan receivables will be prepaid before the call option becomes exercisable.

The call option cannot be considered contingently exercisable on the basis that any specific loan receivable may be prepaid before the option becomes exercisable. To reach this conclusion would be tantamount to a determination that call options on prepayable financial assets cannot cause the transferor to maintain effective control over transferred financial assets, which is inconsistent with ASC 860-10’s guidance on effective control. Since the call option is exercisable upon the mere passage of time, B maintains effective control over the entire transferred loan and may not reflect the transfer as a sale.

Entity C transfers an equity security to a third party for $1 million and simultaneously grants a freestanding put option that allows the transferee to put the equity security back to C in the future at a fixed exercise price of $750,000.

Entity C may account for this transfer as a sale provided that the put option does not prevent the transfer from meeting the legal isolation condition in ASC 860-10-40-5(a) (see also Example 3-1). The put option would not constrain the transferee from pledging or exchanging the security because the transferee is not required to exercise it (i.e., it can choose to transfer the equity security to a third party and let the put option expire). The put option would also not cause C to maintain effective control over the transferred equity security because it is out-of-the-money, as opposed to deep-in-the-money, at inception.

If the transfer is accounted for as a sale, C should recognize a gain or loss for any difference between (1) the cash proceeds and (2) the sum of (a) the carrying amount of the equity security and (b) the initial fair value of the written put option. A gain does not need to be deferred because of the put option. If the transfer is accounted for as a sale, C should subsequently account for the written put option under ASC 815-10 if it meets the definition of a derivative instrument. If the existence of the put option causes C to account for the transfer as a secured borrowing, ASC 815-10-15-63 applies and the put option is not accounted for as a derivative instrument even if it meets the conditions in ASC 815-10-15-83. If the transfer is accounted for as a sale, the put option is subject to the recognition and disclosure requirements of ASC 460 (or just the disclosure requirements if the put option is accounted for as a derivative). If the existence of the put option causes C to account for the transfer as a secured borrowing, the put option is not subject to ASC 460 (see ASC 460-10-15-7(g)).

The above conclusion would not change if the transferred financial asset was a debt security. However, in certain circumstances, a transfer of a security accompanied by a put option can cause the transfer not to meet the conditions in ASC 860-10-40-5(b) or ASC 840-10-40-5(c). It is possible that (1) a put option on a security that is not readily obtainable could constrain the transferee or (2) an in-the-money put option on a security could cause the transferor to maintain effective control over the transferred security. The determination of whether a put option results in failure of either of these two sale accounting conditions is made as of the transfer date on the basis of the fair value of the security and the exercise price of the put option, among other factors. A change in market price of the transferred security after the transfer date would not affect the conclusion reached about these two conditions as of the transfer date.

Entity D transfers finance lease receivables to a static-pool, nonrevolving, multiseller conduit that issues senior interests to third parties and a DPP to D. Monthly lease payments are required for all the transferred receivables, and the receivables have the same final maturity date. The sponsor of the multiseller conduit receives a fee for administering the conduit. The sponsor is not entitled to sell any of the lease receivables held by the conduit.

The senior interests fully mature on the date the transferred receivables have amortized to 30 percent of the aggregate balance of those receivables on the transfer date. After maturity of the senior interests, the only remaining economic interest in the conduit is the DPP owned by D that represents a 100 percent interest in the remaining finance receivables transferred by D (i.e., the 30 percent remaining amortized balance of those receivables). Although D has no contractual right to exchange the DPP for the remaining balance of the transferred receivables, after maturity of the senior interests, the sponsor of the conduit no longer receives any fees and has an incentive to allow D to wind up the structure by exchanging the remaining balances of the transferred receivables for the DPP. Assume that the DPP is exposed only to credit losses on the finance lease receivables transferred by D and that D is not required to consolidate all or any portion of the conduit under ASC 810-10.

If D had a contractual right to exchange the DPP for the transferred receivables once the senior interests are repaid, this right would represent a call option on a specified amortized balance of transferred financial assets, which precludes sale accounting because effective control has been maintained (see Section 3.5.3). Although D has no contractual right to exchange the DPP for the remaining balance of transferred receivables once the senior interests have been extinguished, since the sponsor is incentivized to allow D to exchange the DPP for the remaining balance of transferred receivables, there is an implicit call option on the transferred receivables once they have amortized to 30 percent of their balances as of the transfer date. As a result, D maintains effective control over the transferred receivables under ASC 860-10-40-5(c) and sale accounting is precluded. However, if the sponsor of the conduit had the ability to sell the remaining lease receivables once the senior interests were repaid and to retain all or a portion of any gain on sale, and this sale was considered to represent a substantive right, D could conclude that it did not maintain effective control over the transferred finance lease receivables.

Entity F enters into a mortgage dollar-roll transaction that consists of the following:

• Transfer of an MBS by F to a third party in exchange for cash. This transfer meets the legal isolation condition in ASC 860-10-40-5(a) and the counterparty has the right to freely pledge or exchange the MBS received.
• Entity F enters into a forward contract with the same counterparty to purchase an MBS in the future at a fixed price. The terms of the contract stipulate the parameters of the MBS to be returned by the counterparty (the “trade stipulations”).

Provided that the above transaction is not a repurchase-to-maturity transaction, if the MBS to be purchased under the forward contract meets the substantially-the-same conditions in ASC 860-10-40-24, F should account for the transfer of the MBS as a repurchase agreement (i.e., a secured borrowing). This will depend on the specific terms of the trade stipulations.

Entity G is an investment company that is required to apply trade date accounting under ASC 946. Entity G enters into the following purchase and sale agreements on the same date:

• A TBA MBS purchase contract that is settled in 90 days (i.e., the MBS underlying the TBA is received in 90 days) (the “TBA purchase contract”)
• A TBA MBS sale contract that is settled in 60 days (i.e., the MBS underlying the TBA is delivered in 60 days) (the “TBA sale contract”).

On the trade date, the buyer and seller have entered into forward commitments to purchase or sell an MBS on a TBA basis. The price of each TBA is determined on the trade date and takes into account the imputed present value of the commitment from the trade date to the settlement date. The MBSs to be received and delivered under the TBA purchase and sale transactions are not identical. The parties have agreed to comply with the good delivery standards in SIFMA’s 2019 Uniform Practices.

Entity G should not account for the two transactions described above as a repurchase agreement for the following reasons:

• The good delivery standards in SIFMA’s 2019 Uniform Practices do not cause the MBS to be purchased under the TBA purchase contract to be substantially the same as the MBS to be sold under the TBA sale contract (see Section 3.6.5.1.1.3).
• ASC 860-10-55-17 indicates that dollar-roll transactions for which the underlying securities being sold do not yet exist or are to be announced are outside the scope of ASC 860-10 because those transactions do not arise in connection with a transfer of recognized financial assets. This is the case regardless of whether the entity applies trade date accounting to a TBA purchase contract.

If G determines that it is appropriate to apply trade-date accounting to the purchase of the MBS under the TBA purchase contract, it would recognize the MBS on the date it entered into the TBA purchase contract. In accordance with ASC 946, the MBS would be subsequently recognized at fair value, with changes in fair value reported in earnings. If G concludes that trade-date accounting for the TBA purchase contract is not applicable, it would account for that contract as a derivative instrument under ASC 815-10. The TBA sale contract would be accounted for as a derivative instrument under ASC 815-10 because it represents the sale of an MBS that is not owned by G. Note that this transaction does not represent a short sale since the purchase price for the MBS was not paid as of the date the contract was entered into.