4.4 Accounting for the Proceeds Received in a Sale of Financial Assets

4.4.1 Financial Assets Subject to Prepayment

4.4.1.1 General

ASC 860-20

Financial Assets Subject to Prepayment

35-2 Financial assets, except for instruments that are within the scope of Subtopic 815-10, that can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment shall be subsequently measured like investments in debt securities classified as available for sale or trading under Topic 320. Examples of such financial assets include, but are not limited to, interest-only strips, other beneficial interests, loans, or other receivables. Interest-only strips and similar interests that meet the definition of securities are included in the scope of that Topic. Therefore, all relevant provisions of that Topic (including the disclosure requirements) shall be applied. See related implementation guidance beginning in paragraph 860-20-55-33.

35-3 Interest-only strips and similar interests that are not in the form of securities are not within the scope of Topic 320 but shall be measured like investments in debt securities classified as available for sale or trading. In that circumstance, all of the measurement provisions of that Topic, including those addressing recognition and measurement of impairment, shall be followed. However, other provisions of that Topic, such as those addressing disclosures, are not required to be applied. Paragraph 320-10-15-9 explains that, for debt securities within its scope, Subtopic 325-40 provides incremental guidance on accounting for and reporting discount and impairment.

Pending Content (Transition Guidance: ASC 326-10-65-1)

35-3 Interest-only strips and similar interests that are not in the form of securities are not within the scope of Topic 320 but shall be measured like investments in debt securities classified as available for sale or trading. In that circumstance, all of the measurement provisions of that Topic, as well as the provisions of Topic 326 on measurement of credit losses, shall be followed. However, other provisions of Topics 320 and 326, such as those addressing disclosures, are not required to be applied. Paragraph 320-10-15-9 explains that, for debt securities within its scope, Subtopic 325-40 provides incremental guidance on accounting for and reporting discount and credit losses.

35-6 The guidance in this Subtopic does not specifically address the subsequent measurement of a transferor’s beneficial interests that cannot be contractually prepaid or settled in such a way that the owner would not recover substantially all of its recorded investment.

ASC 860-20-35-2 requires that financial assets “that can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment” be accounted for as available-for-sale or trading securities unless those financial assets meet the definition of a derivative instrument in ASC 815-10-15-83 in their entirety. Such financial assets must be accounted for as available-for-sale or trading securities even if they do not meet the definition of a debt security; classification as a held-to-maturity debt security is not appropriate. See Section 4.4.1.2.2 for the meaning of “substantially all.”

ASC 860-20-35-2 gives the following examples of such financial assets:

IO strips.
Beneficial interests.
Loans.
Other receivables.

The guidance in ASC 860-20-35-2 applies to both financial assets received as proceeds in a sale and financial assets acquired by other means. A common example of a beneficial interest received in a sale of financial assets that is within the scope of ASC 860-20-35-2 is a DPP in a securitization of trade receivables involving third-party CP entities. Even if not certificated, a DPP must be accounted for as a trading or available-for-sale debt security because the initial recorded investment may not be received as a result of rising interest rates, liquidity risks with the CP interests that are secured by the sold trade receivables, lack of cash returns on the investment because of extended payments on the sold trade receivables (which increases the interest costs incurred on the CP issuances that are secured by the sold trade receivables), and other fees and costs charged by the facility that may vary on the basis of a number of factors unrelated to credit risk. See Table 4-3 for further discussion of financial assets that are within the scope of ASC 860-20-35-2.

The Basis for Conclusions of FASB Statement 140 explains the FASB’s rationale for requiring the subsequent accounting that is specified in ASC 860-20-35-2 and states:

292. Paragraph 362 of this Statement carries forward without reconsideration from Statement 125 the amendment to Statement 115 to eliminate the use of the held-to-maturity category for securities subject to substantial prepayment risk, thereby requiring that they be classified as either available-for-sale or trading and subsequently measured at fair value. Paragraph 14 extends that measurement principle to interest-only strips, loans, other receivables, and retained interests in securitizations subject to substantial prepayment risk.

293. The justification for using historical-cost-based measurement for debt securities classified as held-to-maturity is that no matter how market interest rates fluctuate, the holder will recover its recorded investment and thus realize no gains or losses when the issuer pays the amount promised at maturity. The same argument is used to justify historical-cost-based measurement for other receivables not held for sale. That justification does not extend to receivables purchased at a substantial premium over the amount at which they can be prepaid, and it does not apply to instruments whose payments derive from prepayable receivables but have no principal balance, as demonstrated by large losses realized in recent years by many holders of interest-only strips and other mortgage derivatives. As a result, the Board concluded that those receivables must be subsequently measured at fair value with gains or losses being recognized either in earnings (if classified as trading) or in a separate component of shareholders’ equity (if classified as available-for-sale). The Board, by deciding that a receivable may not be classified as held-to-maturity if it can be prepaid or otherwise settled in such a way that the holder of the asset would not recover substantially all of its recorded investment, left room for judgment, so that investments in mortgage-backed securities or callable securities purchased at an insubstantial premium, for example, are not necessarily disallowed from being classified as held-to-maturity.

294. Some respondents to the Exposure Draft of Statement 125 agreed with the Board’s conclusions about financial assets subject to prepayment when applied to interest-only strips but questioned the application of those conclusions to loans, other receivables, and retained interests in securitizations. They maintained that the nature of the instrument and management’s intent should govern classification rather than actions that a borrower might take under the contract.

295. The Board did not agree with those arguments. A lender that holds a portfolio of prepayable loans or bonds at par will realize the carrying amount of its investment if the borrowers prepay. However, if the lender originated or acquired those loans or bonds at a substantial premium to par, it may lose some or all of that premium and thus not recover a substantial portion of its recorded investment if borrowers prepay. The potential loss is less drastic for premium loans or bonds than for interest-only strips, but it can still be substantial. The Board concluded that the rationale outlined in paragraph 293 extends to any situation in which a lender would not recover substantially all of its recorded investment if borrowers were to exercise prepayment or other rights granted to them under the contracts. The Board also concluded that the provisions of paragraph 14 do not apply to situations in which events that are not the result of contractual provisions, for example, borrower default or changes in the value of an instrument’s denominated currency relative to the entity’s functional currency, cause the holder not to recover substantially all of its recorded investment.

Connecting the Dots

ASC 860-20-35-2 applies only if a financial asset does not meet the definition of a derivative in its entirety. In these circumstances, the financial asset would generally represent a hybrid financial instrument with an embedded derivative feature related to prepayment risk or interest rate risk. ASC 815-15-25-26(a) states that, in the following circumstance, an embedded derivative in which the only underlying is an interest rate or an interest rate index is not considered clearly and closely related to the debt host contract:

The hybrid instrument can contractually be settled in such a way that the investor (the holder or the creditor) would not recover substantially all of its initial recorded investment (that is, the embedded derivative contains a provision that permits any possibility whatsoever that the investor’s [the holder’s or the creditor’s] undiscounted net cash inflows over the life of the instrument would not recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms).

In accordance with this guidance, if the investor does not recognize the financial asset as a trading security, it would generally be required to bifurcate the embedded prepayment risk or interest rate risk under ASC 815-15.

4.4.1.2 Interpretive Guidance

4.4.1.2.1 Risks That May Result in Lack of Recovery of Initial Investment

ASC 860-20

Financial Assets Subject to Prepayment

35-4 The requirement in paragraph 860-20-35-2 does not apply to situations in which events that are not the result of contractual provisions, for example, borrower default or changes in the value of an instrument’s denominated currency relative to the entity’s functional currency, cause the holder not to recover substantially all of its recorded investment.

Financial Assets Subject to Prepayment

55-32 The following is implementation guidance related to the subsequent measurement of various types of financial assets subject to prepayment, specifically:

Instruments that can be prepaid or otherwise settled in such a way that the holder would not recover substantially all of the recorded investment
Loan that can be prepaid or otherwise settled in such a way that the holder would not recover substantially all of the recorded investment at initial acquisition
Classification of a residual tranche in a securitization as held to maturity.

Instruments That Can Be Prepaid or Otherwise Settled in Such a Way That the Holder Would Not Recover Substantially All of the Recorded Investment

55-33 The following discusses whether the following types of instruments are subject to the subsequent measurement guidance in paragraph 860-20-35-2:

A financial asset that is not a debt security denominated in a foreign currency
A note for which the repayment amount is indexed to the creditworthiness of a party other than the issuer.

55-34 Investing in a financial asset that is denominated in a foreign currency often exposes an entity to foreign currency exchange rate risk; however, that risk is not addressed in paragraph 860-20-35-2.

55-35 A financial asset that is not a debt security under Topic 320 is not subject to the requirements of paragraph 860-20-35-2 because it is denominated in a foreign currency.

55-36 An entity is not required to measure such an investment like a debt security under paragraph 860-20- 35-2 unless it has provisions that allow it to be contractually prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment, as denominated in the foreign currency. For example, an investment denominated in deutsche marks by an entity with a U.S. dollar functional currency would not be subject to that paragraph if the contract requires that substantially all of the invested deutsche marks be repaid.

55-37 A note for which the repayment amount is indexed to the creditworthiness of a party other than the issuer is subject to the provisions of paragraph 860-20-35-2 because the event that might cause the holder to receive less than substantially all of its recorded investment is based on a contractual provision, not on a default by the borrower (that is, the issuer of the note). That contractual provision indexes the payment terms of the note to a default by a third party unrelated to the issuer of the note. If that note is within the scope of Subtopic 815-10 the guidance of paragraph 860-20-35-2 would not apply.

ASC 860-20-35-4 and ASC 860-20-55-32 through 55-37 provide implementation guidance related to ASC 860-20-35-2. The table below summarizes this guidance and provides additional interpretive guidance on applying ASC 860-20-35-2 to financial assets that do not meet the definition of a derivative instrument in their entirety. (Note that the guidance below applies regardless of how the financial asset was obtained.)

Table 4-3

Risk That Could Result in Not Recovering Initial Recorded Investment	Does ASC 860-20-35-2 Apply?
Prepayment risk(a)	Yes. ASC 860-20-35-2 applies to an investment in a debt security or loan receivable (including a beneficial interest in securitized financial assets) that may be contractually prepaid or otherwise settled at an amount that would cause the investor not to recover substantially all of its initial recorded investment. This evaluation involves comparing the undiscounted contractual cash flows on an investment with the investor’s initial recorded investment. In performing this evaluation, the investor must consider contractual repayments that are theoretically possible, not just probable settlements (see Section 4.4.1.2.3). Certain financial assets meet the condition in ASC 860-20-35-2 regardless of the amount of the initial recorded investment. Examples include: IO strips, whether purchased or received as proceeds upon a sale of financial assets, unless the issuer guarantees recovery of substantially all of the investor’s initial recorded investment(b) IO strips are subject to significant prepayment risk because, if the underlying financial assets are prepaid or otherwise contractually settled, there are no remaining interest cash flows available to be distributed to the holders of IO strips.(c) Beneficial interests, whether purchased or received as proceeds upon a sale of financial assets, that contain significant prepayment risk regardless of the initial recorded investment. A beneficial interest may expose its holder to prepayment risk on the basis of (1) how the securitization entity allocates cash flows received on the underlying financial assets to various classes of beneficial interests (see Example 4-4) or (2) whether the collateral manager of a securitization entity is allowed to purchase prepayable financial assets at a premium. Other financial assets, whether purchased or received as proceeds in a sale of financial assets, meet the condition in ASC 860-20-35-2 if the initial recorded investment is at a substantial premium to the investment’s principal (or stated) amount. Examples include the following: Beneficial interests for which settlement is contractually required for the principal (or stated) amount (see Example 4-6). Loans. Other receivables. When evaluating whether a financial asset is subject to significant prepayment risk, an investor must take into account any prepayment penalty provisions of the financial assets. For example, if an entity purchases a loan for 110 percent of par and that loan requires the borrower to pay a 5 percent penalty upon prepayment, the holder would always receive substantially all of its initial recorded investment upon a prepayment of the loan by the borrower. We generally believe that when evaluating whether guarantee fees receivable are subject to significant prepayment risk, it is acceptable for an entity to consider any extinguishment of a related guarantee obligation as part of the recovery of the asset for the guarantee fees.
Basis risk	Yes. Basis risk is a type of interest rate risk that may exist in beneficial interests in securitized financial assets. Basis risk could arise from a difference between the returns on the financial assets owned by a securitization entity and the allocation of cash flows to the beneficial interests issued by the securitization entity. If basis risk could cause an investor not to recover substantially all of its initial recorded investment in a beneficial interest, that interest is within the scope of ASC 860-20- 35-2 because a contractual settlement could result in a loss to the investor. This conclusion applies regardless of how small the basis risk is expected to be because the likelihood of the lack of recovery of substantially all of the investor’s initial recorded investment is not relevant, as discussed in Section 4.4.1.2.3. See Example 4-5 for an illustration of basis risk.
Reinvestment risk	Yes. Reinvestment risk may exist in beneficial interests in securitized financial assets. For example, reinvestment risk exists if a collateral manager is contractually allowed to purchase financial assets at a premium and sell them at an amount less than the purchase price. Reinvestment risk could even exist if a collateral manager is allowed to purchase financial assets at par or at a discount if it is able to sell them because such sales may occur at losses as a result of changes in market rates of interest. In these circumstances, a beneficial interest holder may not recover substantially all of its initial recorded investment as a result of a contractual provision. Even if the collateral manager can sell such financial assets at a loss only when their credit risk declines, such sales would not result from a default by the obligor on such financial assets.
Credit risk	It depends. An investment in a debt security or loan receivable (including a beneficial interest in securitized financial assets) is subject to ASC 860-20-35-2 only if it may be contractually settled in a manner that would cause the investor not to receive substantially all of its initial recorded investment. Risk of loss results from credit risk of the issuing entity — A financial asset such as a debt security or loan receivable is not within the scope of ASC 860-20-35-2 solely as a result of the credit risk of the borrower. If the only way that the investor would not recover substantially all of its initial recorded investment would be upon a default by the borrower, this lack of recovery of the initial recorded investment represents a credit event that is not subject to ASC 860-20-35-2 (see ASC 860-20-35-4). However, if a debt instrument contains a provision that could contractually cause the investor not to recover substantially all of its initial recorded investment because of a change in credit rating of the borrower, or a beneficial interest in securitized financial assets contains a provision that could contractually cause the investor not to recover substantially all of its initial recorded investment as a result of a change in credit rating of the loans or debt securities held by the securitization entity that issued the beneficial interest, ASC 860-20-35-2 would apply because the debt instrument (or beneficial interest) contractually allows for repayment in a manner that would cause the investor not to recover its initial recorded investment. Note that credit risk associated with a beneficial interest in securitized financial assets does not include the risk of not receiving substantially all of an investor’s initial recorded investment as a result of (1) the allocation of contractual cash flows on underlying financial assets in accordance with a waterfall provision in a securitization trust that issues beneficial interests, (2) basis risk, or (3) reinvestment risk. Risk of loss results from credit risk of a third party — A financial asset, such as an investment in a debt security or a loan receivable (including a beneficial interest in securitized financial assets) that can be contractually prepaid or otherwise settled in a manner that would cause the investor not to recover its initial recorded investment, is within the scope of ASC 860-20-35-2 if the debt instrument is indexed to the creditworthiness of a party other than the issuer. As discussed in ASC 860-20-55-37, a contractual provision in a debt instrument that indexes the payment terms to default by a third party unrelated to the issuer causes the debt instrument to be within the scope of ASC 860-20-55-37. Such an embedded third-party credit risk feature would also generally need to be bifurcated under ASC 815-15.
Foreign currency exchange risk	It depends. An investment in a debt security or loan receivable (including a beneficial interest in securitized financial assets) is not within the scope of ASC 860-20-35-2 if the investor may not recover substantially all of its initial recorded investment solely because of changes in exchange rates between the denomination of the investment and the investor’s functional currency. For example, an investment in a debt security denominated in deutsche marks made by an entity with a U.S. dollar functional currency would not be subject to ASC 860-20-35-2 if the obligor of the debt security is contractually required to repay the principal amount in deutsche marks even though the investor may lose part of its initial recorded investment because of adverse changes in the exchange rate of deutsche marks to U.S. dollars. Investing in a financial asset that is denominated in a foreign currency exposes the investor to foreign exchange risk, but that risk is not addressed in ASC 860-20-35-2 because it does not arise as a result of a contractual settlement provision. (See paragraph 295 of the Basis of Conclusions of FASB Statement 140 and ASC 860-20-35-4 and ASC 860-20-55-34 through 55-36.) If, however, an investor is exposed to foreign currency exchange risk for other reasons (i.e., in a manner similar to basis risk or reinvestment risk), ASC 860-20-35-2 may apply.
Notes to Table: (a) Examples of financial assets with prepayment risk include: Corporate bonds. Asset-backed securities. Mortgage loans. MBSs. CMOs and CLOs. Real estate mortgage investment conduit interests. Other securitized loans and receivables, including trade receivables. Certain repurchase agreements. IO strips. Principal-only strips. Prepayment options may be exercised as a result of (1) changes in interest rates, (2) use of surplus liquidity, (3) availability of alternative financing, (4) death or relocation of the borrower (e.g., mortgage loans), and (5) other factors that result in the acceleration of cash flows. Prepayment risk is governed at least in part, by interest rate risk. Interest rate risk alone may also cause an investor not to recover substantially all of its initial recorded investment (see Basis Risk in table). (b) It would be unusual for the issuer of an IO strip to guarantee the holder’s recovery of any portion of its initial recorded investment. See Section 4.4.1.2.4 for discussion of the impact of guarantees. (c) Principal-only strips are not subject to the accounting in ASC 860-20-35-2 since these instruments are positively affected by prepayment risk.

Note that ASC 860-20 contains specific guidance on applying ASC 860-20-35-2 to accrued interest receivables. See Section 4.4.4.

Example 4-4

Purchase of Subordinated Beneficial Interest in Prepayable Securitized Loans at Par

Entity C acquires a $50 million subordinated beneficial interest in a securitization entity that owns a $500 million static pool of prepayable mortgage loans. The mortgage loans owned by the securitization entity have a weighted-average annual interest rate of 6 percent and a weighted-average remaining estimated life of seven years. The securitization entity issues the following beneficial interests:

$300 million of senior beneficial interests that mature in two years and pay interest at an annual rate of 4.5 percent. In the event that these senior beneficial interests mature early as a result of prepayments on the underlying mortgage loans, the holders are entitled to receive a make-whole payment equal to all of the future interest payments discounted at three-month LIBOR, subject to a floor of zero.
$200 million of subordinated beneficial interests that are entitled to receive all the remaining cash flows on the mortgage loans owned by the securitization entity after payment of principal and interest on the senior interests.

Entity C should account for its subordinated beneficial interest in accordance with ASC 860-20-35-2. The application of ASC 860-20-35-2 is based on whether it is theoretically possible, not probable, that an investor would not recover substantially all of its initial recorded investment in accordance with the contractual provisions of the investment. If all the mortgage loans were to be prepaid immediately after the inception of the securitization entity, holders of senior beneficial interests would be entitled to receive $327 million (i.e., $300 million × [1 + 0.045 + 0.045] = $327 million). (Note that no discounting factor is applied because it is theoretically possible that three-month LIBOR on the day after the inception of the securitization entity is zero.) As a result, holders of subordinated interests would incur a loss of $27 million, or 13.5 percent of their initial recorded investment.

If C does not classify the beneficial interest as a trading security, it would also have to bifurcate the embedded prepayment risk feature under ASC 815-15 because this embedded feature is not considered clearly and closely related to the debt host contract under ASC 815-15-25-26(a). The evaluation of ASC 815-15-25-26(a) is also based on whether it is theoretically possible, not probable, that an investor would not recover substantially all of its initial recorded investment. Under ASC 815-15-25-26(a), an embedded derivative is not clearly and closely related to a debt host contract if it is possible that the investor’s undiscounted net cash inflows over the life of the instrument would not recover substantially all of the investor’s initial recorded investment in the hybrid instrument under its contractual terms. Since all of the underlying loans could potentially be prepaid immediately, C would receive only $43.25 million (i.e., $50 million × [1 – 0.135] = $43.25 million), which would cause C to recover only 86.5 percent of its initial recorded investment in the subordinated beneficial interest.

Example 4-5

Purchase of Subordinated Beneficial Interest in Securitized Loans That Contains Basis Risk

Entity D acquires a $50 million subordinated beneficial interest in a securitization entity that owns a $500 million principal amount of a static pool of nonprepayable commercial loans with an average remaining life of five years. The commercial loans pay interest at three-month LIBOR (subject to a floor of zero) plus 150 basis points. The securitization entity issues the following beneficial interests, each of which has a five-year life:

$300 million of senior beneficial interests that pay interest at an annual rate of 5 percent.
$200 million of subordinated beneficial interests that are entitled to receive all the remaining cash flows on the loans owned by the securitization entity after payment of principal and interest on the senior interests.

Entity D should account for its subordinated beneficial interest in accordance with ASC 860-20-35-2. The application of ASC 860-20-35-2 is based on whether it is theoretically possible, not probable, that an investor would not recover substantially all of its initial recorded investment in accordance with the contractual provisions of the investment. If three-month LIBOR falls to zero immediately after the issuance of the beneficial interests and remains at zero for the remaining term of the securitization entity, which is possible, the senior beneficial interests would be paid $375 million (i.e., $300 million × [1+ 0.05 + 0.05 + 0.05 + 0.05 + 0.05] = $375 million). As a result, holders of subordinated interests would incur a loss of $37.5 million (after considering the $37.5 million of interest payable on the commercial loans), or 18.75 percent of their initial recorded investment.

If D does not classify the beneficial interest as a trading security, it would also have to bifurcate the embedded interest rate risk feature under ASC 815-15 because this embedded feature is not clearly and closely related to the debt host contract under ASC 815-15-25-26(a). The evaluation of ASC 815-15-25-26(a) is also based on whether it is theoretically possible, not probable, that an investor would not recover substantially all of its initial recorded investment. Under ASC 815-15-25-26(a), an embedded derivative is not clearly and closely related to a debt host contract if it is possible that the investor’s undiscounted net cash inflows over the life of the instrument would not recover substantially all of the investor’s initial recorded investment in the hybrid instrument under its contractual terms. Since it is possible that three-month LIBOR is zero for the entire life of the securitization entity, D would receive only $40.625 million (i.e., $50 million × [1 – 0.1875] = $40.625 million), which would cause D to recover only 81.25 percent of its initial recorded investment in the subordinated beneficial interest.

4.4.1.2.2 Meaning of “Substantially All”

ASC 860-20 does not define “substantially all.” With respect to applying ASC 860-20-35-2, we believe that “substantially all” means at least 90 percent of the initial recorded net investment. Thus, for ASC 860-20- 35-2 not to apply, the investor must determine that its investment cannot be contractually settled for less than 90 percent of the initial recorded investment. Because this test is based on the recorded investment, prepayable interests acquired with a substantial premium (e.g., 10 percent or more above their par amounts) would not be eligible for held-to-maturity classification.

Connecting the Dots

In addition to performing the evaluation required by ASC 860-20-35-2, the investor must consider whether the financial asset is a hybrid financial instrument with an embedded derivative that must be bifurcated. In evaluating whether embedded derivatives are clearly and closely related to a debt host contract under ASC 815-15-25-26(a), an investor applies the same meaning of “substantially all” as that discussed above.

4.4.1.2.3 Consideration of Probability of Not Recovering Initial Recorded Investment

ASC 860-20

Financial Assets Subject to Prepayment

35-5 A financial asset that can be contractually prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment shall not be classified as held-to-maturity even if the investor concludes that prepayment or other forms of settlement are remote. The probability of prepayment or other forms of settlement that would result in the holder’s not recovering substantially all of its recorded investment is not relevant in deciding whether the provisions of paragraph 860-20-35-2 apply to those financial assets.

As discussed in ASC 860-20-35-5, the probability that the investor will not recover substantially all of its initial recorded investment in a financial asset is not relevant to the application of ASC 860-20-35-2. Similarly, when applying the guidance in ASC 815-15-25-26(a) on “clearly and closely related,” an investor cannot consider the probability of not recovering its initial recorded investment.

Example 4-6

Purchase of Beneficial Interest in Prepayable Securitized Loans at a Significant Premium

Entity E purchases a beneficial interest in prepayable securitized loans at a purchase price of 112 percent of the stated amount of the interest. Entity E believes that it is remote that the underlying loans will be prepaid in such a way that E will not recover at least 90 percent of the initial recorded carrying amount of the beneficial interest, including the premium paid.

Entity E should account for the beneficial interest in accordance with ASC 860-20-35-2 because that guidance is applied on the basis of whether it is theoretically possible, not probable, that an investor would not recover substantially all of its initial recorded investment in accordance with the contractual provisions of the investment. If E does not classify the beneficial interest as a trading security, it would also have to bifurcate the embedded prepayment risk under ASC 815-15 because this embedded feature is not considered clearly and closely related to the debt host contract under ASC 815-15-25-26(a). The evaluation of ASC 815-15-25-26(a) is also based on whether it is theoretically possible, not probable, that an investor would not recover substantially all of its initial recorded investment. Under ASC 815-15-25-26(a), an embedded derivative is not clearly and closely related to a debt host contract if it is possible that the investor’s undiscounted net cash inflows over the life of the instrument would not recover substantially all of the investor’s initial recorded investment in the hybrid instrument under its contractual terms. Since it is possible that all the underlying loans are prepaid immediately, E would receive only the stated amount of its beneficial interest and, accordingly, would not recover substantially all of its initial recorded investment.

4.4.1.2.4 Consideration of Guarantees

ASC 320-10

Step 1: Determine Whether an Investment Is Impaired

35-23 An entity shall not combine separate contracts (a debt security and a guarantee or other credit enhancement) for purposes of determining whether a debt security is impaired or can contractually be prepaid or otherwise settled in such a way that the entity would not recover substantially all of its cost.

Pending Content (Transition Guidance: ASC 326-10-65-1)

35-23 Paragraph superseded by Accounting Standards Update No. 2016-13.

ASC 326-30

Identifying and Accounting for Impairment

Pending Content (Transition Guidance: ASC 326-10-65-1)

35-5 An entity shall not combine separate contracts (a debt security and a guarantee or other credit enhancement) for purposes of determining whether a debt security is impaired or can contractually be prepaid or otherwise settled in such a way that the entity would not recover substantially all of its cost.

In applying ASC 860-20-35-2, an entity should consider a guarantee that is embedded in the financial asset. However, an entity may not consider any guarantee that represents a freestanding financial asset.

4.4.1.2.5 Relationship of ASC 860-20-35-2 to Other U.S. GAAP

4.4.1.2.5.1 ASC 320-10

ASC 320-10-35-38 through 35-43 address the recognition of interest income and balance sheet classification of structured notes in the form of debt securities. Such debt securities may also be within the scope of ASC 860-20-35-2. In these circumstances, ASC 320-10-35-38(h) applies. ASC 320-10- 35-38(h) states:

Structured note securities that, by their terms, suggest that it is reasonably possible that the entity could lose all or substantially all of its original investment amount (for other than failure of the borrower to pay the contractual amounts due). (Such securities shall be subsequently measured at fair value with all changes in fair value reported in earnings.)

Therefore, the debt securities must be accounted for at fair value, with changes in fair value recognized in earnings.

4.4.1.2.5.2 ASC 323-10

ASC 323-30

Transactions

15-4 This Subtopic does not provide guidance for investments in limited liability companies that are required to be accounted for as debt securities pursuant to paragraph 860-20-35-2.

If an investor is considering whether a beneficial interest in a securitization entity should be accounted for by using the equity method in ASC 323-10 or in accordance with ASC 860-20-35-2, the investment should be accounted for in accordance with ASC 860-20-35-2. This is because the equity method does not apply to investments in LLCs, trusts, and similar entities to which ASC 860-20-35-2 applies. See Section 2.3.5 of Deloitte’s Roadmap Equity Method Investments and Joint Ventures for more information.

4.4.1.2.5.3 ASC 325-40

ASC 325-40 generally applies to financial assets within the scope of ASC 860-20-35-2. ASC 325-40 addresses the recognition of interest income and impairment of financial assets within its scope.

4.4.1.2.5.4 ASC 815-15

As discussed in Section 4.4.1.1, financial assets within the scope of ASC 860-20-35-2 that are not freestanding derivatives in their entirety generally represent hybrid financial assets with an embedded derivative that must be separated under ASC 815-15-25-26(a) unless (1) they are classified as trading securities or (2) a specific exemption from derivative accounting applies.7 Separation of this embedded derivative does not, however, obviate the need to account for the host contract under ASC 860-20-35-2.

4.4.1.2.5.5 ASC 860-30

ASC 860-20-35-2 does not apply to a transfer of financial assets that fails to meet the conditions in ASC 860-10-40-5 for sale accounting because the transferred financial assets are not derecognized. It is not appropriate to change the measurement of transferred financial assets that do not qualify for sale accounting. Thus, ASC 860-20-35-2 would apply to a transferred financial asset that failed to qualify for sale accounting only if it applied before the transfer. In that situation, the transfer would not change the accounting for the transferred financial asset.

4.4.1.2.6 Reconsideration

ASC 860-20

Loan That Can Be Prepaid or Otherwise Settled in Such a Way That the Holder Would Not Recover Substantially All of the Recorded Investment at Initial Acquisition

55-38 A loan (that is not a debt security) that when initially obtained could be contractually prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment may be reclassified as held for investment later in its life (that is, at a date that is so close to the financial asset’s maturity that the holder would recover substantially all of its recorded investment even if it was prepaid). That is, the loan would no longer be required to be measured in accordance with the guidance in paragraph 860-20-35-2 if both of the following conditions are met:

It would no longer be possible for the holder not to recover substantially all of its recorded investment upon contractual prepayment or settlement.
The conditions for amortized cost accounting are met (for example, paragraphs 310-10-35-47 and 948-310-25-1).

However, any unrealized holding gain or loss arising under the available-for-sale classification that exists at the date of the reclassification would continue to be reported in other comprehensive income but should be amortized over the remaining life of the loan as an adjustment of yield. (The loan would not be classified as held to maturity because under Topic 320 only debt securities may be classified as held to maturity.)

ASC 860-20-55-38 indicates that it is possible for a financial asset (other than a freestanding derivative) that was initially subject to ASC 860-20-35-2 to be later reclassified as a held-to-maturity security. However, such reclassification is appropriate only if it is no longer possible for the holder not to recover substantially all of its recorded investment upon contractual prepayment or settlement. Note that this determination is made on the basis of the contractual terms of the instrument and not on the basis of the probability of recovering substantially all of the recorded investment. This guidance should not be interpreted as meaning that continual assessment is required in all circumstances. For example, the evaluation of whether a beneficial interest in securitized financial assets is within the scope of ASC 860-20-35-2 is usually only necessary as of the initial date of investment because a conclusion can be reached on the basis of the contractual terms of the securitization entity (i.e., the entity’s design) and would not change after initial recognition of the beneficial interest.

4.4.2 Credit Risk

4.4.2.1 General

ASC 860-20

Distinguishing New Interests Obtained From Part of a Beneficial Interest Obtained

25-6 In determining whether credit risk is a separate liability or part of a beneficial interest that has been obtained by the transferor, the transferor should focus on the source of cash flows in the event of a claim by the transferee. If the transferee can only look to cash flows from the underlying financial assets, the transferor has obtained a portion of the credit risk only through the interest it obtained and a separate obligation shall not be recognized. Credit losses from the underlying assets would affect the measurement of the interest that the transferor obtained. In contrast, if the transferor could be obligated for more than the cash flows provided by the interest it obtained and, therefore, could be required to reimburse the transferee for credit-related losses on the underlying assets, the transferor shall record a separate liability. It is not appropriate for the transferor to defer any portion of a resulting gain or loss (or to eliminate gain on sale accounting, as it is sometimes described in practice).

Credit Enhancements

35-8 While this Subtopic does not specifically address the subsequent measurement of credit enhancements, there are some factors to consider. Factors such as how much cash the transferor will receive from, for example, a cash reserve account, and when it will receive cash inflows depend on the performance of the transferred financial assets. Entities shall regularly review those assets for impairment because of their nature. Entities shall look to other guidance for subsequent measurement including guidance for impairment based on the nature of the credit enhancement.

Credit Risk Associated With Transferred Assets

55-24 A transferor may hold some portion of the credit risk associated with a transfer of an entire financial asset or group of entire financial assets. For example, a transferor may incur a liability to reimburse the transferee, up to a certain limit, for a failure of debtors to pay when due (a recourse liability). In that circumstance, a liability should be separately recognized and initially measured at fair value. That liability should be subsequently measured according to guidance in other Topics for measuring similar liabilities. In other circumstances, a transferor may provide credit enhancement through its ownership of a beneficial interest in the transferred financial assets if that beneficial interest is not paid until the other investors in the transferred financial assets are paid, thereby resulting in the transferor absorbing much of the related credit risk. As a result, the beneficial interests that are obtained by the transferor should be initially recognized according to paragraph 860-20-25-1.

55-24A If the transfer does not consist of an entire financial asset or group of entire financial assets, the transferred financial asset must meet the definition of a participating interest. Paragraph 860-10-40-6A(c)(4) states that, to meet that definition, participating interest holders shall have no recourse to the transferor (or its consolidated affiliates included in the financial statements being presented or its agents) or to each other, other than any of the following:

Standard representations and warranties
Ongoing contractual obligations to service the entire financial asset and administer the transfer contract
Contractual obligations to share in any set-off benefits received by any participating interest holder.

That recourse would result in the transfer being accounted for as a secured borrowing under Subtopic 860-30.

ASC 860-20-30-1 requires a transferor to initially measure any asset obtained or liability incurred at fair value. ASC 860-20-25-6 provides guidance on determining whether a credit enhancement represents a separate liability incurred in a sale of financial assets or is part of a beneficial interest in transferred financial assets that is received as part of the proceeds in a sale of financial assets. That guidance notes that the transferor should focus on the source of cash flows in the event of a claim by the transferee. If the transferee can look only to the cash flows from underlying financial assets, the transferor is exposed to credit risk only through the beneficial interest that it has obtained. In that situation, credit losses from the underlying financial assets affect the measurement of the transferor’s beneficial interest (i.e., impairment of the beneficial interest). If, however, the transferor could be obligated for more than the cash flows provided by the interest it obtains and, therefore, could be required to reimburse the transferee for credit-related losses on the underlying assets, the transferor must record a separate liability as of the date of sale at fair value.

While ASC 860-20 does not specifically address the subsequent measurement of credit enhancements, ASC 860-20-35-8 discusses some factors to consider. These factors are relevant to both the (1) initial fair value of a beneficial interest or separate liability for a credit enhancement feature and (2) subsequent measurement of these items.

4.4.2.2 Accounting for Recourse Obligations Incurred in a Sale of Financial Assets

4.4.2.2.1 General

ASC 860-30 — Glossary

Recourse

The right of a transferee of receivables to receive payment from the transferor of those receivables for any of the following:

Failure of debtors to pay when due
The effects of prepayments
Adjustments resulting from defects in the eligibility of the transferred receivables.

Transferors of financial assets often provide recourse to transferees. Such obligations must be evaluated under ASC 815-10 to see whether they meet the definition of a derivative. If such obligations do not meet the definition of a derivative, they are generally accounted for as guarantees under ASC 460-10.

There are many forms of recourse that a transferor may provide in a transfer of financial assets that is accounted for as a sale. One common example is representations and warranties made to transferees. In effect, these representations and warranties guarantee certain aspects of the financial assets transferred. In the case of mortgage loans, the transferor could guarantee the validity of the mortgage lien, the accuracy of the mortgage loan characteristics, the status of the mortgage loan, and compliance with federal and local lending requirements. In addition, subprime originators who sell mortgage loans often will include EPD provisions guaranteeing that a transferred loan will not default during the first several months after a loan sale. If a representation, warranty, or other guarantee is triggered, the transferor generally is required to repurchase the related asset, provide a replacement asset, or reimburse the transferee for the loss it incurred.

Representations, warranties, and other guarantees related to transferred financial assets that are recorded as sales between unrelated parties must be accounted for under ASC 460 (or ASC 815 if the guarantees meet the definition of a derivative instrument).

4.4.2.2.2 Initial Measurement

ASC 460-10-15-4(a) states that “[c]ontracts that contingently require a guarantor to make payments . . . to a guaranteed party based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party” are subject to the accounting and disclosure requirements of ASC 460. Both ASC 460-10-30-2 and the example in ASC 860-20-55-43 through 55-45 require that, upon sale, such a liability be initially measured at the fair value of the representation, warranty, or other guarantee. This requirement is consistent with ASC 860-20, under which a liability must be recognized at fair value for any recourse provision in a transfer of financial assets that is accounted for as a sale.

A recourse obligation (i.e., a guarantee liability) must be initially measured in accordance with the fair value guidance in ASC 820. That is, the liability initially recognized as of the sale date should include all expected credit losses over the life of the arrangement. Such initial measurement differs from the measurement of liabilities for loss contingencies in accordance with ASC 450-20. If a present value technique is used to measure the fair value of a guarantee liability, the discount rate used should be commensurate with the risk of the obligation. For more information about fair value measurements, see Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option).

Connecting the Dots

A guarantee liability is a separate unit of account that may not be offset against other assets obtained in a sale of financial assets. However, in certain situations, the transferor may have an interest in an escrow account that is established to fund losses incurred by a transferee. Amounts may accumulate in the escrow account on the basis of the excess of coupon interest on transferred financial assets over the interest paid to the transferee. If the recourse obligation cannot contractually exceed the amount in the escrow account and any remaining amount in that account is reverted to the transferor, there is no recourse obligation for the transferor to recognize. Instead, the transferor has a beneficial interest (i.e., an asset) in the escrow account that it recognizes as of the date of sale. See ASC 860-20-25-6.

4.4.2.2.3 Subsequent Measurement

ASC 460-10

35-2 Depending on the nature of the guarantee, the guarantor’s release from risk has typically been recognized over the term of the guarantee using one of the following three methods:

Only upon either expiration or settlement of the guarantee
By a systematic and rational amortization method
As the fair value of the guarantee changes.

Although those three methods are currently being used in practice for subsequent accounting, this Subsection does not provide comprehensive guidance regarding the circumstances in which each of those methods would be appropriate. A guarantor is not free to choose any of the three methods in deciding how the liability for its obligations under the guarantee is measured subsequent to the initial recognition of that liability. A guarantor shall not use fair value in subsequently accounting for the liability for its obligations under a previously issued guarantee unless the use of that method can be justified under generally accepted accounting principles (GAAP). For example, fair value is used to subsequently measure guarantees accounted for as derivative instruments under Topic 815.

ASC 460 does not include detailed guidance on the subsequent accounting for an entity’s obligation under a guarantee; however, ASC 460-10-35-2 gives examples of methods guarantors have typically used to derecognize guarantee liabilities in subsequent periods. The application of the appropriate method will depend on the nature of the risk underlying the guarantee obligation.

For further discussion of the recognition and measurement of guarantee liabilities under ASC 460-10, including the accounting for guarantees that are subject to ASC 326-20, see Chapter 5 of Deloitte’s Roadmap Contingencies, Loss Recoveries, and Guarantees.

4.4.3 Beneficial Interests

4.4.3.1 General

ASC 860-20

Beneficial Interests

35-9 Beneficial interests shall be evaluated periodically for possible impairment, including at the time paragraphs 860-20-25-8 through 25-10 are applied. See Section 325-40-35 for impairment guidance applicable to beneficial interests in securitized financial assets.

Pending Content (Transition Guidance: ASC 326-10-65-1)

35-9 Beneficial interests shall be evaluated for credit losses, including at the time paragraphs 860-20-25-8 through 25-10 are applied. See Section 325-40-35 for guidance on credit losses applicable to beneficial interests in securitized financial assets.

Estimating the Fair Value of Certain Beneficial Interests

55-16 Trust liquidation methods that allocate receipts of principal or interest between beneficial interest holders and transferors in proportions different from their stated percentage of ownership interests do not affect whether the transferor should obtain sale accounting and derecognize those transferred assets, assuming the trust is not required to be consolidated by the transferor. However, both turbo and bullet provisions in securitization structures (as discussed in paragraph 860-10-05-3) should be taken into consideration in determining the fair values of assets obtained by the transferor and transferee.

ASC 860-10 broadly defines beneficial interests as including any right to receive all or portions of the specified cash inflows received by a trust or other securitization entity. Beneficial interests could include fixed-maturity debt instruments, CP obligations, or residual interests (i.e., equity interests in a securitization trust). ASC 860-20-35-9 reminds entities to evaluate beneficial interests for impairment, which exists when the fair value of a beneficial interest is less than its carrying amount. ASC 860-20-55-16 addresses considerations related to the fair value measurement of a beneficial interest. See Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option) for further discussion of the fair value guidance in ASC 820.

Connecting the Dots

Investments in beneficial interests in securitized financial assets are almost always accounted for as debt securities. Such investments can be accounted for as equity securities only if all the following conditions are met:

The instrument is issued as an equity security in legal form.
The instrument does not contain creditor rights.
The securitized financial assets are equity instruments with no stated cash flows.
The securitization entity is not required to pass through cash flows collected on the underlying financial assets of the securitization entity (either periodically or at any other time) or to redeem the instrument at other than final liquidation of the securitization entity (i.e., the investor does not have the right to put the instrument).

A beneficial interest that is (1) a debt instrument in legal form or (2) within the scope of ASC 860-20-35-2 is always accounted for as a debt security. In addition, most beneficial interests that are equity in legal form meet the definition of a debt security. In the unusual circumstance in which a beneficial interest is classified as an equity security, the guidance in ASC 325-40 would not apply. The guidance in ASC 320-10-35-38 on structured notes addresses the accounting for beneficial interests involving securitized financial assets that do not have contractual cash flows (whether classified as a debt security or an equity security).

4.4.3.2 Classification of Beneficial Interests

4.4.3.2.1 Classification as Held to Maturity

ASC 860-20

Classification of a Residual Tranche in a Securitization as Held to Maturity

55-39 Whether a residual tranche debt security in a securitization of financial assets (for example, receivables) using a securitization entity can be classified as held to maturity depends on the facts and circumstances. If the contractual provisions of the residual tranche debt security provide that the residual tranche can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment, paragraph 860-20-35-2 precludes the residual tranche debt security from being accounted for as held to maturity. In contrast, if the only way that the holder of the residual tranche would not recover substantially all of its recorded investment would be in response to a default by the borrower (debtor), then a held-to-maturity classification is acceptable if the conditions specified for a held-to-maturity classification in paragraphs 320-10-25-1(c) and 320-10-25-5(a) have been met.

To classify a beneficial interest in securitized financial assets as a held-to-maturity security, the investor must be able to demonstrate that the interest cannot be contractually prepaid or otherwise settled in such a way that it would not recover substantially all of its recorded investment. If this condition is not met, the investor must classify its beneficial interest as available for sale or trading (provided that the beneficial interest does not meet the definition of a derivative instrument in ASC 815). In issuing the guidance that is codified in ASC 860-20-35-2, the FASB intended to limit the use of the held-to-maturity category to those instruments for which the holder would recover its recorded value regardless of the interest rate environment (e.g., the investor was not exposed to losses from prepayments). This limitation does not apply to events that are not the result of contractual provisions (e.g., borrower defaults). For further discussion of the guidance in ASC 860-20-35-2, see Section 4.4.1.

It would be rare for an entity not to be required to classify a beneficial interest as an available-for-sale or trading security under ASC 860-20-35-2, except for the most senior interests in a securitization entity. This is because beneficial interests in securitized financial assets are generally exposed to prepayment risk, interest rate risk (e.g., basis risk), or reinvestment risk (see Table 4-3). In FASB Statement 134, the FASB indicated that it does not expect beneficial interests to be classified as held to maturity.

Many beneficial interests are subject to the guidance in ASC 325-40 on interest income and impairment. See Section 4.4.1.2.5.3 for more information.

4.4.3.2.2 Beneficial Interests Held by a Transferor in a Credit Card Securitization

Most credit card securitization entities must be consolidated by the transferor. However, if an entity transfers credit card receivables to an unconsolidated securitization entity that meets the conditions for sale accounting and obtains a beneficial interest in the sold receivables in the form of a pro rata undivided interest that is not certificated, the transferor may account for that interest as a loan provided that it cannot be contractually prepaid or otherwise settled in a manner that would cause the transferor not to recover substantially all of its initial recorded investment. In this situation, the beneficial interest does not need to be accounted for as a debt security because it (1) does not meet the definition of a debt security and (2) is not within the scope of ASC 860-20-35-2. Such interest is often referred to as the “seller’s interest.” If such interest is used to replenish credit card receivables owned by the securitization entity when they are repaid (e.g., the seller’s interest is transferred to third-party beneficial interest holders when receivable balances are paid off), this loan receivable should be classified as HFS rather than as HFI. See Section 4.4.4 for further discussion of accrued interest receivable on an investor’s portion of transferred credit card receivables.

4.4.4 Accrued Interest Receivable

ASC 860-20

Accrued Interest Receivable

55-17 The receivables for accrued fee and finance charge income on an investors’ portion of the transferred credit card receivables, whether billed but uncollected or accrued but unbilled, are commonly referred to as accrued interest receivable. The following addresses how the accrued interest receivable related to securitized and sold receivables should be accounted for and reported under this Subtopic. This guidance applies to credit card securitizations as well as other kinds of securitizations.

55-18 The right to receive the accrued interest receivable, if and when collected, is transferred to the securitization trust. Generally, if a securitization transaction meets the criteria for sale treatment and the accrued interest receivable is subordinated either because the asset has been isolated from the transferor (see paragraph 860-10-40-5) or because of the operation of the cash flow distribution (or waterfall) through the securitization trust, the total accrued interest receivable should be considered to be one of the components of the sale transaction. Therefore, under the circumstances described, the accrued interest receivable asset should be accounted for as a transferor’s interest. It is inappropriate to report the accrued interest receivable related to securitized and sold receivables as loans receivable or other terminology implying that it has not been subordinated to the senior interests in the securitization.

55-19 While, under the circumstances described, the accrued interest receivable is a transferor’s interest, it is not required to be subsequently measured like an investment in debt securities classified as available for sale or trading under Topic 320 or the Transfers and Servicing Topic because the accrued interest receivable cannot be contractually prepaid or settled in such a way that the owner would not recover substantially all of its recorded investment. Entities should follow existing applicable accounting standards, including Topic 450, in subsequent accounting for the accrued interest receivable asset.

Pending Content (Transition Guidance: ASC 326-10-65-1)

55-19 While, under the circumstances described, the accrued interest receivable is a transferor’s interest, it is not required to be subsequently measured like an investment in debt securities classified as available for sale or trading under Topic 320 or the Transfers and Servicing Topic because the accrued interest receivable cannot be contractually prepaid or settled in such a way that the owner would not recover substantially all of its recorded investment. Entities should follow existing applicable accounting standards, including Topic 326 on measurement of credit losses, in subsequent accounting for the accrued interest receivable asset.

ASC 860-20-55-17 describes accrued interest receivables on an investor’s portion of transferred credit card receivables. In addition, ASC 860-20-55-18 indicates that in a securitization transaction that is accounted for as a sale, an accrued interest receivable asset that is subordinated “should be accounted for as a transferor’s interest” (i.e., as a beneficial interest). ASC 860-20-55-18 further notes that it would be inappropriate to report this accrued interest receivable as “loans receivable.” Moreover, ASC 860-20-55-19 clarifies that, in such circumstances, the accrued interest receivable does not need to be subsequently measured in a manner similar to an investment in debt securities classified as available for sale or trading because the accrued interest receivable cannot be contractually prepaid or settled in such a way that the investor would not recover substantially all of its recorded investment. Rather, entities should apply existing applicable accounting standards when subsequently accounting for the accrued interest receivable.

Although the accounting described above is discussed in the context of credit card receivables, this guidance also applies to other types of securitization transactions.

4.4.5 Options Embedded in Transferred Securities

ASC 860-20

Options Embedded in Transferred Securities

55-20 This guidance addresses transactions that involve the sale of a marketable security to a third-party buyer, with the buyer’s having an option to put the security back to the seller at a specified future date or dates for a fixed price. Because of the put option, the seller generally receives a premium price for the security.

55-21 If the transfer is accounted for as a sale, a put option that enables the holder to require the writer of the option to reacquire for cash or other assets a marketable security or an equity instrument issued by a third party should be accounted for as a derivative by both the holder and the writer, provided the put option meets the definition of a derivative in paragraph 815-10-15-83 (including meeting the net settlement requirement, which may be met if the option can be net settled in cash or other assets or if the asset required to be delivered is readily convertible to cash). If multiple put options exist, recognition of the multiple put options as liabilities, and initial measurement at fair value, are required.

55-22 A put option that is issued as part of a transfer being accounted for as a sale that is not accounted for as a derivative under Subtopic 815-10 would be considered a guarantee under paragraph 460-10-55-2(b) and would be subject to its initial recognition, initial measurement, and disclosure requirements. If the written put option is accounted for as a derivative under Subtopic 815-10 by the seller-transferor, then the put option would be subject to only the disclosure requirements of Topic 460.

55-23 If the transaction is accounted for as a secured borrowing under Subtopic 860-30, any difference between the sale proceeds and the put price shall be accrued as interest expense, and any impairment of the underlying security would generally not be recognized. The difference between the original sale price and the put price should be amortized over the period to the first date the securities are eligible to be put back. If the transfer is accounted for as a secured borrowing, the put option falls under paragraph 815-10-15-63, which provides a scope exception for a derivative instrument (such as the put option) that serves as an impediment to sale accounting under Subtopic 860-10. The guidance in paragraph 815-10-55-41 may also be relevant.

ASC 860-20-55-20 through 55-23 address a scenario involving a sale of a marketable security to a third party accompanied by a put option that allows the buyer “to put the security back to the seller at a specified future date . . . for a fixed price.” In this transaction, if the transfer meets the conditions for sale accounting, the transferor must account for the put option as either a derivative instrument under ASC 815 or a guarantee under ASC 460. If the transferor accounts for the transfer as a secured borrowing, the put option should not be accounted for as a derivative instrument because of the scope exception in ASC 815-10-15-63. In this situation, the transferor should also consider the guidance in ASC 815-10-55-41.

4.4.6 Transfer of a Bond Purchased at a Premium

ASC 860-20

Transfer of a Bond Purchased at a Premium

55-25 Assume an entity transfers a bond to an unconsolidated entity for cash and beneficial interests. When the transferor purchased the bond, it paid a premium for it (or bought it at a discount), and that premium (or discount) was not fully amortized (or accreted) at the date of the transfer. In other words, the carrying amount of the bond included a premium (or discount) at the date of the transfer. If the transfer of the bond is accounted for as a secured borrowing under Subtopic 860-30, the transferor would continue to amortize (or accrete) the premium (or discount) because paragraph 860-30-25-2 requires that the transferor continue to report the transferred financial assets in its statement of financial position with no change in their measurement (that is, basis of accounting). If the transfer of the bond satisfies the conditions to be accounted for as a sale, any beneficial interests received as proceeds would be initially recognized at fair value. As a result, the previously existing premium (or discount) would not continue to be amortized (or accreted); rather, the unamortized (or nonaccreted) amount would be included in the calculation of the gain (or loss) as of the transfer date.

ASC 860-20-55-25 addresses how a transferor accounts for the transfer of a bond that contains a premium. The accounting depends on whether the transfer is accounted for as a sale or as a secured borrowing.

4.4.7 Transfer of Lease Receivables

ASC 860-20

Sales or Securitizations of Lease Receivables

55-26 A transferor of lease receivables shall allocate the gross investment in receivables between lease payments, residual values guaranteed at commencement, and residual values not guaranteed at commencement using the individual carrying amounts of those components at the date of transfer. Those transferors also shall record a servicing asset or liability in accordance with Subtopic 860-50, if appropriate.

55-27 See paragraph 860-10-55-6 for further discussion of lease receivables.

Example 5: Transfer of Lease Receivables With Residual Values

55-58 This Example illustrates the guidance in paragraph 860-20-25-1. At the beginning of the second year in a 10-year sales-type lease, Entity E transfers for $505 a nine-tenths participating interest in the lease receivable to an independent third party, and the transfer is accounted for as a sale. Entity E retains a one-tenth participating interest in the lease receivable and a 100 percent interest in the unguaranteed residual asset, which is not subject to the requirements of this Subtopic as discussed in paragraph 860-10-55-6 because it is not a financial asset and, therefore, is excluded from the analysis of whether the transfer of the nine-tenths participating interest in the lease receivable meets the definition of a participating interest. The servicing asset has a fair value of zero because Entity E estimates that the benefits of servicing are just adequate to compensate it for its servicing responsibilities. The carrying amounts and related gain computation are as follows.

55-59 The following journal entry is made by Entity E.

ASC 860-20-55-26 and 55-27 discuss how a transferor of lease receivables allocates the carrying amount of those receivables in the calculation of a gain or loss when the transfer meets the conditions for sale accounting. ASC 860-20-55-58 and 55-59 include an example illustrating the application of such guidance.

4.4.8 Forward Contracts in Revolving-Period Securitizations

4.4.8.1 General

ASC 860-20

Forward Contracts in Revolving-Period Securitizations

55-29 The requirement that all financial assets obtained and liabilities incurred by the transferor of a securitization that qualifies as a sale shall be recognized and measured as provided in this Subtopic includes the implicit forward contract to sell additional financial assets during a revolving period. Such a forward contract may become valuable or onerous to the transferor as interest rates and other market conditions change.

55-30 The value of the forward contract implicit in a revolving-period securitization arises from the difference between the agreed-upon rate of return to investors on their beneficial interests in the trust and current market rates of return on similar investments. For example, if the agreed-upon annual rate of return to investors in a trust is 6 percent, and later market rates of return for those investments increased to 7 percent, the forward contract’s value to the transferor (and burden to the investors) would approximate the present value of 1 percent of the amount of the investment for each year remaining in the revolving structure after the receivables already transferred have been collected. If a forward contract to sell receivables is entered into at the market rate, its value at inception may be zero. Changes in the fair value of the forward contract are likely to be greater if the investors receive a fixed rate than if the investors receive a rate that varies based on changes in market rates.

55-31 Gain or loss recognition for revolving-period receivables sold to a securitization trust is limited to receivables that exist and have been sold.

In some securitization transactions, the transferor agrees to sell additional financial assets to a securitization entity during a revolving period. ASC 860-20-55-29 requires the transferor to recognize the fair value of such a forward sale arrangement as part of the proceeds received (or liabilities incurred) that are recognized in accordance with ASC 860-20-25-1 and ASC 860-20-30-1 as of the date of sale.

However, any gain or loss recognition for revolving-period receivables sold to a securitization entity is limited to the receivables that exist and have been sold. Similarly, a servicing asset or servicing liability is only recognized for receivables that exist and have been sold. Section 4.4.8.2 discusses the transferor’s accounting for a securitization transaction that involves a prefunding provision.

4.4.8.2 Securitization Transactions With Prefunding Provisions

Some securitization transactions contain a prefunding feature in which the principal amount of beneficial interests that are issued is greater than the principal amount of the financial assets that are initially transferred to the securitization entity. The excess proceeds are deposited in a prefunding account and reinvested until additional eligible financial assets are subsequently transferred to the securitization entity. Because the interest rate earned by the securitization entity from investing the amounts in the prefunding account is generally less than the interest rate on the beneficial interests issued to third-party investors, the transferor is required to fund a capitalized interest account to make up for the “negative carry” (i.e., the interest deficit during the funding period). If the transferor is unable to deliver additional eligible financial assets, the amounts in the prefunding account are paid out to beneficial interest holders.

In a securitization transaction with a prefunding provision that qualifies as a sale, in calculating the gain or loss on sale at the initial transfer date, a transferor may not assume that additional eligible financial assets will be transferred because ASC 860-20-55-31 does not permit recognition of gains or losses on financial assets that have not yet been transferred. ASC 860-20-55-31 states that “[g]ain or loss recognition for revolving-period receivables sold to a securitization trust is limited to receivables that exist and have been sold” (emphasis added). Accordingly, regardless of its prior experience with similar transactions, the transferor must assume, as of the initial transfer date, that no additional financial assets will be transferred to the securitization entity and that the prefunding account will be paid out to the beneficial interest holders according to the “waterfall” (contractual terms specifying the allocation of cash flows to the vehicle’s interests and obligations) on the earliest possible date. As the transferor makes additional transfers to the securitization entity, additional gains or losses should be recorded on the basis of the proceeds received and the carrying amount of the financial assets sold.

4.4.9 Purchase of Credit Card Receivables

4.4.9.1 Acquisition of Individual Credit Card Receivables

ASC 310-20

Credit Card Arrangements

05-4 An entity (credit card issuer) may acquire credit card accounts by paying an amount to a third party. The credit card accounts typically have no outstanding receivable balances at the time acquired. The credit card accounts are acquired individually (one at a time) by paying an amount for each approved credit card agreement. The third party may be any of the following:

A direct marketing specialist
An affinity group (a professional, cultural, or other organization)
A cobrander (an airline entity, automobile manufacturing entity, hotel entity, or other commercial or retailing entity). Under a cobranding arrangement, the third party’s name is included on the credit card, and the third party has a continuing obligation to provide goods or services, such as product discounts, to cardholders for an extended period that directly or indirectly benefits the credit card issuer.

Credit Card Fees and Costs

25-18 Credit card accounts acquired individually shall be accounted for as originations under this Subtopic. Amounts paid to a third party to acquire individual credit card accounts shall be deferred and netted against the related credit card fee, if any.

Credit Card Fees and Costs

35-8 Any net amount deferred in accordance with paragraph 310-20-25-18 shall be amortized on a straight-line basis over the privilege period.

Credit card accounts acquired individually, as discussed in ASC 310-20-05-4, are considered originations. Therefore, in such situations, the purchaser (transferee) does not apply ASC 860. Rather, the above guidance in ASC 310-20 applies.

4.4.9.2 Acquisition of Portfolio of Credit Card Receivables

ASC 310-10

Credit Card Portfolio Purchased

25-7 When an entity purchases a credit card portfolio that includes the cardholder relationships at an amount that exceeds the sum of the amounts due under the credit card receivables, the difference between the amount paid and the sum of the balances of the credit card loans at the date of purchase (the premium) shall be allocated between the cardholder relationships acquired and the loans acquired. The premium relating to the cardholder relationships represents an identifiable intangible asset that shall be accounted for in accordance with Topic 350.

Premium Allocated to Loans Purchased in a Credit Card Portfolio

35-52 When an entity purchases a credit card portfolio that includes the cardholder relationships as discussed in paragraph 310-10-25-7, at an amount that exceeds the sum of the amounts due under the credit card receivables, the premium allocated to the loans shall be amortized over the life of the loans in accordance with Subtopic 310-20. If the credit card agreement provides for a repayment period beyond expiration of the card if the card is not renewed, that period shall be considered in determining the life of the credit card loan.

ASC 860-10 applies to the purchase of a portfolio of credit card receivables. If the transfer meets the conditions for a sale, the transferee must allocate the purchase price to the financial assets and nonfinancial assets acquired. ASC 310-20-35-4 through 35-8 provide guidance that entities may find helpful in amortizing the premium assigned to the credit card receivables.