Chapter 6 — Servicing Assets and Liabilities

6.4 Subsequent Measurement

6.4.1 General

6.4.1.1 Accounting Election

ASC 860-50

35-1 An entity shall subsequently measure each class of servicing assets and servicing liabilities using either of the following methods:

Amortization method. Amortize servicing assets or servicing liabilities in proportion to and over the period of estimated net servicing income (if servicing revenues exceed servicing costs) or net servicing loss (if servicing costs exceed servicing revenues), and assess servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date.
Fair value measurement method. Measure servicing assets or servicing liabilities at fair value at each reporting date and report changes in fair value of servicing assets and servicing liabilities in earnings in the period in which the changes occur.

35-1A A servicing asset may become a servicing liability, or vice versa, if circumstances change.

35-2 The election described in paragraphs 860-50-35-1 through 35-5 shall be made separately for each class of servicing assets and servicing liabilities.

35-3 The following guidance applies to the election of a method for subsequent measurement of servicing assets and servicing liabilities: . . .

b. Different elections can be made for different classes of servicing assets and servicing liabilities. . . .

f. If an entity recognizes a new class of servicing assets and servicing liabilities, and no servicing assets and servicing liabilities that would belong to this class had previously been recognized by the entity, the entity may elect to subsequently measure that new class of servicing assets and servicing liabilities at fair value at the date of initial recognition of those servicing assets and servicing liabilities.

35-4 An entity shall apply the same subsequent measurement method to each servicing asset and servicing liability in a class.

Contractual rights to service financial assets are initially recorded at fair value and are subsequently accounted for by using the amortization method or fair value method, as elected by the servicer. That is, ASC 860-50 requires entities to elect an accounting policy, at the class level, of subsequently measuring servicing assets and servicing liabilities at amortization cost or fair value. Entities can make different elections for different classes of servicing rights. However, once an election is made for a class, this election must apply to any subsequently recognized servicing assets or servicing liabilities that become part of that class. If an entity recognizes a new class of servicing assets and servicing liabilities, it may elect to subsequently measure that new class by using the amortization method or fair value method as of the date of initial recognition of those servicing rights.

Connecting the Dots

A class may consist of only servicing assets (i.e., because there are no servicing liabilities for the class of servicing rights) or only servicing liabilities. However, classes are not determined on the basis of whether servicing rights constitute servicing assets or servicing liabilities (e.g., a class may not be designated as including only servicing assets if there are servicing liabilities that fall within the class). As discussed in ASC 860-50-35-1A, a servicing asset may become a servicing liability because of changes in circumstances, or vice versa. Such changes would not cause those servicing rights to switch classes. See Section 6.4.1.1.2 for more information about the subsequent accounting for servicing contracts that no longer provide adequate compensation.

The table below compares the two accounting methods that may be elected for subsequently measuring servicing rights.

Table 6-2

	Amortization Method	Fair Value Method
Initial recorded amount	Fair value.	Fair value.
Income recognition	Recognize periodic servicing fee income; amortize the servicing rights in proportion to and over the period of estimated net servicing income (loss).	Recognize both servicing fee income and fair value adjustments in earnings currently. (ASC 860-50 does not specifically address income statement classification.)
Balance sheet carrying value	Servicing assets — Adjust initial recorded amount for accumulated amortization, valuation allowances, write-downs, and fair value hedge adjustments, if any. Servicing liabilities — Record an increase in the servicing obligation if the fair value of the liability increases above its carrying value. Record subsequent decreases in fair value; however, do not reduce the obligation below the amortized measurement of the recognized servicing liability.	Fair value.
Recognition of impairment on servicing assets	Recognize via a valuation allowance established for an individual stratum of servicing assets when the carrying amount exceeds fair value. Recognize changes in the valuation allowance in earnings; however, fair value in excess of the carrying amount of a stratum cannot be recognized. ASC 860-50 does not preclude a direct write-down of servicing assets.	Any impairment is reflected in the change in fair value of the servicing asset that is recognized in earnings.

6.4.1.1.1 Subsequent-Measurement Election for Contracts With an Initial Fair Value of Zero

An entity may enter into a contract to service financial assets that initially has a fair value of zero because the benefits of servicing approximate adequate compensation. Although no servicing asset or servicing liability is initially recognized, the entity must still elect a subsequent-measurement method under ASC 860-50-35-1 at inception of the servicing contract. Further, while the fair value of the servicing right is zero at inception, the subsequent accounting for the servicing right depends on the measurement method elected at inception. A change in circumstances could cause the servicing contract to become an asset or a liability in the future. Accordingly, it must be assigned to a class measured by using the fair value method or the amortization method. If the contract is subsequently measured by using the amortization method, it can never be recognized as a servicing asset because the initial amortized cost is zero. Sections 6.4.1.1.2 and 6.4.2.2.3 discuss the subsequent accounting for servicing assets that no longer provide adequate compensation. Section 6.4.1.2 discusses the identification of classes of servicing rights.

6.4.1.1.2 Servicing Asset That No Longer Provides Adequate Compensation

An entity may enter into a contract to service financial assets that, on the basis of the facts and circumstances at inception, will provide more than adequate compensation. As a result, a servicing asset is recognized at inception. If, in a subsequent period, it is determined that the contract no longer provides adequate compensation, the servicer must recognize a servicing liability in accordance with ASC 860-50-35-1A. See Sections 6.4.2.2.3 and 6.4.3 for discussion of the accounting for the change, which depends on the subsequent-measurement method elected.

6.4.1.2 Determining Classes of Servicing Assets and Servicing Liabilities

6.4.1.2.1 General

ASC 860-50

35-5 Classes of servicing assets and servicing liabilities shall be identified based on any of the following:

The availability of market inputs used in determining the fair value of servicing assets or servicing liabilities
An entity’s method for managing the risks of its servicing assets or servicing liabilities.

35-6 Under the approach in the preceding paragraph, a servicer may or may not consider the major asset type of the underlying financial asset being serviced when identifying its classes of separately recognized servicing assets and servicing liabilities. Further, this approach for defining classes of servicing assets and servicing liabilities is not analogous to the stratification guidance for determining impairment of servicing assets or servicing liabilities that are subsequently measured using the amortization method.

35-7 An entity shall first identify its classes of separately recognized servicing assets and servicing liabilities under the approach in paragraph 860-50-35-5. For any class subsequently measured using the amortization method, an entity shall then stratify that class to determine if impairment has occurred, as discussed in paragraph 860-50-35-9(a).

ASC 860-50-35-2 requires entities to make a separate measurement election to subsequently measure each class of servicing rights. Even if an entity elects to subsequently measure all of its servicing rights by using a single method (i.e., the entity elects the amortization method or fair value method for all servicing rights) or a servicing right is initially recognized at zero because the benefits of servicing equal adequate compensation, the entity must still identify classes of servicing rights because ASC 860-50-50-3 requires additional disclosures by class (see Sections 6.6.2.2 and 6.6.2.3).

A servicer should identify its classes of servicing rights on the basis of (1) the availability of market inputs used in determining the fair value of servicing rights, (2) the servicer’s method for managing the risks inherent in servicing rights, or (3) a combination of the two. ASC 860-50 is silent regarding the number of classes that an entity must identify. Therefore, an entity is not precluded from identifying only one class of servicing rights. However, if an entity has only one class of servicing rights, all servicing rights must be accounted for by using the same measurement attribute (i.e., either the amortization method or the fair value method).

6.4.1.2.2 Strata Versus Classes of Servicing Rights

Classes of servicing rights are used for making subsequent-measurement elections under ASC 860-50-35 and for meeting certain disclosure requirements. Strata are used to evaluate servicing assets that are accounted for by using the amortization method for impairment. Under ASC 860-50-35-5, an entity should identify its classes of servicing rights on the basis of (1) the availability of market inputs used in determining the fair value of servicing rights, (2) the entity’s method for managing the risks of its servicing rights, or (3) a combination of the two. A stratum for an impairment analysis can be based on any predominant risk characteristic, such as financial asset type, size, interest rate, origination date, term, or geographic location. Thus, depending on an entity’s facts and circumstances, the entity could conceivably conclude that one of its existing strata also constitutes a class.

In determining fair value, an entity does not have to perform a separate impairment analysis for classes of servicing rights measured under the fair value method because the fair value includes the effects of any impairment. To evaluate and measure impairment, an entity must stratify each class of servicing rights measured under the amortization method. No stratum can be part of more than one class of servicing assets; however, multiple strata can exist within a class.

6.4.1.3 Changes to Subsequent-Measurement Methods

ASC 860-50

35-3 The following guidance applies to the election of a method for subsequent measurement of servicing assets and servicing liabilities:

a. Once an entity elects the fair value measurement method for a class of servicing assets and servicing liabilities, that election shall not be reversed. . . .

c. Once a servicing asset or a servicing liability is reported in a class of servicing assets and servicing liabilities that an entity elects to subsequently measure at fair value, that servicing asset or servicing liability shall not be placed in a class of servicing assets and servicing liabilities that is subsequently measured using the amortization method.

d. An entity may make an irrevocable decision to subsequently measure a class of servicing assets and servicing liabilities at fair value at the beginning of any fiscal year.

e. Transferring servicing assets and servicing liabilities from a class subsequently measured using the amortization method to a class subsequently measured at fair value is permitted as of the beginning of any fiscal year. If an entity makes such a transfer, subsequent measurement of servicing assets and servicing liabilities at fair value shall be applied prospectively with a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year to reflect the difference between the fair value and the carrying amount, net of any related valuation allowance, of the servicing assets and servicing liabilities that exist at the beginning of the fiscal year in which the entity makes the fair value election. . . .

ASC 860-50-30-1 requires entities to initially measure separately recognized servicing rights at fair value. An entity may subsequently elect to (1) apply the amortization method or (2) measure servicing rights at fair value, with changes in fair value recognized in earnings. ASC 860-50-35-2 requires entities to make a separate measurement election for each class of servicing rights. ASC 860-50-35-3(a) indicates that once a fair value method election is made for a class of servicing rights, it should not be reversed.

Because the fair value election is irrevocable, an entity is never allowed to transfer a class of servicing rights from a class measured under the fair value method to a class measured under the amortization method (see ASC 860-50-35-3(c)). However, in accordance with ASC 860-50-35-3(d) and (e), an entity may transfer servicing rights from a class measured under the amortization method to a class measured under the fair value method as of the beginning of any fiscal year (provided that no financial statements have been issued for that year). Any transfer of servicing rights from a class measured under the amortization method to a class measured under the fair value method must be consistent with the parameters established for identifying classes of servicing rights. For example, it may not be appropriate to transfer subprime loans to a class of conforming loans. The entry for the difference between the carrying amount, net of any valuation allowance, and the fair value should be recorded as a cumulative-effect adjustment to retained earnings as of the beginning of the year. The cumulative-effect adjustment also must be disclosed separately in the financial statements.

6.4.2 Amortization Method

6.4.2.1 General

ASC 860-50

Amortization Method — Measurement of Impairment or Increased Obligation

35-9 An entity shall evaluate and measure impairment of each class of separately recognized servicing assets that are subsequently measured using the amortization method described in paragraph 860-50-35-1(a) as follows:

Stratify servicing assets within a class based on one or more of the predominant risk characteristics of the underlying financial assets. Those characteristics may include financial asset type, size, interest rate, date of origination, term, and geographic location. For mortgage loans, financial asset type refers to the various conventional or government guaranteed or insured mortgage loans and adjustable-rate or fixed-rate mortgage loans.
Recognize impairment through a valuation allowance for an individual stratum. The amount of impairment recognized separately shall be the amount by which the carrying amount of servicing assets for a stratum exceeds their fair value. The fair value of servicing assets that have not been recognized shall not be used in the evaluation of impairment.
Adjust the valuation allowance to reflect changes in the measurement of impairment after the initial measurement of impairment. Fair value in excess of the carrying amount of servicing assets for that stratum, however, shall not be recognized.

35-10 This Subtopic does not address when an entity should record a direct write-down of recognized servicing assets.

35-11 For servicing liabilities subsequently measured using the amortization method, if subsequent events have increased the fair value of the liability above the carrying amount, for example, because of significant changes in the amount or timing of actual or expected future cash flows relative to the cash flows previously projected, the servicer shall revise its earlier estimates and recognize the increased obligation as a loss in earnings. That is, if subsequent events increase the fair value of a stratum of servicing liabilities within a class that an entity has elected to subsequently measure using the amortization method, that increase shall be recognized in earnings as a loss. Similar to the accounting for changes in a valuation allowance for an impaired asset, increases in the servicing obligation may be recovered, but the obligation shall not be reduced below the amortized measurement of the initially recognized servicing liability.

35-12 The impairment provisions of paragraphs 860-50-35-9 and 860-50-35-11 for classes of servicing assets and servicing liabilities subsequently measured using the amortization method are based on the fair value of the contract rather than the gain or loss from subsequently carrying out the terms of the contract.

35-13 An entity is not required to use either the most predominant risk characteristic or more than one predominant risk characteristic to stratify the servicing assets for purposes of evaluating and measuring impairment. An entity must exercise judgment when determining how to stratify servicing assets (that is, when selecting the most appropriate characteristic[s] for stratification). An entity may use different stratification criteria for the purposes of impairment testing under this Subtopic and for the purposes of grouping similar assets to be designated as a hedged portfolio in a fair value hedge under Subtopic 815-20. If an entity chooses not to restratify servicing assets for impairment testing under this Subtopic consistent with any restratification done for compliance with hedging criteria under Subtopic 815-20, the entity shall record any adjustments resulting from a fair value hedge to the risk strata used for impairment testing under paragraph 860-50-35-9.

35-14 Once an entity has determined the predominant risk characteristics to be used in identifying the resulting stratums within each class of servicing assets subsequently measured using the amortization method, that decision shall be applied consistently unless significant changes in economic facts and circumstances clearly indicate that the predominant risk characteristics and resulting stratums should be changed. If a significant change in economic facts and circumstances occurs, that change shall be accounted for prospectively as a change in accounting estimate in accordance with paragraphs 250-10-45-17 through 45-19 and 250-10-50-4.

6.4.2.2 Impairment Assessments of Servicing Assets

6.4.2.2.1 General

ASC 860-50 requires that entities evaluate and measure the impairment of servicing assets that are subsequently measured by using the amortization method. Therefore, a lower-of-cost-or-fair-value approach is used for subsequently measuring servicing assets under the amortization method.

Entities must periodically assess impairment on the basis of strata. Servicing assets are stratified within a class on the basis of one or more predominant risk characteristics of the underlying financial assets. ASC 860-50-35-13 indicates that an entity must use judgment to determine how to stratify servicing assets; however, once an entity has determined the strata within a class of servicing assets measured under the amortization method, that decision should not change “unless significant changes in economic facts and circumstances clearly indicate that the predominant risk characteristics and resulting stratums should be changed” (see ASC 860-50-35-14). A change in the determination of strata would be considered a change in estimate, not a change in accounting principle. Section 6.4.1.2.2 discusses the difference between a class of servicing assets and a stratum.

On a stratum basis, the impairment evaluation involves a comparison of the amortized cost of the servicing assets with their fair value. (Note that ASC 860-50-35-9(b) prohibits an entity from including in this analysis the fair value of any servicing rights that are not separately recognized.) If there is any excess of amortized cost over fair value, an allowance for impairment losses or a direct write-down must be recognized. Any valuation account may be reversed in subsequent periods if the fair value of the servicing assets increases or the amortized cost basis of the servicing assets declines; however, direct write-downs establish a new amortized cost basis. Entities may not recognize servicing assets accounted for by using the amortization method at an amount in excess of the amortized cost basis.

In some situations, entities that are considering selling servicing rights may solicit bids from third parties. In determining the fair value of servicing assets, an entity should consider any bids received from unrelated parties that would represent an arm’s-length transaction (i.e., an orderly transaction). The receipt of a single binding bid would generally only represent the “floor” or lowest value of a servicing asset. If an entity solicits and receives several bids, it may determine that the fair value of its servicing assets falls somewhere within the range of the bid prices. In making this determination, an entity will need to consider the specific facts and circumstances as well as the nature of the bids (i.e., indicative vs. binding), the relative “tightness” or disparity in the bid prices, and other factors. An entity should consider any bids received not only to determine the fair value of the servicing assets but also to calibrate its valuation technique for its servicing assets. For more information about the use of bid prices to determine fair value, see Section 10.4.4 and Example 10-20 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option).

Some entities use third parties to estimate the fair value of their servicing assets. While such pricing information may provide evidence of fair value, the relevance of the information depends on the facts and circumstances. Furthermore, management must assume overall responsibility for determining the fair value of its servicing assets. See Section 10.8 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option) for more information about the use of prices provided by third parties.

6.4.2.2.2 Including Servicing Liabilities in a Stratum of Servicing Assets

An entity may not include servicing liabilities in a stratum of servicing assets that is being evaluated for impairment under the amortization method. Rather, the assessment of servicing liabilities for increased obligation is separate from the determination of the impairment of servicing assets. ASC 860-50-35-9 provides guidance on the subsequent evaluation and measurement of servicing assets and states that servicing assets within a class should be stratified on the basis of “one or more of the predominant risk characteristics.” Servicing liabilities are not stratified and therefore should not be included in a stratum of servicing assets. A servicing asset that becomes a servicing liability should be removed from a stratum of servicing assets.

6.4.2.2.3 Servicing Rights That Become Servicing Liabilities

An entity may enter into a servicing contract in return for contractually specified servicing fees that equal adequate compensation, in which case no asset or liability would be initially recognized for the servicing right. If the amortization method is elected, the initial amortized cost of the servicing right is zero.1 If subsequent events (e.g., increases in adequate compensation or changes in interest rates) result in the need to recognize a servicing liability, the entity must recognize the servicing liability at fair value, with an offsetting loss in earnings, even though the amortization method applies (see Section 6.4.2.3 for discussion of the subsequent measurement of servicing liabilities that are accounted for under the amortization method). In this situation, if there is a positive increase in the fair value of the servicing right, the entity may reduce the liability for this positive increase and recognize an offsetting gain in earnings. However, because the initial amortized cost basis of the servicing right was zero, the entity may never recognize an asset for the servicing right.

If a servicing right is initially recognized as a servicing asset and accounted for under the amortization method, that servicing asset could become a servicing liability because of subsequent changes in circumstances. In this situation, the entity should recognize the servicing liability at fair value and recognize the absolute change (i.e., the amortized cost of the servicing asset plus the initial fair value of the servicing liability) as a loss in earnings. However, because the servicing right was initially recognized as a servicing asset, the entity is not limited to recognizing positive changes in fair value only to the point at which the servicing liability would be eliminated, provided that a direct write-down has not occurred. Rather, the entity can recognize positive increases in fair value up to an amount that would not exceed the amortized cost of the servicing asset.

As discussed in Section 6.4.2.2.2, under no circumstances can a servicing liability be included in any stratum of servicing assets to measure impairment on those assets.

6.4.2.2.4 Direct Write-Down of a Servicing Asset

ASC 860-50-35-10 indicates that ASC 860-50 does not address when an entity should record a direct write-down of a servicing asset included in a class of servicing rights measured by using the amortization method. We believe that, under the amortization method, an entity should record a direct write-down of a servicing asset (i.e., a permanent reduction in the amortized cost basis) if the decrease in fair value of the servicing asset is other than temporary. Temporary decreases in the fair value of a servicing asset should be recorded through a valuation allowance.

Factors that an entity should consider in determining whether a decline in fair value is other than temporary include, but are not limited to, the severity and duration of the impairment and the cause of the impairment (e.g., whether it results from changing market conditions for servicing assets, discount rates, historical prepayment rates, or expected future prepayments). Servicing rights have no stated principal. Thus, such rights may be other-than-temporarily impaired even if the servicer intends to hold the rights until maturity or even if there are no concerns about the underlying borrower’s ability to pay.

A direct write-down of a servicing asset represents a new cost basis; therefore, any future recoveries of value above the adjusted basis should not be recognized. The write-down should be recorded as a loss in earnings, unless a sufficient valuation allowance has already been established. In that circumstance, the servicing asset and the valuation allowance would be reduced, resulting in no direct income statement impact.

An entity’s method for recognizing a direct write-down of a servicing asset constitutes an accounting policy decision that should be documented and applied consistently. Entities should consider disclosing their accounting policy in accordance with ASC 235.

6.4.2.2.5 Refinanced Mortgage Loans

ASC 860-50

Obligation to Service Refinanced Mortgage Loans

35-17 When an entity that is servicing mortgage loans refinances a mortgage loan that is being serviced (resulting in prepayment of the old mortgage loan and origination of a new mortgage loan), the entity shall not consider the estimated future net servicing income (that is, servicing revenue in excess of servicing costs) from the new mortgage loan in determining how to amortize any capitalized cost related to acquiring the mortgage servicing asset for the old mortgage loan. The mortgage servicing asset represents a contractual relationship between the servicer and the investor in the mortgage loan, not between the servicer and the borrower.

35-18 The cost of a mortgage servicing asset that is subsequently measured using the amortization method may require adjustment as a result of the refinancing transaction depending on the servicer’s assumptions in recording the servicing asset. If the refinancing transaction represents prepayment activity anticipated by the servicer when the servicing asset was recorded, an adjustment would not be necessary. However, if actual prepayments differ from anticipated prepayments, an adjustment to the servicing asset would be required. If the servicing assets or liabilities are subsequently measured using the fair value measurement method, the entity shall recognize any adjustment as a result of the refinancing transaction directly in earnings.

ASC 860-50-35-17 and 35-18 address the potential impact on MSRs that are accounted for by using the amortization method when the underlying mortgage loans are refinanced. That guidance describes adjustments that may need to be made to the amortized cost of an MSR asset.

6.4.2.3 Increased Obligation for Servicing Liabilities

Entities must determine the classes to which servicing liabilities are assigned, because the subsequent-measurement election under ASC 860-50-35-2 is made at the class level. However, there is no need to further stratify servicing liabilities that are subsequently measured under the amortization method, because a higher-of-cost-or-fair-value approach is used for the subsequent measurement of such servicing liabilities.

ASC 860-50-35-11 addresses the subsequent measurement of servicing liabilities under the amortization method and indicates that if the fair value of the liability increases above the carrying amount, the entity should recognize the increased obligation and a corresponding loss in earnings. In a manner similar to the accounting for changes in a valuation allowance for an impaired servicing asset that is accounted for under the amortization method, increases in the servicing obligation may be recovered, but the obligation may not be reduced below the amortized cost of the servicing liability (e.g., the initial liability amount adjusted for amortization).

6.4.3 Fair Value Method

If a servicing right is included within a class that is subsequently measured by using the fair value method, any subsequent change in fair value of a servicing asset or increased obligation of a servicing liability is recognized immediately in earnings. There is no need to evaluate servicing assets for impairment that are recognized at fair value with changes in fair value reported in earnings. Sections 6.3.2 and 6.4.2.2.1 discuss considerations related to the fair value measurement of servicing rights. Section 6.4.2.2.5 addresses refinanced mortgage loans.

Footnotes

As discussed in Section 6.4.1.2.1, the entity must still assign the servicing contract to a class of servicing rights.

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