Deloitte's Roadmap: Transfers and Servicing of Financial Assets

Preface

We are pleased to present the 2024 edition of Transfers and Servicing of Financial Assets, which provides an overview of the FASB’s authoritative guidance, as well as our insights and interpretations, on (1) the transferor’s and transferee’s accounting for a transfer of financial assets or servicing rights and (2) the servicer’s accounting for a right or obligation to service financial assets.

It can be time-consuming and complex to appropriately account for a transfer of financial assets or servicing rights because of the need to consider both legal and accounting rules and interpretations. To properly apply U.S. GAAP to such a transaction, an entity must closely analyze the transaction’s terms and conditions as well as the related facts and circumstances. As part of such an analysis, an entity must generally consult legal experts to determine whether a transfer of financial assets represents a sale under relevant law. The outcome of the analysis could significantly affect the classification, measurement, and earnings impact of the transaction as well as the related financial statement ratios.

No significant updates were made to the 2024 edition of this Roadmap, other than minor clarifications and the removal of discussions related to guidance that was superseded upon the adoption of ASC 842.1 These revisions are highlighted in Appendix D.

Be sure to check out On the Radar (also available as a stand-alone publication), which briefly summarizes emerging issues and trends related to the accounting and financial reporting topics addressed in the Roadmap.

We hope you find this Roadmap a useful resource in applying the guidance, and we welcome your suggestions for future improvements. If you need assistance with applying the guidance on transfers and servicing of financial assets or have other questions about this topic, we encourage you to consult our technical specialists and other professional advisers.

Footnotes

For a list of abbreviations used in this publication, see Appendix C. For the full titles of standards, topics, and regulations used in this publication, see Appendix B.

On the Radar

Determining whether a transfer of financial assets or servicing rights qualifies as a sale for financial reporting purposes can be time-consuming and complex. An entity must consider both the form and substance of the transfer. As part of such an analysis, the entity would evaluate relevant legal and accounting rules and interpretations and generally must consult legal experts. The outcome of this analysis could significantly affect the classification, measurement, and earnings impact of the transaction as well as the related financial statement ratios. This guidance has not significantly changed for more than a decade, and no changes are expected in the near term.

Accounting for Transfers of Financial Assets

The flowchart below illustrates the steps an entity would perform in evaluating whether a transfer of financial assets (e.g., trade receivables, loan receivables, or equity securities) qualifies as a sale for financial reporting purposes.

For a transfer of financial assets to be accounted for as a sale, the three conditions in ASC 860-10-40-5 must be met. However, before evaluating those conditions, a transferor must reach the following two conclusions to avoid accounting for the transfer as a secured borrowing:

The transferor does not consolidate the transferee — ASC 810 addresses consolidation. Sale accounting can never be achieved for a transfer of financial assets to a consolidated affiliate.
The transfer involves an entire financial asset or a participating interest — If a transfer involves an interest in a financial asset, as opposed to the asset itself, sale accounting can only potentially be achieved if the interest meets the definition of a participating interest. ASC 860 addresses the conditions that an interest must meet to be a participating interest. The application of such guidance can be time-consuming and complex.

An entity that reaches the above two conclusions must evaluate the three conditions for sale accounting in ASC 860. In evaluating these three conditions, an entity would consider both the legal nature and the substance of the transfer. To meet the conditions for sale accounting, the transfer must be a true legal sale. This determination is made by attorneys, not accountants. Even if the transfer meets this legal isolation condition, the transferee must be able to freely pledge or exchange (i.e., sell) the financial asset received (or the beneficial interests received from a securitization entity) and the transferor cannot maintain effective control over the transferred financial asset (e.g., by being able to repurchase it). An entity may need to use significant judgment in evaluating these two conditions and often must consult its accounting advisers.

ASC 860 also addresses the initial and subsequent recognition and measurement for a transfer, as well as the related disclosures an entity must provide. The guidance an entity applies will differ depending on whether the transfer is accounted for as a sale or a borrowing.

Accounting Symmetry

The accounting for a transfer as a sale or secured borrowing is symmetrical. That is, if the transferor meets the conditions to account for a transfer of financial assets as a sale and therefore derecognizes the transferred financial assets, the transferee accounts for the transfer as a purchase of financial assets. Similarly, if the transferor does not meet the conditions to account for a transfer of financial assets as a sale and reflects the transfer as a secured borrowing (i.e., it does not derecognize the financial assets), the transferee accounts for the transfer as a receivable from the transferor.

Accounting for Servicing Assets and Servicing Liabilities

ASC 860-50 separately addresses the accounting for servicing of financial assets, including transfers of servicing assets and disclosures. The derecognition model for transfers of servicing assets differs from that for transfers of financial assets. However, as with transfers of financial assets, the accounting for a transfer of servicing rights is symmetrical between the transferor and transferee.

This Roadmap comprehensively discusses the accounting for transfers and servicing of financial assets, including disclosures, in accordance with ASC 860. Entities may also need to refer to Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial Interest to determine whether a transferee must be consolidated by a transferor.

Contacts

Chapter 1 — Overview

Chapter 2 — Scope

2.5 Summary of Transactions Within and Outside the Scope of ASC 860-10

2.5.1 The Asset

The table below lists certain assets and indicates whether they represent recognized assets that are subject to ASC 860-10. Provided that there is a transfer of a recognized financial asset and the transfer is not subject to an exception in ASC 860-10-15-4, an entity applies ASC 860-10 to determine whether the transfer is accounted for as a sale or a secured borrowing by both the transferor and the transferee. See Section 1.2 for additional background information on certain types of transfers of financial assets.

Table 2-1

Asset	Recognized Asset Within the Scope of ASC 860-10?	Additional Discussion
Loan receivables (e.g., mortgages, outstanding balances on credit cards, commercial loans, and other installment loans)	Yes. Loan receivables are financial assets subject to ASC 860-10.	Section 2.2.2.5 Section 2.2.2.6 Section 2.4.4.3
Loan participations	Yes. Loan participations are financial assets subject to ASC 860-10.	Section 2.3.1
ADC arrangements	It depends. ADC arrangements that are accounted for as loan receivables are financial assets subject to ASC 860-10. ADC arrangements that are accounted for as investments in real estate are not financial assets.	Section 2.2.3.7
Trade and other accounts receivables	Yes. Trade and other accounts receivables are financial assets subject to ASC 860-10.	Section 2.2.2.4.2 Section 2.2.2.5 Section 2.2.2.6
Note receivables	Yes. Note receivables that are classified as assets (rather than as contra equity) are financial assets subject to ASC 860-10.	Section 2.2.2.5 Section 2.2.2.6 Section 2.4.4.1 Section 2.4.4.3
Debt securities	Yes. Debt securities are financial assets subject to ASC 860-10.	Section 2.2.2.5 Section 2.2.2.6
Equity securities, including equity method investments (e.g., common stocks, preferred stocks, general or limited partnership interests)	Yes. Equity securities are financial assets subject to ASC 860-10 unless they represent in-substance nonfinancial assets under ASC 610-20. However, an investment that represents a controlling financial interest in a consolidated subsidiary is generally not within the scope of ASC 860-10.	Section 2.2.5 Section 2.4.3
Short sales	No. Short sales do not involve recognized financial assets.	Section 2.2.2.8
Options or forward contracts to purchase or sell debt or equity securities	Yes. Options or forward contracts to purchase or sell debt or equity securities that are recognized as assets are financial assets subject to ASC 860-10.	Section 2.2.2.2
Options or forward contracts to purchase or sell nonfinancial assets	It depends. Only options or forward contracts to purchase or sell nonfinancial assets that are accounted for as derivative instruments under ASC 815-10 are subject to ASC 860-10.	Section 2.2.2.2 Section 2.2.3.2
Beneficial interests in securitized assets (whether the securitized assets are financial or nonfinancial assets)	Yes. Beneficial interests in securitized financial assets are financial assets subject to ASC 860-10, regardless of whether the underlying securitized assets are financial assets or nonfinancial assets. If the investor in the beneficial interests consolidates the securitization entity, it should consider whether a transfer of those beneficial interests represents a transfer of financial assets in substance.	Section 2.2.5.3 Section 2.4.3
Negotiable instruments such as certificates of deposit and banker’s acceptances	Yes. Negotiable instruments such as certificates of deposits and drafts related to banker’s acceptances are financial assets subject to ASC 860-10.	Section 2.3.4
Insurance contracts — insured party	It depends. Insurance contracts that permit the insurer to settle a claim by either making a cash payment or providing goods or services do not meet the definition of financial assets. Insurance contracts that require a cash payment if the insured event occurs meet the definition of financial assets. However, only amounts recognized by an insured party may represent financial assets subject to ASC 860-10.	Section 2.2.2.7.2
Insurance contracts — insurance entity	It depends. Generally, only earned premiums receivable represent financial assets subject to ASC 860-10.	Section 2.2.2.7.3
Sales-type and direct financing lease receivables	Yes. Receivables under sales-type and financing leases, which include residual values guaranteed at lease commencement represent financial assets subject to ASC 860-10. However, neither unguaranteed residual values nor residual values guaranteed after lease commencement are financial assets.	Section 2.2.3.5
Operating leases	No. Lease payments receivable under operating leases are not recognized financial assets.	Section 2.2.2.3
Rights to future revenues	No. Rights to future revenues are not recognized financial assets. ASC 470-10 addresses sales of future revenues.	Section 2.2.2.4.1
Contract assets	No. Contract assets are not recognized financial assets.	Section 2.2.2.4.2
Servicing assets	No. Servicing assets are not financial assets subject to ASC 860-10. ASC 860-50 addresses transfers of servicing assets.	Section 2.2.3.1 Chapter 6
Nonderivative financial assets	Yes. Although not financial assets, ASC 860-10-15-5 states that transfers of nonfinancial derivative assets are subject to ASC 860-10.	Section 2.2.3.2
Regulatory assets	No. Regulatory assets are not financial assets.	Section 2.2.3.3
Litigation judgments	It depends. Litigation judgments are not recognized financial assets unless a judgment is enforceable by a government or court of law and has been contractually reduced to a fixed payment schedule.	Section 2.2.3.4
Taxes receivable	No. Receivables arising from taxes are not financial assets.	Section 2.2.3.6
Treasury stock	No. Treasury stock is recognized as a contra-equity account and is not a financial asset.	Section 2.4.4.1

2.5.2 Application of the Term “Transfer”

The table below discusses whether certain transactions involving financial assets represent transfers under ASC 860-10. Transfers of recognized financial assets are subject to ASC 860-10 unless an exception in ASC 860-10-15-4 applies. See Section 1.2 for additional background information on certain types of transfers of financial assets.

Table 2-2

Transaction Involves	Transfer Within the Scope of ASC 860-10?	Additional Discussion
The origination of a loan receivable	No. The origination of a loan receivable does not meet the definition of a transfer in ASC 860-10.	Section 2.1.3
A loan syndication	No. Loan syndications involve the origination of loan receivables to participating lenders. In a loan syndication, the lead bank does not transfer the loans that are originated by other participating banks.	Section 2.3.1
The settlement of an obligation	No. A conveyance of a noncash financial asset to the holder of a loan or other receivable in full or partial settlement of that obligation does not meet the definition of a transfer in ASC 860-10. Nevertheless, application of ASC 860-10 is still often relevant to whether derecognition of the financial asset is appropriate.	Section 2.3.1 Section 2.3.2
A legal defeasance of debt	Yes. A conveyance of financial assets to a defeasance trust meets the definition of a transfer in ASC 860-10.	Section 2.3.2
A repurchase agreement or securities lending	It depends. The conveyance of an existing financial asset as part of a repurchase agreement or securities lending transaction meets the definition of a transfer in ASC 860-10. However, dollar-roll repurchase transactions for which the underlying securities being sold do not yet exist or are to be announced are outside the scope of ASC 860-10 because those transactions do not arise in connection with recognized financial assets.	Section 2.3.3
A banker’s acceptance	It depends. The origination or settlement of a banker’s acceptance does not meet the definition of a transfer in ASC 860-10. However, the following meet this definition: A vendor transfers its draft receivable from the bank to a third party. A bank transfers its receivable from the customer to a third party.	Section 2.3.4
A wash sale	Yes. The sale of a financial asset in a wash sale meets ASC 860-10’s definition of a transfer.	Section 2.3.5
A desecuritization	Yes. ASC 860-10-40-5 applies to desecuritizations.	Section 2.3.6

2.5.3 Transfers Not Subject to ASC 860-10

The table below discusses certain transfers that are not within the scope of ASC 860-10 even if the transaction involves recognized financial assets.

Table 2-3

Transaction Involves	ASC 860-10 Reference	Additional Discussion
The custody of financial assets for safekeeping	ASC 860-10-15-4(c)	Section 2.4.1
A contribution	ASC 860-10-15-4(d)	Section 2.4.2
An ownership interest in a consolidated subsidiary unless (1) the transfer involves financial assets in substance or (2) the investor accounts for the interest at fair value in accordance with industry-specific accounting guidance	ASC 860-10-55-13	Section 2.4.3
An investment by an owner or a distribution to an owner of a business entity	ASC 860-10-15-4(f)	Section 2.4.4
Certain lease transactions	ASC 860-10-15-4(h) and (i)	Section 2.4.6

Chapter 3 — Accounting for Transfers of Financial Assets

3.1 Conditions for Sale of Financial Assets

3.1.1 Objective

3.1.1.1 General

ASC 860-10

Conditions for a Sale of Financial Assets

40-4 The objective of paragraph 860-10-40-5 and related implementation guidance is to determine whether a transferor and its consolidated affiliates included in the financial statements being presented have surrendered control over transferred financial assets or third-party beneficial interests. This determination:

Shall first consider whether the transferee would be consolidated by the transferor (for implementation guidance, see paragraph 860-10-55-17D)
Shall consider the transferor’s continuing involvement in the transferred financial assets
Requires the use of judgment that shall consider all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer, even if they were not entered into at the time of the transfer.

With respect to item (b), all continuing involvement by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents shall be considered continuing involvement by the transferor. In a transfer between two subsidiaries of a common parent, the transferor-subsidiary shall not consider parent involvements with the transferred financial assets in applying paragraph 860-10-40-5.

40-4C Items (b) through (c) in paragraph 860-10-40-4 do not apply to a transfer of financial assets and a related repurchase financing. In transactions involving a contemporaneous transfer of a financial asset and a repurchase financing of that transferred financial asset with the same counterparty, a transferor and transferee shall separately account for the initial transfer of the financial asset and the related repurchase agreement. Paragraphs 860-10-55-17A through 55-17C provide implementation guidance related to repurchase financings.

A transfer of a financial asset that is within the scope of ASC 860-10 will be accounted for in its entirety as either a sale or a secured borrowing. ASC 860-10-40-4 states that the objective of the sale accounting guidance in ASC 860-10 “is to determine whether a transferor and its consolidated affiliates included in the financial statements being presented have surrendered control over transferred financial assets.” With two exceptions (see Section 3.1.3.1), this objective results in symmetry between the transferor’s and transferee’s accounting. Because only one party can control a financial asset, that asset should be on one, and only one, party’s balance sheet at any given moment.

ASC 860-10 prescribes a control model. Each party to a transaction should recognize only assets it controls and liabilities for which it is the primary obligor. Financial assets should only be derecognized when control has been surrendered, and liabilities should only be derecognized when they have been extinguished. The objective of sale accounting does not focus solely on when risks and rewards of ownership have been transferred or whether a transfer is legally characterized as a sale or a secured borrowing. However, the extent to which risks and rewards have been transferred will be relevant to an attorney’s determination of whether the transfer provides sufficient legal isolation and the condition in ASC 860-10-40-5(a) is met.

Sale accounting may be achieved for a transfer of financial assets only if one of the following two conditions is met:

An entity transfers an entire financial asset (or a group of entire financial assets) to a transferee that is not consolidated by the transferor.
An entity transfers an interest in an entire financial asset (or a group of entire financial assets) that meets the definition of a participating interest to a transferee that is not consolidated by the transferor.

A transfer of financial assets may never be accounted for as a sale if (1) the assets are transferred to an entity that is consolidated by the transferor or its consolidated affiliates included in the financial statements being presented or (2) the transfer involves an interest in financial assets that does not meet the definition of a participating interest.1 Therefore, the transferor should first consider these two matters before applying the sale accounting guidance in ASC 860-10-40-5. See Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial Interest for discussion of when consolidation of another entity is required. See Sections 3.1.2 and 3.2 for discussion of the definition of a participating interest.

Connecting the Dots

For transfers of entire financial assets, an entity should first determine whether it is required to consolidate the transferee. If the transferor consolidates the transferee under ASC 810-10, there is no need to evaluate the conditions in ASC 860-10-40-5 because the transfer must be accounted for as a secured borrowing. If a transfer involves a portion of an entire financial asset, the transferor should consider whether the transferred interest is a participating interest and whether the transferee must be consolidated before evaluating the conditions in ASC 860-10-40-5. The order in which these two considerations are addressed is not relevant because the transfer must be accounted for as a secured borrowing if either (1) the transferred interest is not a participating interest or (2) the transferor consolidates the transferee to which a participating interest is transferred. In transfers of portions of financial assets to third parties, the transferor will generally not be required to consolidate the transferee because it will not have a variable interest in the transferee.

There are two situations in which sale accounting is not precluded even though the transferor consolidates a transferee involved in the transfer of financial assets:

In two-step transfers of entire financial assets (see Section 3.3.1.4.3), for accounting purposes, the transferor consolidates the BRSPE whose sole purpose is to ensure that the transfer meets the isolation condition. In such cases, the transferor is not required to account for the transfer as a secured borrowing. Rather, in two-step transfers of entire financial assets, the focus is on whether the transferor is required to consolidate the second entity involved in the transfer (i.e., the ultimate securitization entity).
An entity may transfer an entire financial asset to a transferee that is consolidated under ASC 810-10. If that entity transfers a participating interest in the entire financial asset received to a third party, the transfer of that participating interest could meet the conditions for sale accounting.

In both situations described above, although a consolidated entity is involved in the transfer, sale accounting may be achieved only because the ultimate transferee is not consolidated by the transferor.

If a transaction involves a transfer of an entire financial asset (or a group of entire financial assets) or a participating interest to an unconsolidated entity, the conditions for sale accounting in ASC 860-10-40-5 must be evaluated. In performing this analysis, an entity must consider all forms of continuing involvement that the transferor, its consolidated affiliates included in the financial statements being presented, or its agents have with the transferred financial assets (see Section 3.1.1.2). Under ASC 860-10-40-4(c), “all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer” must be considered in the evaluation (see Section 3.1.1.3).

3.1.1.2 Meaning of Continuing Involvement

ASC 860-10 — Glossary

Continuing Involvement

Any involvement with the transferred financial assets that permits the transferor to receive cash flows or other benefits that arise from the transferred financial assets or that obligates the transferor to provide additional cash flows or other assets to any party related to the transfer. For related implementation guidance, see paragraph 860-10-55-79A.

ASC 860-10

Application of the Term Continuing Involvement

55-79A This implementation guidance addresses the application of the glossary term continuing involvement. All available evidence shall be considered, including, but not limited to, all of the following:

Explicit written arrangements
Communications between the transferor and the transferee or its beneficial interest holders
Unwritten arrangements customary in similar transfers.

55-79B Examples of continuing involvement include, but are not limited to, all of the following:

a. Servicing arrangements

b. Recourse or guarantee arrangements

c. Agreements to purchase or redeem transferred financial assets

cc. Options written or held

d. Derivative instruments that are entered into contemporaneously with, or in contemplation of, the transfer

e. Arrangements to provide financial support

f. Pledges of collateral

g. The transferor’s beneficial interests in the transferred financial assets.

ASC 860-10-40-4 requires that “all continuing involvement by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents . . . be considered continuing involvement by the transferor.” Continuing involvement is defined broadly as including any involvement with transferred financial assets that could cause the transferor to receive benefits from the transferred financial assets or to incur obligations with respect to the transferred financial assets. Continuing involvement would include:

Servicing.
Recourse or other guarantees (e.g., EPD or prepayment provisions).
Agreements to repurchase or redeem transferred financial assets, including options purchased or written.
Derivative instruments that are entered into with the transferee.
Arrangements to provide financial support.
Pledges of collateral.
Beneficial interests in transferred financial assets.

Continuing involvement is not defined by the fair value of interests in transferred financial assets; rather, it is determined on the basis of any contract or arrangement, including an implicit arrangement, with transferred financial assets that could cause the transferor to receive or pay cash flows or other assets related to the transfer. Even standard representations and warranties, which are a type of recourse related to transfers, would constitute a form of continuing involvement with transferred financial assets.

Most transfers of financial assets are accompanied by continuing involvement of the transferor, its consolidated affiliates, or its agents. Although such a scenario is not typical in transfers of financial assets, if an entity transfers an entire financial asset (or a group of entire financial assets) to an unconsolidated transferee and has no continuing involvement with the transferred financial assets other than standard representations and warranties, sale accounting is appropriate even if the transferee is prohibited from pledging or exchanging the financial assets received (i.e., the condition in ASC 860-10-40-5(b) is not met).2 However, when the transferor, its consolidated affiliates included in the financial statements being presented, or its agents have continuing involvement in transferred financial assets other than standard representations and warranties (see ASC 860-10-55-17N), that involvement must be considered in the determination of whether the three conditions in ASC 860-10-40-5 are met.

Note that in a transfer between two subsidiaries of a common parent, the subsidiary-transferor does not consider its parent’s involvement with the transferred financial assets. In addition, specific guidance applies to repurchase financings (see Section 3.6.4).

3.1.1.3 Agreements Made Contemporaneously With or in Contemplation of a Transfer

The recognition of financial assets and financial liabilities should not be affected by the sequence of transactions that result in their acquisition or incurrence unless the effect of those transactions is to maintain effective control over a transferred financial asset. Therefore, ASC 860-10-40-4(c) requires entities to consider all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer that are entered into by the transferor, its consolidated affiliates included in the financial statements being presented, and its agents, even if the agreements were not entered into at the time of the transfer. The substance of the transaction must be viewed without regard to its form or the sequence of steps. Otherwise, the transaction could be structured to obtain a desired accounting treatment that is inconsistent with the transaction’s substance. In applying this requirement, entities should consider whether:

One arrangement depends on another arrangement.
The pricing of an arrangement depends on that of another arrangement.
There is no reason to enter into one transaction without entering into another transaction.

Both explicit and implicit factors are considered in this evaluation. Examples 3-1 and 3-2 illustrate the application of this guidance.

3.1.2 Unit of Account

3.1.2.1 General

ASC 860-10

Conditions for a Sale of Financial Assets

40-4D To be eligible for sale accounting, an entire financial asset cannot be divided into components before a transfer unless all of the components meet the definition of a participating interest. The legal form of the asset and what the asset conveys to its holders shall be considered in determining what constitutes an entire financial asset (for implementation guidance, see paragraph 860-10-55-17E). An entity shall not account for a transfer of an entire financial asset or a participating interest in an entire financial asset partially as a sale and partially as a secured borrowing.

40-4E If a transfer of a portion of an entire financial asset meets the definition of a participating interest, the transferor shall apply the guidance in the following paragraph. If a transfer of a portion of a financial asset does not meet the definition of a participating interest, the transferor and transferee shall account for the transfer in accordance with the guidance in paragraph 860-30-25-2. However, if the transferor transfers an entire financial asset in portions that do not individually meet the participating interest definition, the following paragraph shall be applied to the entire financial asset once all portions have been transferred.

Meaning of the Term Entire Financial Asset

55-17E This implementation guidance addresses the application of what constitutes an entire financial asset.

55-17F A loan to one borrower in accordance with a single contract that is transferred to a securitization entity before securitization shall be considered an entire financial asset. Similarly, a beneficial interest in securitized financial assets after the securitization process has been completed shall be considered an entire financial asset. In contrast, a transferred interest in an individual loan shall not be considered an entire financial asset; however, if the transferred interest meets the definition of a participating interest, the participating interest would be eligible for sale accounting.

55-17G In a transaction in which the transferor creates an interest-only strip from a loan and transfers the interest-only strip, the interest-only strip does not meet the definition of an entire financial asset (and an interest-only strip does not meet the definition of a participating interest; therefore, sale accounting would be precluded). In contrast, if an entire financial asset is transferred to a securitization entity that it does not consolidate and the transfer meets the conditions for sale accounting, the transferor may obtain an interest-only strip as proceeds from the sale. An interest-only strip received as proceeds of a sale is an entire financial asset for purposes of evaluating any future transfers that could then be eligible for sale accounting.

55-17H If multiple advances are made to one borrower in accordance with a single contract (such as a line of credit, credit card loan, or a construction loan), an advance on that contract would be a separate unit of account if the advance retains its identity, does not become part of a larger loan balance, and is transferred in its entirety. However, if the transferor transfers an advance in its entirety and the advance loses its identity and becomes part of a larger loan balance, the transfer would be eligible for sale accounting only if the transfer of the advance does not result in the transferor retaining any interest in the larger balance or if the transfer results in the transferor’s interest in the larger balance meeting the definition of a participating interest. Similarly, if the transferor transfers an interest in an advance that has lost its identity, the interest must be a participating interest in the larger balance to be eligible for sale accounting.

Loan Participations

55-61 Paragraph 860-10-05-23 provides background on loan participations. If a loan participation agreement transfers a participating interest in an entire financial asset (as described in paragraph 860-10-40-6A) and the conditions in paragraph 860-10-40-5 are met, the transfers shall be accounted for by the transferor as a sale of a participating interest. However, if the loan participation agreement constrains the transferee from pledging or exchanging its participating interest and that constraint provides a more-than-trivial benefit to the transferor, the transferor has not relinquished control and shall account for the transfer as a secured borrowing.

The unit of account for a transfer of financial assets consists of either of the following:

An entire financial asset (or a group of entire financial assets).
A portion of an entire financial asset (or a group of entire financial assets), often referred to as an “undivided interest.”

ASC 860-10 permits a transferor to obtain a beneficial interest in transferred financial assets as proceeds from a sale provided that it has surrendered control over the original financial assets in a transfer to an unconsolidated entity and all the conditions in ASC 860-10-40-5 are met. However, to be eligible for sale accounting, an entire financial asset cannot be divided into components before a transfer unless all of the components meet the definition of a participating interest. That is, a transfer of a portion of a financial asset can potentially qualify as a sale only if that portion meets the definition of a participating interest. Thus, the financial components approach in ASC 860 is limited to interests in financial assets that meet the definition of participating interests. Section 3.2 discusses the meaning of the term “participating interest.”

The unit of account is determined on the basis of (1) the legal form of the transferred asset and (2) what the transferred asset conveys to its holder. What the asset conveys to its holder is considered from the transferor’s perspective before the transfer. For the transfer to qualify as a transfer of an entire financial asset, the transferee must receive the entire financial asset and not an ownership interest in a portion of a financial asset.3 Whether the right to cash flows from a financial asset is divided into components before or after a transfer is critical to determining the unit of account. If rights to cash flows are separated by the transferor before a transfer, the transfer involves a portion of a financial asset. However, if the transferee separates rights to cash flows after the transfer, the transfer involves an entire financial asset.

Connecting the Dots

The unit-of-account guidance in ASC 860-10 places significant emphasis on form over economic substance. Economically, the following two transactions are similar:

Transaction 1 — An entity transfers a $1 million commercial loan to an SPE and receives cash and a beneficial interest in the last 10 percent of principal and interest cash flows on the loan.
Transaction 2 — An entity transfers a 90 percent senior interest in a $1 million commercial loan and retains a 10 percent subordinated interest in the loan. The senior interest is entitled to the first 90 percent of principal and interest cash flows on the loan, and the subordinated interest is entitled to the last 10 percent of principal and interest cash flows on the loan.

A transfer of an entire financial asset in return for cash and a beneficial interest in the transferred financial asset would subject the transferor to the VIE consolidation guidance in ASC 810-10 provided that the interest is not an interest in specified assets (however, in that case, the silo guidance in ASC 810-10 may apply). In Transaction 1 above, the transferor has a variable interest in the SPE that is subject to evaluation under ASC 810-10 to determine whether the transferor is the primary beneficiary of the SPE. However, in Transaction 2 above, the transferor has no interest in the transferee; therefore, the VIE consolidation guidance in ASC 810-10 does not apply. Consequently, for this transaction, the transferor must evaluate whether the transferred interest meets the definition of a participating interest (and such a transferred interest would not meet this definition). The definition of participating interest does not apply to Transaction 1 above even though it is economically similar to Transaction 2.

The table below summarizes the evaluation of the unit of account under ASC 860-10.

Table 3-1

Transaction	Unit of Account
An entity transfers a loan receivable that was entered into under a single loan agreement to an unconsolidated entity that was established to transform the loan into securities.	The transfer involves an entire financial asset.
An entity transfers a beneficial interest in securitized financial assets (i.e., an asset that results from the completion of the securitization process) to a third party.	The transfer involves an entire financial asset.
An entity transfers an undivided interest in a loan receivable to a third party.	The transfer involves a portion of an entire financial asset. For this transfer to qualify as a sale, the interest must meet the definition of a participating interest.
An entity creates an IO strip from an existing loan receivable and transfers it to a third party.	The transfer involves a portion of an entire financial asset. Since that portion does not meet the definition of a participating interest (i.e., it does not reflect a pro rata separation of cash flows), the transfer must be accounted for as a secured borrowing. In contrast, if an entity transfers an entire loan receivable to an unconsolidated securitization entity and that transfer qualifies as a sale, it may obtain an IO strip as proceeds from the sale. A subsequent transfer of that IO strip involves a transfer of an entire financial asset.
An entity makes an advance on an overall larger construction loan facility. In accordance with the legal agreement involving the loan facility, each advance retains its identity and does not become part of an overall larger loan balance. That advance is transferred to a third party.	The transfer involves an entire financial asset because the advance is not part of an overall larger loan balance.
An entity makes an advance on a revolving credit card arrangement. The credit card arrangement represents a single legal contract. Each advance becomes a component of an overall single loan balance. An entity transfers a single advance on the credit card receivable to a third party.	The transfer involves an interest in an entire financial asset. Advances on credit cards become part of an overall larger single lending arrangement. For this transfer to qualify as a sale, the interest must meet the definition of a participating interest. Interests in credit card receivables generally will not meet the definition of participating interests.
An entity creates a senior interest in a commercial loan receivable, which represents the first 80 percent of principal and interest cash flows on the loan, and transfers that interest to a third party. The entity retains a subordinated interest in the remaining cash flows on the transferred loan receivable.	The transfer involves a portion of an entire financial asset. Since that portion does not meet the definition of a participating interest (i.e., because of the prioritization of cash flows, it does not represent a pro rata interest), the transfer must be accounted for as a secured borrowing.
An entity transfers to a third party a commercial loan receivable that was entered into under a single loan agreement. In conjunction with the transfer, the entity writes a guarantee to the transferee of the payment of 20 percent of the principal and interest on the transferred loan.	The transfer involves an entire financial asset. The guarantee must be considered in the determination of whether the transfer meets the conditions in ASC 860-10-40-5 for sale accounting. Economically, this transfer is similar to the one in the immediately preceding row of this table; however, it is evaluated differently under the unit-of-account guidance in ASC 860-10.

3.1.2.2 Loan Participation Versus Loan Syndication

As discussed in Section 2.3.1, in applying ASC 860-10, it is important for an entity to distinguish between a loan participation and a loan syndication. A loan participation is a transfer within the scope of ASC 860-10 because it represents a transfer of an interest in an existing loan to a third party. To qualify for sale accounting, the interest transferred must meet the definition of a participating interest. However, a loan syndication is not within the scope of ASC 860-10 because it represents an origination of a loan by the participating banks. The transfer would be within the scope of ASC 860-10 only if a participating bank subsequently transfers all or a portion of its loan receivable to a third party.

3.1.3 Sale Accounting Criteria

3.1.3.1 General Conditions

ASC 860-10

Conditions for a Sale of Financial Assets

40-5 A transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset in which the transferor surrenders control over those financial assets shall be accounted for as a sale if and only if all of the following conditions are met:

Isolation of transferred financial assets. The transferred financial assets have been isolated from the transferor — put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. Transferred financial assets are isolated in bankruptcy or other receivership only if the transferred financial assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor or any of its consolidated affiliates included in the financial statements being presented. For multiple step transfers, a bankruptcy-remote entity is not considered a consolidated affiliate for purposes of performing the isolation analysis. Notwithstanding the isolation analysis, each entity involved in the transfer is subject to the applicable guidance on whether it shall be consolidated (see paragraphs 860-10-40-7 through 40-14 and the guidance beginning in paragraph 860-10-55-18). A set-off right is not an impediment to meeting the isolation condition.
Transferee’s rights to pledge or exchange. This condition is met if both of the following conditions are met:
1. Each transferee (or, if the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities and that entity is constrained from pledging or exchanging the assets it receives, each third-party holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received.
2. No condition does both of the following:
  1. Constrains the transferee (or third-party holder of its beneficial interests) from taking advantage of its right to pledge or exchange
  2. Provides more than a trivial benefit to the transferor (see paragraphs 860-10-40-15 through 40-21).
  If the transferor, its consolidated affiliates included in the financial statements being presented, and its agents have no continuing involvement with the transferred financial assets, the condition under paragraph 860-10-40-5(b) is met.
Effective control. The transferor, its consolidated affiliates included in the financial statements being presented, or its agents do not maintain effective control over the transferred financial assets or third-party beneficial interests related to those transferred assets (see paragraph 860-10-40-22A). A transferor’s effective control over the transferred financial assets includes, but is not limited to, any of the following:
1. An agreement that both entitles and obligates the transferor to repurchase or redeem the transferred financial assets before their maturity (see paragraphs 860-10-40-23 through 40-25)
2. An agreement, other than through a cleanup call (see paragraphs 860-10-40-28 through 40-39), that provides the transferor with both of the following:
  1. The unilateral ability to cause the holder to return specific financial assets
  2. A more-than-trivial benefit attributable to that ability.
3. An agreement that permits the transferee to require the transferor to repurchase the transferred financial assets at a price that is so favorable to the transferee that it is probable that the transferee will require the transferor to repurchase them (see paragraph 860-10-55-42D).

40-5A A repurchase-to-maturity transaction shall be accounted for as a secured borrowing as if the transferor maintains effective control (see paragraphs 860-10-40-24 through 40-24A).

40-6 For guidance on accounting for a transfer that satisfies the conditions in paragraph 860-10-40-5, see Subtopic 860-20, including Section 860-20-40’s derecognition guidance and Section 860-20-25’s guidance on recognition of new assets obtained and new liabilities. For guidance on accounting for a transfer that does not satisfy the conditions in paragraph 860-10-40-5, see Subtopic 860-30.

When an entire financial asset (or a group of entire financial assets) or a participating interest is transferred to an unconsolidated entity, the transfer must meet the three conditions in ASC 860-10-40-5 to be accounted for as a sale. Those conditions are relevant to both the transferor’s and the transferee’s accounting. If all three conditions are met, the transferor accounts for the transfer as a sale of a financial asset and the transferee accounts for the transfer as a purchase of a financial asset (see Chapter 4 for further discussion of the transferor’s and transferee’s accounting for a transfer that qualifies for sale accounting). If all three conditions are not met, the transferor accounts for the transfer as a borrowing secured by collateral and the transferee accounts for the transfer as an origination of a receivable from the transferor (see Chapter 5 for further discussion of the transferor’s and transferee’s accounting for a transfer that does not qualify for sale accounting). The accounting as a sale or secured borrowing is symmetrical between the transferor and transferee except in the following two cases:

Securities lending transactions involving noncash collateral (see Section 5.3.3.3.1).
The accounting in the stand-alone financial statements of a transferee (including a BRSPE) when a parent entity transfers financial assets to a subsidiary (see Section 3.1.3.5.3).

Sections 3.3 through 3.5 provide additional guidance on the three conditions in ASC 860-10-40-5. Section 3.6.5.1.2 discusses the accounting for repurchase-to-maturity transactions.

3.1.3.2 Losing Control Over Previously Transferred Financial Assets

ASC 860-10-40-41 indicates that a transferor can regain control over previously sold financial assets. It is also possible for a transferor to lose control over transferred financial assets previously accounted for as a secured borrowing. However, the SEC staff believes that for a transfer previously accounted for as a secured borrowing to achieve sale accounting, a substantive transaction or event needs to occur before an entity can conclude that sale accounting is appropriate.

A mere change in market prices is not sufficient to recognize a sale on a transfer previously accounted for as a secured borrowing. For example, assume that a transferor’s only continuing involvement in transferred financial assets is the ownership of a subordinated interest that precluded sale accounting. The fact that the transferor believes its subordinated interest becomes “worthless” is not sufficient to account for the prior transfer as a sale. Rather, a substantive transaction or event must occur to demonstrate (1) that sale accounting is appropriate and (2) the specific date on which sale accounting is achieved.

A substantive transaction or event that allows for sale accounting for a transfer previously accounted for as a secured borrowing could include:

A change to the contractual terms of a transfer. A modification to the contractual terms of a transfer that requires approval of the transferee or third-party beneficial interest holders in securitized financial assets would be considered a substantive transaction or event provided that the modification affects a substantive contractual term. A modification involving a nonsubstantive contractual term or one that the transferor can undertake unilaterally would not be considered substantive.
Expiration of a call option, put option, or other derivative instrument that precluded sale accounting, provided that the expired instrument was substantive as of the original transfer date. See Example 3-3.
A sale of an interest that was substantive as of the original transfer date and precluded sale accounting. If a transferor believes that the interest to be sold is “worthless,” it should undergo a substantive marketing process to confirm that the interest has no value. Afterwards, a transfer of the interest for no consideration (e.g., a contribution to a not-for-profit entity) may support a conclusion that sale accounting has been achieved.

A nonsubstantive contractual term included in the terms of a transfer may cause one of the conditions in ASC 860-10-40-5 not to be met; in such circumstances, the transfer must be accounted for as a secured borrowing. Removing such a nonsubstantive feature does not achieve sale accounting since this would allow entities to elect the date on which sale accounting is achieved (i.e., choose the date to take a gain on sale). The SEC staff believes that this is unacceptable.

3.1.3.3 Consideration of Involvement of Consolidated Affiliates

In the evaluation of the three conditions in ASC 860-10-40-5, any continuing involvement in the transferred financial assets of a consolidated affiliate is considered continuing involvement of the transferor (i.e., the same as if the involvement was directly with the transferor). For this purpose, a consolidated affiliate includes any entity that is included in the transferor’s consolidated financial statements. Thus, whether a transferor has isolated transferred financial assets may depend on which financial statements are being presented. A financial asset transferred by a subsidiary could meet the conditions in ASC 860-10-40-5 in the subsidiary’s financial statements but not meet the sale accounting conditions in the parent’s consolidated financial statements. This could be the case if, for example, the parent provided recourse or had an obligation to purchase the transferred financial assets.

3.1.3.4 Consideration of Agents

ASC 860-10 — Glossary

Agent

A party that acts for and on behalf of another party. For example, a third-party intermediary is an agent of the transferor if it acts on behalf of the transferor.

In the evaluation of the conditions in ASC 860-10-40-5(b) and (c), any continuing involvement of an agent of the transferor must be considered continuing involvement of the transferor (i.e., the same as if the involvement was with the transferor). If the transferor and transferee use the same agent, the transferor only considers the involvement of the agent in its capacity as acting for and on behalf of the transferor. The agent’s actions on behalf of the transferee should not be attributed to the transferor. For example, an investment manager may act as a fiduciary for both the transferor and the transferee. The transferor would only consider the involvement of the investment manager when it is acting on its behalf.

Entities should focus on the legal terms of arrangements with third-party intermediaries, as well as on the fiduciary obligations of those entities, to determine whether a third party is acting on behalf of the transferor when that party acts as an agent for both the transferor and the transferee. This is especially important when a third-party agent has the right to purchase transferred financial assets, liquidate a transferee entity, or redeem beneficial interests. If, as a result of the activities of an agent, the transferor is required to consolidate the transferee under the VIE guidance in ASC 810-10, the transferor could not achieve sale accounting for the transferred financial assets.

ASC 860-10-40-5(a) does not specifically require that financial assets be put beyond the reach of an agent. Nevertheless, to meet the objective in ASC 860-10-40-4, transferors should consider the involvement of agents in determining whether transferred financial assets are legally isolated.

Examples 3-4 and 3-8 illustrate how the activities of agents are considered in the determination of whether a transfer of financial assets meets the conditions for sale accounting.

3.1.3.5 Transfers Involving Subsidiary Entities

3.1.3.5.1 General

ASC 860-10

Recognition of a Sale in Separate-Entity Financial Statements

55-78 A transfer from one subsidiary (the transferor) to another subsidiary (the transferee) of a common parent would be accounted for as a sale in each subsidiary’s separate-entity financial statements if both of the following requirements are met:

All of the conditions in paragraph 860-10-40-5 (including the condition on isolation of the transferred financial assets) are met.
The transferee’s assets and liabilities are not consolidated into the separate-entity financial statements of the transferor.

Paragraph 860-10-40-4 states that, in a transfer between two subsidiaries of a common parent, the transfer-or-subsidiary shall not consider parent involvements with the transferred financial assets in applying paragraph 860-10-40-5.

Transfers of financial assets between entities within a consolidated group never meet the conditions for sale accounting in the parent’s consolidated financial statements (see ASC 860-10-40-4). However, ASC 860-10 permits a transfer of financial assets between commonly controlled entities to be treated as a sale in the stand-alone financial statements of a subsidiary if certain conditions are met. That is, a transfer that fails to meet the conditions for sale accounting in a parent’s consolidated financial statements because of the involvement of the parent or another consolidated affiliate may be reflected as a sale within the stand-alone financial statements of a subsidiary-transferor or a purchase within the stand-alone financial statements of a subsidiary-transferee.

3.1.3.5.2 Transfers of Financial Assets Among Sister Subsidiaries

ASC 860-10 addresses whether a transfer of financial assets between subsidiaries of a common parent may be treated as a sale in the stand-alone financial statements of the subsidiaries (i.e., a sale of financial assets by the subsidiary-transferor and a purchase of those assets by the subsidiary-transferee). For a transfer of financial assets between subsidiaries of a common parent to be accounted for as a sale in the stand-alone financial statements of the subsidiaries, the following two conditions must be met:

All the conditions in ASC 860-10-40-5 are met — The conditions in ASC 860-10-40-5 are evaluated on the basis of the contractual agreements and arrangements associated with the transfer from the perspective of the stand-alone financial statements of the subsidiary. That is, in evaluating the sale accounting conditions, each subsidiary assumes that the involvement of the parent or the parent’s consolidated affiliates not included in the financial statements being presented (including the sister subsidiary involved in the transfer) represents involvement of an unrelated third party.4 The fact that a transfer is between commonly controlled entities does not preclude a subsidiary from reflecting the transfer as a sale in its stand-alone financial statements. Similarly, the fact that the parent could subsequently require a consolidated affiliate to take a certain action does not result in the need to infer rights and obligations that are not contractual. See below for discussion of the application of the conditions in ASC 860-10-40-5.
The substance of the transaction is not a secured borrowing — Although ASC 860-10-55-17D (reproduced below) does not specifically apply, we believe that an entity must consider whether the substance of the transaction is a secured borrowing. Depending on the facts and circumstances, the entity may conclude that recognizing the transfer as a sale in the stand-alone financial statements of a subsidiary does not reflect the substance of the transaction. The entity will need to use judgment in such situations, especially when the parent or another consolidated affiliate acts as an agent of each subsidiary involved in a transfer.

An entity should consider the following in applying the conditions in ASC 860-10-40-5 to transfers of financial assets between subsidiaries of a common parent:

Isolation of transferred financial assets (ASC 860-10-40-5(a)) — The subsidiary-transferor should evaluate whether the transferred financial assets have been legally isolated from the subsidiary and any consolidated affiliates included in the subsidiary’s stand-alone financial statements. Any involvement of the parent should not be considered. For example, a guarantee provided by the parent should not affect whether the isolation condition is met.
Transferee’s ability to pledge or exchange (ASC 860-10-40-5(b)) — One of the following must be met:
- Each transferee of the financial assets (including subsidiaries or other entities controlled by the common parent) has the right to pledge or exchange the transferred financial assets.
- If the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities, each holder of beneficial interests in the transferred financial assets has the right to pledge or exchange those beneficial interests except for:
  - The subsidiary-transferor.
  - An entity included in the consolidated financial statements of the subsidiary-transferor.
  - An entity that is acting as an agent of the subsidiary-transferor.
  Connecting the Dots
  
  When a transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities, the evaluation of ASC 860-10-40-5(b) focuses on the ability of third-party holders of beneficial interests in the transferred financial assets to pledge or exchange those interests. Thus, this condition may be met even if the transferor receives, as proceeds, a beneficial interest in the transferred financial assets that it cannot freely pledge or exchange.
  
  In transfers of financial assets among sister subsidiaries that involve securitization or asset-backed financing activities, an entity must consider which beneficial interest holders should be evaluated as third parties. With respect to the stand-alone financial statements of the transferor, we believe that “third party” should be interpreted as any party other than (1) the subsidiary-transferor or (2) its consolidated subsidiaries or agents. Thus, in addition to beneficial interest holders that are unrelated to the subsidiary-transferor, other entities within the consolidated group that acquire the beneficial interests need to have the ability to pledge or exchange those interests for the condition in ASC 860-10-40-5(b) to be met.
  
  A securitization or asset-backed financing entity that is consolidated, directly or indirectly, by the parent may acquire financial assets from, and issue beneficial interests to, various subsidiaries that are included in the parent’s consolidated financial statements. In an individual subsidiary-transferor’s evaluation of the condition in ASC 860-10-40-5(b), only holders of beneficial interests in the transferred financial assets need to have the right to pledge or exchange those interests. That is, the condition in ASC 860-10-40-5(b) is in line with an “asset” view rather than an “entity” view. As a result, there is no need for a subsidiary-transferor to evaluate the rights of holders of beneficial interests in a securitization or asset-backed financing entity to pledge or exchange those interests if they are not entitled to any of the cash flows of the transferred financial assets. We have confirmed this view through discussions with the FASB staff. Example 3-8 illustrates this concept.
Effective control (ASC 860-10-40-5(c)) — Any continuing involvement of the parent or other commonly controlled entities that are not included in the subsidiary-transferor’s consolidated financial statements, and that are not agents of the subsidiary-transferor, does not have to be taken into account by the subsidiary-transferor in its evaluation of whether it maintains effective control over the transferred financial assets. The subsidiary-transferor should, however, consider any involvement in the transferred financial assets of the subsidiary-transferor’s consolidated affiliates included in the financial statements being presented and any involvement of the subsidiary-transferor’s agents.

3.1.3.5.3 Transfers of Financial Assets From a Parent to a Subsidiary

ASC 860-10

Consolidation of Transferee by Transferor

55-17D Paragraph 860-10-40-4 states that the determination of whether a transferor and its consolidated affiliates included in the financial statements being presented have surrendered control over transferred financial assets shall first consider whether the transferee would be consolidated by the transferor. If all other provisions of this Topic are met with respect to a particular transfer, and the transferee would be consolidated by the transferor, then the transferred financial assets would not be treated as having been sold in the financial statements being presented. However, if the transferee is a consolidated subsidiary of the transferor (its parent), the transferee shall recognize the transferred financial assets in its separate entity financial statements, unless the nature of the transfer is a secured borrowing with a pledge of collateral (for example, a repurchase agreement that would not be accounted for as a sale under the provisions of paragraph 860-10-40-24).

A transfer of financial assets from a parent to a consolidated subsidiary is not reflected as a sale in the parent’s consolidated financial statements. Rather, such a transfer has no impact on the consolidated financial statements. However, ASC 860-10-55-17D indicates that the subsidiary-transferee may reflect the purchase of those transferred financial assets in its stand-alone financial statements unless the transfer is a secured borrowing. An entity must use judgment in making this determination.

3.1.3.6 Transfers to Equity Method Investees

ASC 860-10

Recognition of a Sale in Separate-Entity Financial Statements

55-79 If the transferee was an equity method investee of the transferor, only the investment and not the investee’s assets and liabilities would be reported in the transferor subsidiary’s separate-entity financial statements. Therefore, the transferee would not be a consolidated affiliate of the transferor, and such a transfer could isolate the transferred financial assets and be accounted for as a sale if all other conditions of paragraph 860-10-40-5 are met.

ASC 860-10-55-79 explains that a transferee that is an equity method investee of a transferor is not a consolidated affiliate of the transferor. Therefore, a transfer of financial assets to an equity method investee could meet the conditions in ASC 860-10-40-5 for sale accounting.

Footnotes

Under ASC 860-10, a transfer is accounted for entirely as either a sale or a secured borrowing. An entity cannot account for any transfer of financial assets as partially a sale and partially a secured borrowing. A transfer to a consolidated subsidiary can achieve sale accounting only if the consolidated subsidiary transfers the financial assets received or a participating interest in those financial assets to another transferee that is not consolidated by the transferor or its consolidated affiliates.

Without any continuing involvement in transferred financial assets other than standard representations and warranties, the conditions in ASC 860-10-40-5(a) and (c) would generally be met (although analysis of these conditions is still required). The lack of continuing involvement takes precedence in the evaluation of whether a transferee is constrained from pledging or exchanging the transferred financial assets. See further discussion in Section 3.4.1.1.

An asset that represents an ownership interest in an entity (e.g., common shares or limited partnership interests) is considered an entire financial asset and would be the unit of account to which the sale accounting conditions in ASC 860-10-40-5 are applied.

Any involvement by an entity that is acting as an agent of the subsidiary should be considered continuing involvement of the subsidiary.

3.2 Meaning of the Term “Participating Interest”

3.2.1 General

ASC 860-10

Meaning of the Term Participating Interest

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

From the date of the transfer, it represents a proportionate (pro rata) ownership interest in an entire financial asset. The percentage of ownership interests held by the transferor in the entire financial asset may vary over time, while the entire financial asset remains outstanding as long as the resulting portions held by the transferor (including any participating interest retained by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents) and the transferee(s) meet the other characteristics of a participating interest. For example, if the transferor’s interest in an entire financial asset changes because it subsequently sells another interest in the entire financial asset, the interest held initially and subsequently by the transferor must meet the definition of a participating interest.
From the date of the transfer, all cash flows received from the entire financial asset are divided proportionately among the participating interest holders (including any interest retained by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents) in an amount equal to their share of ownership. An allocation of specified cash flows is not an allowed characteristic of a participating interest unless each cash flow is proportionately allocated to the participating interest holders. In determining proportionate cash flows:
1. Cash flows allocated as compensation for services performed, if any, shall not be included provided those cash flows meet both of the following conditions:
  1. They are not subordinate to the proportionate cash flows of the participating interest.
  2. They are not significantly above an amount that would fairly compensate a substitute service provider, should one be required, which includes the profit that would be demanded in the marketplace.
2. Any cash flows received by the transferor as proceeds of the transfer of the participating interest shall be excluded provided that the transfer does not result in the transferor receiving an ownership interest in the financial asset that permits it to receive disproportionate cash flows.
The priority of cash flows has all of the following characteristics:
1. The rights of each participating interest holder (including the transferor in its role as a participating interest holder) have the same priority.
2. No participating interest holder’s interest is subordinated to the interest of another participating interest holder.
3. The priority does not change in the event of bankruptcy or other receivership of the transferor, the original debtor, or any other participating interest holder.
4. Participating interest holders have no recourse to the transferor (or its consolidated affiliates included in the financial statements being presented or its agents) or to each other, other than any of the following:
  1. Standard representations and warranties
  2. Ongoing contractual obligations to service the entire financial asset and administer the transfer contract
  3. Contractual obligations to share in any set-off benefits received by any participating interest holder.
  That is, no participating interest holder is entitled to receive cash before any other participating interest holder under its contractual rights as a participating interest holder. For example, if a participating interest holder also is the servicer of the entire financial asset and receives cash in its role as servicer, that arrangement would not violate this requirement.
No party has the right to pledge or exchange the entire financial asset unless all participating interest holders agree to pledge or exchange the entire financial asset.

A set-off right is not an impediment to meeting the participating interest definition. For implementation guidance on the application of the term participating interest, see paragraphs 860-10-55-17I through 55-17N.

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

40-41 A change in law or other circumstance may result in a transferred portion of an entire financial asset no longer meeting the conditions of a participating interest (see paragraph 860-10-40-6A) or the transferor’s regaining control of transferred financial assets after a transfer that was previously accounted for as a sale, because one or more of the conditions in paragraph 860-10-40-5 are no longer met. See the related guidance beginning in paragraph 860-20-25-8.

Application of the Term Participating Interest

55-17I Paragraph 860-10-40-6A(b) states that an allocation of specified cash flows precludes a portion from meeting the definition of a participating interest unless each cash flow is proportionately allocated to the participating interest holders. Following are several examples implementing that guidance:

In the circumstance of an individual loan in which the borrower is required to make a contractual payment that consists of a principal amount and interest amount on the loan, the transferor and transferee shall share in the principal and interest payments on the basis of their proportionate ownership interest in the loan.
In contrast, if the transferor is entitled to receive an amount that represents the principal payments and the transferee is entitled to receive an amount that represents the interest payments on the loan, that arrangement would not be consistent with the participating interest definition because the transferor and transferee do not share proportionately in the cash flows received from the loan.
In other circumstances, a transferor may transfer a portion of an individual loan that represents either a senior interest or a junior interest in an individual loan. In both of those circumstances, the transferor would account for the transfer as a secured borrowing because the senior interest or junior interest in the loan do not meet the requirements to be participating interests (see paragraph 860-10-40-6A(c)).

55-17J Given the conditions in paragraph 860-10-40-6A(b)(1), cash flows allocated as compensation for services performed that are significantly above an amount that would fairly compensate a substitute service provider would result in a disproportionate division of cash flows of the entire financial asset among the participating interest holders and, therefore, would preclude the portion of a transferred financial asset from meeting the definition of a participating interest. Examples of cash flows that are compensation for services performed include all of the following:

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

55-17K The transfer of a portion of an entire financial asset may result in a gain or loss on the transfer if the contractual interest rate on the entire financial asset differs from the market rate at the time of transfer. Paragraph 860-10-40-6A(b)(2) precludes a portion from meeting the definition of a participating interest if the transfer results in the transferor receiving an ownership interest in the financial asset that permits it to receive disproportionate cash flows. For example, if the transferor transfers an interest in an entire financial asset and the transferee agrees to incorporate the excess interest (between the contractual interest rate on the financial asset and the market interest rate at the date of transfer) into the contractually specified servicing fee, the excess interest would likely result in the conveyance of an interest-only strip to the transferor from the transferee. An interest-only strip would result in a disproportionate division of cash flows of the financial asset among the participating interest holders and would preclude the portion from meeting the definition of a participating interest.

55-17L Paragraph 860-10-40-6A(c) addresses the priority of cash flows. In certain transfers, recourse is provided to the transferee that requires the transferor to reimburse any premium paid by the transferee if the underlying financial asset is prepaid within a defined time frame of the transfer date. Such recourse would preclude the transferred portion from meeting the definition of a participating interest. However, once the recourse provision expires, the transferred portion shall be reevaluated to determine if it meets the participating interest definition.

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

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

The characteristics, nature, and quality of the underlying financial asset, including any of the following:
1. Characteristics of the underlying borrower
2. The type and nature of the collateral securing the underlying financial asset.
The quality, accuracy, and delivery of documentation relating to the transfer and the underlying financial asset
The accuracy of the transferor’s representations in relation to the underlying financial asset.

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

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

SEC Considerations

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

Table 3-2

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

ASC 860-10-40-41 states that a “change in law or other circumstance may result in a transferred portion of an entire financial asset no longer meeting the conditions of a participating interest.” Furthermore, ASC 860-10-55-17L states, in part, that when an interest holder’s recourse to the transferor expires, the “transferred portion shall be reevaluated to determine if it meets the participating interest definition.” On the basis of this guidance, entities should continually assess whether portions of an entire financial asset are participating interests.

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

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

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

3.2.2 Interpretive Guidance

3.2.2.1 Transition to ASU 2009-16

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

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

Question

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

Answer

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

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

Question

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

Answer

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

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

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

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

3.2.2.2 Scope of Guidance on Participating Interest

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

Question

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

Answer

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

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

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

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

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

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

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

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

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

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

Table 3-3

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

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

Question

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

Answer

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

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

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

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

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

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

Table 3-4

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

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

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

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

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

Question

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

Answer

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

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

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

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

Question

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

Answer

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

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

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

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

Question

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

Answer

Yes. ASC 860-10-40-41 states, in part, that a “change in law or other circumstance may result in a transferred portion of an entire financial asset no longer meeting the conditions of a participating interest (see paragraph 860-10-40-6A).” ASC 860-20-25-9 indicates that the transferor should account for such a change in the same manner as a purchase of such transferred financial asset from the former transferee(s). ASC 860-10-40-4 notes that the objective of sale accounting “is to determine whether a transferor and its consolidated affiliates included in the financial statements being presented have surrendered control over transferred financial assets.” That paragraph states that certain arrangements involving transferred financial assets must be considered even if they were not entered into at the time of transfer. In accordance with this guidance, B should apply the guidance on participating interests as of the date it purchases the subordinated interest in the commercial loan. Because B owns a disproportionate interest in the entire commercial loan, that interest is not a participating interest. Therefore, B must rerecognize the entire commercial loan receivable and recognize a liability for the 80 percent senior interest owned by C. See Section 4.3 for further discussion of the accounting when a transferor regains control of a financial asset previously considered sold.

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

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

Question

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

Answer

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

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

Q&A 3-9 GNMA Securitizations

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

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

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

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

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

Question

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

Answer

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

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

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

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

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

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

Question

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

Answer

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

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

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

Question

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

Answer

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

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

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

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

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

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

Question

Does the transfer meet the definition of a participating interest?

Answer

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

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

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

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

Question

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

Answer

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

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

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

3.2.2.5 Transfers of Interests With Recourse

Q&A 3-14 Limited Recourse Provisions

Question

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

Answer

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

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

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

ASC 860-10-40-6A(b)(1)(ii) indicates that cash flows allocated as compensation for servicing are not included in the evaluation of whether an interest is a participating interest if they “are not significantly above an amount that would fairly compensate a substitute service provider, should one be required, which includes the profit that would be demanded in the marketplace.”

Question

What is the meaning of “an amount that would fairly compensate a substitute service provider, should one be required, which includes the profit that would be demanded in the marketplace”?

Answer

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

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

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

Question

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

Answer

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

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

Q&A 3-17 Incentive Servicing Fees

Question

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

Answer

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

Q&A 3-18 Seniority of Servicing Fees

Question

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

Answer

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

Q&A 3-19 Servicer Advances

Question

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

Answer

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

Q&A 3-20 Servicer Remittances

Question

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

Answer

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

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

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

Question

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

Answer

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

3.2.2.7 Interest Payments on Transferred Interests in Entire Financial Assets

Q&A 3-22 Interest Rates on Transferred Interests

Question

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

Answer

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

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

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

Question

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

Answer

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

3.2.2.8 Rights of Holders of Interests in Entire Financial Assets

Q&A 3-24 Rights of Interest Holders

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

Question

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

Answer

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

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

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

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

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

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

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

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

Question

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

Answer

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

3.2.2.9 Specific Transaction Structures

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

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

Question

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

Answer

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

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

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

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

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

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

Question

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

Answer

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

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

Q&A 3-28 A/B Note Structures

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

Question

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

Answer

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

Q&A 3-29 LIFO and FIFO Participations

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

Question

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

Answer

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

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

Question

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

Answer

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

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

Question

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

Answer

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

Footnotes

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

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

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

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

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

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

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

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

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

This conclusion has been discussed informally with the FASB staff.

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

3.4 Transferee’s Rights to Pledge or Exchange

3.4.1 General

3.4.1.1 Overview of Pledge or Exchange Condition

ASC 860-10

Conditions for a Sale of Financial Assets

b. Transferee’s rights to pledge or exchange. This condition is met if both of the following conditions are met:

1. Each transferee (or, if the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities and that entity is constrained from pledging or exchanging the assets it receives, each third-party holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received.

2. No condition does both of the following:

i. Constrains the transferee (or third-party holder of its beneficial interests) from taking advantage of its right to pledge or exchange

ii. Provides more than a trivial benefit to the transferor (see paragraphs 860-10-40-15 through 40-21).

If the transferor, its consolidated affiliates included in the financial statements being presented, and its agents have no continuing involvement with the transferred financial assets, the condition under paragraph 860-10-40-5(b) is met. . . .

Transferee’s Rights to Pledge or Exchange Transferred Financial Assets

40-15 Many transferor-imposed or other conditions on a transferee’s right to pledge or exchange both constrain a transferee from pledging or exchanging and, through that constraint, provide more than a trivial benefit to the transferor. Judgment is required to assess whether a particular condition results in a constraint. Judgment also is required to assess whether a constraint provides a more-than-trivial benefit to the transferor. If the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities, that entity may be constrained from pledging or exchanging the transferred financial assets to protect the rights of beneficial interest holders in the financial assets of the entity. Paragraph 860-10-40-5(b) requires that the transferor look through the constrained entity to determine whether each third-party holder of its beneficial interests has the right to pledge or exchange the beneficial interests that it holds. The considerations in paragraphs 860-10-40-16 through 40-18 apply to the transferee or the third-party holders of its beneficial interests in an entity that is constrained from pledging or exchanging the assets it receives and whose sole purpose is to engage in securitization or asset-backed financing activities.

40-16 A condition imposed by a transferor that constrains the transferee presumptively provides more than a trivial benefit to the transferor. A condition not imposed by the transferor that constrains the transferee may or may not provide more than a trivial benefit to the transferor. For example, if the transferor refrains from imposing its usual contractual constraint on a specific transfer because it knows an equivalent constraint is already imposed on the transferee by a third party, it presumptively benefits more than trivially from that constraint. However, the transferor cannot benefit from a constraint if it is unaware at the time of the transfer that the transferee is constrained.

40-16A In some circumstances in which the transferor has no continuing involvement with the transferred financial assets, some conditions may constrain a transferee from pledging or exchanging the financial assets. Paragraph 860-10-40-5(b) states that if the transferor, its consolidated affiliates included in the financial statements being presented, and its agents have no continuing involvement with the transferred financial assets, the condition under paragraph 860-10-40-5(b) is met. For example, if a transferor receives only cash in return for the transferred financial assets and the transferor, its consolidated affiliates included in the financial statements being presented, and its agents have no continuing involvement with the transferred financial assets, sale accounting is allowed under paragraph 860-10-40-5(b) even if the transferee entity is significantly limited in its ability to pledge or exchange the transferred assets.

40-21 As discussed in paragraphs 860-10-40-22 through 40-39, some rights or obligations to reacquire transferred financial assets, regardless of whether they constrain the transferee, may result in the transferor’s maintaining effective control over the transferred financial assets, thus precluding sale accounting under paragraph 860-10-40-5(c). For example, an attached call option in itself would not constrain a transferee who is able, by exchanging or pledging the asset subject to that call, to obtain substantially all of its economic benefits. However, an attached call option could result in the transferor’s maintaining effective control over the transferred asset(s) because the attached call option gives the transferor the unilateral ability to cause whoever holds that specific asset to return it.

Transferee Is Significantly Limited in Its Ability to Pledge or Exchange the Transferred Financial Assets With No Continuing Involvement

55-28 An entity transfers financial assets to a transferee that is significantly limited in its ability to pledge or exchange the transferred financial assets (the transferee is not an entity whose sole purpose is to engage in securitization or asset-backed financing activities). The transferor receives cash in return for the transferred financial assets, and has no continuing involvement with the transferred assets. The transfer described in this example meets the condition in paragraph 860-10-40-5(b).

55-29 While the condition in paragraph 860-10-40-5(b) is met in the example described in the previous paragraph, in general, for transfers in which the transferor does have any continuing involvement, an evaluation shall be made as to whether the condition in paragraph 860-10-40-5(b) has been met.

55-30 For a transfer to fail to meet the condition in paragraph 860-10-40-5(b), the transferee must be constrained from pledging or exchanging the transferred financial asset and the transferor must receive more than a trivial benefit as a result of the constraint.

For a transfer to be accounted for as a sale, the “pledge or exchange” condition in ASC 860-10-40-5(b) must be met. The objective of this condition is for the transferee to have the ability to obtain the economic benefits of the transferred financial asset by pledging or exchanging it. Paragraph 161 of FASB Statement 140 states:

The second criterion [ASC 860-10-40-5(b)] for a transfer to be a sale focuses on whether the transferee has the right to pledge or exchange the transferred assets. That criterion is consistent with the idea that the entity that has an asset is the one that can use it in the various ways set forth in Concepts Statement 6, paragraph 184 (quoted in paragraph 143 of this Statement). A transferee may be able to use a transferred asset in some of those ways but not in others. Therefore, establishing criteria for determining whether control has been relinquished to a transferee necessarily depends in part on identifying which ways of using the kind of asset transferred are the decisive ones. In the case of transfers of financial assets, the transferee holds the assets, but that is not necessarily decisive because the economic benefits of financial assets consist primarily of future cash inflows. The Board concluded that the ways of using assets that are important in determining whether a transferee holding a financial asset controls it are the ability to exchange it or pledge it as collateral and thus obtain all or most of the cash inflows that are the primary economic benefits of financial assets. As discussed in paragraph 173, if the transferee is [an entity whose sole purpose is to engage in securitization or asset-backed financing activities], the ultimate holders of the assets are the beneficial interest holders (BIHs), and the important rights concern their ability to exchange or pledge their interests.

Paragraph 169 of the Basis for Conclusions of FASB Statement 140 further explains that the key concept is “the ability [of the transferee] to obtain all or most of the cash inflows, either by exchanging the transferred asset or by pledging it as collateral.” To determine whether the condition in ASC 860-10-40-5(b) is met, an entity first considers whether it has any continuing involvement in the transferred financial assets. If the transferor, its consolidated affiliates included in the financial statements being presented, and its agents have no continuing involvement with the transferred financial assets other than standard representations and warranties, the condition in ASC 860-10-40-5(b) is met even if the transferee is prohibited, or significantly constrained, from pledging or exchanging the transferred financial assets or beneficial interests in the transferred financial assets (see ASC 860-10-40-16A and ASC 860-10-40-55-28 through 55-30). Under ASC 860-10, the lack of continuing involvement takes precedence in the evaluation of whether a transferee is able to pledge or exchange transferred financial assets. The theory is that if the transferor has no continuing involvement in transferred financial assets, the transferor can obtain no future benefit from the transferred financial assets and therefore should derecognize them in the absence of other conditions preventing sale accounting. However, in most cases, the transferor has continuing involvement in the transferred financial assets. In fact, it is unusual for the transferor not to have continuing involvement when it transfers financial assets to a securitization or asset-backed financing entity since these transactions are typically credit-enhanced through the transferor’s receipt of beneficial interests in the transferred financial assets.

If the transferor, its consolidated affiliates included in the financial statements being presented, or its agents have continuing involvement with the transferred financial assets, an entity must consider the following steps to determine whether the condition in ASC 860-10-40-5(b) is met:

Step 1 — Determine whether the evaluation focuses on the transferee’s ability to pledge or exchange (1) the transferred financial assets or (2) the third-party beneficial interests in the transferred financial assets.
Step 2 — Assess whether the transferee has rights to pledge or exchange the transferred financial assets (or third-party beneficial interests in the transferred financial assets). If yes, go to step 3. If no, the condition in ASC 860-10-40-5(b) is not met.
Step 3 — Evaluate whether there are any constraints on the transferee’s rights to pledge or exchange the transferred financial assets (or third-party beneficial interests in the transferred financial assets). If yes, go to step 4. If no, the condition in ASC 860-10-40-5(b) is met.
Step 4 — Determine whether the constraints on the transferee’s rights to pledge or exchange the transferred financial assets (or third-party beneficial interests in the transferred financial assets) provide a more than trivial benefit to the transferor. If yes, the condition in ASC 860-10-40-5(b) is not met. If no, the condition in ASC 860-10-40-5(b) is met.

The condition in ASC 860-10-40-5(b) is met unless (1) the transferee is constrained from pledging or exchanging the transferred financial assets (or third-party beneficial interests in the transferred financial assets) and (2) that constraint provides the transferor with a more than trivial benefit. Section 3.9 summarizes the effect that options to repurchase financial assets (and third-party beneficial interests in transferred financial assets) have on the evaluation of whether a transferee can pledge or exchange transferred financial assets.

3.4.1.2 Step 1: Perspective From Which Pledge or Exchange Condition Is Evaluated

If financial assets are transferred to an entity whose sole purpose is to engage in securitization or asset-backed financing activities, that entity is generally constrained from pledging or exchanging the assets it receives because they are pledged as collateral on beneficial interests issued by the transferee. Therefore, ASC 860-10 allows transferors to focus the pledge or exchange condition on the rights of third-party holders of beneficial interests in the transferred financial assets. That is, the transferor should “look through” the transferee entity to the third-party holders of beneficial interests in the transferred financial assets and determine whether those holders have rights to pledge or exchange their interests without being constrained from doing so. The ability of third-party beneficial interest holders to pledge or exchange their interests is the equivalent of a transferee’s rights to pledge or exchange the transferred financial assets themselves. Accordingly, a constraint on the transferee that issues those beneficial interests (i.e., the transferee is unable to pledge or exchange the financial assets received) does not mean that the transferor has retained control over the transferred financial assets.

To determine the perspective from which the pledge or exchange condition is evaluated, a transferor should consider whether, by design, the purpose of the transferee is to transfer interests in the financial assets received to investors by issuing beneficial interests in those assets. If that is the case, and the securitization or asset-backed financing entity that received the transferred financial assets is constrained from pledging or exchanging them, the condition in ASC 860-10-40-5(b) should focus on the rights of third-party holders of beneficial interests in the transferred financial assets. If, however, the transferee is not constrained from pledging or exchanging the financial assets received, the condition in ASC 860-10-40-5(b) would be met without the need to consider whether third-party beneficial interest holders can pledge or exchange their interests.

When the condition in ASC 860-10-40-5(b) focuses on the rights of third-party beneficial interest holders to pledge or exchange their interests, the following should be considered in the evaluation:

In two-step securitization transactions, the transferred financial assets for which beneficial interests have been issued represent the assets transferred from the BRSPE to the securitization entity. If an entity has transferred entire financial assets to a BRSPE, but that BRSPE transfers interests in those entire financial assets received to a securitization entity, those interests must meet the definition of a participating interest for sale accounting to be possible.
A transferor may need to “look through” more than one transferee to identify the third-party holders of beneficial interests in transferred financial assets (e.g., if an entity transfers financial assets to a multiseller conduit that is designed to sell interests in the assets it receives to third-party investors). The objective is to identify the ultimate third-party holders of beneficial interests in the transferred financial assets regardless of the number of entities that a transferor “looks through” in a securitization or asset-backed financing transaction. ASC 860-10 is clear that constraints on the ability to pledge or exchange financial assets received by entities designed solely as part of a securitization or asset-backed financing activity serve to protect the beneficial interest holders and do not preclude the condition in ASC 860-10-40-5(b) from being met. There is no limit on the number of “down-stream” entities the analysis “looks through” to identify the ultimate third-party beneficial interest holders.

Connecting the Dots

Assume that an entity transfers entire trade receivables to a BRSPE that, in turn, transfers those receivables to an unconsolidated intervening SPE whose sole purpose is to engage in securitization or asset-backed financing activities. Further assume that the intervening SPE transfers senior interests in the trade receivables received to multiple other SPEs that issue CP to third parties to finance such purchases. The intervening SPE is generally prohibited from taking any action with respect to the trade receivables received other than transferring senior interests in those receivables to the SPEs that issue CP. In addition, the SPEs that acquire those senior interests from the intervening SPE cannot freely pledge or exchange those interests since they must be pledged as collateral on the CP issued by these SPEs. If the evaluation of ASC 860-10-40-5(b) focused on the intervening SPE, this condition for sale accounting would not be met. However, it is appropriate to “look through” to the ultimate third-party beneficial interest holders in the transferred receivables, which are the investors in the CP issued by the SPEs that acquired interests from the intervening SPE. Provided that the investors in the CP are not restricted in their ability to pledge or exchange those interests, the condition in ASC 860-10-40-5(b) would be met for the transferor of the trade receivables. We have discussed this issue informally with the FASB staff.

Situations similar to the one described above can exist in resecuritization transactions. See Example 3-12 for an illustration.
A transferor only needs to consider whether third-party holders of beneficial interests may pledge or exchange their interests without being constrained from doing so. The fact that the transferor, its consolidated affiliates included in the financial statements being presented, or its agents are unable to pledge or exchange their beneficial interests in the transferred financial assets, or are constrained from pledging or exchanging those interests, has no impact on the evaluation of whether the condition in ASC 860-10-40-5(b) is met. There is no requirement that the transferor, its consolidated affiliates included in the financial statements being presented, or its agents be able to pledge or exchange any beneficial interests held. In many cases, such interests serve as a credit enhancement and may not be pledged or exchanged or can be pledged or exchanged only if certain conditions are met.

Connecting the Dots

Any involvement of an agent of a transferor is considered in the same manner as if the involvement was with the transferor. Therefore, any beneficial interests in transferred financial assets held by an agent on behalf of the transferor are not subject to the pledge or exchange condition in ASC 860-10-40-5(b). In transfers of financial assets by subsidiary entities, it is common for other entities within the same commonly controlled group to hold beneficial interests on behalf of the subsidiary-transferor.
In some cases, an entity involved in securitization or asset-backed financing activities may receive financial assets, or interests in financial assets, from multiple transferor entities. In those situations, the beneficial interests issued may represent interests in specified financial assets or interests in the entity as a whole. When beneficial interests represent interests in specified financial assets, entities can elect to apply either of the following views as an accounting policy in determining whether the condition in ASC 860-10-40-5(b) is met:
- “Asset view” — Only third-party holders of beneficial interests in the financial assets transferred by the transferor need to meet the pledge or exchange condition in ASC 860-10-40-5(b). According to this view, in securitization or asset-backed financing transactions involving multiple sellers, any beneficial interests received as proceeds by other third-party transferors are not relevant if those interests do not derive any of their cash flows from the financial assets transferred by the transferor.
- “Entity view” — All third-party holders of beneficial interests issued by a securitization or asset-backed financing entity must meet the condition in ASC 860-10-40-5(b). According to this view, in securitization or asset-backed financing transactions involving multiple sellers, any beneficial interests received as proceeds by other third-party transferors (i.e., those that are not consolidated affiliates or agents of the transferor) must be able to pledge or exchange their interests without being constrained from doing so to meet the condition in ASC 860-10-40-5(b).
The acceptability of these alternative views has been discussed informally with the FASB staff. Examples 3-8 and 3-12 illustrate the “asset view,” which we believe is most often applied in practice.

3.4.1.3 Step 2: Rights to Pledge or Exchange

The agreements involving transfers of financial assets will generally contain transfer or assignment provisions that indicate whether the transferee (or a third-party holder of beneficial interests in transferred financial assets) may pledge or exchange its interests. If the agreements indicate that a transfer, assignment, or pledge is prohibited, the condition in ASC 860-10-40-5(b) is not met. If the agreements involving the transfer are silent on the ability of the transferee (or a third-party holder of beneficial interests in transferred financial assets) to pledge or exchange its interests, the evaluation of whether the transferee (or a third-party holder of beneficial interests in transferred financial assets) has such rights is a legal determination that should be made on the basis of the relevant laws that would apply in the circumstances. The certification of a beneficial interest is not a prerequisite for meeting the condition in ASC 860-10-40-5(b).

3.4.1.4 Step 3: Constraints on Transferee’s Rights to Pledge or Exchange

ASC 860-10

Transferee’s Rights to Pledge or Exchange Transferred Financial Assets

40-17 All of the following are examples of conditions that both constrain the transferee and presumptively provide the transferor with more than trivial benefits:

A provision that prohibits selling or pledging a transferred loan receivable. This condition not only constrains the transferee but also provides the transferor with the more-than-trivial benefit of knowing who holds the financial asset (a prerequisite to repurchasing the financial asset) and of being able to block the financial asset from being transferred to a competitor for the loan customer’s business.
Transferor-imposed contractual constraints that narrowly limit timing or terms, for example, allowing a transferee to pledge only on the day assets are obtained or only on terms agreed to with the transferor.
Some rights or obligations to reacquire transferred financial assets or beneficial interests, including all of the following:

1. A freestanding call option written by a transferee to the transferor. Such an option may benefit the transferor and, if the transferred financial assets are not readily obtainable in the marketplace, is likely to constrain a transferee because the transferee might have to default if the call option was exercised and the transferee had pledged or exchanged the financial assets.

1a. A call option to repurchase third-party beneficial interests at the price paid plus a stated return if the third-party holders of its beneficial interests are constrained from pledging or exchanging their beneficial interests due to that call option.

2. A call option written by a transferee to the transferor that is sufficiently deep-in-the-money, if the transferred financial assets are not readily obtainable in the marketplace, because the transferee would be more likely to have to hold the assets to comply with a potential exercise of the call option.

3. A freestanding forward purchase-sale contract between the transferor and the transferee on transferred financial assets not readily obtainable in the marketplace would benefit the transferor and is likely to constrain a transferee.

4. Subparagraph superseded by Accounting Standards Update No. 2009-16.

40-18 All of the following are examples of conditions that presumptively would not constrain a transferee from pledging or exchanging the transferred financial asset:

A transferor’s right of first refusal on the occurrence of a bona fide offer to the transferee from a third party, because the right in itself does not enable the transferor to compel the transferee to sell the financial asset and the transferee would be in a position to receive the sum offered by exchanging the financial asset, albeit possibly from the transferor rather than the third party
A requirement to obtain the transferor’s permission to sell or pledge that is not to be unreasonably withheld
A prohibition on sale to the transferor’s competitor if other potential willing buyers exist
A regulatory limitation such as on the number or nature of eligible transferees (as in the circumstance of securities issued under Securities Act Rule 144A or debt placed privately)
Illiquidity, for example, the absence of an active market
Subparagraph superseded by Accounting Standards Update No. 2009-16.
Freestanding rights to reacquire transferred assets that are readily obtainable.

40-19 Judgment is required to assess the significance of some conditions. For example, a prohibition on sale to the transferor’s competitor would be a constraint if that competitor were the only potential willing buyer other than the transferor.

Transferee’s Right to Pledge or Exchange Transferred Financial Assets

55-26 The following provides implementation guidance on the application of the condition in paragraph 860-10-40-5(b) related to the transferee’s right to pledge or exchange transferred assets in certain circumstances and transactions, specifically:

Transferee is precluded from exchanging the transferred financial assets but has the unconstrained right to pledge them.
Transferee is significantly limited in its ability to pledge or exchange the transferred financial assets.
Transferor’s approval is required for transferee’s subsequent transfers or pledges.
Transactions involving Rule 144A securities.

Transferee Is Precluded From Exchanging the Transferred Financial Assets but Has the Unconstrained Right to Pledge Them

55-27 In a transaction in which a transferee (that is not an entity whose sole purpose is to engage in securitization or asset-backed financing activities) is precluded from exchanging the transferred financial assets but obtains the unconstrained right to pledge them, the determination of whether the sale condition in paragraph 860-10-40-5(b) is met depends on the facts and circumstances. In a transfer of financial assets, a transferee’s right to both pledge and exchange transferred financial assets suggests that the transferor has surrendered its control over those financial assets. However, more careful analysis is warranted if the transferee may only pledge the transferred financial assets.

Transferor’s Approval Required for Transferee’s Subsequent Transfers or Pledges

55-31 Judgment is necessary to determine whether a requirement to obtain the transferor’s permission to sell or exchange should preclude sale accounting. For example, in certain loan participation agreements involving transfers of participating interests, the transferor is required to approve any subsequent transfers or pledges of the interests in the loans held by the transferee. Whether that requirement would be a constraint that would prevent the transferee from taking advantage of its right to pledge or to exchange the transferred financial asset and, therefore, accounting for the transfer as a sale, depends on the nature of the requirement for approval.

55-32 A prohibition on sale to the transferor’s competitor may or may not constrain a transferee from pledging or exchanging the financial asset, depending on how many other potential buyers exist. If there are many other potential willing buyers, the prohibition would not be constraining. In contrast, if that competitor were the only potential willing buyer (other than the transferor), then the condition would be constraining.

Transactions Involving Rule 144A Securities

55-33 Issuing beneficial interests in the form of securities issued under Rule 144A presumptively would not constrain a transferee’s ability to transfer those beneficial interests for purposes of this Subtopic. The primary limitation imposed by Rule 144A is that a potential buyer must be a sophisticated investor. If a large number of qualified buyers exist, the holder could transfer those securities to many potential buyers and, thereby, realize the full economic benefit of the assets. In such circumstances, the requirements of Rule 144A would not be a constraint that precludes sale accounting under paragraph 860-10-40-5(b).

An entity must use judgment in determining whether a holder’s right to pledge or exchange transferred financial assets (or beneficial interests in the transferred financial assets) is constrained and whether that constraint affects the evaluation of the condition in ASC 860-10-40-5(b). The guidance on this topic in ASC 860-10-40-17 through 40-19, ASC 860-10-55-26 and 55-27, and ASC 860-10-55-31 through 55-33 should be considered.

As noted in ASC 860-10-55-27, the condition in ASC 860-10-40-5(b) is more likely not to be met if the transferee is unable to exchange (i.e., sell) a transferred financial asset. That is, if the transferee is only able to pledge the asset, the transferee’s ability to obtain access to the economic benefits of the transferred financial asset is significantly limited. See Q&A 3-44 for further discussion of what constitutes a pledge.

When a transferee is able to exchange a transferred financial asset (or third-party beneficial interest in transferred financial assets) but the entity’s ability to obtain the economic benefits of the asset is limited, an entity must consider whether the constraint is relevant to the evaluation of the condition in ASC 860-10-40-5(b). This will generally depend on whether the limitation is inherent in the asset being transferred or arises because of the transfer. The former is less likely to cause the condition in ASC 860-10-40-5(b) not to be met than the latter.

Certain limitations on a transferee’s ability to pledge or exchange transferred financial assets that arise from the nature of the transferred assets (or third-party beneficial interests in the transferred financial assets) presumptively do not prevent the condition in ASC 860-10-40-5(b) from being met. Examples of such limitations include the following:

Lack of liquidity for the transferred financial asset (see ASC 860-10-40-18(e)).
A regulatory limitation on the sale of beneficial interests in transferred financial assets (see ASC 860-10-40-18(d) and ASC 860-10-55-33).

Connecting the Dots

Limitations on the ability to transfer a financial asset that are inherent in the asset (i.e., that do not arise from the transfer) will generally not represent constraints that preclude a transfer from meeting the condition in ASC 860-10-40-5(b). However, this is not always true. For example, assume that a transferee would incur a significant negative tax consequence from further transferring a financial asset (e.g., a BOLI asset) because of how that subsequent transfer would be treated under income tax law. This would be likely to result in a constraint that prevents the condition in ASC 860-10-40-5(b) from being met.

As discussed in ASC 860-10-40-15, transferor-imposed constraints on an entity’s ability to pledge or exchange transferred financial assets (or third-party beneficial interests in transferred financial assets) that arise from the terms of the transfer generally cause the condition in ASC 860-10-40-5(b) not to be met. However, a condition that allows a transferee to pledge or sell transferred financial assets (or third-party beneficial interests in transferred financial assets) only with the transferor’s consent is not considered a constraint if such consent cannot be unreasonably withheld unless there is evidence to the contrary regarding how such a condition would be interpreted under the relevant laws governing this requirement.25 Other conditions representing constraints that would not be expected to cause the condition in ASC 860-10-40-5(b) not to be met include the following:

A transferor’s right of first refusal related to the occurrence of a bona fide offer to the transferee from a third party, because this right in itself does not allow the transferor to compel the transferee to sell the financial asset and the transferee would be in a position to receive the sum offered by exchanging the financial asset, albeit possibly from the transferor rather than the third party (see ASC 860-10-40-18(a)).26
A prohibition on a sale to a competitor of the transferor if other potential willing buyers exist (see ASC 860-10-40-18(c) and ASC 860-10-55-32).
A constraint that the transferor is not aware of at the time of the transfer (ASC 860-10-40-16).
Certain rights or obligations to reacquire the transferred financial assets (see below).

The following examples will generally represent constraints that preclude the transferor from meeting the condition in ASC 860-10-40-5(b):

The inability of the transferee to pledge or exchange the asset received without the transferor’s consent, which can be withheld for any reason.
Transferor-imposed contractual constraints that narrowly limit the timing or terms of pledges or exchanges (e.g., allowing a transferee to pledge or sell transferred financial assets only on the day those assets are received or only on terms the transferor specifically agrees to). See Examples 3-14 and 3-15 for related illustrations.
A prohibition on sale to the transferor’s competitor if there are no or only a few other willing buyers.
A constraint imposed by a third party if the transferor is aware of the constraint and would have imposed a similar constraint in the absence of the constraint’s existence.
Certain rights or obligations to reacquire the transferred financial assets.

The determination of whether rights or obligations to reacquire transferred financial assets constitute constraints that prevent the condition in ASC 860-10-40-5(b) from being met depend on the nature of such rights or obligations. Some rights and obligations to reacquire transferred financial assets (or third-party beneficial interests in transferred financial assets) represent constraints that prevent the condition in ASC 860-10-40-5(b) from being met. Other rights and obligations to reacquire transferred financial assets (or third-party beneficial interests in transferred financial assets) do not represent constraints; however, such rights or obligations could still prevent sale accounting because the transferor maintains effective control over the transferred financial assets (see Section 3.5). The table below discusses how rights and obligations to reacquire transferred financial assets (or third-party beneficial interests in transferred financial assets) affect the evaluation of the condition in ASC 860-10-40-5(b).

Table 3-5

Repurchase Feature	Discussion
A freestanding call option written by the transferee (or third-party beneficial interest holder) to the transferor that allows the transferor to repurchase the transferred financial assets (or third-party beneficial interests in the transferred financial assets). Note that while call options on beneficial interests may be freestanding options, they are generally considered attached to the beneficial interests.	If the financial assets or beneficial interests that may be repurchased are not readily obtainable, the freestanding call option would constrain the transferee because it would have to default on the option if it was exercised and the transferee had previously transferred the financial assets or beneficial interests. This is the case regardless of whether (1) the exercise price is fixed or variable or (2) the transferor asserts that exercise of the option is remote (unless that is due to the exercise price being deep-out-of-the-money as of the date the option is written). A freestanding call option would not constrain a transferee (or third-party beneficial interest holder) in the following situations: The call option requires net cash settlement or can be net-cash-settled at the option of the transferee (or third-party beneficial interest holder). See Example 3-13. The transferred financial assets or third-party beneficial interests are readily obtainable. Regardless of the exercise price, freestanding rights to reacquire assets that are readily obtainable presumptively do not constrain the holder of those assets. However, such options could still prevent sale accounting because the transferor may retain effective control over the transferred financial assets (see Section 3.5). As of the date the option is written, the exercise price is so far out-of-the-money that it is probable that the option would not be exercised. Note that such circumstances would be unusual.
An attached call option written by the transferee (or third-party beneficial interest holder) to the transferor that allows the transferor to repurchase the transferred financial assets (or beneficial interests). Unlike a freestanding option, an attached option is transferred with the asset if it is sold to a third party.	Attached call options generally do not constrain a transferee or third-party beneficial interest holder from pledging or exchanging the asset subject to the option because the holder can obtain all or substantially all of the economic benefits of the asset by transferring it to a third party that becomes subject to the call option. However, as discussed in ASC 860-10-40-21, attached call options generally cause the transferor to maintain effective control over the transferred financial assets (see Section 3.5.3).
A freestanding put option written by the transferor that allows the transferee to require the transferor to repurchase the transferred financial assets (or third-party beneficial interests in the transferred financial assets).	A freestanding put option generally does not constrain a transferee or third-party beneficial interest holder because it can forgo exercising the option and sell the asset to a third party. See Section 3.5.4 for discussion of the effect that freestanding put options have on the condition in ASC 860-10-40-5(c).
Freestanding forward contracts that require the transferor to repurchase transferred financial assets (or third-party beneficial interests in transferred financial assets).	Unless the financial assets (or beneficial interests) to be purchased are readily obtainable, regardless of whether the forward price is fixed or at fair value, the condition in ASC 860-10-40-5(b) is not met because the transferee (or beneficial interest holder) cannot pledge or exchange its interests and meet the resale requirement. If the financial assets to be repurchased by the transferor are readily obtainable, but they are the same or substantially the same as the transferred financial assets, sale accounting is generally still precluded because the condition in ASC 860-10-40-5(c) is not met. See Section 3.5.2 for further discussion of forward repurchase agreements.

The above table discusses unilaterally exercisable repurchase features. The determination of whether conditionally exercisable repurchase features constrain the transferee’s right to pledge or exchange the transferred financial assets depends on the circumstances (i.e., the nature of the condition and whether the transferred financial assets are readily obtainable). If such a feature is determined to constrain the transferee, the transferor should consider Section 3.4.1.5. Such conditionally exercisable repurchase features will generally not cause the condition in ASC 860-10-40-5(b) not to be met.

3.4.1.5 Step 4: Transferor’s Ability to Benefit From Constraints on a Transferee’s Rights to Pledge or Exchange

If a transferee can freely pledge or exchange the transferred financial assets (or third-party beneficial interests in the transferred financial assets) or any limitation is not a constraint as discussed in Section 3.4.1.4, the condition in ASC 860-10-40-5(b) is met. Otherwise, an entity must consider whether the constraint provides the transferor with a more than trivial benefit. The threshold for what constitutes a more than trivial benefit is extremely low. The focus is on whether there is any potential economic or other benefit to the transferor from a constraint on the transferee’s ability to pledge or exchange the transferred financial assets (or third-party beneficial interests in transferred financial assets). Therefore, any time a transferor has a unilaterally exercisable fixed-price option to repurchase transferred financial assets, such an option provides the transferor with a more than trivial benefit unless it is deep out-of-the-money when written. However, the mere fact that a repurchase option held by the transferor does not have a fixed exercise price does not mean that such an option does not provide the transferor with a more than trivial benefit. A transferor cannot assert that a more than trivial benefit does not exist because it does not intend to enforce a constraint (e.g., it does not have the funding to purchase the transferee’s interest).

If the constraint was imposed by the transferor, it would provide a more than trivial benefit to the transferor in the absence of compelling evidence to the contrary. (see ASC 860-10-40-16). We believe that it would be rare for an entity to conclude that a transferor-imposed constraint does not provide the transferor with a more than trivial benefit. In some cases, it may be clear whether a constraint not imposed by the transferor would provide the transferor with a more than trivial benefit; in other cases, an entity may need to use judgment in performing this assessment. As part of this evaluation, an entity should consider whether the transferor refrained from imposing a constraint because it knows that an equivalent constraint is already imposed by a third party. However, constraints that the transferor is not aware of cannot provide it with a more than trivial benefit (see ASC 860-10-40-16).

Connecting the Dots

Sale accounting is precluded if a transferee is constrained from selling or pledging transferred financial assets (or third-party beneficial interests in transferred financial assets) and the constraint, whether imposed by the transferor or a third party, provides a more than trivial benefit to the transferor. Rights or obligations to reacquire transferred financial assets (or third-party beneficial interests in transferred financial assets) may not constrain the transferee but may still cause the transferor to maintain effective control over the transferred financial assets under ASC 860-10-40-5(c). See Section 3.5 for more information.

3.4.2 Interpretive Guidance

3.4.2.1 Transition to ASU 2009-16

Q&A 3-43 Continued Relevance of QSPE Concept

Before ASU 2009-16, some transfers met the condition in ASC 860-10-40-5(b) because financial assets were transferred to QSPEs. ASU 2009-16 eliminated the QSPE concept. The transition provisions of ASU 2009-16 are prospective (i.e., they apply to transfers that occur after the effective date).

Question

Should an entity that transferred financial assets to a QSPE before adoption of ASU 2009-16 continue to evaluate whether the transferee is a QSPE?

Answer

Considering the transition provisions of ASU 2009-16, entities would continue to determine whether transferees are QSPEs. However, for practical purposes, if there was a substantive transaction or event (e.g., a modification of terms) that caused a transferee to no longer be a QSPE, the transferor could consider the change as resulting in a new transfer and apply the current guidance in ASC 860-10-40-5(b). Note that this Q&A would not be relevant to QSPEs that were consolidated upon adoption of ASU 2009-17.

3.4.2.2 Pledges of Financial Assets

Q&A 3-44 Meaning of Pledge

The condition in ASC 860-10-40-5(b) is met if each transferee (or third-party beneficial interest holder in transferred financial assets) has the right to “pledge or exchange” the assets (or beneficial interests) received and is not constrained from doing so.

Question

What is the meaning of “pledge” in ASC 860-10-40-5(b)?

Answer

A pledge exists only if the transferee can obtain all or nearly all of the economic benefits from the financial asset (i.e., the transferee can monetize and realize the benefits as if it sold the financial asset). For this purpose, the transferee would need to obtain 95 percent or more of the economic benefits from the financial asset. In contrast to a security interest, in a pledge, an entity generally transfers custody and legal title of the financial asset to the secured party, which generally can repledge the financial asset.

The granting of a security interest in a financial asset is not the same as pledging a financial asset as collateral. The ASC master glossary defines a security interest as “[a] form of interest in property that provides that upon default of the obligation for which the security interest is given, the property may be sold to satisfy that obligation.” Therefore, the condition in ASC 860-10-40-5(b) is not satisfied if a transferee is only able to grant a security interest in the financial asset. In a security interest, the counterparty is unable to repledge the financial asset because it must wait until a default on the obligation has occurred to take control of the asset.

3.4.2.3 Scope

Q&A 3-45 Transfers of Participating Interests

Question

Does the condition in ASC 860-10-40-5(b) apply to transfers of participating interests?

Answer

Yes. ASC 860-10-40-5(b) applies to all transfers of financial assets within the scope of ASC 860-10. ASC 860-10-40-5 and ASC 860-10-55-31 indicate that this condition applies in transfers of participating interests.

Q&A 3-46 Guarantee Fees

Conforming mortgage loans are often transferred in transactions that involve a guarantee provided by the FHLMC or FNMA. As guarantor, the FHLMC and FNMA receive guarantee fees from the coupon on transferred mortgage loans. The evaluation of ASC 860-10-40-5(b) for these transactions generally focuses on whether third-party beneficial interest holders have the right to pledge or exchange their interests.

Question

Does the condition in ASC 860-10-40-5(b) apply to guarantee fees receivable by the FHLMC or FNMA?

Answer

No. The definition of a beneficial interest in ASC 860-10-20 includes “premiums due to guarantors.” However, we do not believe that a transferor should conclude that a transfer of financial assets does not meet the condition in ASC 860-10-40-5(b) because the FHLMC or FNMA cannot pledge or exchange its guarantee fees or would be significantly constrained in doing so. The basis for this conclusion is that if the pledge or exchange condition were applied to the guarantee fees receivable by the FHLMC or FNMA, most transfers of mortgage loans involving the FHLMC or FNMA would fail to meet the conditions for sale accounting. We do not believe that this was the FASB’s intent. Rather, we believe that it is acceptable to focus on the FHLMC’s and FNMA’s guarantee obligation collectively, including the guarantee fees for accepting this obligation, and conclude that the obligation as a whole is not a beneficial interest in the transferred financial assets. The same conclusion would apply to any guarantee fees involved in GNMA securitization transactions. This conclusion should not, however, be applied by analogy to other transactions.

3.4.2.4 U.S. Risk Retention Requirements

Q&A 3-47 Application of ASC 860-10-40-5(b) to CMBS Securitization Transactions Subject to U.S. Risk Retention Rules

Commercial mortgage loans may be securitized into commercial mortgage-backed securities (CMBS). Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act contains risk retention rules that require sponsors to retain a specified percentage of the credit risk associated with commercial mortgage loans that are securitized into CMBS. Sponsors of issuances of CMBS are generally required to retain 5 percent of the credit risk of the underlying commercial mortgage loans securitized for a certain period after the securitization closing date. Such risk is retained by holding beneficial interests in the CMBS, which may consist of a 5 percent interest in each tranche of the CMBS, a subordinated interest in an amount equal to 5 percent of the fair value of all beneficial interests issued, or a combination of the two that is a 5 percent interest in the aggregate. A given transaction may have multiple sponsors; in such a transaction, each sponsor transfers commercial mortgage loans into the securitization but only one of the sponsors acts as the retaining sponsor under the rules (the “Retaining Sponsor”). During the risk retention period, the Retaining Sponsor and other permitted TPPs must hold the risk interest (the “Risk Retention Interest”) and may not transfer such interest, enter into certain credit hedges, or borrow against the interest on a full nonrecourse basis.

As an alternative to directly owning the Risk Retention Interest, the Retaining Sponsor may satisfy the risk retention requirements by having one or two TPPs purchase the most subordinate class or classes of securities issued in the offering in an amount equal to 5 percent of the fair value of all of the CMBS issued in the offering. In the event that the TPPs do not purchase enough subordinated interests in the CMBS to meet the full 5 percent fair value requirement, the Retaining Sponsor can satisfy the 5 percent risk retention requirement by retaining an incremental interest in the CMBS. The risk retention requirements cannot be met by a TPP owning other than subordinated interests in the CMBS.

In the event that a TPP is used to satisfy all or a portion of the 5 percent risk retention requirement, the TPP is subject to the same requirements to which the Retaining Sponsor would have been subject, including constraints on sale and certain restrictions on hedging and pledging on a nonrecourse basis. In particular, the TPP is generally precluded from pledging or exchanging its interests for five years. (Note that while certain pledges may be permissible, a TPP is unable to obtain nearly all of the economic benefits of its interests by pledging them on a nonrecourse basis.)

CMBS transactions typically occur through two-step securitization transactions. In a single-transferor CMBS, if the Retaining Sponsor entirely meets the risk retention requirements, the condition in ASC 860-10-40-5(b) would generally be met because third-party holders of beneficial interests in the CMBS would not be constrained from pledging or exchanging their interests. However, in the following two situations, from the transferor’s perspective, third-party owners of beneficial interests would be constrained from pledging or exchanging their interests:

In a single-transferor CMBS securitization transaction, if a TPP is used to meet the risk retention requirements, the TPP will be constrained from pledging or exchanging its subordinated interests.
In a multiple-transferor CMBS, even if TPPs are not used to meet the risk retention requirements, unless there is only a single Retaining Sponsor, the other sponsors will be constrained from pledging or exchanging the interests they own to meet the risk retention requirements.

For the question below, assume that (1) entire commercial mortgage loan receivables are transferred to a CMBS securitization entity and (2) the Retaining Sponsor is not required to consolidate the CMBS securitization entity.

Question

Do the constraints on the ability of a TPP or other sponsors in a CMBS securitization prevent a transferor from meeting the condition in ASC 860-10-40-5(b) for commercial mortgage loans transferred in CMBS securitization transactions subject to the risk retention requirements of Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act?

Answer

No. In 2017, the Securities Industry and Financial Markets Association (SIFMA) submitted a preclearance letter to the SEC’s Office of the Chief Accountant regarding this question. In response, the staff of the SEC’s Office of the Chief Accountant indicated that it would not object to SIFMA’s conclusion that the condition in ASC 860-10-40-5(b) is met regardless of the restrictions imposed by U.S. law on the ability of a TPP or other sponsor of a CMBS securitization transaction to pledge or exchange its interests during the risk retention period. The staff did not say why it did not object to this view but indicated that its decision was based on the unique facts and circumstances associated with the regulation of the U.S. securitization market. The staff further noted that the conclusion cannot be analogized to.

Although the staff did not give its rationale, we believe that the basis for its view may be that an entity would consider the TPP or other sponsors in CMBS securitization transactions to represent agents of the transferor in performing the evaluation under ASC 860-10-40-5(b). As discussed in Section 3.4.1.2, agents of a transferor do not need to be able to pledge or exchange their interests to meet the condition in ASC 860-10-40-5(b).

3.4.2.5 Reassessment

Q&A 3-48 Change in Assessment After the Transfer Date

Question

Can the evaluation of the condition in ASC 860-10-40-5(b) change after the transfer date?

Answer

Yes. The condition in ASC 860-10-40-5(b) is typically evaluated as of the transfer date and does not change. However, in the following circumstances, this condition could change after the transfer date:

The contractual terms of the transfer change in such a way that the transferee (or third-party beneficial interest holder) becomes constrained from pledging or exchanging its assets or is no longer constrained from doing so.
A change in law causes a transferee (or third-party beneficial interest holder) to become constrained.
A constraint included in the terms of the transfer expires after the passage of time.

In the absence of a substantive modification to the terms of a transfer, the assessment of whether a constraint provides the transferor with a more than trivial benefit is performed only as of the transfer date and does not change because of changes in market prices. This view has been confirmed in discussions with the staff of the SEC’s Office of the Chief Accountant. However, if, after the transfer date, the transferor determines that a constraint does provide it with a more than trivial benefit and there were no amendments to the agreements involving the transfer, the benefit was more than trivial as of the transfer date and sale accounting therefore was inappropriate as of this date. This is because any benefit identified after the transfer date was a potential benefit as of the transfer date.

Footnotes

If the contractual documents specifically state that the consent cannot be unreasonably or unduly withheld and there are no other factors indicating that the consent constrains the transferee, the consent does not result in a constraint. A consent would result in a constraint if the transaction documents do not specifically state that the consent may not be unreasonably or unduly withheld.

However, if the transferor (or a consolidated affiliate included in the financial statements being presented or an agent) has the right to require the asset be put up for sale, the combination of this right and the right of first refusal would place the transferor in a position to unilaterally cause the return of specific transferred financial assets and the condition in ASC 860-10-40-5(c) would not be met.

3.5 Effective Control

3.5.1 General

3.5.1.1 Overview of Effective-Control Condition

ASC 860-10

Conditions for a Sale of Financial Assets

c. Effective control. The transferor, its consolidated affiliates included in the financial statements being presented, or its agents do not maintain effective control over the transferred financial assets or third-party beneficial interests related to those transferred assets (see paragraph 860-10-40-22A). A transferor’s effective control over the transferred financial assets includes, but is not limited to, any of the following:

1. An agreement that both entitles and obligates the transferor to repurchase or redeem the transferred financial assets before their maturity (see paragraphs 860-10-40-23 through 40-25)

2. An agreement, other than through a cleanup call (see paragraphs 860-10-40-28 through 40-39), that provides the transferor with both of the following:

i. The unilateral ability to cause the holder to return specific financial assets

ii. A more-than-trivial benefit attributable to that ability.

3. An agreement that permits the transferee to require the transferor to repurchase the transferred financial assets at a price that is so favorable to the transferee that it is probable that the transferee will require the transferor to repurchase them (see paragraph 860-10-55-42D).

40-5A A repurchase-to-maturity transaction shall be accounted for as a secured borrowing as if the transferor maintains effective control (see paragraphs 860-10-40-24 through 40-24A).

To achieve sale accounting for a transfer of entire financial assets or participating interests, the transferor cannot maintain effective control over the transferred assets. Effective control is maintained in the following situations:

Forward repurchase agreement — The transferor is entitled and obligated to repurchase (1) the transferred financial assets or assets that are substantially the same before their maturity or (2) third-party beneficial interests in the transferred financial assets. See Section 3.5.2 and 3.6.5 for further discussion.
Call option held by transferor — The transferor has the unilateral ability to cause the transferee to return specific financial assets (or third-party beneficial interests in transferred financial assets) through an agreement other than a cleanup call option, and this right provides the transferor with a more than trivial benefit. See Sections 3.5.3 and 3.9 for further discussion.
Put option held by transferee — The transferee has the unilateral ability to cause the transferor to repurchase specific financial assets (or third-party beneficial interests in transferred financial assets) at a fixed price that is so favorable on the date the option is written that exercise of the option is probable. See Sections 3.5.4 and 3.9 for further discussion.

A transferor may need to use judgment to determine whether it maintains effective control over transferred financial assets. In exercising such judgment, the transferor must evaluate whether maintaining such control results from a combination of agreements. When an entity transfers financial assets to a transferee whose sole purpose is to engage in securitization or asset-backed financing activities, the evaluation must take into account whether the transferor maintains effective control over both (1) the transferred financial assets and (2) the third-party beneficial interests in the transferred financial assets. The transferor needs to consider whether it maintains effective control over third-party beneficial interests because the sale accounting conditions are applied by using the beneficial interests as a proxy for the transferred financial assets.

3.5.1.2 Agreements Made Contemporaneously With or in Contemplation of a Transfer

As discussed in Section 3.1.1.3, the recognition of financial assets and financial liabilities should not be affected by the sequence of transactions that result in their acquisition or incurrence unless the effect of those transactions is to maintain effective control over a transferred financial asset. Therefore, ASC 860-10-40-4(c) requires entities to consider all arrangements or agreements made contemporaneously with, or in contemplation of, a transfer, even if they were not entered into at the time of the transfer. As discussed in Section 3.5.1.3, the transferor must consider arrangements or agreements made contemporaneously with, or in contemplation of, a transfer that were entered into with consolidated affiliates and agents of the transferor.

Arrangements or agreements entered into after the transfer date should generally result in a reassessment of the sale accounting conditions unless the changes to the terms of the prior transfer are not substantive. This is the result of the “stickiness” aspect of the sale accounting guidance in ASC 860-10. The guidance in ASC 860-10 on rerecognizing financial assets applies if an amendment or change to the terms of a transfer causes the transferor to have effective control over transferred financial assets. See further discussion in Section 4.3.

There may be a significant amount of time between the original transfer date and the date an agreement is entered into between the transferor and transferee that causes the transferor to have effective control over previously sold financial assets. Although there may be a substantive business purpose for entering into such an agreement, it is extremely difficult to account for such an agreement separately from the transfer of the related financial assets. As a result, the accounting should be the same as when conditional repurchase features become unconditional (i.e., the guidance on rerecognizing previously sold financial assets applies).

3.5.1.3 Involvement of Consolidated Affiliates and Agents

ASC 860-10

Involvement of Agents

40-22A Paragraph 860-10-40-4 states that, to assess whether the transferor maintains effective control over the transferred financial assets, all continuing involvement by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents shall be considered continuing involvement by the transferor. When assessing effective control, the transferor only considers the involvements of an agent when the agent acts for and on behalf of the transferor. If the transferor and transferee have the same agent, the agent’s activities on behalf of the transferee shall not be considered in the transferor’s evaluation of whether it has effective control over a transferred financial asset. For example, an investment manager may act as a fiduciary (agent) for both the transferor and the transferee; therefore, the transferor need only consider the involvements of the investment manager if it is acting on its behalf.

Under ASC 860-10-40-22A, in evaluating whether effective control over transferred financial assets has been maintained, a transferor must consider any continuing involvement of (1) consolidated affiliates included in the financial statements being presented, and (2) its agents, in the same manner in which the transferor would consider its own direct continuing involvement. As discussed in Section 3.1.3.4, a transferor considers the involvement of an agent only when it acts for and on behalf of the transferor.

3.5.2 Forward Contracts

3.5.2.1 Forward to Repurchase Before Maturity

ASC 860-30 — Glossary

Repurchase Agreement

An agreement under which the transferor (repo party) transfers a financial asset to a transferee (repo counterparty or reverse party) in exchange for cash and concurrently agrees to reacquire that financial asset at a future date for an amount equal to the cash exchanged plus or minus a stipulated interest factor. Instead of cash, other securities or letters of credit sometimes are exchanged. Some repurchase agreements call for repurchase of financial assets that need not be identical to the financial assets transferred.

Repurchase Agreement Accounted for as a Collateralized Borrowing

A repurchase agreement (repo) refers to a transaction in which a seller-borrower of securities sells those securities to a buyer-lender with an agreement to repurchase them at a stated price plus interest at a specified date or in specified circumstances. A repurchase agreement accounted for as a collateralized borrowing is a repo that does not qualify for sale accounting under Topic 860. The payable under a repurchase agreement accounted for as a collateralized borrowing refers to the amount of the seller-borrower’s obligation recognized for the future repurchase of the securities from the buyer-lender. In certain industries, the terminology is reversed; that is, entities in those industries refer to this type of agreement as a reverse repo.

ASC 860-10

Effective Control Through Both a Right and an Obligation

40-23 Although paragraph 860-10-40-5 sets forth criteria that must be met to achieve sale accounting, this guidance addresses criteria that must be met for a transfer to fail the condition in paragraph 860-10-40-5(c) through an agreement of the type described in paragraph 860-10-40-5(c)(1) and thus preclude sale accounting and result in accounting for the transfer as a secured borrowing.

40-24 An agreement that both entitles and obligates the transferor to repurchase or redeem transferred financial assets from the transferee maintains the transferor’s effective control over those assets as described in paragraph 860-10-40-5(c)(1), if all of the following conditions are met:

The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred. To be substantially the same, the financial asset that was transferred and the financial asset that is to be repurchased or redeemed need to have all of the following characteristics:
1. The same primary obligor (except for debt guaranteed by a sovereign government, central bank, government-sponsored enterprise or agency thereof, in which circumstance the guarantor and the terms of the guarantee must be the same)
2. Identical form and type so as to provide the same risks and rights
3. The same maturity (or in the circumstance of mortgage-backed pass-through and pay-through securities, similar remaining weighted-average maturities that result in approximately the same market yield)
4. Identical contractual interest rates
5. Similar assets as collateral
6. The same aggregate unpaid principal amount or principal amounts within accepted good delivery standards for the type of security involved. Participants in the mortgage-backed securities market have established parameters for what is considered acceptable delivery. These specific standards are defined by the Securities Industry and Financial Markets Association and can be found in Uniform Practices for the Clearance and Settlement of Mortgage-Backed Securities and Other Related Securities, which is published by the Securities Industry and Financial Markets Association.
See paragraph 860-10-55-35 for implementation guidance related to these conditions.
Subparagraph superseded by Accounting Standards Update No. 2011-03.
The agreement is to repurchase or redeem the financial assets before maturity, at a fixed or determinable price.
The agreement is entered into contemporaneously with, or in contemplation of, the transfer.

40-25 With respect to the condition in (a) in paragraph 860-10-40-24 to maintain effective control under the condition in paragraph 860-10-40-5(c) as illustrated in paragraph 860-10-40-5(c)(1), the transferor must have both the contractual right and the contractual obligation to repurchase or redeem financial assets that are identical to those transferred or substantially the same as those concurrently transferred. Transfers that include only the right to reacquire, at the option of the transferor or upon certain conditions, or only the obligation to reacquire, at the option of the transferee or upon certain conditions, may not maintain the transferor’s control, because the option might not be exercised or the conditions might not occur. Similarly, expectations of reacquiring the same securities without any contractual commitments (for example, as in wash sales) provide no control over the transferred securities.

Whether Securities Exchanged Are Substantially the Same

55-35 This guidance addresses criteria that must be met for a transfer to fail the condition in paragraph 860-10-40-5(c) through an agreement of the type described in paragraph 860-10-40-5(c)(1), precluding sale accounting and resulting, instead, in secured-borrowing accounting. The following are examples of whether securities exchanged are substantially the same as discussed in paragraph 860-10-40-24:

The same primary obligor (see paragraph 860-10-40-24(a)(1)). The exchange of pools of single-family loans would not meet this criterion because the mortgages comprising the pool do not have the same primary obligor, and would therefore not be considered substantially the same.
Identical form and type (see paragraph 860-10-40-24(a)(2)). The following exchanges would not meet this criterion:
1. GNMA I securities for GNMA II securities
2. Loans to foreign debtors that are otherwise the same except for different U.S. foreign tax credit benefits (because such differences in the tax receipts associated with the loans result in instruments that vary in form and type)
3. Commercial paper for redeemable preferred stock.
The same maturity (or in the case of mortgage-backed pass-through and pay-through securities, similar remaining weighted-average maturities that result in approximately the same market yield) (see paragraph 860-10-40-24(a)(3)). The exchange of a fast-pay GNMA certificate (that is, a certificate with underlying mortgage loans that have a high prepayment record) for a slow-pay GNMA certificate would not meet this criterion because differences in the expected remaining lives of the certificates result in different market yields.
Similar assets as collateral (see paragraph 860-10-40-24(a)(5)). Mortgage-backed pass-through and paythrough securities must be collateralized by a similar pool of mortgages, such as single-family residential mortgages, to meet this characteristic.

ASC 860-10 precludes sale accounting when a transfer of financial assets is accompanied by an agreement that requires the transferor to repurchase the transferred financial assets or substantially the same assets before their maturity at a fixed or determinable price. Therefore, transferors and transferees generally account for repurchase agreements and securities lending transactions as secured borrowings. If, however, a transferor has only a right, or only an obligation, to repurchase transferred financial assets, the transferor may not maintain effective control over transferred financial assets (see Sections 3.5.3 and 3.5.4). Effective control does not exist if the transferor expects to reacquire the same or substantially the same financial assets without being contractually required to do so.

A repurchase agreement is accounted for as a secured borrowing if the following conditions in ASC 860-10-40-24 are met:

“The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred.”
“The agreement is to repurchase or redeem the financial assets before maturity, at a fixed or determinable price.”
“The agreement is entered into contemporaneously with, or in contemplation of, the transfer.”

The nature or extent of collateral is not relevant.27

ASC 860-10-40-24 and ASC 860-10-55-35 address whether financial assets subject to repurchase are substantially the same as those transferred. While there is no requirement that financial assets be readily obtainable for a transfer to be accounted for as a repurchase agreement (i.e., a secured borrowing), if the financial asset to be returned is not the same as the one transferred, it is unlikely that the financial asset to be returned is substantially the same as the one transferred if it is not readily obtainable. Therefore, the “substantially the same” guidance in ASC 860-10 focuses on readily obtainable financial assets. See Section 3.6.5.1.1.3 for further discussion of the “substantially the same” guidance.

Connecting the Dots

Assume that an entity transfers a non-readily-obtainable financial asset that is accompanied by an agreement requiring the transferor to repurchase either the transferred financial asset or one that is similar to, but not substantially the same as, the transferred financial asset. Although the condition in ASC 860-10-40-5(c) may be considered met because the transferee can transfer back a financial asset that is neither the same nor substantially the same as the one received, the forward repurchase provision may nevertheless require an entity to account for the transfer as a secured borrowing. If there is limited availability to purchase a financial asset that meets the conditions in the resale arrangement (i.e., only other non-readily-obtainable financial assets meet the conditions in the repurchase provision), the transferor has most likely either (1) constrained the transferee from pledging or exchanging the transferred financial asset under ASC 860-10-40-5(b) or (2) maintained effective control over the transferred financial asset under ASC 860-10-40-5(c).

For further discussion of repurchase agreements and securities lending transactions, see Section 3.6.5.

3.5.2.2 Forward to Repurchase at Maturity

ASC 860-10 — Glossary

Repurchase-to-Maturity Transaction

A repurchase agreement in which the settlement date of the agreement to repurchase a transferred financial asset is at the maturity date of that financial asset and the agreement would not require the transferor to reacquire the financial asset.

ASC 860-10

Exception for a Repurchase-to-Maturity Transaction

40-24A Notwithstanding the characteristic in paragraph 860-10-40-24 that refers to a repurchase of the same (or substantially-the-same) financial asset, a repurchase-to-maturity transaction shall be accounted for as a secured borrowing as if the transferor maintains effective control.

A repurchase-to-maturity transaction is always accounted for as a secured borrowing. See Section 3.6.5.1.2 for further discussion of repurchase-to-maturity transactions.

3.5.3 Call Options

3.5.3.1 General

ASC 860-10

Effective Control Through Unilateral Ability

40-28 This guidance addresses whether any of the following agreements maintain effective control under paragraph 860-10-40-5(c)(2):

A call option or other right conveys more than a trivial benefit (that is, fails the condition in paragraph 860-10-40-5(c)(2)(ii)) if the price to be paid is fixed, determinable, or otherwise potentially advantageous, unless because that price is so far out of the money or for other reasons it is probable when the option is written that the transferor will not exercise it.
A transferor’s unilateral ability to cause a securitization entity to return to the transferor or otherwise dispose of specific transferred financial assets, for example, in response to its decision to exit a market or a particular activity, has the characteristic in paragraph 860-10-40-5(c)(2)(i) and, thus, would provide the transferor with effective control over the transferred financial assets if it also has the characteristic in paragraph 860-10-40-5(c)(2)(ii) — that is, if it also provides more than a trivial benefit to the transferor.
A call option on readily obtainable assets at fair value may not provide the transferor with more than a trivial benefit.

Paragraph 860-10-40-35 provides an example in which, due to the combination of arrangements, the transferor would maintain effective control.

40-28A Effective control over transferred financial assets can be present even if the right to reclaim is indirect. For example, if a call allows a transferor to buy back the beneficial interests at a fixed price, the transferor may maintain effective control of the financial assets underlying those beneficial interests. If the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities, that entity may be constrained from choosing to pledge or exchange the transferred financial assets. In that circumstance, any call held by the transferor on third-party beneficial interests is effectively an attached call on the transferred financial assets. Depending on the price and other terms of the call, the transferor may maintain effective control over the transferred financial assets.

Call Options

40-31 Cash-settled call options do not constrain the transferee, nor do they result in the transferor maintaining effective control because they do not provide the transferor with an opportunity to reclaim the transferred financial assets. Therefore, this guidance addresses call options that can be physically settled.

40-32 An embedded call option would not result in the transferor’s maintaining effective control because it is the issuer rather than the transferor who holds the call option and the call option does not provide more than a trivial benefit to the transferor. For example, a call embedded by the issuer of a callable bond or the borrower of a prepayable mortgage loan would not provide the transferor with effective control over the transferred financial asset.

40-34 Paragraph 860-10-40-5(c)(2) excludes a cleanup call from the general principle that a transferor maintains effective control over transferred financial assets if the transferor has the unilateral ability to cause the holder to return specific financial assets and that ability provides more than a trivial benefit to the transferor. A cleanup call on beneficial interests in the transferred financial assets is permitted because burdensome costs in relation to benefits may arise when the remaining financial assets or beneficial interests fall to a small portion of their original level. Parties other than the servicer cannot hold the option, because only the servicer is burdened when the amount of outstanding financial assets falls to a level at which the cost of servicing the financial assets becomes burdensome — the defining condition of a cleanup call — and any other party would be motivated by some other incentive in exercising a call.

40-35 A right to reclaim specific transferred financial assets by paying their fair value when reclaimed generally does not maintain effective control if it does not convey a more-than-trivial benefit to the transferor. However, a transferor has maintained effective control if it has such a right and also holds the residual interest in the transferred financial assets. See paragraph 860-10-55-42A for discussion of a related example.

Removal-of-Accounts Provisions

40-36 Many transfers of financial assets that involve transfers of a group of entire financial assets to an entity whose sole purpose is to engage in securitization or asset-backed financing activities empower the transferor to reclaim assets subject to certain restrictions. Such a power is sometimes called a removal-of-accounts provision. Whether a removal-of-accounts provision precludes sale accounting depends on whether the removal-of-accounts provision results in the transferor’s maintaining effective control over transferred financial assets.

40-37 The following are examples of removal-of-accounts provisions that preclude transfers from being accounted for as sales:

An unconditional removal-of-accounts provision or repurchase agreement that allows the transferor to specify the financial assets that may be removed and that provides a more-than-trivial benefit to the transferor, because such a provision allows the transferor unilaterally to remove specific financial assets
A removal-of-accounts provision conditioned on a transferor’s decision to exit some portion of its business that provides a more-than-trivial benefit to the transferor, because whether it can be triggered by canceling an affinity relationship, spinning off a business segment, or accepting a third party’s bid to purchase a specified (for example, geographic) portion of the transferor’s business, such a provision allows the transferor unilaterally to remove specific financial assets.

40-38 The following are examples of removal-of-accounts provisions that do not preclude transfers from being accounted for as sales:

A removal-of-accounts provision for random removal of excess financial assets, if the provision is sufficiently limited so that the transferor cannot remove specific transferred financial assets, for example, by limiting removals to the amount of the transferor’s interests and to one removal per month
A removal-of-accounts provision for defaulted receivables, because the removal would be allowed only after a third party’s action (default) and could not be caused unilaterally by the transferor
A removal-of-accounts provision conditioned on a third-party cancellation, or expiration without renewal, of an affinity or private-label arrangement, because the removal would be allowed only after a third party’s action (cancellation) or decision not to act (expiration) and could not be caused unilaterally by the transferor
A removal-of-accounts provision that does not allow the transferor to unilaterally reclaim specific financial assets from the transferee. For related implementation guidance, see paragraph 860-10-55-41.

40-39 A removal-of-accounts provision that can be exercised only in response to a third party’s action that has not yet occurred does not maintain the transferor’s effective control over financial assets potentially subject to that removal-of-accounts provision.

Rights to Reacquire (Call) Transferred Assets

55-39 Rights or obligations to reacquire transferred financial assets may result in the transferor’s maintaining effective control over the transferred assets, therefore precluding sale accounting under paragraph 860-10-40-5(c). The following guidance addresses how different types of rights of a transferor to reacquire (call) transferred assets affect sale accounting, specifically:

Removal-of-accounts provisions (see paragraphs 860-10-40-36 through 40-39)
Call options (see paragraphs 860-10-40-28 and 860-10-40-34)
Other arrangements.

Removal-of-Accounts Provisions

55-41 The following are examples of application of effective control principles to removal-of-accounts provisions:

An unconditional removal-of-accounts provision that allows the transferor to specify the financial assets that may be removed from a group of financial assets precludes sale accounting for all financial assets in the group that might be specified if such a provision allows the transferor unilaterally to remove specific financial assets and provides a more-than-trivial benefit to the transferor (see paragraph 860-10-40-37(a)), even if the transferor’s right to remove specific financial assets from a group of transferred financial assets is limited, for example, to 10 percent of the fair value of the financial assets transferred and all of the financial assets are smaller than that 10 percent. In that circumstance, none of the transferred financial assets would be derecognized at the time of transfer because no transferred financial asset is beyond the reach of the transferor. If the transferor reclaims all the financial assets it can and thereby extinguishes its option, its control has expired and the rest of the financial assets have been sold at that time.
A removal-of-accounts provision that provides the right to random removal of excess financial assets from a group of transferred financial assets up to 10 percent of the fair value of the financial assets transferred (all financial assets in the group are less than this 10 percent of the fair value of transferred financial assets) does not preclude sale accounting if the transferor has no other interest in the group. The transferor has, in essence, obtained a 10 percent beneficial interest in the group and should account for it as such. This treatment is permitted because the removal-of-accounts provision is sufficiently limited and the transferor cannot unilaterally remove specific transferred financial assets, because the timing of the removal (when the excess develops) and the assets being removed (which are randomly determined) are not under the control of the transferor (see paragraph 860-10-40-38).
A removal-of-accounts provision conditioned on a transferor’s decision to exit some portion of its business precludes sale accounting for all financial assets that might be affected, because it permits the transferor unilaterally to remove specific financial assets and provides a more-than-trivial-benefit to the transferor (see paragraph 860-10-40-37(b)).
A removal-of-accounts provision for defaulted receivables does not preclude sale accounting at the time of transfer, because the removal would be allowed only after a third party’s action (default) and could not be caused unilaterally by the transferor (see paragraph 860-10-40-38(b)). However, once the default has occurred, the transferor would have the unilateral ability to remove those specific financial assets and would need to recognize the defaulted receivable if that ability provides a more-than-trivial benefit to the transferor.
A removal-of-accounts provision conditioned on a third-party cancellation, or expiration without renewal, of an affinity or private-label arrangement does not preclude sale accounting at the time of transfer, because the removal would be allowed only after a third party’s action (cancellation) or decision not to act (expiration) and could not be caused unilaterally by the transferor (see paragraph 860-10-40-38(c)). However, once the cancellation or expiration has occurred, the transferor would have the unilateral ability to remove specific financial assets and would need to recognize those financial assets if that ability provides a more-than-trivial benefit to the transferor.
Because the transferor could not cause the reacquisition unilaterally a transferor does not maintain effective control through a removal-of-accounts provision that obligates the transferor to reacquire transferred financial assets from a securitization entity only after either:
1. A specified failure of the servicer to properly service the transferred financial assets that could result in the loss of a third-party guarantee
2. Third-party beneficial interest holders require a securitization entity to repurchase that beneficial interest.

Call Options

55-42 The following are other examples of the application of effective control principles:

In a loan participation, the lead bank (that is also the transferor) allows the participating bank to resell but reserves the right to call at any time from whoever holds it and can enforce the call option by cutting off the flow of interest at the call date; such a call option precludes sale accounting.
In a securitization, a call option permits the transferor to reclaim all of the transferred financial assets from the securitization entity at any time; such a call option precludes sale accounting unless both of the following conditions exist:
1. The call option is an option to call, at fair value, a financial asset that is readily obtainable in the marketplace.
2. The transferor does not hold a residual beneficial interest in the transferred financial assets (see paragraph 860-10-40-35).
A transferor-servicer transfers a group of entire financial assets to a securitization entity and has the right to call all of the financial assets when the group amortizes to 20 percent of its value (determined at the date of transfer). The transferor-servicer determines that at that level of financial assets, its cost of servicing them would not be burdensome in relation to the benefits of servicing, and therefore that the call option is not a cleanup call. Such a call option precludes sale accounting for the entire group of transferred financial assets (see paragraph 860-10-55-70).
If the third-party beneficial interests contain an embedded option and the transferor holds the residual interest in the securitization entity, the combination has the same kind of effective control as a scheduled auction provision if the transferor holds a residual beneficial interest. Sale accounting would be precluded for all of the transferred financial assets affected by the call option.
If the third-party beneficial interests in a securitization entity pay off first (a so-called turbo structure, where principal payments and prepayments are allocated on a non-pro rata basis, as discussed in paragraph 860-10-05-13), the transferor may not maintain effective control over transferred financial assets (see paragraph 860-10-40-32). To some extent, these repayments are contractual cash flows of the underlying assets, but repayments also result from prepayments in the underlying assets (that is, the prepayment options in the underlying assets are mirrored in the third-party beneficial interests). In this circumstance, call options embedded in the third-party beneficial interests result from the options embedded in the underlying assets (that is, they are held by the underlying borrowers rather than the transferor), and thus do not preclude sale accounting.
A transferor’s contractual right to repurchase, at any time, a loan that is not a readily obtainable financial asset would preclude sale accounting, because the transferor’s contractual right to repurchase is effectively a call option of the type described in paragraph 860-10-40-17(c)(2).

55-42A This guidance illustrates the concept in paragraph 860-10-40-35 that a transferor maintains effective control if it has a right to reclaim specific transferred assets by paying fair value and also holds the residual interest in the transferred financial assets. If a transferor holds the residual interest in securitized financial assets and can reclaim the transferred financial assets at termination of the securitization entity by purchasing them in an auction, and thus at what might appear to be fair value, then sale accounting for the transfer of those financial assets it can reclaim would be precluded. Such circumstances provide the transferor with a more-than-trivial benefit and effective control over the financial assets, because it can pay any price it chooses in the auction and recover any excess paid over fair value through its residual interest in the transferred financial assets.

Transfer Involving Certain Transferor Powers

55-67 If the transferor has the ability to dissolve a securitization entity (for example, through the beneficial interests that it holds) and reassume control of the financial assets at any time, the transferor is precluded from accounting for the transfer as a sale for the following reason:

Subparagraph superseded by Accounting Standards Update No. 2009-16.
The transferor’s current ability to dissolve the securitization entity and reassume control of the transferred financial assets entitles it to unilaterally cause the return of the transferred financial assets, indicating that the transferor has maintained control over the transferred financial assets which precludes sale accounting under paragraph 860-10-40-5(c).

Transferor Option to Repurchase Individual Financial Assets

55-68 In certain transactions, the transferor is entitled to repurchase a transferred amortizing, individual (specific) financial asset when its remaining principal balance reaches some specified amount, for example, 30 percent of the original balance. To exercise that call option, the transferor would pay the remaining principal balance. Paragraph 860-10-40-5(c)(2) states that a transferor maintains effective control through a call option, other than through a cleanup call, that provides the transferor with both:

The unilateral ability to cause the holder to return specific financial assets
A more-than-trivial-benefit attributable to that ability.

55-68A Such a call option on the remaining portion of an entire financial asset precludes sale accounting for the entire financial asset. Paragraph 860-10-40-5 applies to an entire financial asset, a group of entire financial assets, or a participating interest. Paragraph 860-10-40-4A states that, to be eligible for sale accounting, an entire financial asset cannot be divided into components before a transfer unless all of the components meet the definition of a participating interest. That paragraph states also that an entity shall not account for a transfer of an entire financial asset or a participating interest in an entire financial asset partially as a sale and partially as a secured borrowing.

55-70 If a transferor holds a call option to repurchase at any time a few specified, individual loans from an entire group of loans transferred in a securitization transaction, then sale accounting is precluded only for the specified loans subject to the call option, not the whole group of loans. In contrast, if the transferor holds a call option to repurchase from the group any loans it chooses, up to some specified limit, then sale accounting is precluded for the transfer of the entire group while that option remains outstanding. See paragraphs 860-10-55-39 through 55-42 for related guidance.

There are several different types of repurchase options that may exist for transferred financial assets (or third-party beneficial interests in transferred financial assets), including:

Unilaterally exercisable options that permit a transferor to repurchase transferred financial assets (or third-party beneficial interests in transferred financial assets) at any time or at a future date.
ROAPs that allow a transferor to specify the transferred financial assets that may be removed, including default ROAPs, which allow a transferor to reclaim transferred financial assets that become past due or delinquent or are in default (e.g., EPD call options).
Other conditionally exercisable call options that allow a transferor to reclaim transferred financial assets (or third-party beneficial interests in transferred financial assets) upon the occurrence of a specified condition or an event outside the transferor’s control.
Cleanup call options.

Effective control is maintained over transferred financial assets if the transferor, its consolidated affiliates included in the financial statements being presented, or its agents have the unilateral ability to cause the return of specific assets and that right provides the transferor with a more than trivial benefit.28 ASC 860-10-40-28A explains that effective control over transferred assets can be present even if the right to reclaim is indirect. For example, if a call option allows a transferor to purchase third-party beneficial interests issued by a securitization entity at a fixed price, the transferor is considered to have effective control over the financial assets underlying those beneficial interests.29 An exception is provided for cleanup call options.

ASC 860-10 contains principles, primarily through discussion of specific types of repurchase options, related to whether a transferor has maintained effective control over transferred financial assets (or third-party beneficial interests in transferred financial assets). A transferor must evaluate the relevant facts and circumstances to determine whether a repurchase option maintains effective control over transferred financial assets (or third-party beneficial interests in transferred financial assets). In determining whether a call option maintains its effective control over transferred financial assets, the transferor must consider the following:

The type of call option (i.e., freestanding, embedded, or attached, and whether the option is cash-settled or physically settled) (see Section 3.5.3.1.1).
Whether the transferor has the unilateral ability to exercise the option (see Section 3.5.3.1.2).
Whether the financial asset that may be reclaimed is readily obtainable (see Section 3.5.3.1.3).
Whether the call option pertains to specific financial assets (see Section 3.5.3.1.4).
Whether the transferor receives a more than trivial benefit from the call option (see Section 3.5.3.1.5).
Whether the call option is a clean-up call option (see Section 3.5.3.1.6).

Throughout the remaining discussion in this section, “transferor” includes consolidated affiliates of the transferor included in the financial statements being presented and agents of the transferor.30

3.5.3.1.1 Type of Call Option

3.5.3.1.1.1 Freestanding, Embedded, and Attached Call Options

ASC 860-10 — Glossary

Attached Call Option

A call option held by the transferor of a financial asset that becomes part of and is traded with the underlying instrument. Rather than being an obligation of the transferee, an attached call option is traded with and diminishes the value of the underlying instrument transferred subject to that call option.

Embedded Call Option

A call option held by the issuer of a financial instrument that is part of and trades with the underlying instrument. For example, a bond may allow the issuer to call it by posting a public notice well before its stated maturity that asks the current holder to submit it for early redemption and provides that interest ceases to accrue on the bond after the early redemption date. Rather than being an obligation of the initial purchaser of the bond, an embedded call option trades with and diminishes the value of the underlying bond.

Freestanding Call Option

A call option that is neither embedded in nor attached to an asset subject to that call option.

ASC 860-10 describes three types of call options. Freestanding call options are traded separately and apart from the underlying financial asset. The determination of whether a freestanding call option causes the transferor to maintain effective control over transferred financial assets depends on whether the option is unilaterally exercisable, the exercise price, and whether the transferred financial assets are readily obtainable.

Embedded call options are included in the original terms of a transferred financial asset. Such options are part of, and are traded with, the financial asset. The issuer of the financial asset is a counterparty to an embedded call option. An example would be a callable bond or prepayable mortgage loan receivable. If the option is exercised, the issuer must repay the outstanding principal amount of its obligation. As discussed in ASC 860-10-40-32, an embedded call option cannot cause the transferor to maintain effective control over a transferred financial asset.

Attached call options are similar to embedded call options in that they are traded with the underlying financial asset. However, attached call options are unlike embedded call options in that the issuer of the financial asset is not a counterparty to the option. Rather, the option is “attached” to the financial asset in conjunction with a transfer. The counterparty to the option is the current holder of the asset or beneficial interest. An example is a nonprepayable loan receivable that the transferor can require the current holder to return at a specified price. As discussed in ASC 860-10-40-28A, call options on third-party beneficial interests in transferred financial assets are generally attached call options.31 Since attached call options are imposed by the transferor, they presumptively provide a more than trivial benefit and cause the transferor to maintain effective control over the transferred financial assets.

3.5.3.1.1.2 Cash-Settled and Physically Settled Call Options

Only call options that may result in the return of transferred financial assets (or third-party beneficial interests in transferred financial assets) may provide the transferor with effective control. A call option on transferred financial assets (or third-party beneficial interests in transferred financial assets) that requires net-cash settlement in all circumstances in which it is exercised does not cause a transferor to maintain effective control over transferred financial assets (or third-party beneficial interests in transferred financial assets) because settlement of the option would not allow the transferor to actually reclaim transferred financial assets. See ASC 860-10-40-31.

3.5.3.1.2 Unilateral Ability

ASC 860-10 — Glossary

Unilateral Ability

A capacity for action not dependent on the actions (or failure to act) of any other party.

A call option does not maintain the transferor’s effective control over transferred financial assets (or third-party beneficial interests in transferred financial assets) if it is not unilaterally exercisable. A transferor has the unilateral ability to exercise a call option if there are no conditions or contingencies outside the transferor’s control that must be met for the transferor to elect to exercise the option. An option to repurchase or reclaim transferred financial assets (or third-party beneficial interests in transferred financial assets) that is exercisable only upon the occurrence of a specified condition or event that is not within the sole control of the transferor does not cause the transferor to maintain effective control over transferred financial assets regardless of the likelihood that the condition or event will occur. However, if the condition or event occurs, and the transferor has the right to repurchase or reclaim transferred financial assets (or third-party beneficial interests in transferred financial assets), the transferor has regained control over previously sold financial assets. See Section 4.3 for further discussion.

The table below provides examples of when a transferor has the unilateral ability to exercise a call option.

Table 3-6

Unilateral Ability Exists	Unilateral Ability Does Not Exist
An entity can specify the financial assets that may be removed (repurchased) at its discretion.	An entity can repurchase a transferred financial asset once it becomes past due or is in default.(e)
An entity owns all the equity interests in a securitization trust and can liquidate the trust and obtain some or all of the underlying financial assets.(a)	An entity can repurchase a transferred financial asset if, upon using its best efforts, a remarketing is unsuccessful.(f)
An entity has a right to rescind a transfer of financial assets.(b)	An entity can repurchase a transferred financial asset if interest rates increase to an objectively defined level.(g)
An entity can repurchase transferred financial assets if it defaults under the terms of an agreement to service those financial assets.(c)	An entity can repurchase transferred financial assets if a third-party servicer defaults under the terms of an agreement to service those financial assets.(g)
An entity can repurchase transferred financial assets when it decides to exit some portion of its business (i.e., by canceling an affinity relationship, spinning off a business segment, or accepting a third party’s bid to purchase a specified portion of the entity’s business)(d)	An entity can repurchase a financial asset if a customer does not renew an agreement in accordance with a stated unconditional renewal option that can be exercised by the customer.(h)
An entity can cause a securitization entity to return to the transferor or otherwise dispose of specific transferred financial assets in response to the entity’s decision to exit a market for a particular activity.(d)	An entity can repurchase a transferred financial asset if the transferee proposes to sell it to the entity’s competitor.(g)
An entity transfers a municipal bond to a trust. The trust liquidates before maturity of the bond. At maturity of the trust, or earlier upon the occurrence of certain events within the transferor’s control, there is a mandatory tender event, which requires the bond to be sold and the proceeds distributed to the beneficial interest holders. The transferor can bid on the municipal bond and holds a residual interest in the trust (therefore, the transferor can pay any price to reclaim the bond since any excess paid will be recovered through the residual beneficial interest).	An entity has the first right of refusal if a transferee proposes to sell a transferred financial asset or a third-party beneficial interest holder proposes to put its interests back to a securitization entity.(g),(i)
Notes to Table: (a) A transferor could have the right to dissolve a securitization entity through beneficial interests it owns or other rights it obtained in a transfer. ASC 860-10-55-67 indicates that a “transferor’s current ability to dissolve [a] securitization entity and reassume control of the transferred financial assets entitles it to [the unilateral ability to reclaim] transferred financial assets.” If a transferor can only dissolve a securitization entity with the consent of other parties, the transferor would not be considered to have the unilateral ability to reclaim transferred financial assets unless the other parties for which consent must be obtained are related parties or agents. See Example 3-20 for an illustration. (b) An entity maintains effective control over transferred financial assets if it has the unilateral ability to require the transferee to return specific financial assets by rescinding the transfer and paying an amount other than fair value to reclaim the transferred financial assets. When a transferor has the right to rescind a transfer, the legal isolation condition in ASC 860-10-40-5(a) would also generally not be met and the transferee would be constrained from pledging or exchanging the transferred financial assets unless they are readily obtainable. A common example of a transfer of a financial asset with a rescission right is a tender option bond structure. (c) Although the repurchase right is unilaterally exercisable, depending on the consequences of defaulting on the servicing agreement, the right may not provide the transferor with a more than trivial benefit. See also ASC 860-10-55-41(f)(1). (d) A transferor’s decision to exit a particular business or market is within its control. See also ASC 860-10-40-28(b), ASC 860-10-40-37(b), and ASC 860-10-55-41(c). (e) ASC 860-10-55-41(d) indicates that a ROAP on defaulted receivables does not preclude sale accounting when the removal of transferred financial assets is allowed only after a third party’s action (e.g., the borrower’s default) that is outside the transferor’s control. However, once the default has occurred, the transferor has the unilateral ability to remove specific financial assets and would rerecognize those financial assets unless the repurchase right does not provide the transferor with a more than trivial benefit. See Section 4.3 for further discussion of regaining control over previously sold financial assets. (f) If the entity is required to use its best efforts to remarket a transferred financial asset, the failure of such remarketing would be outside the entity’s control. (g) Once the event occurs and the transferor has the ability to repurchase transferred financial assets, if the transferor obtains a more than trivial benefit from this repurchase right, it must rerecognize the transferred financial assets. See Section 4.3 for further discussion of regaining control over previously sold financial assets. (h) ASC 860-10-40-38(c), ASC 860-10-40-39, and ASC 860-10-55-41(e) indicate that a ROAP conditioned on a third-party cancellation or expiration, without renewal, of an affinity or private-label arrangement does not maintain the transferor’s effective control over transferred financial assets if the third party’s decision has not yet been made because the transferor’s repurchase right is conditional. However, once the cancellation or expiration has occurred, the transferor would have the unilateral ability to remove specific financial assets and would need to rerecognize those financial assets unless the repurchase right does not provide the transferor with a more than trivial benefit. See Section 4.3 for further discussion of regaining control over previously sold financial assets. (i) ASC 860-10-55-41(f) indicates that a transferor does not have the unilateral ability to repurchase transferred financial assets if this repurchase may occur only after third-party beneficial interest holders require a securitization entity to repurchase those beneficial interests.

See Example 3-17 for an illustration of a conditionally exercisable call option.

3.5.3.1.3 Readily Obtainable Financial Assets

A transferor does not maintain effective control over transferred financial assets when it has a freestanding call option that gives it the unilateral ability to repurchase those assets if they are readily obtainable in the marketplace and the exercise price of the option equals the fair value of the assets on the date the assets are purchased.32 ASC 860-10 does not define what constitutes a readily obtainable financial asset, and ASC 860-10 provides little interpretive guidance on this concept. In determining whether a financial asset is readily obtainable, an entity must use judgment and consider the specific facts and circumstances. Factors to consider in this determination include the following:

Paragraphs A13 and A14 of FSP FAS 140-3 indicate that, to be readily obtainable, a financial asset must be marketable and cannot be unique.
A financial asset that has a quoted price in an active market (i.e., a fair value measurement for the asset would be classified in Level 1 of the fair value hierarchy in ASC 820) is readily obtainable.
For the financial asset to be considered readily obtainable, the fair value measurement of a financial asset does not need to be classified in Level 1 of the fair value hierarchy but there does need to be sufficient trading activity in the marketplace (i.e., illiquid financial assets are not readily obtainable). The evaluation of the level of market activity for an asset should focus on the willingness of market participants to transact for the asset at fair value (i.e., not on the assessment of whether market participants would transact “at the right price” or in a distressed sale) and should take into account the nature of transactions occurring in the marketplace.33 In performing this evaluation, an entity should not focus solely on the availability of an asset without considering the volume of transactions in the asset. To determine whether a financial asset is readily obtainable, an entity should consider evidence from all available and relevant sources related to the volume of market activity in light of current market conditions.34 The determination of whether a financial asset is readily obtainable could change depending on market conditions (i.e., there may be less liquidity in times of economic uncertainty).
If the transferee is the only party that holds a financial asset, the asset cannot be considered readily obtainable.

Examples of financial assets that are readily obtainable may include:

U.S. Treasury securities.
Agency MBSs.
Certain TBA on Agency MBSs.
Certain municipal bonds.
Corporate bonds of large public companies that are actively traded.
Other securities that are classified in Level 1 of the fair value hierarchy.

Examples of financial assets that are not readily obtainable may include:

A specific commercial loan receivable.
A debt security collateralized by a single commercial real estate property.
Nonagency MBSs (e.g., beneficial interests in subprime mortgage loans).

Connecting the Dots

The fact that two assets are substantially the same does not necessarily mean that each of them is readily obtainable. Generally, a financial asset would need a Committee on Uniform Securities Identification Procedures (CUSIP) number to be considered readily obtainable.

Attached call options on transferred financial assets and third-party beneficial interests in transferred financial assets maintain the transferor’s effective control over transferred financial assets if they are unilaterally exercisable unless they represent fixed-price options that are so far out-of-the-money when written that it is probable that they will not be exercised. As a result, if attached call options are unilaterally exercisable by the transferor, the condition in ASC 860-10-40-5(c) is not met for the affected transferred financial assets regardless of whether those assets are readily obtainable.

3.5.3.1.4 Specific Financial Assets

ASC 860-10-40-5(c)(2) indicates that a right, other than a cleanup call option, that provides a transferor with the “unilateral ability to cause the holder to return specific financial assets” maintains the transferor’s effective control over transferred financial assets unless that right does not provide a more than trivial benefit to the transferor. ASC 860-10-40-38(d) indicates that a ROAP that does not allow the transferor to unilaterally reclaim specific financial assets may not cause the transferor to maintain effective control over transferred financial assets. For example, a ROAP for random removal of excess financial assets would not cause the transferor to maintain effective control over transferred financial assets if the provision is sufficiently limited so that the transferor cannot remove specific financial assets (see ASC 860-10-40-38(a) and ASC 860-10-55-41(b)). As noted in the guidance, the term “specific financial asset” does not mean a non-readily-obtainable asset. Rather, a readily obtainable asset may also be a “specific financial asset” when the condition in ASC 860-10-40-5(c) is evaluated.

Attached call options always pertain to specific financial assets. A freestanding call option pertains to specific financial assets unless, upon exercise, the transferor will receive randomly selected financial assets.

Connecting the Dots

ASC 860-10-55-70 explains the importance of identifying the rights that a freestanding call option conveys to a transferor when groups of financial assets are transferred. If a freestanding call option allows the transferor to purchase only specific financial assets transferred (i.e., only certain transferred financial assets), other transferred financial assets would not be affected by this right. For example, if an entity transfers five loan receivables from five different issuers and retains a freestanding option to repurchase only the loan receivable from a specific issuer, only that transferred loan receivable could fail to meet the condition in ASC 860-10-40-5(c). If, however, an entity transfers a group of financial assets and retains a freestanding option to reclaim some, but not all, of the transferred financial assets, the option causes the transferor to maintain effective control over all the transferred financial assets if the transferor can specify the assets to be returned and receives a more than trivial benefit from the option (see ASC 860-10-55-41(a)). For example, if an entity transfers five non-readily-obtainable loan receivables from five different issuers and retains a fixed-price freestanding call option to repurchase any two of the transferred loan receivables it chooses, that call option causes the transferor to maintain effective control over all five transferred loan receivables until the option is exercised or expires.

3.5.3.1.5 More Than Trivial Benefit

3.5.3.1.5.1 General

ASC 860-10-40-28(a) indicates that “[a] call option or other right conveys more than a trivial benefit . . . if the price to be paid is fixed, determinable, or otherwise potentially advantageous, unless because that price is so far out of the money or for other reasons it is probable when the option is written that the transferor will not exercise it.” The focus is on whether there is any potential economic or other benefit to the transferor. As discussed in Section 3.4.1.5, the threshold for a more than trivial benefit is extremely low. The evaluation of whether a more than trivial benefit exists is not based solely on the transferor’s intent regarding whether it would exercise an option to repurchase transferred financial assets or third-party beneficial interests in transferred financial assets. For example, a call option could not be considered as not providing a transferor with a more than trivial benefit on the basis that the transferor does not have the liquidity necessary to repurchase transferred financial assets.

Attached call options provide a more than trivial benefit to the transferor because they are created by the transferor during the transfer of financial assets.35 Therefore, unilaterally exercisable attached call options provide the transferor with effective control over transferred financial assets (see Section 3.5.3.1.3).

Whether a freestanding call option provides a transferor with a more than trivial benefit is determined on the basis of the following:

The pricing of the call option (i.e., fair value vs. not fair value) and whether the exercise price is deep-out-of-the-money when written.36
Whether the financial asset that can be repurchased is readily obtainable.

3.5.3.1.5.2 Fair Value Call Options

As discussed in ASC 860-10-40-28(c) and ASC 860-10-40-35, a freestanding call option that allows a transferor to repurchase readily obtainable transferred financial assets by paying fair value on the exercise date does not provide the transferor with a more than trivial benefit unless the transferor also owns a residual interest in the transferred financial assets. In this situation, the call option is evaluated as a non–fair value call option because the amount paid to reclaim the transferred financial assets is not relevant. For example, if a transferor holds the residual interest in securitized financial assets and can reclaim the transferred financial assets by purchasing them in an auction, sale accounting is precluded for the transferred financial assets that the transferor may reclaim because it can pay any price it chooses in the auction and recover any excess amount paid over fair value through its residual interest (see ASC 860-10-55-42(b) and (d), and ASC 860-10-55-42A).37

A freestanding call option that allows a transferor to repurchase non-readily-obtainable transferred financial assets by paying fair value on the exercise date provides a more than trivial benefit because the transferor could not readily purchase those assets elsewhere. If the transferor can unilaterally exercise a freestanding option to reclaim non-readily-obtainable financial assets, the condition in ASC 860-10-40-5(c) is not met and sale accounting is precluded for the transferred financial assets subject to the call option. See Example 3-16 for an illustration.

3.5.3.1.5.3 Non–Fair Value Call Options

As discussed in ASC 860-10-40-28(a) and ASC 860-10-55-42(b), a freestanding call option with a fixed or determinable exercise price that does not represent the fair value of the financial assets on the date they are reclaimed provides a more than trivial benefit because the call option is potentially advantageous to the transferor. A more than trivial benefit exists regardless of whether the financial assets to be reclaimed are readily obtainable (see Example 3-16 for an illustration). Therefore, if a transferor has a freestanding call option with a non–fair value exercise price that gives it the unilateral ability to reclaim transferred financial assets, the transferor maintains effective control over those assets and sale accounting is precluded. As a limited exception, a more than trivial benefit does not exist if, when written, the call option is deep-out-of-the-money.

3.5.3.1.6 Cleanup Call Options

ASC 860-10 — Glossary

Cleanup Call Option

An option held by the servicer or its affiliate, which may be the transferor, to purchase the remaining transferred financial assets, or the remaining beneficial interests not held by the transferor, its affiliates, or its agents in an entity (or in a series of beneficial interests in transferred financial assets within an entity) if the amount of outstanding financial assets or beneficial interests falls to a level at which the cost of servicing those assets or beneficial interests becomes burdensome in relation to the benefits of servicing.

ASC 860-10

Call Options

55-42B Sale accounting is not appropriate if a cleanup call on a group of financial assets in a securitization entity is held by a party other than the servicer. A transferor’s call option on the transferred financial assets in the securitization entity is not a cleanup call for accounting purposes because it is not the servicer or an affiliate of the servicer. [Sometimes] the fair value of beneficial interests obtained by a transferor of financial assets that is not the servicer or an affiliate of the servicer is adversely affected by the amount of transferred financial assets declining to a low level.

55-42C In a securitization transaction involving not-readily-obtainable financial assets, a transferor that is also the servicer may hold a cleanup call if it enters into a subservicing arrangement with a third party without precluding sale accounting. Under a subservicing arrangement, the transferor remains the servicer from the perspective of the securitization entity because the securitization entity does not have an agreement with the subservicer (that is, the transferor remains liable if the subservicer fails to perform under the subservicing arrangement). However, if the transferor sells the servicing rights to a third party (that is, the agreement for servicing is between the securitization entity and the third party after the sale of the servicing rights), then the transferor could not hold a cleanup call without precluding sale accounting.

ASC 860-10-40-34 offers an exception to the effective-control guidance in ASC 860-10-40-5(c)(2) for cleanup call options. To qualify for this exception, the option must be (1) held by the servicer and (2) exercisable only when the amount of outstanding financial assets or beneficial interests falls to a level at which the cost of servicing those assets or beneficial interests becomes burdensome in relation to the benefits of servicing. An option held by a transferor cannot meet the definition of a cleanup call option if the transferred financial assets are serviced by a third party.

The determination of whether an option held by the servicer represents a cleanup call option is made as of the transfer date on the basis of the relevant facts and circumstances. ASC 860-10 does not specify the level at which the cost of servicing financial assets or third-party beneficial interests becomes burdensome in relation to the benefits of servicing. However, ASC 860-10-55-41(c) does indicate that the transferor-servicer’s right to call all of the transferred financial assets when the group amortizes to 20 percent of its value as of the transfer date is not a cleanup call option. ASC 860-10-55-68 and 55-68A contain another example of a call option on an amortized balance of a transferred financial asset that does not meet the definition of a cleanup call option. In practice, a call option for 10 percent or less of the original pool of financial assets transferred is often considered sufficiently low to meet the definition of a cleanup call option. However, a servicer should be prepared to support such an assertion because there is no “bright line” or “safe harbor” that indicates when the costs of servicing financial assets or beneficial interests becomes burdensome in relation to the benefits of servicing.

A cleanup call option may have an exercise price equal to the fair value of the remaining transferred financial assets. Alternatively, the price may equal the sum of (1) the unpaid principal balance of the remaining financial assets, (2) accrued interest, (3) the fair value of any real estate owned, and (4) unreimbursed servicing advances.

3.5.3.2 Interpretive Guidance

3.5.3.2.1 Freestanding Options on Transferred Financial Assets

Q&A 3-49 Non-Fair-Value Call Options

Question

Why do all unilaterally exercisable, freestanding non–fair value call options on transferred financial assets other than fixed-price options that are deep-out-of-the-money when written cause the transferor to maintain effective control over the specific financial assets subject to the options?

Answer

ASC 860-10-40-5(c)(2) indicates that a transferor maintains effective control over transferred financial assets if the transferor, its consolidated affiliates included in the financial statements being presented, or its agents have:

An agreement, other than through a cleanup call (see paragraphs 860-10-40-28 through 40-39), that provides the transferor with both of the following:

The unilateral ability to cause the holder to return specific financial assets
A more-than-trivial benefit attributable to that ability.

Only certain freestanding call options that allow a transferor, its consolidated affiliates included in the financial statements being presented, or its agents to reclaim readily obtainable financial assets by paying fair value for those financial assets do not cause the transferor to maintain effective control over the transferred financial assets.39 See Q&A 3-51.

Q&A 3-50 Call Options on Non-Readily-Obtainable Financial Assets

Question

Why do all unilaterally exercisable, freestanding call options on non-readily-obtainable transferred financial assets other than fixed-price call options that are deep-out-of-the-money when written cause the transferor to maintain effective control over those specific financial assets?

Answer

An agreement, other than through a cleanup call (see paragraphs 860-10-40-28 through 40-39), that provides the transferor with both of the following:

The unilateral ability to cause the holder to return specific financial assets
A more-than-trivial benefit attributable to that ability.

Thus, when the transferor, its consolidated affiliates included in the financial statements being presented, or its agents have the unilateral ability to cause the transferee to return specific financial assets, effective control is maintained unless that right does not provide a more than trivial benefit. The threshold for whether a more than trivial benefit is obtained is very low. A call option on non-readily-obtainable financial assets that is not a deep-out-of-the-money fixed-price option when written always provides a more than trivial benefit to the transferor, regardless of whether the exercise price is fair value, because such a call option allows the transferor to obtain financial assets that are not readily available for purchase in the market and to know who owns such financial assets. Thus, regardless of its price, a unilaterally exercisable option to reclaim non-readily-obtainable financial assets maintains the transferor’s effective control over transferred financial assets (see ASC 860-10-55-42(f)). As discussed in Section 3.4.1.4, freestanding call options on non-readily-obtainable transferred financial assets also prevent the transfer from meeting the condition in ASC 860-10-40-5(b).

Only certain freestanding call options that allow a transferor, its consolidated affiliates included in the financial statements being presented, or its agents to reclaim readily obtainable transferred financial assets by paying fair value for those financial assets would not cause the transferor to maintain effective control over the transferred financial assets.40 See the Q&A below.

Q&A 3-51 Fair Value Call Options on Readily Obtainable Financial Assets

Question

Do unilaterally exercisable, freestanding call options on readily obtainable transferred financial assets that have an exercise price equal to the fair value of the financial assets on the exercise date cause the transferor to maintain effective control over those specific financial assets?

Answer

It depends. ASC 860-10-40-5(c)(2) indicates that a transferor maintains effective control over transferred financial assets if the transferor, its consolidated affiliates included in the financial statements being presented, or its agents have:

An agreement, other than through a cleanup call (see paragraphs 860-10-40-28 through 40-39), that provides the transferor with both of the following:

The unilateral ability to cause the holder to return specific financial assets
A more-than-trivial benefit attributable to that ability.

A freestanding call option that allows a transferor, its consolidated affiliates included in the financial statements being presented, or its agents to reclaim readily obtainable transferred financial assets by paying fair value for those financial assets would generally not result in a more than trivial benefit for the transferor (see ASC 860-10-40-28(c)). However, as discussed in ASC 860-10-40-35, if a transferor has a unilateral right to reclaim a readily obtainable financial asset by paying fair value when the asset is reclaimed and also holds a residual interest in the transferred financial assets, the fair value call option causes the transferor to maintain effective control over the transferred financial assets because it is evaluated in the same manner as a non–fair value call option.41 Anytime a transferor has the right to require the sale of transferred financial assets through any mechanism within its control and also owns a residual interest in the transferred financial assets, the transferor is deemed to maintain effective control over the transferred financial assets unless the relevant agreements either prohibit the transferor from bidding on the asset or only allow the transferor to pay the highest price of a substantive bid from a third party.

Q&A 3-52 Readily Obtainable Financial Asset Becomes Non-Readily-Obtainable

Question

Would a freestanding fair value call option on readily obtainable financial assets that did not preclude sale accounting as of the original transfer date result in the failure to qualify for sale accounting at a later date if the transferred financial asset becomes illiquid (i.e., is no longer readily obtainable)?

Answer

No. The assessment of whether the transferor maintains effective control over a transferred financial asset, including whether a more than trivial benefit is obtained, is made as of the transfer date and does not change solely as a result of market events, such as changes in market prices or illiquidity in a financial asset that was readily obtainable on the transfer date. However, if a sale agreement was modified, the transferor would need to reevaluate the impact of a freestanding call option to determine whether the effective-control condition in ASC 860-10-40-5(c) is met.

Q&A 3-53 Call Options on Amortized Portions of Entire Financial Assets

An entity transfers prepayable loan receivables to a third party. After the balance of each transferred loan receivable amortizes to 30 percent of its balance as of the transfer date, the entity has a unilateral right to repurchase it at the unpaid principal balance. Assume that this freestanding call option provides a more than trivial benefit because the loan receivables are not readily obtainable in the marketplace.

Question

Does the entity maintain effective control over transferred financial assets?

Answer

Yes. Although possible credit losses or prepayments may affect when the entity can exercise the option, it will become exercisable upon the passage of time. Because this option is not a cleanup call option, sale accounting is precluded. Under ASC 860-10-55-68, a freestanding call option that gives the transferor the unilateral ability to return the remaining portion of an entire financial asset and provides a more than trivial benefit precludes sale accounting for the entire financial asset. ASC 860 does not permit an entity to account for a transfer of an entire financial asset as partially a sale and partially a financing.

If, however, a transferor holds a freestanding call option that allows it only to reclaim a few specific transferred loan receivables from a larger group of loan receivables, effective control would be maintained only for the loan receivables that may be reclaimed (i.e., the specific loan receivables that can be repurchased at the transferor’s option). In contrast, if a transferor holds a freestanding call option to repurchase from a group of loan receivables any loan that it chooses, up to a specified limit, sale accounting is precluded for the entire transfer while that option remains outstanding unless that option does not provide a more than trivial benefit to the transferor.

Q&A 3-54 Call Options on Prepayable Financial Assets

Question

Is a freestanding call option on a prepayable financial asset considered conditionally, as opposed to unilaterally, exercisable because the financial asset could be prepaid before the option may be exercised?

Answer

No. A freestanding call option exercisable upon the passage of time is treated the same for effective-control purposes regardless of whether the related financial assets are prepayable. The fact that an issuer of a financial asset may prepay it before the transferor can reclaim it does not make the call option contingently exercisable in the evaluation of effective control. See Example 3-18.

Q&A 3-55 Call Options Exercisable After Maturity of a Financial Asset

Question

How should an entity treat a freestanding call option that is exercisable only after maturity of a financial asset?

Answer

A right to repurchase a transferred financial asset only after its maturity would generally be treated as a default ROAP because the transferor can reclaim the transferred financial asset only if the borrower does not repay the amounts due at maturity (i.e., the borrower defaults on repayment).

3.5.3.2.2 More Than Trivial Benefit

Q&A 3-56 Assessment of More Than Trivial Benefit for Default ROAPs

Question

On what date should an entity evaluate whether a default ROAP on transferred financial assets provides a more than trivial benefit?

Answer

The evaluation of whether a conditionally exercisable call option provides a more than trivial benefit should be performed in accordance with ASC 860-10-40-28, which states that a call option conveys a more than trivial benefit “if the price to be paid is fixed, determinable, or otherwise potentially advantageous, unless because that price is so far out of the money or for other reasons it is probable when the option is written that the transferor will not exercise it.” This assessment focuses on whether, on the basis of the pricing of the option, there is a reasonably possible future scenario in which the call price is advantageous compared with the cost of exercising it. The holder’s liquidity position (i.e., its ability to exercise the option) should not be taken into account in this assessment. The transferor evaluates whether a conditionally exercisable repurchase right conveys a more than trivial benefit as of the date on which sale accounting for the transferred financial assets is achieved, which could be later than the original transfer date. The conclusion is not reconsidered because of a change in market prices or market conditions. This is consistent with (1) ASC 860-10-40-28(a), which indicates that the assessment of probability for a deep-out-of-the-money option is performed when the option is written, and (2) ASC 860-20-25-9(b), which indicates that a change in market prices should not affect a transferor’s assessment of whether it has regained control over specific transferred financial assets. Because the threshold for determining whether a repurchase option conveys a more than trivial benefit is very low, it would be rare for a transferor not to rerecognize specific financial assets previously considered sold when it subsequently regains control over them.

3.5.3.2.3 Options on Beneficial Interests in Transferred Financial Assets

Q&A 3-57 Put Option on Beneficial Interests Held by Transferor

An entity transfers $100 million of corporate bonds of 10 different issuers to an entity whose sole purpose is to engage in securitization activities. The bonds are traded in denominations of $1,000. In return for the transferred bonds, the entity receives cash and a beneficial interest in the transferred bonds. The entity has a right, at any time, to put its beneficial interest to the securitization entity in return for any of the transferred bonds. Each dollar amount of the beneficial interest can be put for a dollar of unpaid principal amount on the transferred bonds.

Question

Does the put option cause the entity to maintain effective control over the transferred bonds?

Answer

Yes. The entity maintains effective control over all the transferred bonds because it can choose to reclaim any of the 10 transferred bonds by putting its beneficial interest and this option provides a more than trivial benefit to the entity since it contains a non–fair value exercise price. The fact that the transferor cannot reclaim all the transferred bonds because its beneficial interest is less than the unpaid principal amount of all the transferred bonds does not matter. See also Example 3-20.

Q&A 3-58 Call Options on Third-Party Beneficial Interests

Question

How should a transferor evaluate whether a call option on third-party beneficial interests causes it to maintain effective control over transferred financial assets?

Answer

A call option on third-party beneficial interests is generally evaluated as an attached call option on transferred financial assets. If the call option is unilaterally exercisable, it precludes sale accounting for the transferred financial assets regardless of whether the transferor can actually reclaim the transferred financial assets underlying the beneficial interests. When financial assets are transferred to an entity whose sole purpose is to engage in securitization or asset-backed financing activities, the beneficial interests in the transferred financial assets are treated as proxies for the transferred financial assets themselves in accordance with the accounting conditions in ASC 860-10-40-5(b) and (c).

Although atypical, it is possible for a transferor to enter into a separate contract with a third-party beneficial interest holder that allows the entity to repurchase that third party’s beneficial interests, but the option is not transferred with the beneficial interests if they are sold by the third-party holder. In these situations, the call option is evaluated in the same manner as a freestanding call option on transferred financial assets regardless of whether the transferor can actually reclaim the transferred financial assets underlying such beneficial interests.

3.5.4 Put Options

ASC 860-10

Other Arrangements

55-42D This implementation guidance addresses the application of paragraph 860-10-40-5(c)(3) through the following examples:

A put option written to the transferee generally does not provide the transferor with effective control over the transferred financial asset under paragraph 860-10-40-5(c)(3).
A put option that is sufficiently deep in the money when it is written would, under that paragraph, provide the transferor effective control over the transferred financial asset because it is probable that the transferee will exercise the option and the transferor will be required to repurchase the transferred financial asset.
A sufficiently out-of-the-money put option held by the transferee would not provide the transferor with effective control over the transferred financial asset if it is probable when the option is written that the option will not be exercised.
A put option held by the transferee at fair value would not provide the transferor with effective control over the transferred financial asset.

The focus of the effective-control condition in ASC 860-10-40-5(c) is on whether the transferor can reclaim or repurchase transferred financial assets. Put options written by a transferor to a transferee give the transferee the ability to require the transferor to repurchase transferred financial assets (or third-party beneficial interests in transferred financial assets). With one exception, put options do not cause the transferor to maintain effective control over transferred financial assets (or third-party beneficial interests in transferred financial assets) because the transferee, not the transferor, decides whether the transferor repurchases the transferred financial assets (or beneficial interests in transferred financial assets). ASC 860-10 indicates that when a put option is sufficiently deep-in-the-money that it is probable when written that it will be exercised by the transferee, it functions, in substance, as a call option. ASC 860-10 includes this guidance as an anti-abuse condition. For a put option to function as a call option and preclude a transfer from meeting the condition in ASC 860-10-40-5(c), the following conditions must be met:

The exercise price is not fair value (i.e., it is fixed, determinable, or subject to a formula that allows the exercise price to exceed the fair value of the financial asset or third-party beneficial interest).
The option is unilaterally exercisable by the transferee.
As of the date the option is written (e.g., the transfer date), it is probable that it will be exercised.42

A put option cannot prevent a transfer from meeting the condition in ASC 860-10-40-5(c) if it is more than remote that the option will not be exercised (i.e., reasonably possible that exercise would not occur). Because this is a low threshold, put options rarely preclude sale accounting in practice. See Example 3-19 for an illustration.

Footnotes

While it is common by contract or custom for there to be collateral sufficient to (1) fund all or substantially all of the cost of purchasing replacement assets if the transferee (lender) defaults and (2) repay the obligation if the transferor (borrower) defaults, such collateral does not need to exist for a transferor to conclude that it maintains effective control when it is required to repurchase transferred financial assets or substantially the same assets. ASU 2011-03 eliminated the requirement for entities to consider whether a transferor has the ability to repurchase the transferred financial assets in a repurchase agreement.

A call option may be entered into after the transfer date, or a conditionally exercisable call option entered into as of the transfer date may later become unilaterally exercisable. In these situations, the transferor does not maintain effective control over transferred financial assets (or third-party beneficial interests in transferred financial assets) as of the original transfer date. Rather, it regains control over previously sold financial assets. See Section 4.3 for further discussion.

As discussed in Section 3.5.3.1.1.1, a call option held by the transferor on third-party beneficial interests in securitized financial assets that is part of, and transferred with, the beneficial interests is an attached call option on the transferred financial assets.

See Example 3-8 for an illustration of the evaluation of effective control for transfers of financial assets from a subsidiary entity to a securitization entity that is consolidated by the parent.

See ASC 860-10-55-42 for an exception to this general principle.

See Section 3.5.3.1.5.2 for guidance on situations in which the transferor holds a residual interest in securitized financial assets.

For example, if the only transactions occurring in the marketplace are repurchase financing transactions, the underlying financial asset is not readily obtainable.

Evidence may be obtained from published trading activity or from discussions with dealers in the financial asset.

One exception is when the exercise price is fixed and is so far out-of-the-money when written that it is probable that the transferor will not exercise it.

ASC 860-10 discusses call options that contain fixed or determinable prices. This means that the option’s exercise price is not at fair value on the date the financial asset is reclaimed. Call options with fixed or determinable prices are also referred to herein as “non–fair value” options.

If a securitization entity offers to sell the remaining financial assets as of the maturity or termination date of the securitization entity, and the transferor is precluded from bidding an amount that exceeds bona fide offers from unrelated third parties, the transferor’s ability to participate in the auction would not be viewed as the equivalent of holding a non–fair value call option.

Even a right to reclaim a readily obtainable financial asset from the transferee at a fixed price provides the transferor with effective control over that financial asset because the transferee cannot sell that asset without having to potentially incur a loss in the future from the requirement to repurchase that same asset in the marketplace at a higher price.

This view is consistent with comments made by board members at the March 4, 2009, FASB meeting. These comments are discussed in paragraphs 13 and 14 of the official minutes of this meeting.

See footnote 39.

If a transferred financial asset is not readily obtainable, a transferor would maintain effective control over the transferred asset if it holds a unilaterally exercisable, freestanding fair value call option even if it did not hold a residual interest in the transferred asset. See Q&A 3-50.

For put options that are exercisable at a future date, the exercise price must be deep-in-the-money as of the date the option is written and the volatility of the financial asset must be low enough to conclude that the option will be in-the-money as of the date it can be exercised.

3.9 Summary of the Effect of Repurchase Options on the Conditions in ASC 860-10 Related to Pledge and Exchange and Effective Control

Sale accounting is precluded if either (1) a transferor’s right to reacquire transferred financial assets (or third-party beneficial interests in transferred financial assets) constrains a transferee’s ability (or, if the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities, each third-party beneficial interest holder) to pledge or exchange the transferred financial assets (or beneficial interests) received and provides the transferor with a more than trivial benefit (ASC 860-10-40-5(b)) or (2) a transferor, its consolidated affiliates included in the financial statements being presented, or its agents maintain effective control over transferred financial assets (ASC 860-10-40-5(c)). The tables below summarize the effect of various options to reacquire transferred financial assets (or third-party beneficial interests) on these sale accounting conditions.

Table 3-7

Options on Transferred Financial Assets
Type	Fail to Meet Condition in ASC 860-10-40-5(b)?	Fail to Meet Condition in ASC 860-10-40-5(c)?
Unilaterally Exercisable Freestanding Call Options on Specific Financial Assets(a)
Readily Obtainable Financial Assets
Fixed or determinable purchase price	No(b)	Yes(d)
Fair value purchase price	No(b)	Generally, no(e)
Non-Readily-Obtainable Financial Assets
Fixed or determinable purchase price	Yes(c)	Yes(d)
Fair value purchase price	Yes(c)	Yes(d)
A conditionally exercisable freestanding call option generally does not preclude sale accounting under ASC 860-10-40-5(b) or (c). Once the condition is resolved and the transferor controls the ability to exercise the option, it is evaluated as a unilaterally exercisable freestanding call option.
Unilaterally Exercisable Freestanding Put Options on Specific Financial Assets(f)
Readily Obtainable Financial Assets
Fixed or determinable purchase price	No(g)	Generally, no(h)
Fair value purchase price	No(g)	No(h)
Non-Readily-Obtainable Financial Assets
Fixed or determinable purchase price	Generally, no(g)	Generally, no (h)
Fair value purchase price	No(g)	No(h)
A conditionally exercisable freestanding put option generally does not preclude sale accounting under ASC 860-10-40-5(b) or (c). Once the condition is resolved and the transferee controls the ability to exercise the option, it is evaluated as a unilaterally exercisable freestanding put option. The evaluation of whether the option is deep-in-the-money is performed as of the date sale accounting is achieved and not on the date the exercise condition is resolved.
Attached Call Options(i)
Whether unilaterally or conditionally exercisable, an attached call option does not constrain a transferee that is able, by exchanging or pledging the asset subject to the option, to obtain substantially all of its economic benefits. An attached call option is related to specific financial assets. Since the call is attached by the transferor, regardless of the exercise price (i.e., fair value or not fair value) and whether the asset is readily obtainable, it presumptively provides a more than trivial benefit to the transferor. Therefore, with one exception, an attached call option that gives the transferor the unilateral ability to cause whoever holds a specific asset to return it maintains effective control over transferred financial assets. If an attached call option has a fixed purchase price and the option is so far out-of-the-money when written that it is probable that the transferor would not exercise it, the option would not provide the transferor with a more than trivial benefit and therefore would not preclude the condition in ASC 860-10-40-5(c) from being met. A conditionally exercisable attached call option does not preclude sale accounting under ASC 860-10-40-5(c) if the transferor does not control the ability to exercise the option. Once the condition is resolved and the transferor controls the ability to exercise the option, it is evaluated as a unilaterally exercisable attached call option. The evaluation of whether a fixed-price attached call option is deep-out-of-the-money is performed as of the date sale accounting is achieved and not on the date the exercise condition is resolved.
Attached Put Options
Whether unilaterally or conditionally exercisable, an attached put option does not constrain a transferee that is able, by exchanging or pledging the asset subject to the option, to obtain substantially all of its economic benefits. A unilaterally exercisable attached put option does not maintain the transferor’s effective control over transferred financial assets unless the option has a fixed price and is so far in-the-money when written that it is probable that the transferee will exercise it and the option requires the transferor to repurchase the transferred financial assets. If this condition is met, the put option maintains the transferor’s effective control over the transferred financial assets regardless of whether they are readily obtainable since an attached call option is related to specific transferred financial assets.
Embedded Call Options(j)
An embedded call option in a transferred financial asset neither constrains the transferee from pledging or exchanging the asset nor maintains the transferor’s effective control over the transferred financial asset.
Other Considerations
Options to Purchase Transferred Financial Assets Once They Have Amortized to a Specified Level A right to repurchase a transferred financial asset once it amortizes to a certain amount or percentage compared with its value as of the transfer date is evaluated as a call option on the entire financial asset. For example, if an entity transfers a loan receivable and has the unilateral right to repurchase it for a fixed price once its balance reaches 25 percent of the balance as of the transfer date, the transferor maintains effective control over the loan receivable as of the transfer date.
Other Considerations
Removal-of-Accounts Provisions ROAPs commonly exist in transfers of groups of financial assets to securitization or asset-backed financing entities. They may also exist in other transfers. Depending on the facts and circumstances, a ROAP may be considered a freestanding call option or an attached call option. Whether a ROAP precludes sale accounting depends on the facts and circumstances as follows: Unilaterally exercisable ROAP that allows the transferor to specify the financial assets to be removed — A unilaterally exercisable right of a transferor to specify the financial assets that may be reclaimed from a group of transferred financial assets is evaluated as a freestanding call option on each individual transferred financial asset that could be repurchased even if all of those assets could not be reclaimed because the aggregate amount of repurchases is limited. As discussed above, a freestanding call option precludes sale accounting unless it is a right to purchase (1) readily obtainable financial assets at fair value on the purchase date or (2) financial assets at a fixed price and is so far out of the money when written that it is probable that the transferor would not exercise the option. If a transferor reclaims all the financial assets that can be repurchased from a unilaterally exercisable ROAP that permits selection of the assets to be removed, or the option expires, the remaining transferred financial assets can be derecognized if no other condition in ASC 860-10-40-5 prevents sale accounting. Unilaterally exercisable ROAP for random removal of excess financial assets — A unilaterally exercisable call option that allows a transferor to randomly remove excess financial assets is generally evaluated as a freestanding call option. Such an option does not prevent the condition in ASC 860-10-40-5(b) from being met and may not prevent the condition in ASC 860-10-40-5(c) from being met if it is limited to the extent that the transferor cannot remove specific transferred financial assets and the assets that may be removed are limited to the transferor’s interests. For example, a ROAP that gives a transferor the unilateral right to randomly remove excess financial assets from a group of transferred financial assets up to 10 percent of the fair value of the financial assets transferred (all financial assets in the group are less than this 10 percent of the fair value of transferred financial assets) does not preclude sale accounting if the transferor has no other interest in the group. In this situation, the transferor has obtained a 10 percent beneficial interest in the transferred financial assets. This treatment is permitted only if a ROAP is sufficiently limited and the transferor cannot unilaterally remove specific transferred financial assets. A ROAP that allows a transferor to randomly remove a significant amount of transferred financial assets maintains effective control over all the transferred financial assets subject to the ROAP. Conditionally exercisable ROAP — A ROAP whose exercise is contingent on an event or circumstance within the transferor’s control (e.g., the decision to exit some portion of the transferor’s business) is evaluated as a unilaterally exercisable call option. A ROAP whose exercise is contingent on an event or circumstance that is not solely within the transferor’s control (e.g., an option to repurchase defaulted loan receivables) generally does not prevent the conditions in ASC 860-10-40-5(b) and (c) from being met until the condition that allows exercise is resolved. At that point, the ROAP is evaluated as a unilaterally exercisable call option and the transferor may be required to rerecognize financial assets previously considered sold.
Right to Rescind a Transfer A transferor’s unilateral right to rescind a transfer causes the conditions in ASC 860-10-40-5(b) and (c) not to be met.
Notes to Table: (a) ASC 860-10-20 defines a freestanding call option as “[a] call option that is neither embedded in nor attached to an asset subject to that call option.” In this table, it is assumed that the freestanding call option held by the transferor is not a cash-settled option or a cleanup call option. Net-cash-settled options do not preclude sale accounting under ASC 860-10-40-5(b) or (c). Cleanup call options do not preclude the conditions in ASC 860-10-40-5(b) or (c) from being met. (b) A unilaterally exercisable freestanding call option held by the transferor on readily obtainable financial assets does not constrain the transferee because it can otherwise acquire the assets in the marketplace. (c) A unilaterally exercisable freestanding call option on non-readily-obtainable financial assets conveys a more than trivial benefit to the transferor and constrains the transferee from pledging or exchanging the assets because the transferee might have to default if the call option is exercised and the transferee had pledged or exchanged the assets. If the option has a fixed or determinable price, there is a potential economic benefit to the transferor unless the option is so far out-of-the-money when written that it is probable that the transferor would not exercise it. If the option has an exercise price equal to the fair value of the financial asset when purchased, it provides a more than trivial benefit because the transferor has the ability to obtain an asset that is not readily obtainable, always knows who holds the asset, and can prevent it from being obtained by a competitor. (d) A unilaterally exercisable freestanding call option that permits the transferor to cause the transferee to return specific transferred financial assets (regardless of whether they are readily obtainable) provides a more than trivial benefit if the option has a fixed or determinable price unless the option is so far out-of-the-money when written that it is probable that the transferor would not exercise it. A freestanding call option that permits the transferor to cause the transferee to return specific non-readily-obtainable transferred financial assets provides a more than trivial benefit if the option’s exercise price is equal to the fair value of the financial assets when purchased because the transferor has the ability to obtain assets that are not readily obtainable, always knows who holds the assets, and can prevent them from being obtained by a competitor. (e) A unilaterally exercisable freestanding call option that permits the transferor to cause the transferee to return readily obtainable transferred financial assets by paying fair value for such assets when purchased does not provide a more than trivial benefit to the transferor unless it also owns a residual interest in the transferred financial assets. (f) In this table, it is assumed that any freestanding put option held by a transferee that allows it to require the transferor to repurchase transferred financial assets is not a cash-settled option. Net-cash-settled options do not preclude sale accounting under ASC 860-10-40-5(b) or (c). (g) Regardless of its price (i.e., fair value or not fair value), a unilaterally exercisable freestanding put option held by a transferee on readily obtainable financial assets does not constrain the transferee because it can pledge or exchange the transferred assets and exercise the put option by otherwise acquiring the assets in the marketplace. A unilaterally exercisable freestanding put option held by a transferee on non-readily-obtainable financial assets also generally does not constrain the transferee because it can always pledge or exchange the transferred assets since it does not have to exercise the put option. However, if the put option’s exercise price is fixed or determinable and is sufficiently deep-in-the-money when written in such a way that it is probable it will be exercised, the option constrains the transferee from pledging or exchanging the transferred financial assets because it would have to hold the financial assets to exercise the put option. The transferor obtains a more than trivial benefit since it has access to assets that are not readily obtainable, always knows who holds the assets, and can prevent these assets from being obtained by a competitor. (h) A unilaterally exercisable put option held by a transferee does not maintain the transferor’s effective control over transferred financial assets unless it has a fixed or determinable price and is sufficiently deep-in-the-money when written in such a way that it is probable that the transferee will exercise the option and require the transferor to repurchase the transferred financial assets. In these circumstances, regardless of whether the assets are readily obtainable, effective control is maintained by the transferor because the option is considered to provide a more than trivial benefit. (i) ASC 860-10-20 defines an attached call option as “[a] call option held by the transferor of a financial asset that becomes part of and is traded with the underlying instrument. Rather than being an obligation of the transferee, an attached call option is traded with and diminishes the value of the underlying instrument transferred subject to that call option.” An attached call option is not an option originally embedded in a financial asset by the issuer of the financial asset; rather, such an option is created by the transferor as part of a transfer of financial assets (i.e., the transferor attaches a call option to a transferred financial asset). (j) ASC 860-10-20 defines an embedded call option as “[a] call option held by the issuer of a financial instrument that is part of and trades with the underlying instrument. For example, a bond may allow the issuer to call it by posting a public notice well before its stated maturity that asks the current holder to submit it for early redemption and provides that interest ceases to accrue on the bond after the early redemption date. Rather than being an obligation of the initial purchaser of the bond, an embedded call option trades with and diminishes the value of the underlying bond.”

Table 3-8

Options on Third-Party Beneficial Interests in Transferred Financial Assets
Type	Fail ASC 860-10-40-5(b)?	Fail ASC 860-10-40-5(c)?
Unilaterally Exercisable Freestanding Call Options on Third-Party Beneficial Interests(a)
Readily Obtainable Beneficial Interests
Fixed or determinable purchase price	No(b)	Yes(d)
Fair value purchase price	No(b)	Generally, no(e)
Non-Readily-Obtainable Beneficial Interests
Fixed or determinable purchase price	Yes(c)	Yes(d)
Fair value purchase price	Yes(c)	Yes(d)
A conditionally exercisable freestanding call option on beneficial interests generally does not preclude sale accounting under ASC 860-10-40-5(b) or ASC 460-10-40-5(c). Once the condition is resolved and the transferor controls the ability to exercise the option, it is evaluated as a unilaterally exercisable freestanding call option on beneficial interests.
Unilaterally Exercisable Freestanding Put Options on Third-Party Beneficial Interests(f)
Readily Obtainable Financial Assets
Fixed or determinable purchase price	No(g)	Generally, no(h)
Fair value purchase price	No(g)	No(h)
Non-Readily-Obtainable Financial Assets
Fixed or determinable purchase price	Generally, no(g)	Generally, no(h)
Fair value purchase price	No(g)	No(h)
A conditionally exercisable freestanding put option on beneficial interests generally does not preclude sale accounting under ASC 860-10-40-5(b) or ASC 460-10-40-5(c). Once the condition is resolved and the option becomes exercisable by the transferee, it is evaluated as a unilaterally exercisable freestanding put option on beneficial interests. The evaluation of whether the option is deep-in-the-money is performed as of the date sale accounting is achieved and not on the date the exercise condition is resolved.
Attached Call Options(i)
Whether unilaterally or conditionally exercisable, an attached call option does not constrain a third-party beneficial interest holder since it is able to pledge or exchange the interest and obtain substantially all of the interest’s economic benefits. Attached call options on beneficial interest are analyzed as indirect attached call options on the transferred financial assets underlying the beneficial interest. An attached call option is related to specific beneficial interests. Since the call is attached by the transferor, regardless of the exercise price (i.e., fair value or not fair value) and whether the beneficial interest is readily obtainable, the call presumptively provides a more than trivial benefit to the transferor. Therefore, with one exception, an attached call option that gives the transferor the unilateral ability to cause a third-party beneficial interest holder to return it maintains effective control over the transferred financial assets underlying the beneficial interest. This is the case even if the transferor cannot obtain direct access to those transferred financial assets. If an attached call option has a fixed purchase price and the option is so far out-of-the-money when written that it is probable that the transferor would not exercise it, the option would not provide the transferor with a more than trivial benefit and therefore would not preclude the condition in ASC 860-10-40-5(c) from being met. A conditionally exercisable attached call option on a beneficial interest does not preclude sale accounting under ASC 860-10-40-5(c) if the transferor does not control the ability to exercise the option. Once the condition is resolved and the transferor controls the ability to exercise the option, it is evaluated as a unilaterally exercisable attached call option on a beneficial interest. The evaluation of whether a fixed-price attached call option is deep-out-of-the-money should be performed as of the date sale accounting is achieved and not on the date the exercise condition is resolved.
Attached Put Options
Whether unilaterally or conditionally exercisable, an attached put option on a beneficial interest in transferred financial assets does not constrain the holder of the beneficial interest because it can pledge or exchange the interest and obtain substantially all of its economic benefits. A unilaterally exercisable attached put option on a beneficial interest does not maintain the transferor’s effective control over transferred financial assets unless the option has a fixed price and is so far in-the-money when written that it is probable that the beneficial interest holder will exercise it and require the transferor to repurchase the beneficial interest. If this condition does exist, the put option maintains the transferor’s effective control over the transferred financial assets regardless of whether the beneficial interest is readily obtainable.
Embedded Call Options
N/A. A call option embedded in a beneficial interest issued by a securitization or asset-backed financing entity is analyzed as an attached call option.
Other Considerations
A transferor always maintains effective control over transferred financial assets when any of the following conditions are met: The transferor has a unilateral right to redeem a beneficial interest in transferred financial assets that was received as proceeds from a transfer and, upon such redemption, the transferor can reclaim specific transferred financial assets. In this circumstance, the transferor would maintain effective control over the specific financial assets that it can reclaim. The transferor has the unilateral ability to liquidate or dissolve a securitization or other asset-backed financing entity (e.g., such a right could exist in a residual interest owned by the transferor). The transferor has a unilateral right to direct a securitization or asset-backed financing entity to dispose of specific financial assets, the transferor holds a residual interest in the entity, and the transferor is able to bid on the assets. A securitization or asset-backed financing entity must be liquidated before the maturity of the transferred financial assets, the transferor holds a residual interest in the entity, and the transferor is able to bid on the assets.
Notes to Table: (a) ASC 860-10-20 defines a freestanding call option as “[a] call option that is neither embedded in nor attached to an asset subject to that call option.” Generally, call options on beneficial interests are attached options because they are part of, and are transferred with, the beneficial interests. A call option on a beneficial interest is a freestanding option only if it is a contract between the transferor and a specific third-party beneficial interest holder and is not part of, and would not be transferred with, the beneficial interest. In this table, it is assumed that any call option held by a transferor on third-party beneficial interests is not a cash-settled option or a cleanup call option. Net-cash-settled options on third-party beneficial interests do not preclude sale accounting under ASC 860-10-40-5(b) or (c). (An option whose settlement requires a securitization or asset-backed financial entity to sell transferred financial assets is not considered a cash-settled option.) Cleanup call options do not preclude the condition in ASC 860-10-40-5(b) or (c) from being met. (b) A unilaterally exercisable freestanding call option on a beneficial interest is evaluated as an indirect call option on the transferred financial assets underlying that beneficial interest. A unilaterally exercisable freestanding call option on a readily obtainable beneficial interest does not constrain the transferee because it can otherwise acquire the beneficial interest in the marketplace. In practice, beneficial interests in securitized transferred financial assets are rarely considered readily obtainable. (c) A unilaterally exercisable freestanding call option on a beneficial interest is evaluated as an indirect call option on the transferred financial assets underlying the beneficial interest. A unilaterally exercisable freestanding call option on a non-readily-obtainable beneficial interest conveys a more than trivial benefit to the transferor and constrains the holder from pledging or exchanging its interest because it might have to default if the call option was exercised and the interest had been pledged or exchanged. If the option has a fixed or determinable price, there is a potential economic benefit to the transferor unless the option is so far out-of-the-money when written that it is probable that the transferor would not exercise it. If the option has an exercise price equal to the fair value of the beneficial interest when purchased, it provides a more than trivial benefit because the transferor is able to obtain an asset that is not readily obtainable, always knows who holds the asset, and can prevent the asset from being obtained by a competitor. (d) A unilaterally exercisable freestanding call option on a beneficial interest is evaluated as an indirect call option on the transferred financial assets underlying that beneficial interest. A unilaterally exercisable freestanding call option that permits the transferor to cause the holder to return its beneficial interest (regardless of whether it is readily obtainable) provides a more than trivial benefit if the option has a fixed or determinable price unless the option is so far out-of-the-money when written that it is probable that the transferor would not exercise it. A freestanding call option that permits the transferor to cause the return of a specific non-readily-obtainable beneficial interest provides a more than trivial benefit if the option’s exercise price is equal to the fair value of the beneficial interest when purchased because the transferor is able to obtain an asset that is not readily obtainable, always knows who holds the beneficial interest, and can prevent the asset from being obtained by a competitor. (e) A unilaterally exercisable freestanding call option on a beneficial interest is evaluated as an indirect call option on the transferred financial assets underlying that beneficial interest. A unilaterally exercisable freestanding call option that permits the transferor to cause the holder to return a readily obtainable beneficial interest by paying fair value for such an interest when purchased does not provide a more than trivial benefit to the transferor unless the transferor also owns a residual interest in the transferred financial assets. In practice, beneficial interests in securitized transferred financial assets are rarely considered readily obtainable. (f) Generally, put options on beneficial interests are attached options because they are part of, and are transferred with, the beneficial interests. A put option on a beneficial interest is a freestanding option only if it is a contract between the transferor and a specific third-party beneficial interest holder and is not part of, and would not be transferred with, the beneficial interest. In this table, it is assumed that any freestanding put option held by a third-party beneficial interest holder that allows it to require the transferor to repurchase its interest is not a cash-settled put option. Net-cash-settled options do not preclude sale accounting under ASC 860-10-40-5(b) or ASC 460-10-40-5(c). (An option whose settlement requires a securitization or asset-backed financial entity to sell transferred financial assets is not considered a cash-settled option.) (g) A unilaterally exercisable freestanding put option on a beneficial interest is evaluated as an indirect put option on the transferred financial assets underlying that beneficial interest. Regardless of its price (i.e., fair value or not fair value), a unilaterally exercisable freestanding put option held by a third-party beneficial interest holder on readily obtainable beneficial interests does not constrain the holder because it can pledge or exchange the interest and still exercise the put option by otherwise acquiring the interests in the marketplace. In practice, beneficial interests in securitized financial assets are rarely readily obtainable. A unilaterally exercisable freestanding put option held by a third-party beneficial interest holder on non-readily-obtainable beneficial interests also generally does not constrain the transferee because it can always pledge or exchange the interests since it does not have to exercise the put option. However, if the put option’s exercise price is fixed or determinable and is sufficiently deep-in-the-money when written such that it is probable that it will be exercised, the option constrains the transferee from pledging or exchanging its interests because it would have to hold the interests to exercise the put option. The transferor obtains a more than trivial benefit since it has access to assets that are not readily obtainable, always knows who holds the interests, and can prevent them from being obtained by a competitor. (h) A unilaterally exercisable freestanding put option on a beneficial interest is evaluated as an indirect put option on the transferred financial assets underlying that beneficial interest. A unilaterally exercisable put option held by a beneficial interest holder does not cause the transferor to maintain effective control over the transferred financial assets unless the option is fixed-price and sufficiently deep-in-the-money when written in such a way that it is probable that the holder will exercise the option and require the transferor to repurchase the beneficial interest. In these circumstances, regardless of whether the beneficial interests are readily obtainable, effective control is maintained by the transferor because the option is considered to provide a more than trivial benefit. (i) ASC 860-10-20 defines an attached call option as “[a] call option held by the transferor of a financial asset that becomes part of and is traded with the underlying instrument. Rather than being an obligation of the transferee, an attached call option is traded with and diminishes the value of the underlying instrument transferred subject to that call option.” An attached call option is created by the transferor as part of a transfer of financial assets to a securitization or asset-backed financing entity.

Chapter 4 — Sale Accounting

4.2 Recognition of a Sale of Financial Assets

4.2.1 Derecognition of Assets Sold and Recognition of Proceeds

4.2.1.1 General

ASC 860-20

25-1 Section 860-20-40 provides derecognition guidance a transferor (seller) applies upon completion of a transfer of financial assets that satisfies paragraph 860-10-40-5’s conditions to be accounted for as a sale. Upon completion of such a transfer, the transferor (seller) shall also recognize any assets obtained or liabilities incurred in the sale, including, but not limited to, any of the following:

Cash
Servicing assets
Servicing liabilities
In a sale of an entire financial asset or a group of entire financial assets, any of the following:
1. The transferor’s beneficial interest in the transferred financial assets
2. Put or call options held or written (for example, guarantee or recourse obligations)
3. Forward commitments (for example, commitments to deliver additional receivables during the revolving periods of some securitizations)
4. Swaps (for example, provisions that convert interest rates from fixed to variable).

See Examples 1, 2, and 5 (paragraphs 860-20-55-43 through 55-59) for illustration of this guidance.

25-3 The transferee shall recognize all assets obtained (including any participating interest(s) obtained) and any liabilities incurred.

Assets Obtained and Liabilities Incurred as Proceeds

25-4 The proceeds from a sale of financial assets consist of the cash and any other assets obtained, including beneficial interests and separately recognized servicing assets, in the transfer less any liabilities incurred, including separately recognized servicing liabilities. Any asset obtained is part of the proceeds from the sale. Any liability incurred, even if it is related to the transferred financial assets, is a reduction of the proceeds. Any derivative financial instrument entered into concurrently with a transfer of financial assets is either an asset obtained or a liability incurred and part of the proceeds received in the transfer.

30-1 The transferor shall initially measure at fair value any asset obtained (or liability incurred) and recognized under paragraph 860-20-25-1.

30-2 The transferee shall initially measure, at fair value, any asset or liability recognized under paragraph 860-20-25-3.

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

30-2 The transferee shall initially measure, at fair value, any asset or liability recognized under paragraph 860-20-25-3, unless it is a purchased financial asset with credit deterioration or is a beneficial interest that meets the criteria in paragraph 325-40-30-1A, in which case the transferee shall apply the guidance in Topic 326 on measurement of credit losses to determine the initial amortized cost basis.

Sale of a Participating Interest

40-1A Upon completion of a transfer of a participating interest that satisfies the conditions in paragraph 860-10-40-5 to be accounted for as a sale, the transferor (seller) shall:

Allocate the previous carrying amount of the entire financial asset between both of the following on the basis of their relative fair values at the date of the transfer:
1. The participating interest(s) sold
2. The participating interest that continues to be held by the transferor.
Derecognize the participating interest(s) sold
Apply the guidance in paragraphs 860-20-25-1 and 860-20-30-1 on recognition and measurement of assets obtained and liabilities incurred in the sale
Recognize in earnings any gain or loss on the sale
Report any participating interest(s) that continue to be held by the transferor as the difference between the following amounts measured at the date of the transfer:
1. The previous carrying amount of the entire financial asset
2. The amount derecognized.

Pending Content (Transition Guidance: ASC 815-20-65-6)

40-1A Upon completion of a transfer of a participating interest that satisfies the conditions in paragraph 860-10-40-5 to be accounted for as a sale, the transferor (seller) shall:

Allocate the previous carrying amount of the entire financial asset between both of the following on the basis of their relative fair values at the date of the transfer:
1. The participating interest(s) sold
2. The participating interest that continues to be held by the transferor.
Derecognize the participating interest(s) sold
Apply the guidance in paragraphs 860-20-25-1 and 860-20-30-1 on recognition and measurement of assets obtained and liabilities incurred in the sale
Recognize in earnings any gain or loss on the sale
Report any participating interest(s) that continue to be held by the transferor as the difference between the following amounts measured at the date of the transfer:
1. The previous carrying amount of the entire financial asset
2. The amount derecognized.

For the transfer of a participating interest in a financial asset included in a closed portfolio hedged in an existing portfolio layer method hedge in accordance with Topic 815 on derivatives and hedging, when applying the guidance in (a) through (e) an entity shall not include any portion of the hedge basis adjustment that is maintained on the closed portfolio basis in accordance with paragraphs 815-20-25-12A(b) and 815-25-35-1(c).

Sale of an Entire Financial Asset or Group of Entire Financial Assets

40-1B Upon completion of a transfer of an entire financial asset or a group of entire financial assets that satisfies the conditions in paragraph 860-10-40-5 to be accounted for as a sale, the transferor (seller) shall:

Derecognize the transferred financial assets
Apply the guidance in paragraphs 860-20-25-1 and 860-20-30-1 on recognition and measurement of assets obtained and liabilities incurred in the sale
Recognize in earnings any gain or loss on the sale

Pending Content (Transition Guidance: ASC 815-20-65-6)

Derecognize the transferred financial assets
Apply the guidance in paragraphs 860-20-25-1 and 860-20-30-1 on recognition and measurement of assets obtained and liabilities incurred in the sale
Recognize in earnings any gain or loss on the sale

If the transferred financial asset was accounted for under Topic 320 as available for sale before the transfer, item (a) requires that the amount in other comprehensive income be recognized in earnings at the date of transfer. If the transferred financial asset was included in a closed portfolio hedged in an existing portfolio layer method hedge in accordance with Topic 815 before the transfer, when applying the guidance in (a) through (c) an entity shall not include any portion of the hedge basis adjustment that is maintained on the closed portfolio basis in accordance with paragraphs 815-20-25-12A(b) and 815-25-35-1(c).

A transferor accounts for a sale of financial assets by derecognizing the carrying amounts of the transferred financial assets and recognizing the fair value of all assets obtained or liabilities incurred in the sale. Any difference between the carrying amount of the financial assets derecognized and the net proceeds received in the sale (i.e., the fair value of the assets obtained less the fair value of any liabilities incurred) is recognized in earnings as a gain or loss on sale. Special consideration is required when a transfer involves the sale of a participating interest. In such a transfer, the transferor must allocate the previous carrying amount of the entire financial asset between the participating interest sold and the interest that continues to be held by the transferor in accordance with ASC 860-10-40-1A.

Although ASC 860-20-25-1 and ASC 860-20-25-4 discuss types of assets obtained and liabilities incurred, these are only examples. ASC 860-20 requires that all assets obtained and all liabilities incurred (regardless of their nature or form) be recognized by the transferor in a sale and initially measured at fair value. The following are examples of assets that may be received and liabilities that may be incurred in a transfer that meets the conditions for sale accounting:1

Servicing assets or liabilities (see Chapter 6).
Beneficial interests in securitized financial assets, including IO strips in transferred financial assets (see Section 4.4.3).
Contingently exercisable or settleable repurchase features.
ROAPs.
Cleanup call options (see Section 4.3.1.3).
Call and put options.
Forward commitments to transfer additional financial assets (see Section 4.4.8).
Derivative assets or liabilities.
Credit enhancements, guarantees, and other recourse obligations to the transferee (see Section 4.4.2).

These assets obtained and liabilities incurred must be recognized at fair value as part of sale accounting for the transferred financial assets. They must be classified and subsequently measured in accordance with other applicable U.S. GAAP (e.g., ASC 320 for debt securities, ASC 325-40 for beneficial interests in securitized financial assets, ASC 815-10 for derivatives, ASC 860-50 for servicing assets and liabilities). See Section 4.4 for discussion of the classification and subsequent measurement of assets obtained and liabilities assumed in a sale of financial assets.

A transferee recognizes all assets obtained and all liabilities incurred at fair value in accordance with ASC 860-20-30-2. Such assets and liabilities are classified and subsequently measured in accordance with other applicable U.S. GAAP. For entities that have adopted ASU 2016-01, the guidance on purchased credit-deteriorated assets in ASC 326-20 may apply. Section 4.4.9 discusses the accounting for acquired credit card receivables. If a transferee has a nonderivative option to acquire securities that will be within the scope of ASC 320 and that option contract has all the characteristics in ASC 815-10-15-141 (i.e., an instrument within the scope of the “Certain Contracts on Debt and Equity” subsections of ASC 815-10), the subsequent-measurement guidance in ASC 815-10-35-5 will apply. Under ASC 815-10-35-5, if such an option expires as worthless and the transferee subsequently purchases the same debt security in the market, the purchased debt security must be recorded at its market price plus the remaining unamortized premium related to the expired option, if any.

4.2.1.2 Trade-Date Versus Settlement-Date Accounting

4.2.1.2.1 General

ASC 860-20

25-2 Although a transfer of securities may not be considered to have reached completion until the settlement date, this Subtopic does not modify other generally accepted accounting principles (GAAP) that require accounting at the trade date for certain contracts to purchase or sell securities.

4.2.1.2.2 Transferor’s Accounting

The transferor’s accounting for sales of financial assets on a trade-date or settlement-date basis depends on the type of financial asset sold and certain industry practices. Except for certain sales of securities and sales of derivative instruments, entities generally recognize sales of financial assets, including those sold in securitization transactions, on a settlement-date basis. For example, settlement-date accounting is generally applied to sales of loan receivables by financial services entities.

In certain industries, sales involving regular-way security trades (and certain other regular-way trades of financial assets) are recognized on a trade-date basis. For example, broker-dealers (see ASC 940-320- 25-1), depository and lending entities (see ASC 942-325-25-2), investment companies (ASC 946-320- 25-1), and defined benefit and defined contribution plans (see ASC 960-325-25-1 and ASC 962-325-25-1) are required to apply trade-date accounting to sales of securities on a regular-way basis. If the basis for recognizing security sales is not specifically addressed in U.S. GAAP, entities can elect an accounting policy. However, no entity should apply trade-date accounting to a sale of a security that is not made on a regular-way basis or if there are any conditions before closing that have not been met. In addition, there may be industry-prescribed exceptions for certain transactions (e.g., ASC 946-320-25-2 and 25-3 address private placements and tender offers).

Sales of derivative instruments are generally accounted for on the trade date by all entities.

4.2.1.2.3 Transferee’s Accounting

The transferee’s accounting for purchases of financial assets on a trade-date or settlement-date basis depends on the type of financial asset purchased and certain industry practices. Except for certain purchases of securities and purchases of derivative instruments, entities generally recognize purchases of financial assets on a settlement-date basis. For example, settlement-date accounting is generally applied to purchases of loan receivables by financial services entities.

In certain industries, purchases involving regular-way security trades (and certain other regular-way trades of financial assets) are recognized on a trade-date basis. For example, broker-dealers (see ASC 940-320-25-1), depository and lending entities (see ASC 942-325-25-2), investment companies (ASC 946-320-25-1), and defined benefit and defined contribution plans (see ASC 960-325-25-1 and ASC 962-325-25-1) are required to apply trade-date accounting to purchases of securities on a regular-way basis. If the basis for recognizing security purchases is not specifically addressed in U.S. GAAP, entities can elect an accounting policy. However, no entity should apply trade-date accounting to a purchase of a security that is not made on a regular-way basis or if there are any conditions before closing that have not been met. In addition, there may be industry-prescribed exceptions for certain transactions (e.g., ASC 946-320-25-2 and 25-3 address private placements and tender offers).

Purchases of derivative instruments are generally accounted for on the trade date by all entities.

4.2.1.3 Transaction Costs

4.2.1.3.1 General

ASC 860-20

Transaction Costs

35-10 Transaction costs relating to a sale of the receivables may be recognized over the initial and reinvestment periods in a rational and systematic manner unless the transaction results in a loss. Transaction costs for a past sale are not an asset and thus are part of the gain or loss on sale. In a credit card securitization, however, some of the transaction costs incurred at the outset relate to the future sales that are to occur during the revolving period, and thus can qualify as an asset.

4.2.1.3.2 Transferor’s Accounting

Transaction costs incurred in a sale of financial assets (including those sold in securitization transactions) that represent costs incurred in a single transaction should be treated as a reduction of the proceeds of the transfer (i.e., they factor into the gain or loss on sale). There is no basis for capitalizing transaction costs in a sale of financial assets unless the transfer involves a securitization structure that features ongoing, multiple sales (e.g., a revolving-period securitization). In these situations, ASC 860-20-35-10 indicates that “[t]ransaction costs . . . may be recognized over the initial and reinvestment periods in a rational and systematic manner unless the transaction results in a loss.” If a loss is incurred on the initial transfer or on contractually expected transfers, however, third-party transaction costs should be expensed as incurred. See Section 4.4.8 for further discussion of revolving-period securitizations.

If a transferor obtains assets other than cash as proceeds in a sale of financial assets, those noncash assets should be recognized at fair value in accordance with ASC 860-20-30-1. Similarly, liabilities incurred in conjunction with a sale of financial assets are also initially measured at fair value in accordance with ASC 860-20-30-1. The initial measurement of those assets and liabilities should not include any transaction costs incurred in the sale because ASC 820 indicates that transaction costs are not an attribute of the fair value of an asset or liability and, as stated above, transaction costs reduce the net proceeds received and factor into the gain or loss on sale.

The accounting above does not apply to transactions that are accounted for as secured borrowings. See Section 5.2.5 for discussion of the accounting for transaction costs associated with secured borrowings.

4.2.1.3.3 Transferee’s Accounting

Entities should consider other Codification topics in accounting for transaction costs incurred in a purchase of financial assets. Although transaction costs are recognized in earnings as incurred for purchased financial assets that are subsequently measured at fair value through earnings, immediate recognition of transaction costs in earnings may not be appropriate when the investor subsequently measures a purchased financial asset by using an attribute other than fair value through earnings. For example, when a debt security is classified as held to maturity (i.e., accounted for subsequently at amortized cost), it is appropriate to capitalize transaction costs as part of the cost of the asset.

Furthermore, some Codification topics require subsequent recognition of a financial asset at fair value less costs to sell (i.e., the subsequent measurement of the asset is reduced by the anticipated costs of selling the asset). Thus, both the transaction costs incurred to acquire the financial asset and those that will be incurred to sell the financial asset may be recognized in earnings while the entity owns the asset. The subsections below discuss other Codification topics (not all-inclusive) that address the accounting for transaction costs incurred to purchase financial assets.

4.2.1.3.3.1 Debt Securities

Under ASC 320, an entity may classify investments in debt securities as held to maturity, available for sale, or trading. The table below discusses the accounting for transaction costs incurred when a debt security is acquired.

Table 4-1

Accounting for Transaction Costs Incurred in Connection With Acquiring a Debt Security
Classification of Security	Accounting for Transaction Costs
Held to maturity	Capitalized. In accordance with ASC 310-20-15-2 and 15-3, nonrefundable fees and costs associated with acquiring debt securities classified as held to maturity are within the scope of ASC 310-20. ASC 310-20-30-5 states that the “initial investment in a purchased loan or group of loans shall include the amount paid to the seller plus any fees paid or less any fees received.” Because transaction costs associated with the acquisition of held-to-maturity debt securities are within the scope of ASC 320, fees paid to a third party that are directly related to the acquisition (e.g., brokerage fees paid to a broker-dealer) would be capitalized as part of the original carrying amount. In accordance with ASC 310-20, entities should separately expense any other costs incurred in connection with acquiring securities (e.g., internal costs, portfolio management fees, investment consultation, or due diligence costs paid to an adviser). Held-to-maturity debt securities are subsequently measured at amortized cost and are subject to evaluation for impairment.
Available for sale	Capitalized initially. In accordance with ASC 310-20-15-2 and 15-3, nonrefundable fees and costs associated with acquiring debt securities classified as available for sale are within the scope of ASC 310-20. ASC 310-20-30-5 states that the “initial investment in a purchased loan or group of loans shall include the amount paid to the seller plus any fees paid or less any fees received.” Because transaction costs associated with the acquisition of available-for-sale debt securities are within the scope of ASC 320, fees paid to a third party that are directly related to the acquisition (e.g., brokerage fees paid to a broker-dealer) would be capitalized as part of the original carrying amount. In accordance with ASC 310-20, entities should separately expense any other costs incurred in connection with acquiring securities (e.g., internal costs, portfolio management fees, investment consultation, or due diligence costs paid to an adviser). An entity must subsequently measure debt securities classified as available for sale at fair value, with changes in fair value recognized in OCI (provided that there is no impairment). This fair value should not include any transaction costs because ASC 820 indicates that such costs are not a characteristic of an asset or liability measured at fair value. Therefore, entities will immediately recognize an unrealized loss in OCI after the purchase of a debt security classified as available for sale. Given the security’s classification as available for sale, such a loss will be reported in AOCI unless the security is subsequently impaired and measured at fair value on the basis of the entity’s conclusion that it is more likely than not that the security will be sold or that there is an intent to sell it.
Trading	Expensed as incurred. ASC 820 indicates that transaction costs are not a characteristic of an asset or liability measured at fair value. ASC 310-20-15-3(c) states that ASC 310-20 does not apply to securities that are subsequently measured at fair value through earnings.

4.2.1.3.3.2 Equity Securities

Unless the measurement alternative in ASC 321-10-35-2 is applied or the investment qualifies for the equity method of accounting, investments in equity securities must be initially and subsequently recognized at fair value, with changes in fair value reported in earnings. Since transaction costs are not a characteristic of an asset measured at fair value (see ASC 820-10-35-9B), unless the measurement alternative in ASC 321-10-35-2 is elected, transaction costs incurred to acquire an equity security are immediately expensed. See Example 4-2.

ASC 321-10-35-2 indicates that when the measurement alternative is applied to an equity security without a readily determinable fair value, that security is measured at “cost minus impairment, if any,” and adjustments are also made for “observable price changes in orderly transactions for the identical or a similar investment of the same issuer.” Thus, securities measured according to this alternative are initially measured at the transaction price, which includes incremental direct costs related to acquiring the security (i.e., transaction costs). However, these capitalized transaction costs would be subsequently expensed in earnings upon (1) a remeasurement event under ASC 321, including an impairment or an observable price decline (which represent fair value measurements under ASC 820); (2) a sale of the security; or (3) a reclassification of the security to fair value through earnings.

Equity method investments are generally initially measured on a cost accumulation basis, which would include transaction costs. However, there are exceptions to this general principle. ASC 323-10-30-2 addresses two situations in which an equity method investment is initially recognized at fair value. In these circumstances, the initial measurement should not include any transaction costs.

4.2.1.3.3.3 Investment Securities Owned by an Investment Company

ASC 946-320-35-1 states that “[a]n investment company shall measure investments in debt and equity securities subsequently at fair value.” In addition, ASC 946-320-30-1 states that “[a]n investment company shall initially measure its investments in debt and equity securities at their transaction price. The transaction price shall include commissions and other charges that are part of the purchase transaction.” According to this guidance, investment companies initially recognize investments in debt and equity securities at the transaction price, including related commissions and other direct costs incurred in connection with acquisition of the securities (i.e., an entry price and not fair value), and subsequently measure the investments at fair value under ASC 820. If any other potential differences between entry and exit prices are ignored, the capitalization of transaction costs into the initial measurement of investment securities by investment companies will result in a loss on initial recognition. For example, assume that Mutual Fund X purchases a publicly traded equity security for $99 immediately before the market closing (the fair value is therefore also $99). Further assume that X incurred a $1 commission in purchasing the security. Under ASC 946, the initial cost basis is $100 ($99 plus the $1 transaction cost). The fair value would be $99; therefore, a $1 loss would be recognized on the acquisition date. This loss on initial recognition is presented as a “net unrealized appreciation (depreciation) on investments” rather than as a separate expense in the investment company’s statement of operations.

Some have questioned whether ASC 820’s exit price notion and guidance indicating that transaction costs are not a characteristic of an asset measured at fair value conflict with the guidance in ASC 946-320-30-1. The implication is that investment companies would not be permitted to present transaction costs as part of the net change in unrealized appreciation (depreciation) on investments. However, we believe that investment companies that apply ASC 946 should present commissions and other charges that are directly related to the acquisition of investment securities in the net change in unrealized appreciation (depreciation) on investments. ASC 820-10-35-9B states, in part, “[t]ransaction costs shall be accounted for in accordance with other Topics.” ASC 946-320-30-1 specifies that the initial amount recorded for investment purchases “shall include commissions and other charges that are part of the purchase transaction.” ASC 820 does not affect this guidance. Accordingly, ASC 946 continues to require investment companies to include commissions and other charges incurred as part of securities purchase transactions in the net change in unrealized appreciation (depreciation) on investments. After initial recognition, an investment company measures its investment at the exit price in accordance with ASC 820. The difference between the initial recognized amount and subsequent fair value measurement would be presented as a “net unrealized appreciation (depreciation) on investments” rather than as a separate expense in the statement of operations.

4.2.1.3.3.4 Plan Assets of Pension and Other Postretirement Benefit Plans

The fair value measurement of investments held by a pension or other postretirement plan should be reduced by the costs of disposing of the assets. ASC 715-30-35-50 states, in part:

The fair value of an investment shall be reduced by brokerage commissions and other costs normally incurred in a sale if those costs are significant (similar to fair value less cost to sell).

4.2.1.3.3.5 Financial Assets Measured at the Lower of Cost or Fair Value

Certain Codification topics require that financial assets be measured at the lower of cost or fair value. Those Codification topics specify whether the fair value measurement should be reduced for transaction costs. For example, under ASC 310-10-35-48, nonmortgage loans classified as HFS must be reported at the lower of amortized cost or fair value. ASC 310-10-35-48 does not indicate that fair value should be reduced for anticipated costs to sell. Conversely, under ASC 310-10-35-23 (or ASC 326-20-35-4 for entities that have adopted ASU 2016-13), when an HFI-classified loan receivable is measured for impairment on the basis of the fair value of the collateral and repayment of the loan depends on the sale of the collateral, impairment measurement must be based on fair value less costs to sell.

4.2.2 Examples

The following two examples in ASC 860-20 illustrate the initial measurement of proceeds and other liabilities in a transfer of financial assets that meets the conditions for sale accounting:

ASC 860-20

Example 1: Recording Transfers With Proceeds of Cash, Derivative Instruments, and Other Liabilities

55-43 This Example illustrates the guidance in paragraphs 860-20-25-1 and 860-20-30-1. Entity A transfers entire loans with a carrying amount of $1,000 to an unconsolidated securitization entity and receives proceeds with a fair value of $1,030, and the transfer is accounted for as a sale. Entity A undertakes no obligation to service and assumes a limited recourse obligation to repurchase delinquent loans. Entity A agrees to provide the transferee a return at a variable rate of interest even though the contractual terms of the loan are fixed rate in nature (that provision is effectively an interest rate swap).

55-44 This Example has the following assumptions.

55-45 The following journal entry is made by Entity A.

Example 2: Recording Transfers of Participating Interests

55-46 This Example illustrates the guidance in paragraph 860-20-25-1. This Example assumes the conditions for a sale in paragraph 860-10-40-5 are met. Entity B transfers a nine-tenths participating interest in a loan with a fair value of $1,100 and a carrying amount of $1,000, and the transfer is accounted for as a sale. The servicing contract has a fair value of zero because Entity B estimates that the benefits of servicing are just adequate to compensate it for its servicing responsibilities.

55-47 This Example has the following assumptions.

55-48 The following journal entry is made by Entity B.

Below is another example illustrating initial recognition in a securitization transaction accounted for as a sale.

Example 4-1

Securitization With Servicing Rights Retained

Entity A transfers mortgage loans to an SPE that issues beneficial interests to third parties. Entity A retains an IO strip and will continue to service the transferred loans. The details of the transaction, as well as the calculation and journal entries associated with the transfer, are shown below. For simplicity, this example excludes (1) consideration of the need for a two-step transfer, as discussed in ASC 860-10-55-22 and 55-23, and (2) an evaluation of the IO strip under ASC 815.

The following example illustrates the transferee’s accounting for transaction costs incurred in the purchase of equity securities:

Example 4-2

Acquisition of Equity Security Subsequently Accounted for at Fair Value

An entity acquires an investment in an exchange-traded equity security on December 31, 20X7. The asset will be accounted for at fair value through earnings on a recurring basis in accordance with ASC 321. The entity paid $100 for the security (which was also the security’s closing price), plus a $1 broker commission, for a total transaction price of $101. The entity transacted in its principal market for the security. However, in accordance with ASC 820-10-30-3A(c), the entity determines that the transaction price does not represent fair value at initial recognition because of the transaction costs. The closing price on December 31, 20X7, is $100. If A were to subsequently sell the security, it would incur a $1 broker commission.

The fair value of the security as of the December 31, 20X7, reporting date is the security’s $100 closing price. Since ASC 321 does not indicate otherwise, the entity should record a $1 expense for the broker commission paid to acquire the security. The broker commission is not a characteristic of the security and does not add value to it. Transaction costs are a separate unit of account and therefore do not enter into the fair value measurement of the security. The $1 broker commission indicates that the transaction price of $101 is not fair value at inception. Another market participant would not reimburse the entity for the broker commission; instead, it would pay the entity the closing market price of $100 for the security. In a manner consistent with ASC 820-10-35-9B and Example 4 in ASC 820-10-55-42 through 55-45A, the entity should not adjust the security for the $1 broker commission it would incur to sell the security. In other words, the entity should not write down the security to $99 (the net proceeds it would receive upon selling the security).

Footnotes

In this list, it is assumed that sale accounting is not precluded for the assets and liabilities.

4.3 Regaining Control of Financial Assets Sold

4.3.1 Transferor’s Accounting

4.3.1.1 General

ASC 860-20

Regaining Control of Financial Assets Sold

25-8 Paragraph 860-10-40-41 explains that a change in law or other circumstance may result in a transferred portion of an entire financial asset no longer meeting the conditions of a participating interest (see paragraph 860-10-40-6A) or the transferor’s regaining control of transferred financial assets after a transfer that was previously accounted for as a sale, because one or more of the conditions in paragraph 860-10-40-5 are no longer met.

25-9 Such changes shall be accounted for in the same manner as a purchase of the transferred financial assets from the former transferee(s) in exchange for liabilities assumed unless they arise solely from either:

Consolidation of an entity involved in the transfer at a subsequent date (see paragraph 860-20-25-10)
A change in market prices (for example, an increase in price that moves into the money a freestanding call option on a non-readily-obtainable, transferred financial asset that was originally sufficiently out of the money that it was judged not to constrain the transferee).

See the related guidance beginning in paragraph 860-20-25-1.

25-10 After that change, the transferor shall do all of the following:

Recognize in its financial statements those transferred financial assets together with liabilities to the former transferee(s) or beneficial interest holders of the former transferee(s).
Not change the accounting for the servicing asset related to the previously sold financial assets. That is, even though the transferor has regained control over the previously sold assets, the cash flows from those assets will contractually be paid to the special-purpose entity, which will then distribute the proceeds to satisfy its contractual obligations (including obligations to the beneficial interest holders). Because the transferor, as servicer, is still contractually required to collect the asset’s cash flows for the benefit of the special-purpose entity and otherwise service the assets, it shall continue to recognize the servicing asset and assess the asset for impairment if subsequently measured using the amortization method, as required by paragraph 860-50-35-9. Once a servicing asset is recognized it shall not be added back to the underlying asset. Even when the transferor has regained control over the underlying assets through an event that triggers a transferor to rerecognize previously transferred assets that were accounted for as having been sold, the related servicing asset shall continue to be separately recognized.
Continue to account for the transferor’s interests in those underlying financial assets apart from any rerecognized financial assets. That is, the transferor’s interests shall not be combined with and accounted for with the rerecognized financial assets. Example 10 (see paragraph 860-20-55-83) illustrates this guidance. However, a subsequent event that results in the transferor reclaiming those financial assets from the transferee, for example, the exercise of a removal-of-accounts provision or the consolidation by the transferor of the securitization entity in accordance with applicable GAAP, including the Variable Interest Entities Subsections of Subtopic 810-10, would result in a recombination of the transferor’s interests with the underlying financial assets.

For guidance on consolidation, which is relevant to determining whether a transferor must consolidate an entity involved in a transfer that was accounted for as a sale, see Topic 810.

25-12 Upon application of paragraph 860-20-25-10, no gain or loss shall be recognized in earnings with respect to any of the transferor’s beneficial interests. A gain or loss may be recognized upon the exercise of a removal-of- accounts provision or similar contingent right with respect to the repurchased transferred financial assets that were sold if the removal-of-accounts provision or similar contingent right held by the transferor is not accounted for as a derivative instrument under Subtopic 815-10 and is not at the money, resulting in the fair value of those repurchased financial assets being greater or less than the related obligation to the transferee.

25-13 Under no circumstances shall a loan loss allowance be initially recorded for loans that do not meet the definition of a security when they are rerecognized pursuant to paragraph 860-20-25-10. If a security is subsequently repurchased, it shall be recorded in accordance with Topic 320.

Pending Content (Transition Guidance: ASC 326-10-65-4)

25-13 For financial assets rerecognized in accordance with paragraph 860-20-25-10, an entity shall initially recognize a financial asset at fair value. An entity shall then apply relevant guidance, including this Topic, Topic 310 on receivables, Topic 320 on investments — debt securities, Topic 321 on investments — equity securities, Topic 323 on investments — equity method and joint ventures, and Topic 325 on investments — other. In addition, an entity shall measure an allowance for credit losses in accordance with Topic 326, if applicable.

For those financial assets that are not purchased financial assets with credit deterioration within the scope of Topic 326, an entity shall recognize an allowance for credit losses with a corresponding charge to credit loss expense as of the reporting date.
For those financial assets that are purchased financial assets with credit deterioration (which includes beneficial interest that meets the criteria in paragraph 325-40-30-1A) within the scope of Topic 326, an entity shall recognize an allowance for credit losses in accordance with Topic 326 with a corresponding increase to the amortized cost basis of the financial asset(s) as of the recognition date.

Regaining Control of Financial Assets Sold

30-3 The transferor shall initially measure transferred financial assets and liabilities that are rerecognized under paragraph 860-20-25-10(a) as a result of regaining control of the financial assets sold at fair value on the date of the change as if the transferor purchased the transferred financial assets and assumed the liabilities on that date.

ASC 860-10

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

ASC 860-20 provides guidance on situations in which a transferor regains control of financial assets previously considered sold. A transferor may regain control of previously sold financial assets in the following circumstances:

A contingency underlying a repurchase option is resolved, resulting in the transferor’s unilateral ability to repurchase specific financial assets. (Note that ASC 860-20-55-41 indicates that the transferor must rerecognize the related financial assets even if it does not intend to exercise its purchase option, unless the repurchase option does not provide the transferor with a more than trivial benefit.)
A contingency underlying a forward repurchase contract is resolved, resulting in the requirement for the transferor to repurchase specific financial assets.
An interest in a previously sold financial asset no longer meets the definition of a participating interest. (Note that this could occur if an entity transfers a new interest in the entire financial asset that does not meet the definition of a participating interest, as discussed in Example 3-5.)
Changes in laws or regulations or amendments to the underlying sales agreement cause the transferor to no longer meet all of the conditions in ASC 860-10-40-5 for sale accounting (e.g., amendments to the sales agreement cause the transfer to no longer meet the legal isolation condition or impose constraints on the transferee’s ability to pledge or exchange the transferred financial assets).2

Connecting the Dots

The evaluation of whether a transferor’s right to purchase a specific transferred financial asset provides a more than trivial benefit applies only to options held by the transferor. That is, if the contingent repurchase feature is a forward rather than an option, then once the contingency is resolved, the transferor must repurchase the previously sold financial assets and an evaluation of whether this repurchase provides the transferor with a more than trivial benefit is not relevant.

In evaluating whether a transferor would receive a more than trivial benefit from a contingently exercisable repurchase option, an entity would apply the guidance in ASC 860-10-40-28(a), which indicates that a call option or other right conveys a more than trivial benefit “if the price to be paid is fixed, determinable, or otherwise potentially advantageous, unless because that price is so far out of the money or for other reasons it is probable when the option is written that the transferor will not exercise it.” In other words, the assessment focuses on whether, on the basis of the pricing of the option, there is a potentially reasonable scenario in which the call price is advantageous compared with the cost of exercising the call option. The holder’s liquidity position (i.e., ability to exercise the option) should not be taken into account in this assessment.

The transferor evaluates whether a repurchase option conveys a more than trivial benefit to the transferor as of the date sale accounting for the transferred financial assets is achieved (which could be later than the initial transfer date) and should not reconsider this evaluation. This view is consistent with the guidance in ASC 860-10-40-28(a), which indicates that the assessment of probability for a deep-out-of-the-money option is performed when the option is written, as well as with that in ASC 860-20-25-9(b), which indicates that a change in market prices should not affect a transferor’s assessment of whether it has regained control over specific transferred financial assets. Because the threshold for determining that the transferor receives a more than trivial benefit from a repurchase option is very low, we believe that it would be rare for a transferor not to rerecognize specific financial assets previously considered sold when it has subsequently regained control over those financial assets.

Sections 4.3.1.2 and 4.3.1.3 discuss the accounting in situations in which a transferor regains control over previously sold financial assets. For discussion of when a transferor controls a transferred financial asset, see Sections 3.4 and 3.5.

4.3.1.2 Removal-of-Accounts Provisions

4.3.1.2.1 General

ASC 860-20

Regaining Control of Financial Assets Sold

25-11 Whether the removal-of-accounts provision is exercised or not, the transferor shall recognize any financial assets subject to the removal-of-accounts provision if all of the following conditions are met:

A third party’s action (such as default or cancellation) or decision not to act (expiration) occurs.
The occurrence allows removal of assets to be initiated solely by the transferor.
The provision provides a more-than-trivial benefit to the transferor.

For example, once a contingency is met (such as when a given loan goes into default), the call option on that asset (loan) is no longer contingent.

Regaining Control Through a Removal-of-Accounts Provision

55-40 This guidance addresses implementation of paragraph 860-20-25-11. Under that paragraph’s guidance, if the removal-of-accounts provision is not exercised, the financial assets are recognized because the transferor now can unilaterally cause the transferee to return those specific financial assets and, therefore, the transferor once again has effective control over those transferred financial assets (see paragraphs 860-20-25-8 through 25-10).

55-41 Similarly, when a contingency related to a transferor’s contingent right has been met, the transferor generally must account for the repurchase of a specific subset of the financial assets transferred to and held by the entity. When the contingency has been met, the transferor has a unilateral right to purchase a specific transferred financial asset. At that point, the transferor must determine whether the unilateral right to purchase a specific transferred financial asset provides the transferor with a more-than-trivial benefit. If the unilateral right to purchase a specific transferred financial asset provides the transferor with a more-than-trivial benefit, the transfer fails the criterion in paragraph 860-10-40-5(c)(2). The transferor must perform this analysis regardless of whether it intends to exercise its call option.

55-42 Although this guidance uses removal-of-accounts provisions as an example, the guidance is not limited to removal-of-accounts provisions. Contingent rights can arise in many other situations. See paragraphs 860-10-55-39 through 55-42 for more information.

ASC 860-20-25-11 and ASC 860-20-55-40 through 55-42 provide guidance on the transferor’s accounting for a ROAP. While this guidance specifically discusses ROAPs, it is relevant to any type of contingent repurchase right. For example, when a default ROAP becomes exercisable by the transferor because previously sold financial assets default, the transferor must rerecognize the specific financial assets for which it has regained control.

4.3.1.2.2 Accounting When the Transferor Regains Control Over Previously Sold Financial Assets

4.3.1.2.2.1 General

ASC 860-20-25-9 requires a transferor to account for regaining control over previously sold financial assets in the same manner as if it purchased the financial assets in exchange for liabilities. If, however, the control is associated with the consolidation of the transferee, ASC 810 applies rather than ASC 860-20-25-9. In the discussion below, it is assumed that the transferor is not required to consolidate the transferee in accordance with ASC 810.

As of the date a transferor regains control over specific transferred financial assets (e.g., a contingently exercisable call option becomes exercisable or a contingently settleable forward repurchase contract becomes settleable), ASC 860-20-25-10 requires the transferor to do all of the following:

Recognize the previously sold financial assets and a liability for the purchase price payable to the transferee or beneficial interest holders in the transferred financial assets. ASC 860-20-30-3 requires that these amounts be recognized at the fair value of the financial assets as of the date control is obtained.

The fair value amount recognized for the financial assets is not reduced by the value of any beneficial interest in those financial assets that is owned by the transferor. Before FASB Statement 166 was issued, the examples in EITF Issue 02-9 indicated that the transferor should rerecognize the fair value of “the portion of the originally transferred financial assets that were previously accounted for as sold.” As a result, the transferor rerecognized the fair value of the specific financial assets for which control was regained less the transferor’s beneficial interests in those assets. The liability for the purchase price was determined on the basis of the amounts payable to third parties (i.e., it excluded the amount that would ultimately be paid to the transferor as a result of its beneficial interest in the transferred financial assets). However, FASB Statement 166 amended EITF Issue 02-9 to require the transferor to rerecognize the entire fair value of the financial assets for which control is regained. See Example 4-3 for an illustration.
Continue to separately account for any servicing asset or servicing liability related to the previously sold financial assets. Previously recognized servicing rights continue to be separately accounted for because the transferor is still required to service the financial assets previously sold (e.g., the transferor still services the financial assets held by an unconsolidated trust and passes through the cash flows on those financial assets to the trust’s beneficial interest holders) and the transferor has not yet repurchased the financial assets previously sold. As discussed in ASC 860-20-25-10(b), “[o]nce a servicing asset is recognized it shall not be added back to the underlying asset.” Because the price payable to repurchase the financial assets for which control has been regained would not include any amounts related to the rights to service those financial assets, the continued recognition of a servicing asset or servicing liability will not cause the same asset to be counted twice. See Section 6.2.2.5 for more information about accounting for servicing rights when control is regained over the related financial assets.
Continue to separately account for any beneficial interests in the previously sold financial assets. The transferor should not combine any beneficial interests in the previously sold financial assets with the rerecognized financial assets. However, ASC 860-20-35-9 requires the transferor to evaluate its beneficial interests for impairment as of the date control is regained over financial assets previously sold. (Any impairment loss would be recognized in accordance with other U.S. GAAP applicable to the beneficial interests.) Beneficial interests in the previously sold financial assets would only be derecognized when the transferor repurchases the financial assets for which it has regained control (see Section 4.3.1.2.5).
Recognize no gain or loss in earnings as a result of rerecognizing the previously sold financial assets and the liability for the purchase price. While a gain or loss may be recognized when the previously sold financial assets are repurchased (i.e., a repurchase option is exercised), no gain or loss is recognized as of the date of initial recognition of the financial assets for which the transferor has regained control.

Connecting the Dots

ASC 860-20-25-12 indicates that “no gain or loss shall be recognized in earnings with respect to any of the transferor’s beneficial interests.” Further, ASC 860-20-35-9 requires the transferor to evaluate any beneficial interests for impairment when financial assets are rerecognized under ASC 860-20-25-10. In most cases, any impairment of the transferor’s beneficial interests would have existed and would have been recognized before the date on which the event occurs that requires the transferor to rerecognize transferred financial assets.

With the exception of any impairment of a transferor’s beneficial interests that could be recognized in conjunction with the rerecognition of previously sold financial assets, no gain or loss should be recognized as of the date the transferor regains control over previously sold financial assets. This is evident from the examples in EITF Issue 02-9.3 A gain or loss may, however, be recognized when the transferor repurchases the financial assets (see Section 4.3.1.2.5).

Example 4-3 illustrates the accounting as of the date a transferor regains control over previously sold financial assets.

4.3.1.2.2.2 Accounting for a Previously Recognized Asset or Liability That Causes the Transferor to Regain Control Over Previously Sold Financial Assets

ASC 860-20-25-1 requires a transferor to recognize all assets obtained and liabilities incurred in a sale of financial assets. Therefore, the transferor may have previously recognized an asset or liability for an option or forward that subsequently causes the transferor to regain control over previously sold financial assets. In some situations, the transferor may have recognized that asset or liability as a derivative instrument.

Connecting the Dots

A ROAP (e.g., a default ROAP), cleanup call option, or other contingently exercisable repurchase right that a transferor recognizes upon a sale of financial assets is often not accounted for as a derivative instrument under ASC 815. For example, a default ROAP generally does not meet the definition of a derivative instrument in ASC 815-10-15-83 because it must be physically settled and the underlying financial assets are not considered readily convertible to cash when settlement occurs. Although conforming mortgage loans may be considered readily convertible to cash through the TBA market, defaulted mortgage loans (which would be acquired upon exercise of a default ROAP) would not be considered readily convertible to cash.

ASC 860-20 does not specifically address how a transferor should account for any previously recognized asset or liability (e.g., a contingently exercisable call option or contingently settleable forward repurchase contract) when the financial asset that is the underlying of such an instrument must be rerecognized under ASC 860-20-25-10. While we believe that any such call option or forward contract represents a beneficial interest in the underlying financial assets previously sold, we do not believe that ASC 860-20-25-10(c) specifically addresses such instruments. This conclusion is based, in part, on the fact that the examples in EITF Issue 02-9 (the original pronouncement that was codified in ASC 860-20’s guidance on regaining control over previously sold financial assets) do not include any consideration of previously recognized options or forwards that become exercisable or settleable and result in the need for the transferor to rerecognize the related financial assets previously sold.

We believe that it is appropriate for the transferor to derecognize (wholly or partially, depending on the circumstances) any previously recognized asset or liability for a contingently exercisable call option or contingently settleable forward repurchase contract that gave rise to the requirement to rerecognize financial assets previously considered sold. This accounting is appropriate regardless of whether such an asset or liability was previously recognized as a derivative instrument. The entire asset or liability would be derecognized only if the transferor rerecognizes all the related financial assets under ASC 860-20-25-10. The offsetting entry for any such derecognition should not be made to earnings because no gain or loss should be recognized before rerecognized financial assets are repurchased (see Section 4.3.1.2.2.1). Rather, the offsetting entry should be reflected as an adjustment to the liability recognized under ASC 860-20-25-10(a) for the purchase price payable to repurchase the financial assets for which control has been regained.4

Connecting the Dots

A contingently exercisable call option or contingently settleable forward repurchase contract that was previously accounted for as a derivative instrument would no longer meet the definition of a derivative once the underlying financial asset has been recognized because of the scope exception in ASC 815-10-15-63. Since entities are required to continually evaluate whether an instrument meets the definition of a derivative in ASC 815, it is appropriate to apply the scope exception in ASC 815-10-15-63 and derecognize any derivative asset or liability amount that pertains to the financial assets rerecognized under ASC 860-20-25-10.

4.3.1.2.2.3 Offsetting

When applying the rerecognition guidance in ASC 860-20-25-10, a transferor may recognize a liability for the purchase price of financial assets for which control has been regained that, when paid, will be partially distributed to the transferor as a result of its ownership of a beneficial interest in the previously sold financial assets. It would not be appropriate for the transferor to offset any portion of the liability for the purchase price with the transferor’s beneficial interest unless all the conditions for offsetting in ASC 210-20 are met. It is unlikely that the conditions in ASC 210-20-45-1(b) and (c) would be met because the liability for the purchase price must generally be paid in full to the transferee, who then disburses the proceeds to its beneficial interest holders.

4.3.1.2.3 Subsequent Accounting for the Rerecognized Financial Assets

Once rerecognized, the financial assets should be accounted for in the same manner as if they had been purchased from a third party. For entities that have not adopted ASU 2016-13, a rerecognized loan receivable would be accounted for in accordance with ASC 310-30 if the conditions in ASC 310-30- 15-2 are met. In accordance with ASC 310-30, no allowance for loan losses is recognized upon initial recognition of a purchased credit-impaired loan receivable. For entities that have adopted ASU 2016-13, a rerecognized loan receivable would be accounted for as a purchased financial asset with credit deterioration if, as of the date of initial recognition, the loan receivable has experienced a more-than-insignificant deterioration in credit quality since origination. In accordance with ASC 326-20-30-13, an allowance for credit losses would be recognized in accordance with ASC 326, with a corresponding increase to the amortized cost basis of the asset as of the recognition date. If the rerecognized financial asset is a security, it would be accounted for under ASC 320, ASC 321, ASC 323, or ASC 325-40.

4.3.1.2.4 Subsequent Accounting for the Liability for the Purchase Price

Once recognized, the liability for the amount payable to acquire the rerecognized financial assets should be accounted for in a manner similar to other liabilities incurred to purchase assets. If the FVO is not elected, the accounting for this liability will depend on whether it pertains to an option or a forward repurchase contract:

Option — The transferor is not required to adjust the initial carrying amount of the liability recognized under ASC 860-20-25-10(a) because it is not required to repurchase the related financial assets. That is, the transferor is not required to apply the interest method in ASC 835-30 and therefore would not amortize any discount or premium between the initially recognized amount of the liability and the purchase price. Any difference would be recognized only if the transferor repurchases the financial assets.
Forward — Since the transferor is obligated to repurchase the financial assets over which it has regained control, it must amortize any discount or premium between the initially recognized amount of the liability and the purchase price so that the carrying amount of the liability will equal the purchase price of the financial assets as of the repurchase date.

4.3.1.2.5 Accounting When the Transferor Repurchases the Financial Assets

A transferor’s repurchase of the financial assets over which it had regained control (i.e., the transferor exercises a contingent option, or settles a contingent forward, to repurchase the financial assets) is accounted for as follows:5

Derecognize the carrying amount of the liability for the purchase price.
Derecognize any beneficial interests in the repurchased financial assets (and any related amounts in AOCI). (Note that only the portion of beneficial interests related to the repurchased financial assets should be derecognized; in conjunction with such derecognition, the transferor should recognize a receivable for the proceeds paid to repurchase the financial assets that are due from the transferee as a result of its ownership of the beneficial interests in those transferred financial assets.)
Recognize a gain or loss for any difference between the carrying amounts of assets and liabilities recognized and derecognized and the cash amount paid to repurchase the financial assets. (Note that no gain or loss should exist when the repurchase occurs under a forward repurchase contract because (1) the purchase price payable should equal the carrying amount of the liability as of the purchase date [see Section 4.3.1.2.4] and (2) the derecognition of any beneficial interests held by the transferor should be offset by the recognition of a receivable from the transferee that will be distributed to the transferor.)

Connecting the Dots

As discussed in Section 4.3.1.2.2.1, the transferor should not recognize any gain or loss upon regaining control over previously sold financial assets. However, ASC 860-20-25-12 states that a “gain or loss may be recognized upon the exercise of a removal-of-accounts provision or similar contingent right with respect to the repurchased transferred financial assets that were sold if the removal-of-accounts provision or similar contingent right held by the transferor is not accounted for as a derivative instrument under Subtopic 815-10 and is not at the money, resulting in the fair value of those repurchased financial assets being greater or less than the related obligation to the transferee.” Effectively, in the case of a right to repurchase previously sold financial assets, even though the transferor must rerecognize the financial assets when it regains control of them, it does not recognize any gain or loss on such rerecognition because it is not obligated to repurchase those financial assets (i.e., any such gain or loss is recognized only when the transferor decides to repurchase the financial assets). If the previously sold financial assets are rerecognized as a result of a contingently settleable forward repurchase contract, any income statement effect of such a repurchase will generally be recognized before the related financial assets are repurchased because the transferor is required to adjust the initially recognized carrying amount of the liability for the purchase price so that it equals the purchase price as of the date payment is made to repurchase the financial assets (see Section 4.3.1.2.4).

The transferor should not derecognize any previously recognized servicing asset or servicing liability even though some (or potentially all) of the value of such a recognized servicing right is derived from the financial assets that have been repurchased. ASC 860-20-25-10(b) states that “[o]nce a servicing asset is recognized it shall not be added back to the underlying asset.” Therefore, unless the servicing contract expires as a result of the repurchase of the underlying financial assets (e.g., a contractual separate servicing fee no longer exists), any previously recognized servicing asset should not be derecognized. Note that the continued recognition of the servicing asset or servicing liability related to the financial assets that the transferor has repurchased should not result in “double-counting” the value that pertains to the servicing right because the purchase price of the financial assets reacquired would be expected to be determined on the basis of the purchase price payable to acquire financial assets without the related servicing rights.

Example 4-3 illustrates the accounting when a transferor repurchases financial assets for which control was previously regained.

4.3.1.2.6 Accounting When an Option to Repurchase Financial Assets Expires

If a transferor rerecognizes financial assets under ASC 860-20-25-10(a) because a right to purchase specific financial assets becomes unilaterally exercisable by the transferor, it should not derecognize those financial assets and the related liability for the purchase price unless its right to repurchase those financial assets expires. It is appropriate to derecognize the financial assets once the option expires since the transferor would no longer have effective control over those financial assets. Derecognition of the related liability for the purchase price as of the date the option expires is consistent with ASC 405-20-40-1.

As of the date of expiration of a transferor’s right to repurchase the financial assets, the transferor should:

Derecognize the financial assets.
Derecognize the carrying amount of the liability for the purchase price.
Recognize a gain or loss for any difference between the carrying amount of the financial assets derecognized and the carrying amount of the liability derecognized.

Example 4-3 illustrates the accounting as of the date a repurchase option expires.

4.3.1.3 Cleanup Call Options

4.3.1.3.1 Accounting Before the Option Becomes Exercisable

In accordance with ASC 860-20-25-4, a transferor must recognize a cleanup call option as an asset as part of the proceeds received in the sale. ASC 860-20-30-1 requires initial recognition of an asset for a cleanup call option at fair value even if the cleanup call option is not subsequently accounted for as a derivative instrument.

Connecting the Dots

A cleanup call option generally does not meet the definition of a derivative instrument in ASC 815-10-15-83 because it must be physically settled and the underlying financial assets are not considered readily convertible to cash when settlement occurs. For example, although conforming mortgage loans may be considered readily convertible to cash through the TBA market, seasoned mortgage loans (i.e., what the underlying of a clean-up call option represents) are not considered readily convertible to cash.

4.3.1.3.2 Accounting When the Option Becomes Exercisable

The exercisability of a cleanup call option does not affect the conclusion about prior sale accounting. That is, even when the clean-up call option becomes unilaterally exercisable, the transferor would not be considered to have regained control over financial assets previously sold. ASC 860-10-40-5(c)(2) provides an exception from the effective-control guidance and indicates that control exists when the transferor has “[t]he unilateral ability to cause the holder to return specific financial assets . . . other than through a cleanup call” (emphasis added). Thus, in the case of a cleanup call option, the transferor is not required to rerecognize previously sold financial assets before the option is exercised.

In addition, the transferor would not be required to consolidate a securitization entity that holds the underlying financial assets once a cleanup call option becomes exercisable. That is, if the cleanup call option is exercisable, the transferor would not be required to reevaluate whether any servicing right becomes a variable interest under ASC 810-10-55-37. Requiring consolidation when a cleanup call becomes exercisable would defeat the purpose of the exception in ASC 860-10-40-5(c)(2).

4.3.1.3.3 Accounting When the Option Is Exercised

Once irrevocable notification is given that a cleanup call option has been exercised, the option becomes a forward contract to repurchase financial assets. At this point, there is no exception from rerecognizing the remaining financial assets held by the transferee (i.e., the exception in ASC 860-10-40-5(c)(2) does not apply because the guidance in ASC 860-10-40-5(c)(1) applies).6 We believe that there are two acceptable views on the accounting by the transferor once it exercises a cleanup call option. These two views result in similar accounting and are premised on an assumption that the transferee (i.e., a securitization entity) will be dissolved after the cleanup call option is exercised. The two views are as follows:

View A: Consolidate the transferee (e.g., the securitization entity) under ASC 810 — Under ASC 810, the transferor would:
- Recognize the financial assets (including any cash held by the securitization entity) at fair value.
- Recognize any nonfinancial assets (e.g., other real estate owned) at fair value.
- Derecognize the cleanup call option, any servicing asset or servicing liability previously recognized, and any beneficial interests in the financial assets (including any amounts in AOCI related to such beneficial interests).
- Recognize a liability equal to the purchase price payable to exercise the cleanup call option.
- Recognize a gain or loss for the difference between the purchase price and the assets and liabilities recognized or derecognized.
This accounting is consistent with ASC 810-10-30-3 and 30-4, which state:
30-3 When a reporting entity becomes the primary beneficiary of a VIE that is not a business, no goodwill shall be recognized. The primary beneficiary initially shall measure and recognize the assets (except for goodwill) and liabilities of the VIE in accordance with Sections 805-20-25 and 805-20-30. However, the primary beneficiary initially shall measure assets and liabilities that it has transferred to that VIE at, after, or shortly before the date that the reporting entity became the primary beneficiary at the same amounts at which the assets and liabilities would have been measured if they had not been transferred. No gain or loss shall be recognized because of such transfers.
30-4 The primary beneficiary of a VIE that is not a business shall recognize a gain or loss for the difference between (a) and (b):
1. The sum of:
  1. The fair value of any consideration paid
  2. The fair value of any noncontrolling interests
  3. The reported amount of any previously held interests
2. The net amount of the VIE’s identifiable assets and liabilities recognized and measured in accordance with Topic 805.
Connecting the Dots

When control is regained over previously sold financial assets, the transferor does not change its accounting for any servicing asset or servicing liability related to the transferred financial assets (see ASC 860-20-25-10(b)). The servicing asset or liability is also not derecognized when the transferor repurchases the related financial assets because a contractual obligation to service the financial assets still exists. However, it is appropriate to derecognize any servicing asset or servicing liability when a transferor consolidates the transferee under ASC 810 because the rerecognition guidance in ASC 860-20 is not applied.
View B: Recognize the financial assets under ASC 860-20 — The transferor applies ASC 860-20- 25-10 and ASC 860-20-25-12. The transferor should recognize the financial assets (and any nonfinancial assets, such as other real estate owned) and the related amount payable to purchase those financial assets as of the date an irrevocable notice of exercise of the cleanup call option is given. These amounts are recognized at the fair value of the rerecognized assets. Any remaining beneficial interests in the previously sold financial assets should be derecognized (including any amounts in AOCI related to such beneficial interests). The transferor should also derecognize any servicing asset or servicing liability if, as a result of exercising the cleanup call, a separate servicing fee no longer exists (i.e., the servicing contract terminates or expires). A gain or loss may be recognized. Although the transferor reduces any gain or increases any loss as a result of derecognizing a servicing asset, the fair value of the previously sold loans includes amounts that would have otherwise been attributable to servicing fees. See Section 4.3.1.2.5 for more information.

Connecting the Dots

When control is regained over previously sold financial assets, the transferor does not change its accounting for any servicing asset or servicing liability related to the transferred financial assets (see ASC 860-20-25-10(b)). The servicing asset or liability is also not derecognized when the transferor repurchases the related financial assets when a contractual obligation to service the financial assets still exists. However, it is appropriate to derecognize any servicing asset or servicing liability when a transferor exercises a cleanup call option if a separate servicing fee no longer exists (i.e., the servicing contract terminates or expires).

The table below summarizes the two views and illustrates that the accounting will be similar under each of them.

Table 4-2

Accounting for:	View A (ASC 810)	View B (ASC 860-20)
Rerecognized assets (i.e., financial assets and any nonfinancial assets, such as other real estate owned)	Fair value as of the date an irrevocable notice of exercise of the cleanup call option is given.	Fair value as of the date an irrevocable notice of exercise of the cleanup call option is given.
Liability to purchase rerecognized financial assets	Exercise price of the cleanup call option.	Fair value of the financial assets rerecognized.
Beneficial interests owned by the transferor	Derecognized as of the date an irrevocable notice of exercise of the cleanup call option is given.	Derecognized as of the date an irrevocable notice of exercise of the cleanup call option is given.
Servicing asset or servicing liability	Derecognized as of the date an irrevocable notice of exercise of the cleanup call option is given.	Derecognized as of the date an irrevocable notice of exercise of the cleanup call option is given provided that the transferor is no longer entitled to any separate servicing fees.
Gain or loss recognition	Recognized as of the date an irrevocable notice of exercise of the cleanup call option is given. Recognition is based on (1) the sum of (a) the liability recognized for the purchase price of the cleanup call option, (b) the net carrying amount of any beneficial interests derecognized, and (c) the carrying amount of any servicing assets or servicing liabilities derecognized, compared with (2) the fair value of the rerecognized assets.	Recognized as of the date an irrevocable notice of exercise of the cleanup call option is given. Recognition is based on (1) the sum of (a) the liability recognized for the purchase price of the cleanup call option, (b) the net carrying amount of any beneficial interests derecognized, and (c) the carrying amount of any servicing assets or servicing liabilities derecognized, compared with (2) the fair value of the rerecognized assets. If the carrying amount of the liability recognized for the purchase price of the cleanup call option differs from the purchase price payable, an additional gain or loss will be recognized for this difference no later than when the purchase price is paid.

4.3.2 Transferee’s Accounting

ASC 860-20

Transferor and Transferee Accounting Circumstances Upon Regaining Control

40-3 The guidance beginning in paragraph 860-20-25-8 discusses the transferor’s accounting upon regaining control of financial assets sold. In such circumstances, the former transferee would derecognize the transferred financial assets on that date, as if it had sold the transferred financial assets in exchange for a receivable from the transferor.

ASC 860-20-40-3 requires a transferee to derecognize financial assets on the date the transferor regains control of them. The transferee should account for such derecognition “as if it had sold the transferred financial assets in exchange for a receivable from the transferor.” The amount of the receivable represents the purchase price payable by the transferor, which may differ from the amount the transferor recognizes as a liability as of the date it rerecognizes those previously sold financial assets. The transferee would recognize a gain or loss on the basis of the difference between the receivable recognized and the carrying amount of the financial assets derecognized.

4.3.3 Examples

ASC 860-20

Example 10: Rerecognition of Transferred Assets and Subsequent Accounting for Transferor’s Interest and a Servicing Asset

55-83 This Example illustrates the accounting for a sale of loans in their entirety by a transferor to an unconsolidated entity and the subsequent accounting for the transferor’s interest and a servicing asset. In this Example, the transferor’s interest is an interest-only strip that is accounted for at fair value in the same manner as an available-for-sale security under paragraph 860-20-35-2.

55-84 This Example has the following assumptions.

55-85 On January 2, 20X1, Entity I (the transferor) originates $1,000 of loans, yielding 10.5 percent interest income for their estimated life of 9 years. Entity I later transfers the loans in their entirety to an unconsolidated entity and accounts for the transfer as a sale. Entity I receives as proceeds $1,000 cash plus a beneficial interest that entitles it to receive 1 percent of the contractual interest (an interest-only strip receivable). Entity I will continue to service the loans for a fee of 100 basis points. The guarantor, a third party, receives 50 basis points as a guarantee fee.

55-86 At the date of transfer, the following facts are assumed.

The fair value of the servicing asset is $40.
The total fair value of the loans including servicing is $1,040.
The fair value of the interest-income strip receivable is $60.

55-87 On December 1, 20X1, an event occurs that results in the transfer not meeting the conditions for sale accounting. The fair value of the originally transferred financial assets that remain outstanding in the entity on that date is $929. The fair value of Entity I’s interest (in the form of an interest-only strip) on that date is $58. The fair value of the servicing asset on that date is $38. The guarantee that was entered into by the entity does not trade with the underlying financial assets. The fees on this guarantee will be paid as part of the cash waterfall.

55-88 All cash flows from the financial assets transferred to the trust are initially sent directly to the trust and then distributed in order of priority. The priority of payments in the cash waterfall is as follows: servicing fees, guarantees, amounts due to outside beneficial interest holders, and amounts due to Transferor’s beneficial interest.

55-90 The following journal entries would be made.

55-91 The following illustrates the accounting entry to be made after the event occurs that results in the transfer not meeting the conditions for sale accounting.

55-92 Entity I would account for the rerecognized financial assets and transferor’s interests as follows:

Entity I would continue to account for transferor’s interests (in accordance with paragraph 320-10-35-1) at fair value with changes in fair value recognized in other comprehensive income.
Entity I would account for the loans at cost plus accrued interest in accordance with Subtopic 310-20.

Example 4-3

Accounting for Default ROAP

July 1, 20X1

On July 1, 20X1, Entity B sells 10 high-credit-quality loan receivables to an unconsolidated securitization entity. The transfer meets the conditions in ASC 860-10-40-5 for sale accounting. Assume the following:

The carrying amount of the loans as of the transfer date is $100 million.
In return for selling the loans, B receives the following:
- $90 million in cash.
- A beneficial interest that entitles B to 10 percent of the cash flows related to the transferred loans. This beneficial interest represents a residual interest in the cash flows of the unconsolidated securitization entity; thus, B absorbs the first $10 million of credit losses on the financial assets sold. The fair value of the beneficial interest as of the transfer date is $8 million. There is a $2 million difference between the fair value of the beneficial interest and its stated amount because there are $2 million of estimated losses on the loan receivables acquired by the securitization entity. Entity B classifies this beneficial interest as an available-for-sale debt security. Entity B will recognize an allowance for credit losses on this investment because it has adopted ASU 2016-13.
- The right to service the transferred loans, which have a fair value of $3 million as of the date of sale. Entity B elects to account for the servicing asset at fair value.
- A default ROAP (call option) that gives B 15 days to repurchase the first loan receivable that becomes more than 90 days past due. The purchase price is equal to the principal amount of the loan. The fair value of the repurchase option is $500,000 as of the date of sale. This option does not meet the definition of a derivative instrument in ASC 815.

Entity B recognizes the following entry as of the date of sale:

Note that when a transfer of financial assets achieves sale accounting, the transferor must recognize any default ROAP (which is a conditionally exercisable call option) as part of the recognition of the sale. Such recognition is required even if the default ROAP does not meet the definition of a derivative instrument in ASC 815. However, before the default ROAP option becomes exercisable, the transferor is not required to recognize the related financial assets since it does not control them.

Entity B determines that the beneficial interest is a purchased financial asset with credit deterioration. The expected credit loss is $2 million (i.e., there is no noncredit discount). In accordance with ASC 326-30-30-2, B recognizes the following entry:

Assume that between the date of sale and December 1, 20X1, there are no changes in the carrying amounts of the transferor’s beneficial interest, the servicing asset, or the default ROAP option.

December 1, 20X1

On December 1, 20X1, a loan with a $20 million principal amount unexpectedly defaults. The fair value of the loan on the date of default is $16 million. Entity B recognizes the following entry to reflect that it has regained control over this loan:

Note that B does not recognize any loss as of the date it obtains control over the loan receivable because it is not obligated to repurchase the defaulted loan receivable.

Entity B analyzes the loan receivable and concludes that it represents a purchased financial asset with credit deterioration. The expected credit loss is $3 million. In accordance with ASC 326-20-30-13, B recognizes the following entry:

Entity B evaluates its beneficial interest for impairment. The fair value of the beneficial interest has declined to $5 million. Fair value is determined under ASC 820 on the basis of market-participant assumptions. A market participant would not purchase the transferor’s beneficial interest for more than $5 million because this interest absorbs the credit loss on the defaulted loan and any remaining credit losses on the nine loan receivables that have not defaulted up to the total $10 million stated value of the beneficial interest. A market participant would not assume that B would exercise its option to repurchase the defaulted loan receivable. (Note that in this example, it is assumed that the fair value of the beneficial interest has declined from $8 million to $5 million.) The default on the loan receivable was unexpected. Before such default, it was expected that the securitization entity would incur $2 million in credit losses that would be absorbed by this beneficial interest. As a result of this unexpected default, it is now expected that the beneficial interest will absorb the $4 million loss on this defaulted loan receivable and $1 million in additional losses on the remaining nine loans in the securitization entity. This example uses a simplifying assumption that the decline in fair value of the beneficial interest equals the expected credit losses. In practice, this assumption would generally not be true because the fair value of the beneficial interest would be expected to change for other reasons (e.g., changes in market rates of interest) and expected credit losses do not necessarily equal the decline in fair value of the interest that results from such expected credit losses.

Entity B recognizes the following impairment loss on its beneficial interest:

No adjustments are made to the carrying amount of B’s servicing asset because its fair value remains at $3 million.

December 15, 20X1 (Default ROAP Option Is Exercised)

On December 15, 20X1, B repurchases the defaulted loan, recognizing the following entry on repurchase:

Note that, in this example, no portion of the servicing asset is recombined with the loan receivable purchased. Furthermore, no amortization on the noncredit discount on the loan receivable is shown for simplicity (i.e., assume that B recognizes this amortization only at the end of each financial reporting period).

After this purchase, B reevaluates the need for the allowance for credit losses on its beneficial interest. Because B repurchased the defaulted loan receivable, the securitization entity received $20 million and did not incur a loss on this loan receivable (i.e., the amount received equals the principal amount). As a result, B determines that the fair value of its beneficial interest has increased to $9 million. The $4 million increase equals the $4 million credit loss on the defaulted loan receivable that B purchased from the securitization entity. Entity B recognizes the following entries:

Because the beneficial interest is a residual interest, there is no need to reflect any reduction in the carrying amount of the beneficial interest for the $20 million prepayment on the loan receivable that has occurred from B’s repurchase of that receivable. If the beneficial interest had been a pro rata interest, the carrying amount of the beneficial interest would have been reduced because B would have received a portion of the amount paid to the securitization entity to repurchase the defaulted loan receivable.

Note that after all the entries above are recognized, B has recognized a total charge to earnings of $3.5 million. That loss can be explained as follows:

December 15, 20X1 (Default ROAP Option Expires Unexercised)

Assuming that the default ROAP option expires unexercised, B would recognize the following entry:

Entity B would not reverse the impairment loss recognized on its beneficial interest, but it would reflect the following entry to charge off a portion of the carrying amount of the beneficial interest:

Note that after all the entries above are recognized, B has recognized a total charge to earnings of $3.5 million. That loss can be explained as follows:

Regardless of whether B exercises the default ROAP option, it incurs the same loss in this example because the transferor’s interest in the loan receivables sold to the securitization entity absorbs the first $10 million of losses.

Footnotes

Amendments to the terms of the transfer must be substantive for previously sold financial assets to be rerecognized. See Section 3.1.3.2 for further discussion.

Although these examples were not codified, the concepts in them are still relevant.

The offsetting entry should not adjust the carrying amount of the financial assets that are rerecognized under ASC 860-20-25-10 because those financial assets must be initially recognized at fair value. In addition, ASC 860-20-25-10(c) prohibits combining a beneficial interest with rerecognized financial assets. Recognizing this offsetting entry as an adjustment to the obligation for the purchase price has the effect of adjusting that obligation for the transferor’s previously recognized interest in the financial assets for which the obligation is recognized.

In this discussion, it is assumed that the transferee is not liquidated as a result of the repurchase of the financial assets.

ASC 860-10-40-5(c)(1) states that “[a]n agreement that both entitles and obligates the transferor to repurchase or redeem [financial assets] before their maturity” represents effective control over those assets.

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.

Chapter 5 — Secured Borrowing Accounting

5.3 Collateral in a Secured Borrowing

5.3.1 General

ASC 860-30 — Glossary

Collateral

Personal or real property in which a security interest has been given.

ASC 860-30

Cash Collateral

25-3 Transfers of financial assets in exchange for cash collateral cannot be distinguished from borrowing cash. Further, because cash is fungible, it is impossible to determine whether it has been used by the secured party. Accordingly, all cash collateral shall be recorded as an asset by the party receiving it (the secured party), together with a liability for the obligation to return it to the payer (obligor), whose asset is a receivable.

25-4 Cash collateral used, for example, in securities lending transactions (see paragraphs 860-10-05-16 through 05-18) shall be derecognized by the obligor and recognized by the secured party, not as collateral but rather as proceeds of either a sale or a borrowing. See paragraphs 860-30-25-6 through 25-9 for further discussion of recognition of cash and noncash collateral as proceeds of a transfer.

Noncash Collateral

25-5 The accounting for noncash collateral by the obligor (or debtor) and the secured party depends on whether the secured party has the right to sell or repledge the collateral and on whether the obligor has defaulted. Noncash collateral shall be accounted for as follows:

If the secured party (transferee) has the right by contract or custom to sell or repledge the collateral, then paragraph 860-30-45-1 requires that the obligor (transferor) reclassify that asset and report that asset in its statement of financial position separately (for example, as security pledged to creditors) from other assets not so encumbered.
If the secured party (transferee) sells collateral pledged to it, it shall recognize the proceeds from the sale and its obligation to return the collateral. The sale of the collateral is a transfer subject to the provisions of this Topic.
If the obligor (transferor) defaults under the terms of the secured contract and is no longer entitled to redeem the pledged asset, it shall derecognize the pledged asset as required by paragraph 860-30-40-1 and the secured party (transferee) shall recognize the collateral as its asset. (See paragraph 860-30-30-1 for guidance on the secured party’s initial measurement of collateral recognized. See paragraph 860-30-40-1 for further guidance if the debtor has sold the collateral.)
Except as provided in paragraph 860-30-40-1 the obligor (transferor) shall continue to carry the collateral as its asset, and the secured party (transferee) shall not recognize the pledged asset.

Cash or Securities Received as Proceeds

25-6 Paragraph 860-10-55-55A discusses securities lending transactions in which the criteria in paragraph 860-10-40-5 for a sale are met. The following guidance relates to securities lending or similar transactions in which a transferor (lender) transfers securities and receives either cash or securities as collateral and the transfer does not meet the sale criteria in that paragraph.

25-7 Many securities lending transactions are accompanied by an agreement that both entitles and obligates the transferor to repurchase or redeem the transferred financial assets before their maturity. Paragraph 860-10-40-24 states that an agreement that both entitles and obligates the transferor to repurchase or redeem transferred financial assets from the transferee maintains the transferor’s effective control over those assets as described in paragraph 860-10-40-5(c)(1), if all of the conditions in paragraph 860-10-40-24 are met. Those transactions shall be accounted for as secured borrowings, in which either cash or securities that the holder is permitted by contract or custom to sell or repledge received as collateral are considered the amount borrowed, the securities loaned are considered pledged as collateral against the cash borrowed and reclassified as set forth in paragraph 860-30-25-5(a), and any rebate paid to the transferee of securities is interest on the cash the transferor is considered to have borrowed.

25-8 In a securities lending transaction, the transferor of securities being loaned accounts for cash received in the same way whether the transfer is accounted for as a sale or a secured borrowing. Cash collateral or securities received as collateral that a securities lender is permitted to sell or repledge are the proceeds of a borrowing secured by them. The cash received shall be recognized as the transferor’s asset, as shall investments made with that cash, even if made by agents or in pools with other securities lenders, along with the obligation to return the cash. If securities that may be sold or repledged are received, the transferor of the securities being loaned accounts for those securities in the same way as it would account for cash received. See Example 1 (paragraph 860-30-55-1) for an illustration of a securities lending transaction that is accounted for as a secured borrowing in which cash collateral is transferred.

25-9 As noted in paragraphs 860-30-25-4 and 860-30-25-8, the collateral accounting provisions do not apply to cash, or securities that can be sold or pledged for cash, received as so-called collateral for noncash financial assets, for example, in certain securities lending transactions. Such cash or securities that can be sold or pledged for cash are accounted for as proceeds of either a sale or a borrowing.

Sales of Collateral Held

25-10 Obligations to return to the transferor assets borrowed and then sold have sometimes been effectively recognized as part of a liability for securities sold but not yet purchased, and this Section does not require any change in that practice.

Noncash Collateral

30-1 Noncash collateral recognized by the secured party as its asset under paragraph 860-30-25-5(c) that the secured party has not already sold shall be initially measured at fair value.

Pledged Assets Required to Be Reclassified

35-2 A transferor that has transferred collateral that must be reclassified in accordance with paragraph 860-30-25-5(a) (for example, as securities pledged to creditors) shall not change its measurement of that collateral. The transferor shall follow the same measurement principles as before the transfer. For example, securities reclassified from the available-for-sale category to securities pledged to creditors should continue to be measured at fair value, with changes in fair value reported in comprehensive income, while debt securities reclassified from the held-to-maturity category to securities pledged to creditors should continue to be measured at amortized cost. See Topic 320 for guidance related to measurement of investments in securities classified as available for sale and held to maturity.

Obligation to Return Transferred Collateral

35-3 This Section does not provide specific guidance on the subsequent measurement of the obligation to return transferred collateral. The liability to return the collateral shall be measured in accordance with other relevant accounting guidance. Paragraph 942-405-35-1 requires that a bank or savings institution that, as transferee, sells transferred collateral subsequently measure that liability like a short sale at fair value.

40-1 In circumstances where an obligor (transferor) transfers noncash collateral in a secured borrowing and the obligor (transferor) defaults under the terms of the secured contract and is no longer entitled to redeem the pledged asset, the obligor shall derecognize the pledged asset. If the secured party has already sold the collateral, the secured party shall derecognize its obligation to return the collateral.

40-2 Otherwise paragraph 860-30-25-5(c) addresses the secured party’s accounting for the collateral.

As discussed in Section 5.2.1, a transfer of financial assets subject to ASC 860-10 that does not meet the conditions for sale accounting must be accounted for by the transferor and transferee as a borrowing secured by a pledge of collateral. Each transfer that is accounted for as a secured borrowing has two components: (1) proceeds and (2) collateral.

The recognition and measurement guidance on cash and noncash collateral in ASC 860-30-25-3 through 25-10, ASC 860-30-30-1, ASC 860-30-35-2 and 35-3, and ASC 860-30-40-1 and 40-2 applies to all transfers accounted for as secured borrowings under ASC 860-10. However, the guidance in ASC 860-30-25 on recognition of collateral does not apply when the so-called collateral represents the proceeds in a secured borrowing. Proceeds in a secured borrowing include:

Cash.
Noncash financial assets (e.g., securities) that can be sold or repledged by the secured party.

The transferor and transferee account for cash payments and receipts in the same manner regardless of whether the transfer agreement defines cash as proceeds in a secured borrowing or collateral (see Section 5.3.2.1). The accounting for noncash financial assets depends on whether those assets are considered the proceeds in a secured borrowing or collateral (see Section 5.3.3.3.1).

5.3.2 Accounting for Cash in a Secured Borrowing

5.3.2.1 General

Depending on the terms of the legal agreement for the transfer, cash may be characterized as the proceeds from a sale of financial assets or as the collateral for a borrowing.9 However, this legal distinction is irrelevant since cash is fungible. Under ASC 860-30-25-3, in all circumstances in which one party transfers cash to another party, it must be recognized as an asset by the receiving party and derecognized by the paying party. This requirement applies regardless of whether the cash transferred is considered the proceeds from a borrowing or the collateral posted on a borrowing.

The table below summarizes the accounting for cash transferred in a secured borrowing. See Examples 5-1, 5-2, and 5-11 for illustrations.

Table 5-2

Scope	All secured borrowings within the scope of ASC 860-30 and all cash posted as collateral on a derivative transaction (see Section 5.3.2.3) or securities lending transaction.
Accounting by the payor of cash — The payor is the transferee of financial assets in a secured borrowing (i.e., the creditor or secured party) or the party with a derivative liability.	The payor of cash should account for the payment as follows: Derecognize the cash transferred. Recognize a receivable for the return of the cash paid. ASC 815-10-45-1 through 45-7 apply to the balance sheet presentation of fair value amounts recognized for a receivable that represents the right to reclaim cash posted as collateral for outstanding derivative liabilities.(a)
Accounting by the recipient of cash — The recipient is the transferor in a secured borrowing (i.e., the debtor or pledging party) or the party with a derivative asset.	The recipient of cash should account for the receipt as follows: Recognize the cash as an asset.(b),(c) Recognize an obligation to return the cash received. ASC 815-10-45-1 through 45-7 apply to the balance sheet presentation of fair value amounts recognized for a liability that represents the obligation to return cash received as collateral for outstanding derivative assets. The recipient should also consider whether cash received should be presented and disclosed as restricted cash.
Notes to Table: (a) The payment (receipt) of cash on centrally cleared derivative transactions may legally represent a settlement (or partial settlement) of a derivative. In these situations, there is no receivable (liability) to account for under ASC 860-30; rather, the cash paid (received) is considered a settlement (or partial settlement) of an outstanding derivative liability (asset). (b) Cash held by a third party in custody represents cash that should be recognized by the recipient. (c) If the cash is used to purchase securities, the cash received is derecognized and those securities are accounted for in accordance with other applicable U.S. GAAP (e.g., ASC 320 for debt securities).

See Section 5.4.3 for an example illustrating the accounting for cash payments in a securities lending transaction.

5.3.2.2 Transferor’s Accounting for Liabilities Recognized in a Secured Borrowing

5.3.2.2.1 General

A liability recognized by a debtor in a secured borrowing represents a unit of account that is separate from the assets pledged as collateral for that obligation. ASC 860-30 also does not specifically address the classification or terminology used to describe liabilities recognized in a secured borrowing.

5.3.2.2.2 Initial Measurement

The general principle in ASC 860 is to initially recognize liabilities incurred in transfers at fair value. However, if the FVO is not elected, any fees or costs incurred with third parties that are direct and incremental costs (i.e., debt issue costs) may be capitalized into the initial measurement of the liability.10 Thus, when a liability is incurred in exchange for cash and the FVO is not elected, the initial measurement of the liability equals the sum of:

The amount of cash received.11
The debt issue costs incurred.

5.3.2.2.3 Subsequent Measurement

The liability should be subsequently measured in accordance with applicable U.S. GAAP, which may include:

ASC 470-10 — Addresses increasing-rate debt and indexed debt.
ASC 470-30 — Covers participating mortgage liabilities.
ASC 815-15 — Discusses embedded derivatives.
ASC 825-10 — Addresses application of the FVO.
ASC 835-30 — Covers the interest method.

For further discussion of such subsequent measurement, see Deloitte’s Roadmap Issuer's Accounting for Debt.

Connecting the Dots

Liabilities for secured borrowings are often recourse only to the transferred financial assets. As a result, questions often arise about whether there is an embedded credit derivative that must be separated from the host liability under ASC 815-15. The embedded credit feature in a liability for a secured borrowing may be described as an indexation to the credit risk of the transferred financial assets (as opposed to the liability being subject only to the debtor’s credit risk). ASC 815-15-25-47 addresses when credit risk exposures are not clearly and closely related to a liability host, stating that the requirement to separate an embedded credit derivative does not apply to “a nonrecourse debt arrangement (that is, a debt arrangement in which, in the event that the debtor does not make the payments due under the loan, the creditor has recourse solely to the specified property pledged as collateral).” This exception generally applies to the evaluation of the credit risk of a nonrecourse liability in a secured borrowing. However, it should not be applied in certain situations, including the accounting for credit-linked notes, liabilities that introduce a credit risk unrelated to the transferred financial assets, and liabilities in which payment depends on derivative instruments.

Derecognition of a liability in a secured borrowing is subject to the guidance in ASC 405-20-40-1, which states:

Unless addressed by other guidance (for example, paragraphs 405-20-40-3 through 40-4 or paragraphs 606-10-55-46 through 55-49), a debtor shall derecognize a liability if and only if it has been extinguished. A liability has been extinguished if either of the following conditions is met:

The debtor pays the creditor and is relieved of its obligation for the liability. Paying the creditor includes the following:
1. Delivery of cash
2. Delivery of other financial assets
3. Delivery of goods or services
4. Reacquisition by the debtor of its outstanding debt securities whether the securities are cancelled or held as so-called treasury bonds.
The debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor. For purposes of applying this Subtopic, a sale and related assumption effectively accomplish a legal release if nonrecourse debt (such as certain mortgage loans) is assumed by a third party in conjunction with the sale of an asset that serves as sole collateral for that debt.

Connecting the Dots

An entity may transfer a financial asset in a transaction that represents a nonrecourse borrowing (i.e., the transferee only has recourse to the financial asset pledged as collateral). While the transferor is only “at risk” to the extent of the fair value of the financial asset transferred (i.e., the pledged collateral), if it does not apply the FVO, the transferor cannot write down its liability for declines in the fair value of the financial asset. Rather, if the FVO is not applied, the amount recognized for the liability for the secured borrowing would not be reduced until one of the conditions in ASC 405-20-40-1 is met.

5.3.2.3 Transferor’s Accounting for Pledges of Cash Collateral in Derivative Transactions

A CSA is a contract attached to another transaction that defines certain credit terms between counterparties, such as credit thresholds, collateralization process, and credit termination events. CSAs are often executed in conjunction with derivative transactions. They require the transfer of cash or other noncash collateral from the party in a loss position to the party in a gain position when the fair value of a derivative (or portfolio of derivatives) exceeds a certain posting threshold. Although cash is often posted as collateral, liquid securities with high credit quality (e.g., U.S. Treasury securities) may be eligible to be posted as collateral. When securities are pledged as collateral, the party that receives the pledged securities may be able to sell or repledge those securities. In these situations, the securities to be returned to the party that has posted the collateral must be of the same issuer, series, class, maturity, mortgage pool, CUSIP number, coupon, and principal amount.

The posting of cash as collateral on a derivative contract is not a transfer under ASC 860-10. Nevertheless, ASC 860-30 applies when cash is posted as collateral on derivative transactions. Therefore, the party that posts cash must derecognize the cash and recognize a receivable for the right to reclaim the cash. The party that receives the cash recognizes it as an asset and recognizes a liability for the obligation to return the cash. The posting of noncash financial assets as collateral on a derivative contract is a transfer within the scope of ASC 860-10. See Section 5.3.3.2 for discussion of the accounting for noncash collateral posted on derivative transactions.

Connecting the Dots

The posting of margin or collateral on centrally cleared derivative transactions may legally represent a settlement (or partial settlement) of an outstanding derivative. In these situations, there is no recognized borrowing to account for under ASC 860-30; rather, the payor of cash is considered to have extinguished its derivative liability and the receiver of cash is considered to have been repaid its derivative asset.

5.3.2.4 Transferee’s Accounting for Assets Recognized in a Secured Borrowing

In a transfer of financial assets for cash accounted for as a secured borrowing, the transferee recognizes a receivable from the transferor. The receivable should be subsequently accounted for under other applicable U.S. GAAP (e.g., ASC 310-10 or the FVO in ASC 825-10). See Examples 5-4 and 5-5 for illustrations of the transferee’s subsequent accounting for a receivable from a transferor.

Connecting the Dots

Assets recognized for secured borrowings are often recourse only to the transferred financial assets. As a result, questions often arise about whether there is an embedded credit derivative that must be separated from the host receivable under ASC 815-15. The embedded credit feature in a receivable for a secured borrowing may be described as an indexation to the credit risk of the transferred financial assets (as opposed to the receivable being subject only to the debtor’s credit risk). ASC 815-15-25-47 addresses when credit risk exposures are not clearly and closely related to a receivable host, stating that the requirement to separate an embedded credit derivative does not apply to “a nonrecourse debt arrangement (that is, a debt arrangement in which, in the event that the debtor does not make the payments due under the loan, the creditor has recourse solely to the specified property pledged as collateral).” This exception generally applies to the evaluation of the credit risk of a nonrecourse receivable in a secured borrowing. However, it should not be appropriate in certain situations, including the accounting for credit-linked notes, receivables that contain a credit risk unrelated to the transferred financial assets, and receivables in which payment depends on derivative instruments.

5.3.3 Accounting for Noncash Financial Assets in a Secured Borrowing

5.3.3.1 General

The accounting for noncash collateral is more complex than the accounting for cash payments in a secured borrowing. As discussed in ASC 860-30-25-6 through 25-9, the accounting depends on whether noncash financial assets in a secured borrowing represent collateral or proceeds. That is, noncash financial assets that are pledged in a transfer that does not meet the conditions for sale accounting (including noncash financial assets pledged as collateral on outstanding derivatives) are accounted for differently from noncash financial assets that represent the proceeds in a reciprocal transaction between two parties that does not meet the conditions for sale accounting. Section 5.3.3.2 discusses noncash financial assets that represent collateral, and Section 5.3.3.3 addresses noncash financial assets that represent the proceeds in a secured borrowing.

5.3.3.2 Noncash Financial Assets That Represent Collateral

This section addresses the accounting for the following:

Noncash financial assets that represent the collateral in a secured borrowing.12
Noncash financial assets pledged as collateral on outstanding derivative instruments.

The table below summarizes the accounting in ASC 860-30-25-5 that applies to the transferor and transferee when noncash financial assets represent pledged collateral.

Table 5-3

Scope	All secured borrowings within the scope of ASC 860-30 and noncash collateral posted on a derivative transaction. Does not include noncash financial assets that are considered proceeds in a secured borrowing (see Section 5.3.3.3.1).
Accounting by the party that transfers noncash financial assets as collateral — The party that transfers noncash collateral is the transferor of financial assets in a secured borrowing (i.e., the debtor or pledging party) or the party with a derivative liability.	There is no accounting recognition by the transferor of noncash financial assets unless it defaults on the terms of the secured contract. The transferor should not derecognize noncash financial assets pledged as collateral unless it defaults under the terms of the secured contract and is no longer entitled to redeem the pledged assets (see ASC 860-30-25-5(c) and (d)).(a) The transferor continues to measure noncash financial assets pledged as collateral in the same manner as it would if those assets had not been pledged (see ASC 860-30-35-2). For example, if a debt security is pledged as collateral, the transferor continues to classify that security as trading, available for sale, or held to maturity according to its classification before being pledged. If the secured party has a right by custom or contract to sell or repledge noncash collateral, the transferor should reclassify those financial assets on its balance sheet to distinguish them from other assets not so encumbered (see ASC 860-30-25-5(a)).(b) ASC 860-30 does not specify the classification or terminology for the transferor to use in describing reclassified noncash financial assets that have been pledged as collateral. If the transferor defaults under the terms of the secured contract and is no longer entitled to redeem the pledged asset (i.e., the transferor does not cure the default within any prescribed period it has to cure such default), it should derecognize the pledged noncash financial asset and recognize either a receivable from the transferee or an extinguishment of the liability previously recognized for the secured borrowing (see ASC 860-30-25-5(c) and ASC 860-30-40-1). Derecognition of the liability previously recognized for the secured borrowing is appropriate only to the extent of the amount of derecognition that meets one of the conditions in ASC 405-20-40-1. In other words, after derecognizing the financial assets pledged as collateral, the transferor may still owe amounts to the transferee.
Accounting by the party that receives noncash financial assets pledged as collateral — The recipient is the transferee of financial assets in a secured borrowing (i.e., the creditor or secured party) or the party with a derivative asset.	The secured party is not required to perform any accounting recognition unless either of the following conditions is met: The secured party sells or repledges the pledged collateral. The transferor defaults under the terms of the secured contract and is no longer entitled to redeem the pledged assets. The secured party might sell the noncash financial assets received as collateral to raise cash as part of another secured borrowing transaction. If the secured party sells the collateral, it recognizes the proceeds from the sale and a corresponding obligation to return the collateral to the transferor.(c) Generally, no gain or loss is recognized on the sale. ASC 860-30 does not address the classification or terminology to be used to describe a liability incurred by a secured party that sells pledged collateral or how to subsequently measure this liability. We believe that this liability should be subsequently measured at fair value, with changes in fair value recognized in earnings.(d) If the transferor defaults on the secured contract and does not cure the default within the prescribed period for doing so (i.e., the transferor is no longer entitled to redeem the pledged asset), the secured party should (1) recognize the noncash collateral as an asset, initially measured at fair value in accordance with ASC 860-30-30-1, or (2) derecognize the liability to return the noncash collateral if it has been previously sold.
Notes to Table: (a) In the absence of a default under the terms of the secured contract, the transferor still controls the pledged noncash financial assets and therefore should not derecognize them. The transferor does not derecognize pledged noncash financial assets even if the secured party sells them to a third party. (b) This reclassification is required only if the secured party has the right by custom or contract to sell or repledge the collateral before a default by the transferor. If the secured party only has the right to sell or repledge the collateral upon a default by the transferor under the terms of the secured contract, this reclassification is not required. (c) In this context, “sale” means that the transaction meets the conditions for sale accounting in ASC 860-10-40-5. (d) The sale of a pledged asset represents a sale of a security that is not owned (i.e., a short sale). ASC 942-405-35-1 states that the “obligations incurred in short sales shall be subsequently measured at fair value through the income statement at each reporting date. Interest on the short positions shall be accrued periodically and reported as interest expense.”

5.3.3.3 Noncash Collateral That Represents Proceeds

5.3.3.3.1 General

Special consideration is necessary in securities lending transactions that are collateralized by noncash financial assets that may be sold or repledged by the recipient rather than by cash. In these transactions, there are two types of noncash financial assets: (1) the loaned securities and (2) the securities that are posted as collateral by the borrower of the loaned securities. The noncash financial assets received by the lender of securities as so-called collateral actually represent the proceeds in a secured borrowing when those noncash financial assets can be sold or repledged. That is, ASC 860-30-25-8 requires the lender of securities to account for any noncash financial assets received that may be sold or repledged in the same way that a transferor of financial assets accounts for cash received in a secured borrowing. What is unique is that the lender of securities is considered the borrower for accounting purposes and the borrower of securities is considered the lender for accounting purposes.

The table below describes the accounting in situations in which noncash financial assets are pledged as collateral in a securities lending transaction that is accounted for as a secured borrowing. 13

Table 5-4

	Loaned Securities(a)	Collateral Pledged(a),(b)
Borrower — The borrower in a securities lending transaction is the transferee of the loaned securities. The borrower pledges collateral to the lender of the loaned securities.	The borrower does not recognize the securities borrowed as an asset. However, if the borrower sells or pledges the securities, it recognizes an obligation to return them to the lender (see ASC 860-30-25-5(b) and ASC 860-30-25-10). This is because a transfer of a financial asset that is not owned by the transferor must be accounted for as a secured borrowing. This liability should be initially and subsequently measured at fair value, with changes in fair value recognized in earnings.(c)	Posting securities as collateral is a transfer under ASC 860-10. The borrower does not derecognize the securities posted as collateral because it has not surrendered control over them. However, the borrower should reclassify the securities on its balance sheet to distinguish them from other assets not so encumbered or should disclose that the securities have been pledged (see ASC 860-30-25-5(a) and ASC 860-30-50-1A(b)).(d) If the borrower defaults on the terms of the secured contract and any period available to cure the default lapses, the borrower should derecognize the securities pledged as collateral (see ASC 860-30-25-5(c)).
Lender — The lender in a securities lending transaction is the transferor of the loaned securities. The lender receives the collateral pledged by the borrower of the loaned securities.	Because the lender maintains control over the loaned securities, it does not derecognize them even if they have been sold by the borrower. However, if the borrower defaults on the terms of the secured contract and any period available to cure that default lapses, the lender derecognizes the loaned securities. The lender discloses that the securities have been pledged (see ASC 860-30-50-1A(b)).	If the lender can sell or repledge the collateral, it should recognize (1) an asset for the pledged securities initially measured at fair value and (2) an obligation to return the pledged securities.(e) If the lender cannot sell or repledge the collateral, it does not recognize the pledged securities.(f)
Notes to Table: (a) The loaned securities are not considered collateral. Collateral represents the securities pledged by the borrower to the lender to secure the lending transaction. (b) The collateral pledged often represents liquid, high-credit-quality securities, such as U.S. Treasury securities, and the borrower often has the right to substitute the collateral. As noted in the table, the lender treats the so-called collateral as proceeds in a secured borrowing if it can sell or repledge those securities. In this table, it is assumed that the lender of securities must return the same or substantially the same securities upon settlement of the secured contract. (c) The sale of a pledged asset represents a sale of a security that is not owned (i.e., a short sale). ASC 942-405-35-1 states: The obligations incurred in short sales shall be subsequently measured at fair value through the income statement at each reporting date. Interest on the short positions shall be accrued periodically and reported as interest expense. (d) The borrower does not derecognize the pledged securities even if they are sold by the lender because the borrower maintains effective control over the securities. In addition, the borrower must apply the same measurement method to the pledged securities as it did before the transfer (see ASC 860-30-35-2). As noted below, the lender recognizes the pledged securities because they represent the proceeds in a secured borrowing. This is one of the unique situations in which the transferor’s accounting under ASC 860 is not symmetrical to that of the transferee (i.e., the same securities are recognized on the balance sheet of two entities). Such accounting conforms with ASC 860-30-25-8. If, however, the lender was not required to return the same or substantially the same securities, the borrower would derecognize the pledged securities and recognize a receivable from the lender. (e) If the lender can sell or repledge noncash financial assets received as collateral, such pledged securities that are received as so-called collateral are accounted for as the proceeds of a secured borrowing. In these circumstances, the lender accounts for the pledged securities in the same manner as if cash had been received as collateral (see ASC 860-30-25-8). Therefore, the lender recognizes an asset for the pledged securities and an obligation to return the pledged securities. The lender should initially measure the securities at fair value (see ASC 860-30-30-1) and should subsequently account for them in accordance with other applicable U.S. GAAP (e.g., ASC 320 for debt securities). The lender should initially measure the liability for the obligation to return the pledged securities at fair value. The lender should subsequently measure the liability for the obligation to return the pledged securities at fair value, with changes in fair value reported in earnings (see note (c) to this table). Thus, if the lender accounts for pledged securities as available-for-sale debt securities, there will be an earnings “mismatch” during the term of the securities lending transaction because any unrealized gains or losses on the pledged securities will be recognized in OCI while any unrealized gains or losses on the obligation to return the pledged securities will be recognized in earnings immediately. If the lender transfers the pledged securities to a third party, it should apply ASC 860-10 to determine whether that transfer is a sale or secured borrowing. However, the obligation to return the pledged securities would not be derecognized until the lender returns the pledged securities or the borrower defaults on the terms of the secured contract and any period available to cure that default lapses. (f) ASC 860-30 does not address the lender’s accounting in situations in which pledged securities cannot be sold or repledged. (In practice, it would be unusual for the lender to be unable to sell or repledge securities received as collateral.) However, because the lender cannot sell or repledge the securities, they would be considered collateral rather than proceeds. As a result, the lender would not recognize the pledged securities unless the borrower defaults on the terms of the secured contract and any period available to cure that default lapses.

See Example 5-8 for an illustration of a securities lending transaction involving noncash collateral.

5.3.3.3.2 Special Considerations

5.3.3.3.2.1 Use of a Customer’s Securities in a Securities Lending Transaction

Securities owned by customers are not recognized on the balance sheets of broker-dealers that maintain custody of those securities. However, broker-dealers may be able to lend customer securities when they collateralize a margin loan.14 If a broker-dealer lends a customer’s security, it does not derecognize the margin loan receivable from the customer. The broker-dealer should, however, recognize an obligation to return the securities to the customer. See Example 5-9 for an illustration.

A broker-dealer may also use customer securities as collateral to borrow securities in a securities lending transaction. As discussed in Table 5-4, when an entity pledges a security as collateral, it does not derecognize the pledged security from its balance sheet. However, when the security pledged as collateral is not recognized on the broker-dealer’s balance sheet, as is the case with customer securities, the broker-dealer must recognize an obligation to return the customer’s security and a corresponding receivable. This is required since the broker-dealer would not derecognize the margin receivable from its customer. See Example 5-10 for an illustration.

Note that the same accounting would apply if an entity pledges a borrowed security as collateral on a derivative transaction. Because the security pledged is not owned by the entity, a liability must be recognized for the return of the pledged security, with a corresponding asset from the derivative counterparty.

5.3.3.3.2.2 Securities Lending Without Collateral

Although not common in the United States, in some countries collateral is not pledged by the borrower in a securities lending transaction. We understand from informal discussions with the FASB staff that there is no accounting recognition by the lender or borrower unless the borrower pledges or sells the security or defaults on the term of the secured contract. If the borrower pledges or sells the security or defaults on the terms of the lending arrangement (i.e., does not return the security), it must recognize a liability for the obligation to return the borrowed security. If the borrower defaults by not returning the security, the lender must consider the need to derecognize the loaned security.

5.3.3.3.2.3 Simultaneous Borrowing and Lending of Different Securities

In some securities lending transactions, each party is simultaneously lending one security and borrowing another security (also referred to as “lending swaps”). For example, assume that Dealer A needs to borrow Security A to cover a short sale and Dealer B needs to borrow Security B to cover a short sale. Dealer A owns Security B and Dealer B owns Security A. Dealer A and Dealer B enter into a securities lending transaction (accounted for as a secured borrowing) in which Dealer A loans Security B to Dealer B and Dealer B loans Security A to Dealer A. The securities loaned by each party serve as the collateral on the securities borrowed by each party. Each party can sell or repledge the borrowed security. In these transactions, it is difficult to identify which party is the transferor and which party is the transferee. In fact, each party could be viewed as both a transferor and a transferee. Neither party would derecognize the security pledged as collateral (i.e., the securities loaned by each party) unless the other party defaulted on the terms of the secured contract and any period available to cure that default lapses (see ASC 860-30-25-5). ASC 860-30 does not specifically address, however, whether each party should consider the borrowed security as representing the proceeds for the security loaned. If the security is considered proceeds, each party would recognize an asset for the security and a liability for the obligation to return it to the other party. Although this is an acceptable interpretation of ASC 860-30, we do not believe that it constitutes a requirement. Rather, it would also be acceptable for each party to consider the security borrowed to be collateral. According to this view, neither party would recognize the borrowed security at inception of the transaction (i.e., there would be no accounting recognition for either party at inception). Each party should, however, apply the guidance in ASC 860-30 if it pledges or sells the borrowed security or the other party defaults on the terms of the secured contract.

Footnotes

When derivative or securities lending transactions are secured through the posting of cash, entities often view the cash payments as collateral. In repurchase agreements, entities often view the cash payment as the proceeds from a borrowing.

If the FVO is elected, these costs are expensed as incurred.

Unless one of the conditions in ASC 820-10-30-3A is met, the transaction price is considered fair value at recognition of the liability.

When a transfer of financial assets does not achieve sale accounting, the cash received by the transferor represents the proceeds of the secured borrowing and the transferred financial assets represent the noncash collateral pledged by the transferor to the transferee. In this section, the agreement associated with the transfer of financial assets with a pledge of collateral is referred to as the “secured contract.”

Although this table would apply to any transaction in which one party transfers a noncash financial asset and receives another noncash financial asset in return, in practice, these transactions are referred to as securities lending transactions.

The ability to lend a customer’s security is subject to laws and regulations applicable to broker-dealers (see, for example, Regulation U).

Chapter 6 — Servicing Assets and Liabilities

6.2 Recognition of Servicing Assets or Liabilities

6.2.1 General

ASC 860-50

25-1 An entity shall recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in any of the following situations:

A servicer’s transfer of any of the following, if that transfer meets the requirements for sale accounting:
1. An entire financial asset
2. A group of entire financial assets
3. A participating interest in an entire financial asset, in which circumstance the transferor shall recognize a servicing asset or a servicing liability only related to the participating interest sold.
Subparagraph superseded by Accounting Standards Update No. 2009-16.
An acquisition or assumption of a servicing obligation that does not relate to financial assets of the servicer or its consolidated affiliates included in the financial statements being presented.

Example 1 (see paragraph 860-50-55-20) illustrates accounting for a sale of receivables with servicing obtained by the transferor.

25-2 A servicer that transfers or securitizes financial assets in a transaction that does not meet the requirements for sale accounting and is accounted for as a secured borrowing with the underlying financial assets remaining on the transferor’s balance sheet shall not recognize a servicing asset or a servicing liability.

25-3 A servicer that recognizes a servicing asset or servicing liability shall account for the contract to service financial assets separately from those financial assets.

A servicing asset or liability is recognized separately to reflect an entity’s rights (obligations) to service financial assets only when both of the following conditions are met:

The benefits of servicing do not equal adequate compensation.
An entity (1) retains the servicing responsibility in a transfer of financial assets that meets the conditions for sale accounting in ASC 860-10 or (2) enters into a contract to acquire a servicing asset or assume a servicing liability that is not related to the entity’s financial assets.

Connecting the Dots

The accounting for a contract to service financial assets is the same regardless of whether the servicing right results from an outright sale or securitization of transferred financial assets or from a purchase or assumption of the rights to service financial assets that the entity or its consolidated affiliates do not own. It is never appropriate to recognize a servicing asset or servicing liability in (1) a transfer of financial assets that is not accounted for as a sale and (2) an acquisition of loan receivables with the rights to service them.

The examples below illustrate when it is appropriate to recognize a servicing asset or servicing liability.

Example 6-1

Sale of Mortgage Loans

Entity A transfers mortgage loans to an unconsolidated securitization entity and retains the rights to service the transferred mortgage loans. The transfer of the mortgage loans meets the sale accounting conditions in ASC 860-10-40-5. The benefits of servicing the transferred mortgage loans exceed adequate compensation. Entity A should recognize a servicing asset as part of the proceeds received on the transfer of the mortgage loans.

Example 6-2

Purchase of Mortgage Loans

Entity B purchases mortgage loans in a whole-loan purchase transaction. As part of the purchase, B obtains the rights to service the acquired mortgage loans. Entity B should not separately recognize a servicing asset or servicing liability because ASC 860-50-25-1(c) prohibits an entity from recognizing a servicing asset or servicing liability on financial assets that it owns.

That is, when an entity acquires the servicing rights on loans that it recognizes on its balance sheet, a servicing asset or servicing liability cannot be recorded because the servicing is related to financial assets owned by the servicer.

6.2.2 Special Considerations

6.2.2.1 Securitization Transaction in Which the Transferor Obtains the Resulting Securities

ASC 860-50

25-4 An entity that transfers its financial assets to an unconsolidated entity in a transfer that qualifies as a sale in which the transferor obtains the resulting securities and classifies them as debt securities held to maturity in accordance with Topic 320 may either separately recognize its servicing assets or servicing liabilities or report those servicing assets or servicing liabilities together with the asset being serviced.

As discussed in Section 3.6.1, an entity may transfer mortgage loans to an unconsolidated securitization entity and meet the conditions in ASC 860-10 for sale accounting even though the entity retains all the securities issued by the unconsolidated securitization entity. This type of transaction would generally qualify as a sale under ASC 860-10 only if a third party provides a guarantee on the transferred mortgage loans. The accounting for the MSRs in such a transaction depends on how the entity accounts for the debt securities received in the transfer.

ASC 860-50 requires an entity to recognize a servicing asset or servicing liability for MSRs that are acquired or obtained in a mortgage securitization involving an unconsolidated securitization entity in which the transferor retains all of the resulting securities and classifies them as either available for sale or trading. However, ASC 860-50-25-4 indicates that if the securities retained are classified as held to maturity, the entity may choose to separately recognize a servicing asset or servicing liability or recognize the MSR together with the asset being serviced (i.e., the held-to-maturity securities). ASC 860-50-30-1 requires entities to initially measure servicing assets and servicing liabilities at fair value; therefore, MSRs that are recognized in a transfer of financial assets to an unconsolidated securitization entity in which the transferor retains all the underlying securities issued by the securitization entity should be initially measured at fair value.

6.2.2.2 Distinguishing Servicing Assets From IO Strips

ASC 860-50

Distinguishing Servicing From an Interest-Only Strip

25-6 A servicer shall account separately for rights to future interest income from the serviced assets that exceed contractually specified servicing fees. Those rights are not servicing assets; they are financial assets, effectively interest-only strips to be accounted for in accordance with paragraph 860-20-35-2.

25-7 Whether a right to future interest income from serviced assets should be accounted for as an interest-only strip, a servicing asset, or a combination thereof, depends on whether a servicer would continue to receive that amount (that is, the value of the right to future interest income) if a substitute servicer began servicing the assets. Therefore, any portion of the right to future interest income from the serviced assets that would continue to be received even if the servicing were shifted to another servicer would be reported separately as a financial asset in accordance with paragraph 860-20-35-2. For guidance on why an interest-only strip precludes a portion of a financial asset from meeting the definition of a participating interest, see paragraph 860-10-55-17K.

25-8 The value of the right to receive future cash flows from ancillary sources such as late fees shall be included in the measurement of the servicing asset, not the interest-only strip, if retention of the right to receive the cash flows from those fees depends on servicing being performed satisfactorily, as is generally the case.

ASC 860-50-25-6 through 25-8 discuss the importance of distinguishing servicing assets from IO strips. The table below summarizes the significant accounting differences between servicing assets and IO strips (in this table, it is assumed that the assets were retained in a sale or securitization and not purchased separately).

Table 6-1

	Servicing Asset	IO Strip
Definition	The amount by which — on the basis of marketplace conditions — the contractually specified servicing fee exceeds adequate compensation for servicing. See Section 6.1.	Rights to any remaining portion of the interest spread beyond the contractually specified servicing rate.
Initial recorded amount	Fair value. See Section 6.3.	Fair value.
Immediate adjustment required after initial recording	No adjustment.	No adjustment.
Income recognition	An entity may either (1) amortize servicing assets or servicing liabilities in proportion to, and over the period of, estimated net servicing income or (2) measure servicing assets or servicing liabilities at fair value as of each reporting date and report changes in fair value in earnings. See Section 6.4.	Trading and available for sale — Level yield; prospective adjustments are made for changes in estimated income under ASC 325-40. In addition, IO strips often contain an embedded derivative that must be bifurcated under ASC 815-15. In lieu of bifurcation, entities often elect the FVO. IO strips cannot generally be accounted for as held-to-maturity securities (see ASC 860-20-35-2 and ASC 310-10-35-45).
Balance sheet carrying value	Amortized cost or fair value, depending on the method selected. See Section 6.4.	Fair value.
Recognition of impairment	If the amortization method is selected, a valuation allowance is established for an individual stratum of servicing assets when its carrying amount exceeds its fair value. Changes to a valuation allowance are recognized in earnings; however, an entity cannot recognize a fair value amount that is above the stratum’s carrying amount (see ASC 860-50-35-9(c)). See Section 6.4.2.2.4 for discussion of direct write-downs of servicing assets.	Trading — Fair value with periodic changes recorded through earnings. Available for sale — Written down to fair value in accordance with ASC 325-40, ASC 320, and ASC 958-325, if impaired.

Connecting the Dots

The determination of whether a right to receive a strip of cash flows (often referred to in practice as “excess cash flows” or “excess servicing”) is a component of a servicing asset or represents an IO strip depends on whether the holder of such a right can transfer that right independently of the servicing contract. If such a transfer is allowed, the right to the excess cash flows does not depend on servicing and reflects an IO strip. If such a transfer is not allowed, the right to excess cash flows reflects servicing benefits in excess of adequate compensation since the holder cannot receive such cash flows without servicing the related financial assets.

6.2.2.3 Subservicing Contracts

ASC 860-50

Subservicing Contracts

55-10 A transferor may transfer mortgage loans in their entirety to a third party in a transfer that is accounted for as a sale and undertake an obligation to service the loans. After the transfer, the transferor enters into a subservicing arrangement with a third party.

55-11 If the transferor’s benefits of servicing exceed its obligation under the subservicing contract, that differential shall not be accounted for as an interest-only strip. Rather, the transferor should account for the two transactions separately. First, the transferor should account for the transfer of mortgage loans in accordance with Subtopic 860-20. The obligation to service the loans should be initially recognized and measured at fair value according to paragraph 860-50-30-1 as proceeds obtained from the sale of the mortgage loans. Second, the transferor should account for the subcontract with the subservicer.

ASC 860-50-55-10 and 55-11 address when an entity transfers mortgage loans, retains the right to service the mortgage loans, and enters into a contract with a third party to service the mortgage loans (i.e., a subservicing contract). That guidance stipulates that if the transfer of the mortgage loans is accounted for as a sale, the transferor has two separate transactions to account for: (1) the transfer of the mortgage loans and recognition of the servicing asset or servicing liability as part of the proceeds on transfer and (2) the subcontract with the subservicer. Because the transferor has the primary obligation to service the transferred mortgage loans, it would recognize a servicing asset or servicing liability, and not an IO strip, related to that servicing right. The subservicing contract would be accounted for separately.

6.2.2.4 Revolving-Period Securitizations

ASC 860-50

Revolving-Period Securitizations

25-9 Recognition of servicing assets or servicing liabilities for revolving-period receivables shall be limited to the servicing for the receivables that exist and have been sold. As new receivables are sold, rights to service them may become assets or liabilities that are recognized. Therefore, additional transfers under revolving-period securitizations (for example, home equity loans or credit card receivables) may result in the recognition of additional servicing assets or servicing liabilities.

ASC 860-50-25-9 clarifies that servicing assets and servicing liabilities may only be recognized for recognized receivables. Entities may not separately recognize a servicing asset or servicing liability for receivables to be originated in the future. This guidance is consistent with ASC 860-20-55-31, which indicates that the fair value measurement of a beneficial interest in a securitization entity may not include the estimated cash flows associated with receivables that do not yet exist but that will be originated and transferred during the revolving period (e.g., in securitizations with revolving features or prefunding provisions).

6.2.2.5 Regaining Control of Financial Assets Sold

ASC 860-50

Regaining Control of Financial Assets Sold

25-10 Paragraph 860-20-25-10(b) explains that, after a paragraph 860-10-40-41 change, the transferor shall not change, the accounting for the servicing asset related to the previously sold financial assets and provides related guidance.

Entities may be required to rerecognize financial assets that were previously considered sold for many different reasons. Upon such rerecognition, entities do not subsume any previously recognized servicing asset or servicing liability into the carrying amount of the rerecognized financial assets. For more information, see Section 4.3.

6.2.2.6 Acquisition of Rights to Service an Entity’s Owned Financial Assets

Entities may obtain the servicing rights on financial assets that are owned by the entity or its consolidated affiliates. For example, an entity may purchase financial assets with the servicing retained by the seller and then later acquire those servicing rights. In accounting for an acquisition or assumption of servicing rights, an entity should consider the guidance in ASC 860-50-25-1(c), which addresses the recognition of a servicing asset or servicing liability in situations in which an entity acquires or assumes an obligation to service financial assets that it owns. We believe that if, in a manner consistent with this guidance, an entity acquires the servicing rights to financial assets that it owns, it should account for the servicing rights and related financial assets on a combined basis. That is, the offsetting entry for the consideration paid or received for the servicing rights should be recognized as an adjustment to the related receivables. In such circumstances, an entity may be required to make an allocation to each receivable within a larger group by using a systematic and reasonable allocation method.

We understand that recognizing acquired servicing rights as a basis adjustment to the carrying amounts of the related receivables could be considered inconsistent with the guidance in ASC 860-50-25-10 (see Section 6.2.2.5). However, ASC 860-50-25-1(c) prohibits the recognition of a separate servicing asset or servicing liability in this situation.

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.

6.5 Transfers of Servicing Rights

6.5.1 General

ASC 860-50

Overall

40-2 The following criteria shall be considered when evaluating whether a transfer of servicing rights qualifies as a sale:

Whether the transferor has received written approval from the investor if required.
Whether the transferee is a currently approved transferor-servicer and is not at risk of losing approved status.
If the transferor finances a portion of the sales price, whether an adequate nonrefundable down payment has been received (necessary to demonstrate the transferee’s commitment to pay the remaining sales price) and whether the note receivable from the transferee provides full recourse to the transferee. Nonrecourse notes or notes with limited recourse (such as to the servicing) do not satisfy this criterion.
Temporary servicing performed by the transferor for a short period of time shall be compensated in accordance with a subservicing contract that provides adequate compensation.

40-3 Also, the following additional criteria shall be considered when evaluating whether a transfer of servicing rights qualifies as a sale:

Title has passed.
Substantially all risks and rewards of ownership have irrevocably passed to the buyer.
Any protective provisions retained by the seller are minor and can be reasonably estimated.

40-4 If a sale is recognized and minor protection provisions exist, a liability shall be accrued for the estimated obligation associated with those provisions. The seller retains only minor protection provisions if both of the following conditions are met:

The obligation associated with those provisions is estimated to be no more than 10 percent of the sales price.
Risk of prepayment is retained for no longer than 120 days.

40-5 A temporary subservicing contract in which the subservicing will be performed by the transferor for a short period of time would not necessarily preclude recognizing a sale at the closing date.

40-6 The criteria in paragraphs 860-50-40-2 through 40-4 apply to transfers of servicing rights relating to loans previously sold and to transfers of servicing rights relating to loans that are retained by the transferor. The carrying amount of servicing rights sold relating to loans that have been retained shall be allocated at the date of sale between the servicing rights and the loans retained using relative fair values.

Sales of Servicing Rights With a Subservicing Contract

40-7 A sale of mortgage servicing rights with a subservicing contract shall be treated as a sale with gain deferred if substantially all the risks and rewards inherent in owning the mortgage servicing rights have been effectively transferred to the transferee, as discussed in paragraph 860-50-40-3. Attributes of the transferee (for example, ability to perform servicing) would not be significant to the accounting for the transaction. The risks and rewards associated with a transferor performing purely administrative functions under a subservicing contract would not necessarily preclude sales treatment. A loss shall be recognized currently if the transferor determines that prepayments of the underlying mortgage loans may result in performing the future servicing at a loss.

40-8 Substantially all the risks and rewards inherent in owning the mortgage servicing rights have not been transferred to the transferee and, therefore, the transaction shall be accounted for as a financing if any of the following factors are present:

The transferor-subservicer directly or indirectly guarantees a yield to the transferee. For example, the transferor-subservicer guarantees prepayment speeds or maximum loan default ratios to the buyer.
The transferor-subservicer is obligated to advance a portion or all of the servicing fees on a nonrecoverable basis to the transferee before receipt of the loan payment from the mortgagor.
The transferor-subservicer indemnifies the transferee for damages due to causes other than failure to perform its duties under the terms of the subservicing contract.
The transferor-subservicer absorbs losses on mortgage loan foreclosures not covered by the Federal Housing Administration, Department of Veterans Affairs, or other guarantors, if any, including absorption of foreclosure costs and costs of managing foreclosed property.
Title to the servicing rights is retained by the transferor-subservicer.

40-9 The presence of any of the following factors creates a rebuttable presumption that substantially all the risks and rewards inherent in owning the mortgage servicing rights have not been transferred to the transferee and that the transaction shall be accounted for as a financing:

The transferor-subservicer directly or indirectly provides financing or guarantees the transferee’s financing. Nonrecourse financing, for example, would indicate that risks have not been transferred to the transferee. Topic 450 requires a guarantor to recognize, at inception of the guarantee, a liability for the obligation undertaken in issuing the guarantee.
The terms of the subservicing contract unduly limit the transferee’s ability to exercise ownership control over the servicing rights or result in the seller’s retaining some of the risks and rewards of ownership. For example, if the transferee cannot cancel or decline to renew the subservicing contract after a reasonable period of time, the transferee is precluded from exercising certain rights of ownership. Conversely, if the transferor cannot cancel the subservicing contract after a reasonable period of time, the transferor has not transferred substantially all of the risks of ownership.
The transferee is a special-purpose entity without substantive capital at risk.

Sales of Servicing Rights for Participation in an Income Stream

40-10 The following addresses a situation in which an entity sells the right to service mortgage loans that are owned by other parties. The related mortgage loans have been previously sold, with servicing retained, in a separate transaction. Because of the ability to invest the float that results from payments received from borrowers but not yet passed to the owners of the mortgages, the mortgage servicing rights can be sold for immediate cash or for a participation in the future interest stream of the loans.

40-11 If a transfer of mortgage servicing rights qualifies as a sale under the criteria beginning in paragraph 860-50-40-2 and the sale is for a participation in the future interest income stream, gain recognition is appropriate at the sale date. There are difficulties in measuring the amount of the gain if the sales price is based on a participation in future payments and there is no specified upper limit on the computed sales price. The transferor of mortgage servicing rights shall consider all available information, including the amount of gain that would be recognized if the servicing rights were to be sold outright for a fixed cash price.

ASC 860-10 — SEC Materials — SEC Staff Guidance

SEC Observer Comment: Balance Sheet Treatment of a Sale of Mortgage Servicing Rights With a Subservicing Agreement

S99-1 The following is the text of SEC Observer Comment: Balance Sheet Treatment of a Sale of Mortgage Servicing Rights with a Subservicing Agreement.

In accordance with paragraph 860-50-40-7, a sale of mortgage servicing rights with a subservicing contract could be treated as a sale with the gain deferred if substantially all of the risks and rewards have been transferred to the transferree. In the view of the SEC staff, a transaction that, in substance, transfers only a portion of the servicing revenues does not result in transfer of substantially all of the risks and rewards of ownership and the accounting for those transactions should be guided by the guidance in paragraph 470-10-25-1.

ASC 860-50-40-2 through 40-9 provide guidance on when rights to service financial assets should be derecognized. This derecognition guidance differs from the guidance in ASC 860-10 that applies to the derecognition of financial assets. While the derecognition model in ASC 860-10-40 focuses on control, the derecognition guidance related to servicing rights in ASC 860-50-40 focuses primarily on risks and rewards.

6.5.1.1 Scope of Guidance on Transfers of Servicing Rights

The guidance in ASC 860-50-40 on transfers of servicing rights applies to the following:

A transfer of separately recognized servicing assets and servicing liabilities.
A transfer of servicing rights on financial assets owned by the transferor.

Connecting the Dots

An entity can recognize a sale of servicing rights that are attached to the related loans (i.e., the servicing rights are not separately recognized) if the conditions in ASC 860-10-40-5 for recognizing a sale of financial assets are met. We do not believe that an entity must apply the guidance in ASC 860-50-40 on transfers of servicing rights. In addition, when an entity transfers servicing rights on financial assets that it owns but does not transfer the financial assets themselves, the guidance in ASC 860-50-40 applies. In these circumstances, the guidance in ASC 860-10 on participating interests is not relevant.

ASC 860-50-40 does not apply to transfers of financial assets that include the rights to service those transferred financial assets unless the servicing rights have been separately recognized as a servicing asset or servicing liability. Rather, only ASC 860-10-40-5 applies to the transfers of those financial assets. See Examples 6-3 through 6-5.

ASC 860-50-40 also does not apply to a sale of a legal entity that meets the definition of a business (i.e., ASC 860-50-40 would not apply to any servicing rights included in the legal entity). However, if an entity sells a group of assets that does not constitute a legal entity, it would generally need to apply ASC 860-50-40 to any servicing rights that are included in this sale regardless of whether the group of assets meets the definition of a business.

6.5.1.2 Accounting for a Transfer of Servicing Rights by the Transferor

There are three possible accounting outcomes when rights to service loans are transferred:

Sales treatment with immediate gain recognition.
Sales treatment with gain deferral.
Secured borrowing.

Generally, a transfer of servicing rights should be accounted for as a sale only when all of the substantive risks and rewards of ownership have been transferred. Agreements to sell or transfer servicing rights may contain complex provisions designed to protect the buyer. For example, in addition to standard eligibility representations and warranties, agreements may include subsequent adjustments to the sales price depending on higher than agreed-to levels of prepayments or defaults on the underlying loans that occur within a specified time frame. ASC 460 addresses the accounting for guarantees.

Frequently, sellers transfer servicing rights but continue to service the underlying loans under a subservicing agreement. The terms of subservicing arrangements vary widely; sometimes they are temporary and provide for a period after closing during which the parties coordinate systems and controls in anticipation of the actual transfer of data. However, in some situations, the existence of a subservicing agreement may indicate that the original seller/subservicer continues to bear the substantive risks and rewards of ownership.

The table below summarizes the guidance in ASC 860-50-40 on the transferor’s accounting for a transfer of servicing rights.2

Table 6-3

Transfers of Servicing Rights	Guidance	Discussion
Subservicing is not performed by the seller, or subservicing is short-term.(a)	ASC 860-50-40-2 through 40-6	Provided that the conditions in ASC 860-50-40-2 are met, the sale is recognized when (1) title has passed, (2) substantially all risks and rewards have irrevocably passed to the buyer, and (3) protection provisions are minor and can be reasonably estimated(b) (see Examples 6-7 and 6-8). See Section 6.5.1.2.1 for guidance on the transferor’s accounting when the transaction meets the conditions for recognition as a sale. See Section 6.5.1.2.2 for guidance on the transferor’s accounting when the transaction does not qualify as a sale.
Subservicing is not performed by the seller; loans are retained by the seller.	ASC 860-50-40-2	Provided that the conditions in ASC 860-50-40-2 are met, the sale is recognized when (1) title has passed, (2) substantially all risks and rewards have irrevocably passed to the buyer, and (3) protection provisions are minor and can be reasonably estimated(b) (see Examples 6-7 and 6-8). See Section 6.5.1.2.1 for guidance on the transferor’s accounting when the transaction meets the conditions for recognition as a sale. See Section 6.5.1.2.2 for guidance on the transferor’s accounting when the transaction does not qualify as a sale.
Subservicing is performed by the seller, and subservicing is not short-term.	ASC 860-50-40-7 through 40-9	Sales with subservicing agreements should be treated as a sale with a deferred gain if substantially all risks and rewards have been effectively transferred. When certain factors are present, either financing treatment is required or there is a rebuttable presumption that financing treatment is appropriate.(c) See Section 6.5.1.2.1 for guidance on the transferor’s accounting when the transaction meets the conditions for recognition as a sale. See Section 6.5.1.2.2 for guidance on the transferor’s accounting when the transaction does not qualify as a sale.
Notes to Table: (a) An entity generally determines whether the period of subservicing is short-term on the basis of time. Qualitative factors may be relevant to this evaluation, such as the length of time necessary to set up systems and controls (e.g., for an extremely large portfolio or a complex portfolio of commercial loans with unique contractual terms). (b) ASC 860-50-40 defines “protection provisions” as follows: Provisions in some contracts to sell or transfer mortgage servicing rights that could affect the amount ultimately paid to the transferor. For example, the transferor may agree to adjust the sales price for loan prepayments, defaults, or foreclosures that occur within a specified period of time. Provisions that must be evaluated under ASC 860-50-40-3(c) and 40-4 are those designed to (1) reflect a purchase price adjustment or (2) protect a purchaser against losses associated with the servicing rights acquired. That is, protective provisions are contract terms that are intended to adjust the sales price as a result of events that subsequently affect the purchaser’s acquired rights to service loans. Not all contingent payment provisions specified in a sale agreement represent protection provisions. For example, standard eligibility representations and warranties are not protection provisions. In addition, the following reimbursement provisions would generally not constitute protection provisions: Loan origination representations and warranties that were made by the seller of the servicing rights as the originator of the loans related to the servicing rights. Payments to the buyer that result from the seller’s prior actions as servicer of the loans (e.g., faulty servicing actions before the transfer of the servicing rights to the buyer). However, reimbursement provisions related to risks that should be absorbed by the buyer or other third parties constitute protection provisions that must be included in the 10 percent test described in ASC 860-50-40-4. These types of payment provisions differ from the reimbursement provisions discussed above because the seller of servicing rights is taking on a risk that should be absorbed by the buyer. Examples include amounts payable by the seller to the buyer for adverse changes in prepayment speeds, discount rates, or servicing costs. An entity must consider the specific facts and circumstances associated with reimbursement provisions in determining whether they represent protection provisions. For example, some payment provisions that are triggered by actions of the servicer before the sale of the servicing rights could represent protective provisions if the amount payable is not commensurate with the loss incurred by the buyer. (c) The presence of one or more of the following factors would indicate that substantially all the risks and rewards inherent in owning the MSRs have not been transferred to the buyer and that the transaction should therefore be accounted for as a financing: The seller/subservicer directly or indirectly guarantees a yield to the buyer. For example, the seller/subservicer guarantees prepayment speeds or maximum loan default ratios to the buyer. The seller/subservicer is obligated to advance a portion or all of the servicing fees on a nonrecoverable basis to the buyer before receipt of the loan payment from the mortgagor. The seller/subservicer indemnifies the buyer for damages because of causes other than failure to perform its duties under the terms of the subservicing agreement. The seller/subservicer absorbs losses on mortgage loan foreclosures not covered by the FHA, VA, or other guarantors, if any, including absorption of foreclosure costs and costs of managing foreclosed property. Title to the servicing rights is retained by the seller/subservicer. In addition, the presence of the following factors creates a rebuttable presumption that substantially all the risks and rewards inherent in owning the MSRs have not been transferred to the buyer and that the transaction should be accounted for as a financing: The seller/subservicer directly or indirectly provides financing or guarantees the buyer’s financing. Nonrecourse financing, for example, would indicate that risks have not been transferred to the buyer. The terms of the subservicing agreement unduly limit the buyer’s ability to exercise ownership control over the servicing rights or result in the seller’s retaining some of the risks and rewards of ownership. For example, if the buyer cannot cancel or decline to renew the subservicing agreement after a reasonable period, the buyer is precluded from exercising certain rights of ownership. Conversely, if the seller cannot cancel the subservicing agreement after a reasonable period, the seller has not transferred substantially all of the risks of ownership. The buyer is a SPE without substantive capital at risk.

6.5.1.2.1 Recognition if Transfer Meets the Conditions for a Sale

The transferor’s accounting for a sale of servicing rights depends on whether the servicing rights were previously (1) separately recognized or (2) included in the carrying amount of the related financial assets.

If a transfer involves separately recognized servicing assets or servicing liabilities and subservicing is not performed by the seller, the transferor should recognize the sale as follows:

Recognize:
1. An asset (liability) for the proceeds received (paid) in accordance with other U.S. GAAP.
2. A liability for any minor protection provisions.
Derecognize the carrying amount of the servicing assets or servicing liabilities sold.
Recognize a gain or loss on sale for the difference between (1) and (2).

If the transfer involves separately recognized servicing assets or servicing liabilities, and subservicing is performed by the seller on a short-term basis, the transferor should recognize the sale as follows:

Recognize:
1. An asset (liability) for the proceeds received (paid) in accordance with other U.S. GAAP.
2. A liability for any minor protection provisions.
3. An asset (liability) if the short-term subservicing agreement involves benefits of servicing that are greater than (less than) adequate compensation
Derecognize the carrying amount of the servicing assets or servicing liabilities sold.
Recognize a gain or loss on sale for the difference between (1) and (2).

If the transfer involves separately recognized servicing assets or servicing liabilities and the transferor performs subservicing on other than a short-term basis, the transferor should recognize the transaction in a manner similar to that when subservicing is performed by the seller on a short-term basis, except that any gain on sale must be deferred in accordance with ASC 860-50-40-7. Any loss on sale would generally be recognized immediately.

If the transfer involves the sale of servicing rights on financial assets that continue to be owned by the transferor and subservicing is not performed by the seller, or subservicing is performed on a short-term basis, the transferor should recognize the sale as follows:

Recognize:
1. An asset (liability) for the proceeds received (paid) in accordance with other U.S. GAAP.
2. A liability for any minor protection provisions.
3. An asset (liability) if the transaction involves a short-term subservicing agreement in which the benefits of servicing are greater than (less than) adequate compensation.
Adjust the carrying amount of the loans in accordance with ASC 860-50-40-6 (i.e., allocate the carrying amount of the loans between the loans that have been retained and the servicing rights that have been sold on a relative fair value basis). (See Example 6-6 for an illustration that involves the derecognition of a servicing liability.)
Recognize a gain or loss on sale for the difference between (1) and (2).

If the transferor performs subservicing on other than a short-term basis, the transferor is precluded from recognizing any gain on sale (a loss on sale would be immediately recognized). We generally believe that, in these situations, it is unnecessary for the transferor to derecognize any portion of the carrying amounts of the loans.

ASC 860-50-40-10 and 40-11 address a transaction involving a sale of MSRs in return for a participation in the income stream from the sold servicing rights. This guidance highlights the potential difficulty with measuring the amount of gain if the transfer qualifies as a sale.

6.5.1.2.2 Recognition if Transfer Fails to Meet the Conditions for a Sale

If a transfer of servicing rights does not meet the conditions for sale accounting, the transferor should not derecognize the servicing assets or servicing liabilities but should recognize a secured borrowing (lending) equal to the amount of proceeds received (paid). The servicing assets or servicing liabilities involved in the transfer would continue to be subsequently recognized in accordance with ASC 860-50. The entity would account for any liability (asset) for the secured borrowing (lending) in accordance with other U.S. GAAP. See Chapter 5 for further discussion of secured borrowing accounting.

6.5.1.3 Transferee’s Accounting for a Transfer of Servicing Rights

As with the accounting under ASC 860-10, the transferee’s accounting is symmetrical with the transferor’s accounting for a transfer of servicing rights.3 That is, if the transferor recognizes a sale of servicing assets, the transferee recognizes an acquisition of servicing assets. If, however, the transferor recognizes the transfer of servicing assets as a secured borrowing, the transferee must account for the transaction as a receivable from the transferor. The transferee cannot recognize the acquisition of a servicing asset in this situation because the conditions for recognition of a servicing asset in ASC 860-50-25-1(c) are not met. The same symmetrical accounting applies to a transfer of servicing liabilities.

Note that when a transferee recognizes a receivable from, or payable to, a transferor in a transfer of servicing rights that does not qualify for sale accounting, the transferee must apply other U.S. GAAP to subsequently measure the receivable or payable, unless the transferee elects the FVO.

6.5.2 Examples

Example 6-3

Transfer of Financial Assets on a Servicing-Released Basis — Servicing Rights Were Not Separately Recognized

Entity C enters into a whole-loan sale transaction that involves the sale of a portfolio of mortgage loans to a third party. Assume that the transfer (1) meets the conditions for sale accounting in ASC 860-10-40-5 and (2) occurs on a “servicing-released” basis (i.e., the buyer acquires both the transferred mortgage loans and the rights to service those mortgage loans). Entity C recognizes only the mortgage loan receivables on its balance sheet (i.e., the servicing rights are not separately recognized).

Entity C is not required to apply ASC 860-50-40 to determine the accounting for this transfer. Only ASC 860-10-40 applies. Since the conditions for sale accounting in ASC 860-10-40-5 are met, C should derecognize the mortgage loans.

Example 6-4

Transfer of Financial Assets on a Servicing-Released Basis — Servicing Rights Were Separately Recognized

In 20X1, Entity D transfers mortgage loans on a “servicing-retained” basis (i.e., D retains the rights to service those mortgage loans). This transfer qualifies for sale accounting under ASC 860-10-40-5; therefore, D derecognizes the mortgage loans and recognizes an MSR asset as part of the proceeds of the transfer.

In 20X3, D is required to rerecognize the transferred mortgage loans. In accordance with ASC 860-20-25-10(b), D continues to recognize the MSR asset related to those rerecognized mortgage loans.

In 20X4, D enters into an agreement with a third party to transfer the mortgage loans on a “servicing-released” basis (i.e., D transfers the mortgage loans and the rights to service those mortgage loans to the third party).

Entity D is required to apply both ASC 860-10-40 and ASC 860-50-40 to the transfer that occurs in 20X4. ASC 860-10-40 applies to D’s accounting for the transfer of the mortgage loans, and ASC 860-50-40 applies to D’s accounting for the transfer of the MSR asset. Unlike Example 6-3, this example addresses a situation in which ASC 860-50-40 pertains to the transfer of the servicing rights because they were separately recognized as a servicing asset on the date of the transfer.

Example 6-5

Coissue Transaction

Entity E enters into the following transactions at the same time:

A transfer of mortgage loans to the FNMA without transferring the servicing rights (i.e., servicing-retained).
A transfer of the MSRs to X, a third-party FNMA-approved servicer.
A subservicing contract with X under which E will service the transferred mortgage loans for a period of time in return for a fee that equals adequate compensation.

In this tri-party arrangement, the FNMA pays the purchase price for the mortgage loans and X pays E the purchase price for the acquisition of the servicing rights. Both payments equal fair value individually, and E is paid, in total, an aggregate amount equal to the fair value of the mortgage loans sold with servicing rights (i.e., on a servicing-released basis).

In this transaction, it would be acceptable for the transferor-seller (i.e., E) to apply either of the following views:

View A — Apply only ASC 860-10-40-5 to the transfer of the mortgage loans (i.e., assume that the servicing was a component of the mortgage loans transferred).
View B — Apply ASC 860-10-40-5 to the transfer of the mortgage loans (i.e., assume that the mortgage loans were sold with servicing retained) and apply ASC 860-50-40 to the transfer of the MSRs.

Our conclusion that these two views are acceptable is premised on the ambiguity in ASC 860-10 and ASC 860-50 with respect to how to account for such a transaction as well as on the assumption that the three parties had no prior relationships with respect to the mortgage loans transferred. An entity should elect one of the two views as an accounting policy and apply it consistently.

Example 6-6

Separation and Transfer of Servicing Obligation

Entity F is a bank that services GNMA-eligible mortgage loans (“GNMA loans”) that are held in off-balance-sheet securitization entities. The GNMA loans were originated by F, and the transfers of such loans to the securitization entities qualified for sale accounting. Entity F has the option of purchasing delinquent GNMA loans owned by the securitization entities at par under an EBO with the GNMA. The delinquent GNMA loans that may be purchased under the EBO are loans that are in the early stages of foreclosure. Entity F purchases such delinquent GNMA loans because the interest income that accrues on these loans and is paid by another government entity, such as the Department of Housing, offsets some of the foreclosure costs that F incurs to service the loans. Although F services the GNMA loans held in the securitization entities, F did not initially recognize any MSR assets or liabilities because the benefits of servicing initially equaled adequate compensation. Although some GNMA loans have become delinquent, the delinquencies have not exceeded the estimated amounts initially expected; therefore, F has not recognized any servicing liability related to this servicing activity (i.e., overall, the benefits of servicing still equal or exceed adequate compensation).

The EBO is not accounted for as a derivative instrument (therefore, for simplicity, assume that F has not recognized any asset for the EBO). When the GNMA loans become delinquent (i.e., when they become eligible for repurchase), F has regained effective control over these loans and therefore records them on its balance sheet, with an offsetting obligation for the purchase price in accordance with ASC 860-20-25-10(a). When F purchases the GNMA loans in accordance with the EBO, it extinguishes the obligation and recognizes a loss. Over time, F has accumulated a $100 million portfolio of such GNMA loans, which are recognized as receivables on F’s balance sheet. Assume that, in all cases, F has exercised its EBO; therefore, all GNMA loans that were eligible to be purchased by F have been purchased. Entity F previously recognized the following journal entries for the EBO feature and related purchases of GNMA loans:

Entity F had EBOs triggered that allowed for the purchase of $100 million of GNMA loans. In accordance with ASC 860-20-30-3, F recognized at fair value the GNMA loans over which it regained effective control. The fair value equals 98 percent of the total $100 million purchase price. The 2 percent excess of the purchase price over fair value results entirely from the fact that a servicing obligation is embedded in these GNMA loans. The fair value of the GNMA loans is not affected by credit risk because the repayment of principal and interest on these loans is guaranteed by another government entity. It is assumed that the fair value of these GNMA loans has not been affected by changes in interest rates and that recognition of an allowance for credit losses is unnecessary.

Entity F pays par to purchase the GNMA loans under the EBO and therefore recognizes a loss on extinguishment of its obligation for the purchase price. Note that although ASC 860-20 prevents an entity from recognizing a loss when it initially recognizes financial assets upon regaining control, ASC 860-20-25-12 does not preclude the recognition of a loss when the purchase price is paid and the loans are repurchased.

After purchasing these GNMA loans, F enters into an agreement with Y, a third party, to assume the servicing obligation related to these GNMA loans. As of the date of this agreement, the carrying amount of the GNMA loans on F’s balance sheet has not changed. Because the costs of servicing these delinquent loans exceeds adequate compensation, F pays Y $2 million to assume this servicing obligation. Entity F retains the right to service the performing GNMA loans that remain in the securitization entities (i.e., only the MSRs related to the GNMA loans recognized on F’s balance sheet are assumed by Y). Note that the $2 million payment to Y does not represent a prepayment of all future servicing fees; rather, this payment is the amount Y demands to service these loans after taking into account the portion of the interest coupon on the loans that Y is entitled to in return for servicing them.

Assume that the transfer of the MSRs on these GNMA loans meets the conditions for sale accounting. Therefore, F is evaluating how to account for the $2 million payment made to Y to assume this servicing obligation. Entity F considers the following views regarding the recognition of the offsetting entry for the $2 million cash paid to Y:

View A — Recognize as a prepaid servicing cost (i.e., an asset).
View B — Recognize as an increase in the carrying amount of the GNMA loan receivables.
View C — Recognize immediately as a loss.

On the basis of the facts, View B is appropriate. Application of this view is consistent with ASC 860-50-40-6. Note that when the servicing obligation is assumed, a gain or loss could arise if the amount paid differs from the adjustment to the carrying amount of the recognized GNMA loans that is made in accordance with ASC 860-50-40-6. However, there is no difference in this example. Rather, the removal of the inherent servicing obligation by using the allocation approach described in ASC 860-50-40-6, which increases the carrying amounts of the GNMA loans on F’s balance sheet, equals the amount paid to Y to assume the servicing obligation. Therefore, F recognizes the following entry:

After this entry is recognized, the carrying amount of the GNMA loans is $100 million, which equals the loans’ purchase price as well as their aggregate fair value (excluding servicing) when they were initially recognized. As discussed above, a gain or loss would have been recognized if the amount paid to Y to assume the servicing obligation had differed from the allocated carrying amount of the servicing obligation.

View A is not appropriate in this case because the offsetting entry should result in an adjustment to the carrying amount of the GNMA loans. View A and View B might not change total assets but would result in a different presentation on the balance sheet. In addition, the subsequent accounting may differ under View A because the amortization method applied to any prepaid asset may differ from the interest method under ASC 310-20.

View C is not appropriate because the economic loss resulting from the servicing obligation was recognized when the GNMA loans were repurchased and recognizing an additional loss on the transfer of the servicing obligation would result in counting the same loss twice.

Note that applying View B could result in a carrying amount of the GNMA loan receivables that exceeds the amounts for which the borrowers may prepay such loans without penalty. However, ASC 310-20-35-18(a) does not preclude recognition of this amount because it merely represents a premium paid on purchased loans.

Example 6-7

Evaluation of Reimbursement Provisions as Protective Provisions

Entity G enters into a servicing rights purchase and sale agreement (the “agreement”) with a third party to sell G’s MSRs. The MSRs are related to loans originated and sold by G and servicing rights previously acquired from Z, a third party. In addition to standard eligibility representations and warranties, the agreement contains the following reimbursement provisions:

Breach of loan origination and servicing representations — If the purchaser receives any request to repurchase a loan because of (1) a breach of an origination representation or warranty on any mortgage loan that was originated by G or (2) any breach of a servicing obligation by G before the date of the agreement, G is required to indemnify the purchaser for any losses, costs, or expenses related to this repurchase. (Note that this provision is only related to any breach associated with G’s actions upon origination of a mortgage loan or servicing of any mortgage loan. That is, this loss reimbursement is related only to G’s actions that were taken during the loan origination process or servicing process before the date of the agreement.)
Breach of third-party origination representations — If the purchaser receives any request to repurchase a loan that was originated by Z because of a breach of an origination representation or warranty made by Z, as originator of the loan, G is required to indemnify the purchaser for any losses, costs, or expenses related to this repurchase in the event that the purchaser is unable to collect such amounts from Z within 60 days of the purchaser’s submission of a claim to Z. (Note that any payment by G under this provision does not relieve Z from its obligation to indemnify G. That is, G maintains the right to seek reimbursement from Z for any payment made to the purchaser.)
Assessment of compensatory fees — G is responsible and liable for any fees or penalties imposed by the FHLMC and FNMA related to any mortgage loan foreclosures that exceed the required timelines of the FHLMC and FNMA. Entity G is responsible only for such fees that pertain to the period before the date of the agreement (i.e., fees that result from actions of G as servicer).

In view of the definition of protection provisions in ASC 860-50-40, provisions that must be evaluated under ASC 860-50-40-3(c) and 40-4 are those designed to (1) reflect a purchase price adjustment or (2) protect a purchaser against losses associated with the servicing rights acquired. That is, protective provisions are contract terms that are intended to adjust the sales price as a result of events that subsequently affect the purchaser’s acquired rights to service loans. Not all contingent payment provisions specified in a sale agreement represent protection provisions. An entity must use judgment to determine whether a reimbursement provision affects the risks and rewards of ownership of servicing rights.

Breach of Loan Origination and Servicing Representations

These contingent payments are related to G’s past actions. Such obligations would be retained by G regardless of whether G had sold the MSRs or acknowledged such a liability in the agreement. That is, the purchaser of MSRs may incur losses related to G’s past actions and these reimbursement provisions merely serve to acknowledge that any such losses are G’s responsibility. Therefore, these reimbursement provisions are not designed to provide any protection or adjustment related to the purchaser’s rights to service the mortgage loans (i.e., any such payments made by G under these provisions do not result in an adjustment to the sales price of the MSRs). The purchaser of the MSRs is merely acting as a collection agent for the owners of the underlying mortgage loans, and any payments made by G under these reimbursement provisions reflect amounts that ultimately are borne by the owners of the underlying mortgage loans. The obligation of G to make payments for these breaches either existed as of the date the mortgage loans were sold to third-party investors or result from actions of G as servicer (i.e., G’s obligation to make payments under these provisions did not arise from the agreement, and the fact that the purchaser of the MSRs is now servicing the loans does not change G’s obligations). Since this reimbursement provision is merely a mechanism to indemnify the new servicer for obligations that G had before the agreement, these payment provisions do not reflect protection provisions under ASC 860-50. Note that in reaching this conclusion, we determined that any indemnification of the purchaser of the MSRs for damages that result from G’s faulty servicing before the agreement does not protect the purchaser of the MSRs for risks of future changes in the fair value of the MSRs.

Breach of Third-Party Origination Representations

This payment provision requires G to retain a risk that is typically borne by a servicer of mortgage loans. Before the agreement, G was exposed to losses resulting from Z’s breach of origination representations to the extent that G was unable to collect amounts paid from Z. We would expect that, upon the sale of MSRs, this risk would be transferred to the purchaser as subsequent servicer. By agreeing to reimburse the purchaser for any losses incurred as a result of origination representations breached by Z that Z does not reimburse to the purchaser within 60 days, G is retaining a servicing risk associated with the MSRs. In other words, G is effectively becoming obligated for a risk for which only Z should be obligated. Therefore, this reimbursement provision represents a protective provision under ASC 860-50.

Assessment of Compensatory Fees

This payment provision does not represent a protective provision under ASC 860-50 for the same reasons described above for indemnifications that arise from G’s servicing of the mortgage loans before the date of the agreement.

Example 6-8

Evaluation of Repurchase Provision as a Protective Provision

Entity H enters into an agreement to sell MSRs to Entity W. As part of the sale agreement, H has agreed that, for the next two years, it will not solicit a refinancing of any mortgage loan that is being serviced by W after the sale transaction. This nonsolicitation obligation only precludes H from soliciting refinancing transactions; H is permitted to refinance any mortgage loan that is being serviced by W as long as the borrower approaches H regarding the refinancing. Entity H cannot, however, solicit the refinancing unless its nonsolicitation obligation is explicitly waived by W.

The nonsolicitation obligation does not represent a protective provision. While this provision does reduce, to some extent, the prepayment risk to W, any payment arises from an action within the control of H. Furthermore, this provision is akin to a standard representation and warranty.

Footnotes

Note that although some of the guidance in ASC 860-50 is discussed in the context of MSRs, the guidance applies to transfers of all types of servicing rights.

We have previously discussed this issue with staff members of the SEC’s Office of the Chief Accountant.

6.7 Other Considerations

6.7.1 Derivatives and Hedging

ASC 860-50

Derivatives and Hedging

60-1 For guidance on whether an entity may designate as the hedged item in a fair value hedge a portion of a recognized servicing right asset subsequently measured using the amortization method, see paragraph 815-20-55-65.

For risk management purposes, entities often enter into transactions involving derivative instruments and cash instruments (e.g., securities) to economically hedge the change in fair value of MSRs. The related hedging strategies are often complex because of the convexity risk and other duration-related risks associated with MSRs. As a result, entities may economically hedge MSRs without applying hedge accounting. An economic offset will naturally occur, to some extent, if the entity elects use the fair value method to account for MSRs. While ASC 815-20 does not preclude applying fair value hedging to MSRs that are accounted for by using the amortization method, it is often difficult to define a hedging strategy that is highly effective for accounting purposes. For more information on fair value hedging, see ASC 815-20-55-65.

6.7.2 Mortgage Banking

ASC 860-50

Financial Services — Mortgage Banking

60-2 For guidance on the capitalization of interest costs on certain Government National Mortgage Association (GNMA) securities, and the determination of net future servicing income for this purpose, see paragraph 948-340-30-1.

ASC 948-340-30-1 addresses how costs are capitalized when GNMA securities are issued and indicates that the aggregate amount capitalized, including amounts capitalized under other FASB ASC subtopics, may not exceed the present value of net future servicing income.

Chapter 7 — Comparison of U.S. GAAP and IFRS Accounting Standards

7.1 General

Under U.S. GAAP, ASC 860 is the primary source of guidance on accounting for transfers and servicing of financial assets. Under IFRS Accounting Standards, IFRS 9 is the primary source of guidance on accounting for transfers of financial assets and initial recognition of servicing rights. IFRS 9 also is the primary source of guidance on the recognition and measurement of all financial assets and financial liabilities.

This chapter focuses on transfers and servicing of financial assets. ASC 860 and IFRS 9 also provide guidance on accounting for collateral arrangements, but this guidance is substantively the same. The table below summarizes some of the key differences between IFRS Accounting Standards and U.S. GAAP with respect to transfers and servicing of financial assets.1

Table 7-1

Subject	U.S. GAAP	IFRS Accounting Standards
Transfers of financial assets — control versus risks and rewards of ownership (see Section 7.2.1)	A control-based model is used. Under this model, each party to a transfer of financial assets recognizes or continues to recognize the assets that it controls and derecognizes assets when control is surrendered.	A multistep derecognition model is used. Under this model, an entity first considers risks and rewards, then considers control. In certain arrangements, derecognition may apply even when the asset is not transferred but the entity has an offsetting obligation to pass through the cash flows of a particular asset.
Transfers of financial assets — definition of control (see Section 7.2.2)	Control of a financial asset is surrendered only if (1) the transferred asset is legally isolated from the transferor and its consolidated affiliates; (2) the transferee has the ability to freely pledge or exchange the transferred financial asset (or third-party beneficial interest holders have the right to pledge or exchange the beneficial interests if the transferee’s sole purpose is to engage in securitization or asset-backed financing activities); and (3) the transferor, its consolidated affiliates, or agents do not maintain effective control over the transferred asset through other rights.	Control of a financial asset is surrendered if the transferee has the unilateral ability to sell that transferred asset. However, control is not the sole determining factor in the assessment of derecognition.
Transfers of financial assets — transfers of a portion of a financial asset (see Section 7.2.3)	Derecognition of a portion of a financial asset is allowed if the portion of the financial asset meets the definition of a participating interest in ASC 860-10-40-6A and all the conditions in ASC 860-10-40-4 through 40-5A are met for that participating interest.	For a specified portion of a financial asset to be assessed for derecognition, certain conditions must be met. If these conditions are not met, the entire asset must be assessed for derecognition.
Transfers of financial assets — retaining the rights to the cash flows of a financial asset (“pass-through arrangements”) (see Section 7.2.4)	Derecognition of a financial asset is not allowed if the contractual rights to the cash flows of that asset are retained.	An entity can derecognize a financial asset regardless of whether it retains the right to the contractual cash flows of that asset, provided that three restrictive conditions for pass-through arrangements are met.
Transfers of financial assets — impact of a cleanup call (see Section 7.2.5)	A call option held by a transferor that is also the servicer and that meets the definition of a cleanup call does not cause the transferor to maintain effective control over the transferred financial assets.	Regardless of whether a call option is considered a cleanup call, an entity must consider the effect of that call option when determining whether substantially all the risks and rewards of ownership of a financial asset are transferred or retained and whether control over the financial asset is surrendered.
Transfers of financial assets — repurchase agreements (see Section 7.2.6)	An entity must consider the restrictive conditions in ASC 860-10-40-24 and 40-24A, in addition to the criteria in ASC 860-10-40-4 through 40-5A, when determining whether continued recognition of a transferred financial asset subject to a repurchase agreement is appropriate.	Conditions for derecognition that are specific to repurchase agreements are not provided. Rather, derecognition of a repurchase agreement must be determined on the basis of (1) whether substantially all the risks and rewards of ownership of the financial assets are transferred or retained and, (2) in cases in which substantially all the risks and rewards of ownership have been neither transferred nor retained, whether control over the financial assets is surrendered.
Transfers of financial assets — recognition and measurement of a secured borrowing (see Section 7.2.7)	A secured borrowing equal to the consideration received must be recognized if a transfer of financial assets fails to qualify for derecognition. Guidance on the subsequent measurement of a secured borrowing is not provided.	Recognition and measurement of a secured borrowing depend on why the secured borrowing is being recognized. If a secured borrowing is recognized because an entity retains substantially all the risks and rewards of ownership of a financial asset, a secured borrowing equal to the consideration received is initially recognized. If a secured borrowing is recognized because an entity has neither retained nor transferred substantially all risks and rewards but has retained control over the financial asset, the secured borrowing is initially recognized only to the extent of the entity’s continuing involvement in the transferred asset.
Accounting for servicing rights — initial measurement of a servicing asset (see Section 7.3.1)	A servicing asset must be initially recognized at fair value.	A servicing asset retained as part of a transfer of financial assets is considered a retained interest in those transferred assets. Therefore, the servicing asset is initially recognized at its allocated previous carrying amount on the basis of its relative fair value as of the transfer date.
Accounting for servicing rights — subsequent measurement of a servicing asset or liability (see Section 7.3.2)	An entity has the option of subsequently measuring a servicing asset or liability at either fair value or amortized cost.	Guidance is not provided on the subsequent measurement of a servicing right because it is not considered a financial instrument. In practice, entities often account for servicing assets in accordance with IAS 38 and servicing liabilities in accordance with IAS 37.

Footnotes

Differences are based on comparison of authoritative literature under U.S. GAAP and IFRS Accounting Standards and do not necessarily include interpretations of such literature.

7.3 Accounting for Servicing Rights

7.3.1 Initial Measurement of a Servicing Asset or Liability

Under U.S. GAAP, ASC 860-50-30-1 requires that servicing assets and liabilities retained by the transferor in a sale or securitization of financial assets be initially recognized and measured at fair value.

Under paragraph 3.2.10 of IFRS 9, when a transfer of a financial asset qualifies for derecognition in its entirety and a right to service the financial asset is retained, that servicing right is recognized as a servicing asset or liability. If the fee received for servicing the asset is expected to more than adequately compensate the servicer, a servicing asset is initially recognized at the allocated previous carrying amount of the transferred financial asset on the basis of the relative fair values of the assets that continue to be recognized and the assets that are derecognized. A servicing asset under IFRS Accounting Standards, unlike a servicing asset under U.S. GAAP, is not initially recognized at fair value; however, if the transferred asset was previously measured at fair value, the amount allocated to the servicing asset may be expected to equal its fair value. Nevertheless, if the fee received for servicing the asset is not expected to adequately compensate the servicer, a servicing liability is recognized at fair value.

7.3.2 Subsequent Measurement of a Servicing Asset or Liability

Under U.S. GAAP, ASC 860-50-35-1 allows an entity to subsequently measure a recognized servicing asset or liability at either fair value or amortized cost. If subsequent measurement at fair value is elected, that election is irrevocable and the period change in fair value of the servicing asset or liability is recognized in current-period earnings. If subsequent measurement at amortized cost is elected, the servicing asset or liability is amortized to earnings in proportion to and over the period of estimated net servicing income (or loss).

Under IFRS Accounting Standards, while the initial recognition of a servicing asset or liability resulting from a transfer of financial assets is within the scope of IFRS 9, a servicing right is not considered a financial instrument. Therefore, the subsequent measurement of a servicing right is not within the scope of IFRS 9. If the servicing right recognized is an asset, an entity would look to IAS 38 for guidance on subsequent measurement, while a servicing liability would be within the scope of IAS 37.

Appendix A — Glossary of Selected Terms

Appendix B — Titles of Standards and Other Literature

Appendix C — Abbreviations

Abbreviation	Description
ADC	acquisition, development, or construction
AICPA	American Institute of Certified Public Accountants
AOCI	accumulated other comprehensive income
ASC	Accounting Standards Codification
ASU	Accounting Standards Update
BOLI	bank-owned life insurance
BRSPE	bankruptcy-remote special-purpose entity
CFE	collateralized financing entity
CLO	collateralized loan obligation
CMBS	commercial mortgage-backed securities
CMO	collateralized mortgage obligation
COLI	company-owned life insurance
CP	commercial paper
CSA	credit support annex
CUSIP	Committee on Uniform Securities Identification Procedures
DPP	deferred purchase price
EBO	early buyout program
EITF	FASB’s Emerging Issues Task Force
EPD	early payment default
FASB	Financial Accounting Standards Board
FDIC	Federal Deposit Insurance Corporation
FHA	Federal Housing Authority
FHLMC	Federal Home Loan Mortgage Corporation
FIFO	first-in, first-out
FNMA	Federal National Mortgage Association
FSP	FASB Staff Position
FVO	fair value option
GAAP	generally accepted accounting principles
GNMA	Government National Mortgage Association
HFI	held for investment
HFS	held for sale
HUD	U.S. Department of Housing and Urban Development
IASB	International Accounting Standards Board
IFRS	International Financial Reporting Standard
IO	interest-only
LIBOR	London Interbank Offered Rate
LIFO	last-in, first-out
LLC	limited liability company
MBS	mortgage-backed security
MSR	mortgage servicing right
OCI	other comprehensive income
PCAOB	Public Company Accounting Oversight Board
Q&A	question and answer
QSPE	qualified special-purpose entity
ROAP	removal-of-accounts provision
SAB	SEC Staff Accounting Bulletin
SBA	Small Business Act
SEC	Securities and Exchange Commission
SFAS	Statement of Financial Accounting Standard
SIFMA	Securities Industry and Financial Markets Association
SPE	special-purpose entity
TBA	to-be-announced
TPP	third-party purchaser
VA	U.S. Department of Veteran Affairs
VIE	variable interest entity

Appendix D — Roadmap Updates for 2024

The table below summarizes the substantive changes made in the 2024 edition of this Roadmap.

Amended Content

Section	Title	Description
4.2.1.1	Derecognition of Assets Sold and Recognition of Proceeds — General	Added discussion about transferee’s initial measurement of debt securities acquired in the market that were also subject to an expired option within the scope of the “Certain Contracts on Debt and Equity” subsections of ASC 815-10.
5.3.3	Accounting for Noncash Financial Assets in a Secured Borrowing	Clarified accounting for repledging noncash collateral held in a secured borrowing.

	Jonathan Howard Partner Deloitte & Touche LLP +1 203 761 3235 jonahoward@deloitte.com		Ashley Carpenter Partner Deloitte & Touche LLP +1 203 761 3197 ascarpenter@deloitte.com
	Brandon Coleman Partner Deloitte & Touche LLP +1 312 486 0259 brcoleman@deloitte.com		Magnus Orrell Managing Director Deloitte & Touche LLP +1 203 761 3402 morrell@deloitte.com
	Andrew Pidgeon Partner Deloitte & Touche LLP +1 415 783 6426 apidgeon@deloitte.com