Speech by SEC Staff:
2003 Thirty-First AICPA National Conference on Current SEC Developments


Eric Schuppenhauer

Professional Accounting Fellow, Office of the Chief Accountant
U.S. Securities and Exchange Commission

Washington, D.C.
December 11, 2003

As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.


Good morning. It is a pleasure to have the opportunity to speak at this conference. Today, I will provide you with comments related to: (1) loan commitments, (2) the consideration of what have been called "kick-out rights" in the consolidation model, and (3) certain observations related to the implementation of FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities.

Loan Commitments

The appropriate accounting for loan commitments, or what you and I would think of as a mortgage commitment with an interest rate lock, has garnered a lot of attention lately. This attention has focused on whether the loan commitments are derivatives and, if so, how they should be valued. In DIG Issue C131, the FASB staff concluded that loan commitments that relate to the origination of mortgage loans that will be held for resale2 must be accounted for as derivatives in accordance with Statement 133. All other loan commitments have been excluded from Statement 133's scope, pursuant to Statement 149.3

That leaves loan commitments related to mortgage loans that will be held for resale as the only commitments required to be marked to market under Statement 133. Of course, the vast majority of residential mortgage loans are indeed sold in some manner, through either an agency sale or a securitization transaction. As such, the issue of how to value the related loan commitments may be material to many mortgage lenders. Our understanding is that many registrants may have recognized loan commitments that relate to the origination of mortgage loans that will be held for resale even prior to this year's finalization of DIG Issue C13 and Statement 149.

I want to convey two thoughts with respect to these loan commitments.

First, if you had not previously recognized loan commitments that relate to the origination of mortgage loans that will be held for resale, you are now required to do so pursuant to Statement 149. This guidance became effective for fiscal quarters that began after June 15, 2003. Hopefully this does not come as news to anyone.

Second, it has come to our attention that there is diversity in practice related to the measurement of these loan commitments. The FASB has recently added a project to its agenda to deal with this issue. As we understand it, some registrants believe that initial measurement of these loan commitments should result in an asset, while others have concluded that the initial measurement is zero or results in a liability. So, as you can see, there is a little bit of diversity.

The FASB will continue to deliberate this issue and we look forward to the Board's guidance. However, in the meantime, the staff's view of the applicable literature is that, because loan commitments that are recognized as derivatives pursuant to Statement 133 are written options, a liability should be recognized initially, with the offsetting debit (to the extent that consideration is not received) recorded in the income statement. We recognize that given the low levels of volatility in these short-term instruments, the value of the liability may be very small. Subsequent to initial measurement, the staff would expect that the loan commitment would be valued like other written options. That is, the amount would always be reported as a liability until expiration or termination of the commitment.

We reached this position after discussions with constituents who said they believe there is a value in the marketplace that suggests that the loan commitment should be recorded as an asset, as indicated by acquisitions of mortgage banking pipelines in a business combination. The staff observed, however, that these market transactions are valuing two components when pricing the mortgage banking pipeline; first, the written option liability and, second, an internally-developed intangible asset representing the customer or servicing relationship. While such intangibles should be recognized in a business combination, internally-developed customer or servicing relationship intangibles like these should not be recognized. Only the derivative that arises from a loan commitment should be recognized, not the related customer or servicing relationship intangible.

In our discussions regarding loan commitments that relate to the origination of mortgage loans that will be held for resale, we have indicated that we expect the practice of recognizing assets, and no liabilities, to be discontinued. In view of the ongoing discussions and the nature of this particular issue, we would not object if registrants discontinue this practice beginning with commitments entered into in the first reporting period beginning after March 15, 2004. Any previously recognized loan commitments should be taken care of in the normal course of closing loans in the mortgage pipeline. Registrants, however, should disclose this upcoming change in their accounting policies and the anticipated impact of the change in accordance with SAB 744 in any filings with the Commission that pre-date the change. We plan to memorialize our thoughts on this matter in a Staff Accounting Bulletin.

Substantive "Kick-Out" Rights

In 1978, the Accounting Standards Executive Committee (AcSEC) issued a Statement of Position, SOP 78-95, on accounting for investments in real estate ventures. In that SOP, a sole general partner is deemed to control a limited partnership, unless the limited partners have important rights, such as "the right to replace the general partner or partners, approve the sale or refinancing of principal assets, or approve the acquisition of principal partnership assets."6 If those important rights exist and are substantive, the sole general partner is not deemed to control the partnership and therefore, does not consolidate the partnership. Since the issuance of that SOP, there has been diversity in practice on how to determine whether removal or, as they have recently come to be known - kick-out rights, are substantive. The EITF attempted to deal with this issue in EITF Issue 98-67, but a consensus was never reached. No other standard-setting activity has taken place in this area.

As many of you are probably aware, the issue of kick-out rights has most recently surfaced in the context of FIN 46. Specifically, the FASB has concluded that, in determining a primary beneficiary in the variable interest entity model, the fees paid to a decision maker are not a variable interest if, among other things, the decision maker can be removed without cause, otherwise referred to as the ability to be kicked-out, and the kick-out rights are substantive. In its recently issued FASB Staff Position, FSP FIN 46-78, the FASB staff has provided a set of criteria that must be met to conclude that kick-out rights are substantive. In that FSP, the FASB staff concluded that kick-out rights are substantive if they have both of the following characteristics:

  1. The decision maker can be removed by the vote of a simple majority of the voting interests held by parties other than the decision maker and the decision maker's related parties, and
  2. The parties holding the kick-out rights have the ability to exercise those rights if they choose to do so, that is, there are no significant barriers to the exercise of the rights.

The staff believes that this guidance represents the most recent thinking on the topic of whether a kick-out right is substantive. As such, the SEC staff is in the process of evaluating whether this guidance should be extended to other consolidation evaluations, such as those encountered in the context of SOP 78-9. Preparers and auditors may want to do the same as they evaluate newly created entities.

FASB Interpretation No. 46

FIN 46 has been mentioned a couple of times during the course of this conference already and will probably be mentioned many more times before the conference is over, but I could not pass up an opportunity to talk about this very important accounting guidance. Specifically, I would like to provide registrants with some things to consider as they adopt FIN 46.


First, let me hit on the status of things and how registrants should be thinking about the emerging FIN 46 guidance as they head into the end of the year. The FASB re-deliberated most aspects of the modifications exposure draft at its meeting yesterday following the comment period that ended December 1st. My understanding is that the FASB will meet again next week to discuss this project further. I am sure that Bob Herz and Mike Crooch will have more to say on status during their remarks.

Scope Exception for Lack of Information

In its re-deliberations yesterday, the FASB decided to provide enterprises with an exception from applying the interpretation if such enterprise has an interest in a variable interest entity or potential variable interest entity created before December 31, 2003, if the enterprise, after making an exhaustive effort, is unable to obtain the information necessary to do what is required to apply FIN 46.

Our understanding was that this scope exception was provided in response to concerns raised by constituents that they were unable to obtain the information to apply FIN 46 to entities in existence prior to the effective date of FIN 46 because of legal or other barriers, such as privacy laws in foreign jurisdictions. It was intended for those situations and should be limited to those situations.

In this regard, I would like to make a few observations.

First, the scope exception only applies to an enterprise with an interest in a variable interest entity or potential variable interest entity created before December 31, 2003. For instance, in making a determination whether to apply the scope exception, registrants should carefully consider whether the entity was really created prior to December 31st or was merely in existence prior to that date and re-configured in such a way that the "creation date" of the legal entity is not relevant. For instance, if an entity was inactive for a number of years and then re-activated after December 31st to carry out new activities and issue new variable interests, the staff would consider the use of the information scope exception abusive.

Second, the staff has begun to contemplate the meaning of "an exhaustive effort" in applying this limited scope exception. Consistent with the thoughts of the FASB, as expressed in the modifications to FIN 46, the staff anticipates that the use of the exception will be infrequent. We plan to deal with instances where the information scope exception is being applied on a case-by-case basis, considering all of the relevant facts and circumstances. In assessing those facts and circumstances, the staff can be expected to consider whether registrants operating in the same industry with similar types of arrangements were able to obtain the requisite information.

The Hanging Paragraph

Just one more FIN 46 observation before I conclude.

The staff has received a number of inquiries on how to apply the guidance contained in the last sentence of paragraph 5 of FIN 46, soon to be paragraph 5(c) of FIN 46, as soon-to-be-modified. That sentence states, in part: "[t]he equity investors as a group also are considered to lack characteristic (b)(1) if (i) the voting rights of some investors are not proportional to their obligations to absorb the expected losses of the entity, their rights to receive the expected residual returns of the entity, or both and (ii) substantially all of the entity's activities (for example, providing financing or buying assets) either involve or are conducted on behalf of an investor that has disproportionately few voting rights."

The intent of this provision is to move the consolidation analysis from the voting interests model to the variable interests model in those instances where it is clear that the voting arrangements have been skewed such that the investor with disproportionately few voting rights, as compared to its economic interest, derives substantially all of the benefits of the activities of the entity. In other words, it is an abuse-prevention mechanism intended to identify instances where there is something occurring in the relationship that indicates the voting arrangements are not useful in identifying who truly controls the entity.

The first part of the provision is an assessment of whether the votes are consistent with the economics. It's pretty straight-forward.

The second part of this provision is where more judgment is involved. In the event that a registrant concludes that it has disproportionately few voting rights compared to its economics, there must be an assessment of whether substantially all of the activities of the entity either involve or are conducted on behalf of the registrant. There is no "bright-line" set of criteria for making this assessment. All facts and circumstances, qualitative and quantitative, should be considered in performing the assessment.

As always, if you are uncertain, please do not hesitate to contact us in the Office of the Chief Accountant. Russell Hodge will be covering the protocol for consultation with our office during the next panel discussion.