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By Kevin Michel, CPA, CMA, vice-president, financial reporting, Merrill Lynch & Co., Inc.

Recently, the FASB held public hearings on a proposed Statement of Financial Accounting Standards, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (the exposure draft or ED).

The exposure draft has far-reaching implications for any entity engaged in the financing of receivables, investments, trading securities, or other financial assets. Not only would all parties to securitizations and repurchase agreements be affected, but small businesses that pledge stocks and bonds as collateral to obtain a loan would have to follow the new accounting. Even the accounting for the purchase of common stock "on margin" from a broker would be changed if the ED is adopted in its current form.

The exposure draft redefines the criteria for recognizing and derecognizing financial assets on a company's balance sheet. Any time financial assets are transferred to another entity, both the transferor and the transferee must determine whether the assets belong on their respective balance sheets, how they should be classified, what value to recognize, and how changes in valuation should be recorded. The answers to these questions are far from simple, and they challenge our long-held notions of "ownership."

Innovative Transactions

Because financial institutions have found new ways to derive earnings from using assets that "belong" to themselves and others, questions have arisen concerning ownership and recognition. Let us first examine some of these innovative

Securities, in particular U.S. Treasury securities, can be sold with an understanding they will be repurchased at an agreed upon price at some future date. This is known as a repurchase agreement, or "repo." The seller would undertake the transaction as a way to raise cash inexpensively. The difference between the proceeds received today and the amount to be paid in the future may be viewed as a financing cost, or interest. The buyer of the securities pays cash and is compensated for the time value of the money.

Over the life of the agreement, the buyer (who holds the securities) can do a number of things with them.

* It can enter into its own repurchase agreement at a better price and earn a spread. This is known as a "matched-book" repo.

* It can use the securities to deposit as collateral with another party in lieu of cash. By doing this, the depositor of the collateral obtains a return on its funds without incurring interest rate risk. (Remember, the securities will be resold later at a prearranged price.)

* It can use the securities to settle a "short" sale that is costly to keep open.

Now let us examine a simpler situation. A small business has invested funds in U.S. Treasury Bonds due in ten years. The business is in need of cash to purchase merchandise for its peak selling season. The Treasury Bonds could be sold, but after the season, the excess cash will have to be reinvested. In addition, if the bonds are sold, a gain or loss will have to be recognized through the income statement. This is because the investment is appropriately classified as "available for sale."

The business manager discovers a bank will lend money to the business at a low rate of interest if the U.S. Treasury Bonds are used for collateral. The manager is told the interest rate will be an eighth of a point lower if he allows the bank to "hypothecate" or sell the collateral. This means the bank can lend the Treasury Bonds to others or it can sell them. But the bank must return the Treasury Bonds to the business when the loan is repaid, and it must turn over to the small business borrower all interest collected on the bond coupons. Since it lowers the cost of borrowing, and the manager is assured the collateral will be returned, the transaction is completed. Note the bank has paid a price, in the form of lower interest on the loan, for the right to earn money on the collateral.

Who "Owns" an Asset?

The terms of transactions such as these have led the FASB to question who really owns the assets that have been transferred. Does the small business own the Treasury Bonds or has it temporarily sold them? Does the bank own the bonds, or does it simply have custody? What does ownership entail?

The FASB concluded in the exposure draft that the right to control a financial asset should govern the accounting. The ED would require the bank to record the Treasury Bonds on its balance sheet since it has control over their use and can obtain benefits from holding the bonds. The small business would not be required to treat the bonds as sold since they will come back after the loan is paid. However, the bonds would have to be reclassified from Investments Available for Sale to a newly defined asset "Securities Receivable."

The FASB's basis for its conclusion is that an asset represents future benefits, and the party that controls such benefits should recognize the asset. This accounting has been termed the financial components approach. It is deemed preferable because it is said to recognize substance over form.

Current Practice

Current practice differs significantly from the proposed accounting. The risks-and-rewards approach holds that the equitable owner of the instrument recognizes the asset. In our loan example, the small business stands to ultimately gain or lose on its investment in the U.S. Treasury Bonds. If the loan were to default and the bank sold the bonds, any excess would be due to the small business. Similarly, any deficiency would have to be made up. Therefore, the small business continues to record the assets as an investment, but discloses the pledge and hypothecation agreement in its notes to the financial statements. The bank would not record the collateral on its books. But it does disclose information about collateral in accordance with SFAS No. 105, Disclosure of Information About Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentration of Credit Risk.

The only exception in current practice is when cash is used as collateral. In that case, many financial institutions record the cash held. However, practice varies with brokers generally recording the cash while banks often do not. The rationale for recording the cash can be supported in a number of ways:

* The small business would have to remove the cash from its balance sheet, so it should be recorded somewhere.

* Internal control is improved if the accounting records of the holder reflect the cash and the obligation to repay.

* The lender is free to do whatever it pleases with the cash.

It is the last statement that has caused us to reexamine our assumptions about transferred financial assets. The question arises: If cash collateral should be recognized by the holder, why shouldn't securities also be recognized? After all, the lender can sell the U.S. Treasury Bonds in a repo transaction. It can use them to settle a short sale that was effected as a hedge of its own investments. The bank can also lend them to another financial institution that has a need for the bonds.

The only condition is that the bank must return the collateral when the loan is repaid. This is the same condition that exists with respect to the cash, which is recorded. So what's the difference?

Alternative View

The FASB concluded there was no difference, and collateral securities that could be used by a holder to derive revenue through the types of transactions described above should be recorded by the holder. However, this author takes a different view that was expressed at the public hearings.

The author believes the right to use securities owned by another party is incidental to all of the rights embedded in the security. The benefits controlled by the equitable owner are much greater than the benefits controlled by the holder or secured party. In the case of cash collateral, however, the author agrees that the holder of the cash controls all of the benefits and should record the asset (absent any requirement that the cash be segregated, held in safekeeping, or held by a third party).

This argument is supported by reference to the Capital Asset Pricing Model. That theory holds that the value of an asset is equal to the present value ("PV") of all future cash flows. In the case of an equity security, the value is commonly viewed as the PV of all future dividends and returns of capital. In the case of a debt instrument, the value is commonly viewed as the PV of all future interest and principal.

By reference to the innovative transactions described above, it can be seen that additional cash flows can be obtained over the life of an instrument. By entering into repo and securities lending activities, a holder derives a return merely by possession and the right to hypothecate the security. This return can be thought of as "rent."

Since there is an additional cash flow from rent, then there must be a rental value inherent in certain securities. Accordingly, the Capital Asset Pricing Model should incorporate these cash flows. However, it is clear this value of holding a security is incidental; otherwise the model would not have worked in the past. In other words, the rights of an equitable owner of a security to dividends, interest, and return of capital are far superior to the rights of a holder of the security to rent it out.

Now let us examine cash. There have been few attempts to calculate the theoretical value of cash. As many accountants have said, "Cash is cash." Yet it is not difficult to conceive the value of cash in the Capital Asset Pricing Model as simply its rental value. There are no future cash flows. The only return that can be derived from cash is through the holder's renting it out to others.

The Process Is Not Over

Accounting is not a natural science but a means of communication. We will probably never be able to measure precisely the separate benefits of ownership and custody. It is unlikely that possession should be nine-tenths of accounting, but is there any better answer?

By proposing the financial components approach and the control model, the FASB caused the accounting profession to question the assumptions on which current practice is based. This critical thinking exercise has been beneficial to all

In the months ahead the FASB will be working toward a conclusion on this important topic as well as many other aspects of the financial instruments project. It is essential that we as a profession participate in the process. *


Douglas R. Carmichael, PhD, CPA

Baruch College

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