of Financial Assets Under SFAS No. 125

Risks and rewards are out, and control and financial components are in.

By Gregory D. Kane

In Brief

New Accounting Concepts for
Transfer

Under SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, qualifying transactions will be treated as sales, and accounting for all component rights and obligations arising from the transaction will be based on a financial component approach.

To qualify as a sale, the transferor must surrender control. The sale is recognized to the extent consideration other than beneficial interests in the transferred assets are received by the transferor.

Surrendering control is based on tests involving the isolation of the transferred assets, whether the transferee has the right to pledge and/or exchange the transferred assets or is a special purpose entity, and whether the transferor maintains effective control over the transferred assets.

If the transfer qualifies as a sale, the transferred assets are derecognized and decomposed into separate financial components. Retained components remain at book value. Assets obtained and liabilities incurred on the sale are measured at fair value.

Issues addressed by the standard include how to allocate the book value of transferred assets among the resultant components, how to draw the distinction between components retained and those obtained or incurred, and measuring fair value for components. The concept for recognizing income is revolutionary and may become the model for other complex transactions.

In June 1996, the FASB issued statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. The scope of the new standard is quite broad and may apply to any transaction involving the transfer of financial assets. Typical transactions that might be affected include securitizations, collateralized mortgage obligations, sales of financial assets with retained servicing arrangements and/or options for repurchase, transfers of loan receivables with recourse, securities lending transactions and repurchase agreements, loan participations, and factoring arrangements.

For those transactions that qualify for treatment under SFAS 125, current practice will be substantively affected as all qualifying transactions will be treated as sales and all component rights and obligations that arise from such transactions will be recognized in "piecemeal" fashion. The measurement and valuation of such components will be based on a mix of book value allocation--for those components that are viewed as retained by the transferor firm--and fair value for those "assets obtained and liabilities incurred" in a qualifying transaction.

The new standard supersedes the following promulgations: SFAS No. 76, Extinguishment of Debt; No. 77, Reporting by Transferors for Transfers of Receivables with Recourse; No. 122, Accounting for Mortgage Service Rights; and FASB Technical Bulletins No. 84-4, In-Substance Defeasance of Debt; and 85-2, Accounting for Collateralized Mortgage Obligations. The standard is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after December 31, 1996. In December 1996, the FASB issued SFAS No. 127, Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125. Provisions of the statement relating to secured borrowings and collateral and accounting for transfers and servicing of financial assets for repurchase agreement, dollar-roll, securities lending, and similar transactions are effective one year later.

The standard is intended to minimize inconsistencies in how transfers of financial assets are accounted for. Previous standards permitted transfers of financial assets to be recognized as either sales or collateralized loans, depending on what a transaction "purported" to be, i.e., its legal form. The new standard, based on a "financial components" approach, differs conceptually from previous standards. Instead of recognizing asset transfers as a complete sale or loan, the financial components approach separately recognizes each of the component interests that may arise from transactions involving financial asset transfers. Such a decomposition of the original assets allows the recognition process to be more informative and flexible. In particular, some component interests, if they pass to other parties, can be recognized as sold, while other interests retained by the transferor firm can be reported and treated as unsold components. Such components might include options, rights to service assets, forward sales agreements, spread accounts, interest-only strip receivables, recourse agreements, and forward contracts and options. By recording the transfer of financial assets in this piecemeal manner, a number of benefits may occur, including availability of more complete data, avoidance of inconsistencies caused by forcing hybrid transactions to be characterized as a complete sale or loan, and better representation in the financial statements of the economic benefits, obligations, and risks associated with financial asset transfers. In addition to resolving inconsistencies associated with previous reporting practices, the financial components approach is also designed to be more congruous with recent innovations in the financial markets, i.e., the trend toward divisibility and hybridization of financial instruments.

The standard also introduces a new scope criterion to authoritative literature. Under SFAS No. 125, the financial components approach is applicable to all transfers of financial assets in which the transferor has surrendered "control" of the assets. The control criterion differs markedly from the risk and rewards approach that has governed the recognition of previous sales transactions under GAAP.

A broad application of the new standard to sales transactions in general might lead to substantive changes in the way sales are recognized under GAAP. To avoid this outcome, the new standard limits the application of financial components' treatment to transfers of financial assets.

Recognizing Transfers of
Financial Assets

Under SFAS No. 125, if the transferor surrenders control over financial assets that are transferred, the transaction is treated as a sale to the extent that consideration other than beneficial interests in the transferred assets have been received by the transferor. Beneficial interests are rights to receive cash inflows from the transferred assets. Thus, only the rights to cash inflows from the transferred assets relinquished by the transferor firm are effectively recognized as sold. The key criterion that must be met for the standard to apply is control. Control is considered to have been surrendered if all of the following conditions have been met:

* The transferred assets, under all conditions, including bankruptcy of the transferor, have been isolated and put presumptively beyond the reach of the transferor and its creditors;

* The transferee obtains the effectively unencumbered right to pledge and/or exchange the transferred assets or the transferee is a qualifying special purpose entity; and

* The transferor does not maintain effective control over the transferred assets through either a forward contract or an option, in the case of transferred assets that are not readily obtainable.

Isolation. The first condition, isolation, derives from the purpose and process of securitization, a financing event during which financial assets are transferred. In securitization, financial assets are transferred to a special purpose entity (SPE), usually a trust. The SPE issues securities backed by the cash flows to be received from the transferred assets. The proceeds received from the issuance are then transferred back to the transferor firm. Because the SPE is normally a separate legal entity, a separate credit rating is issued for each securitization. Securitizations are typically structured to obtain a favorable credit rating by legally isolating the transferred assets from the transferor's creditors, and providing various remedies to the trust if excessive credit defaults, interest rate changes, or other potentially costly events occur. Because they are specifically designed and structured to isolate securitized assets, most securitizations are likely to easily meet the isolation test included in SFAS No. 125.

One interpretation problem that can arise in some securitizations is that transfers to the trust occur in two steps--first, to a special purpose corporation and then to a trust that ultimately issues asset-backed securities. Because the transaction, in whole, is isolating, the FASB allowed for such two-step transfers to be viewed as a whole. Thus, if the first transfer isolates the assets from the transferor's creditors, the entire transaction may be deemed as a sale of assets to the trust.

The right to freely pledge or exchange transferred assets. This second condition is the only aspect of the control criterion that can be conceptually linked with the risks and rewards notion that has previously governed sales recognition under GAAP. Presumably, if a party holds the right to the economic risks and benefits associated with an asset, it follows that such a right can be exchangeable. Thus, evidence of exchangeability suggests that the holder of such a right has control of the economic substance of the asset and, implicitly, bears the inherent risks and rewards associated with the asset. However, the concept is more limited in scope than that of risks and rewards. It is possible to hold the economic risk of loss associated with an asset without holding the free right of transfer. Numerous examples of this exist. In the case of leases, a lessee may hold all rights to the economic benefits inherent in an asset, via a capital lease, but not have contracted for the legal power to sublease the asset to other parties. Similarly, in securitizations, an SPE that receives transferred assets and issues asset-backed securities usually cannot freely exchange or pledge transferred assets to others. However, because the SPE is dedicated to executing the securitization transaction alone, the FASB made an exception and waived this condition of the control requirement for qualifying SPEs. To qualify, the SPE must meet the conditions specified in the statement.

Effective Control. SFAS No. 125 states that "the transferor does not maintain effective control over the transferred assets through 1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or 2) an agreement that entitles the transferor to repurchase or redeem transferred assets that are not readily obtainable."

The first part, i.e., the absence of a forward contract, was written in the standard to continue the general practice of collateralized loan treatment for most secured lending transactions and repurchase agreements. In both of these cases, a transfer of financial assets is made by the transferor in exchange for cash and a forward contract to repurchase the same or substantially the same assets prior to maturity. Arguably, holding a forward contract to purchase assets is not the same as owning assets--in particular, the holder receives no dividend and/or interest payments. However, in the case of repurchase agreements and other secured lending transactions, such payments are often provided for, thus suggesting that no sale has substantively occurred. This, and the fact most repurchase and security lending transactions have traditionally been treated as collateralized loans, led FASB to write the exception language for transactions that involve forward contracts.

The second part of this exception statement goes further: If the asset is not "readily obtainable," just the existence of an option that entitles, as opposed to requires, the transferor to repurchase transferred assets is sufficient to preclude the sales treatment afforded by SFAS No. 125. Options confuse the issue of control of financial assets because, arguably, the transferor firm can exert power over the assets through the exercise of the option. However, that power is diminished if the assets are readily obtainable in public security markets--in this case, the transferee could write the option naked, i.e., freely exchange the assets and replace them later if the option is exercised. If, however, the assets are not "readily obtainable," so that a later repurchase on the part of the transferee is uncertain, the provision of an option can restrict the transferee's ability to freely exchange and/or pledge the transferred assets. In this case, FASB decided control was not substantively relinquished by the transferor and SFAS No. 125 should not apply.

One last issue concerns the timing constraints on the forward contract, i.e., that it be executed prior to maturity of the transferred assets. Under the exposure draft, the constraint was more conservative, requiring that transfers of financial assets be treated as borrowings only if the period until repurchase was less than three months. Numerous respondents, however, disagreed with the time limit, arguing that it was arbitrary. The FASB concurred and accordingly amended the ultimate standard to permit the more flexible "prior to maturity" rule, although arguably it too is arbitrary and thus, as with previous standards, could lead to inconsistencies in the way similar transactions are treated.

The Measurement of
Financial Components

If a transfer of financial assets qualifies for financial components treatment under the control criteria of SFAS No. 125 at time of transfer, the transferred assets are derecognized and decomposed into separate financial components. Any retained components are recognized at book value since, conceptually, they have not been relinquished or sold. Conversely, cash proceeds received, and any other component assets obtained and liabilities incurred as consideration, are also recognized by the transferor firm, but at fair value at the time of transfer. Three questions surface with respect to measurement and valuation as they relate to this decomposition process: how to allocate the book value of transferred assets among the various components created through the transfer transaction; how to draw the distinction between those financial components that are retained and assets obtained and liabilities incurred in consideration; and how to measure fair values of financial components, especially when no public market exists for such assets.

The Allocation Process. SFAS No. 125 appeals to a familiar allocation method used in much of the authoritative literature: the use of weights based on fair values. Assume for example a $100,000 pool of credit card receivables were transferred, and the transferor retained a servicing asset (i.e., contractually agreed to service the transferred assets for a sum greater than cost), and the fair value of the servicing asset was $10,000 and the remaining interest was $100,000. The amount, $9,091 (10,000/110,000 x 100,000), would be allocated to the servicing asset and $90,909 (100,000/110,000 x 100,000) to the remaining interest sold.

The approach has merit as long as fair values exist for all retained identified component interests. However, public markets are not likely to exist for many securitization components, especially when they derive from unique deals involving private parties. Even marketable, asset-backed securities that result from securitization can trade infrequently and are typically denominated in millions of dollars. In this, and many other cases, obtaining fair values may be problematic and fraught with measurement error. The alternative provided by SFAS No. 125, if no fair value can be obtained, is severe: zero valuation. In this case, two different inconsistencies will occur: To the extent value truly exists for the nonvalue assigned component, assets with fair values will be overweighted, and assets with no determinable fair values, and correspondingly less likely to be sold, will be underweighted with respect to book value allocations. The rule, because it is so conservative, could substantively delay gain and loss recognition and, if the number of assets that cannot be valued becomes large, adversely affect the relevance of reporting
information.

Distinguishing Between Retained Financial Components and Assets Obtained and Liabilities Incurred. This task is difficult because the distinction is, arguably, arbitrary. SFAS No. 125 defines the distinction as follows: "Any asset obtained that is not an interest in the transferred asset is part of the proceeds of sale," i.e., an asset obtained. On the other hand, retained interests are described as "interests over which the transferor has not relinquished control." However, all derivative interests received through securitization can be viewed as interests ultimately derived from the transferred assets. Conversely, all decomposed interests in transferred assets have unique trading characteristics--for example increased liquidity--that have arisen as a result of the transfer transaction. Thus, all financial components that result from the decomposition of financial assets can be viewed as new, i.e., assets obtained. Thus, the distinction appears mostly arbitrary. Perhaps in recognition of this problem, the standard explicitly names which assets belong to which category: Assets obtained are cash proceeds and all derivative financial instruments, e.g., swaps, forward contracts, options, strips, and so forth. Retained interests are nonpurchased servicing assets (expected benefits of servicing in excess of the costs of servicing responsibilities), securities backed by transferred assets, undivided interests, cash reserve accounts, and residual interests in securitization trusts. Any unnamed components and/or new hybrids, any assets for which classification cannot be determined, or any for which there is substantial doubt as to classification, are to be treated as assets obtained.

On the liability side, the problem goes away because all liabilities incurred, irrespective of whether they are viewed as related to the asset, are treated the same way, i.e., with valuation at fair value at time of transfer. In summary, the whole issue of whether assets are viewed as sold or retained remains prescriptive. In this sense, the standard is no better than its predecessor, since simply changing the form of a component can easily circumvent the classification procedures.

The classification prescriptions of SFAS No. 125 do represent an improvement over previous promulgations. Because they are applied at a component level, wholesale inconsistencies are avoided. They also reflect a due process consensus concerning treatment of components as they are now used and defined. In many cases, the issue may prove to be immaterial. Many asset transfers involve short-lived assets such as receivables. For these assets, any differences between book and fair values will likely be minimal, suggesting the classification scheme imposed by SFAS No. 125, while perhaps adding unnecessary complexity, could prove immaterial in terms of accounting differences across the two valuation
approaches.

Measuring Fair Value. The last question concerns the practical question of how to obtain fair values for all of the financial components created when financial assets are transferred in complex transactions such as securitization. For asset-backed securities, an active secondary market has developed for a number of securities and thus quoted prices are likely, in many cases, to be available. Similarly, although not nearly as common, even residual subordinated interests held by the transferor, roughly analogous to equity in the SPE, have been traded in public markets. On the other hand, numerous financial components may not trade publicly or even be privately exchanged under normal circumstances. Examples include interests in excess fees on credit cards, servicing assets, implicit forward contracts and options, recourse guarantees, and swaps. For some of these, typically with analogous trading relatives such as options and forwards, a number of other valuation methods are available and are permitted for use under SFAS No. 125, including discounting of expected future cash flows, option pricing models, matrix pricing, and fundamental analysis.

For many assets not publicly traded, e.g., servicing assets and liabilities, recourse guarantees, and the like, no valuation model now exists. In these cases, estimates of cash flow streams and appropriate discounting rates may have to be used, perhaps based on past performance, if available. In the case of some securitized assets, such as credit card receivables, the assets and their derivative financial components will be short lived, suggesting that choice of discounting rates will have a limited, or even immaterial effect, on fair value. If expected future cash flows are well defined, perhaps because there is ample past experience and the business activity being measured is relatively stable, the valuation process should not be problematic. On the other hand, for longer lived assets and components, the defensible choice of a discount rate for assets that are not traded could prove to be a quite formidable task that might lead to inconsistencies in the way the statement is applied.

As mentioned earlier, if it is not practical to estimate fair values of assets, the assets are to be recorded at zero. In the case of liabilities, however, when fair values are not available, apparently to be conservative, the standard presents an asymmetric solution, relative to the treatment accorded assets. No gain on the transaction shall be recognized. Any gain is essentially absorbed into the carrying value of the liabilities. In particular, the liabilities should be recorded at the greater of

1) the excess of fair values of components obtained less liabilities incurred over the sum of carrying values of assets transferred, or

2) the amount that would be recognized in accordance with SFAS No. 5 Accounting for Contingencies as interpreted by SFAS No. 14 (Reasonable Estimation of the Amount of a Loss).

Income Measurement

SFAS No. 125 does permit sales recognition, thus allowing for, in the case of components of noncurrent financial assets that fit the assets obtained and liabilities incurred categorization, accelerated recognition into income of expected future cash flows. In addition, it can also suppress income recognition, in the aggregate, to the extent that valuation changes occur in components that are classified as available-for-sale. However, in the case of current financial assets--for example, credit card loans--there should be little or no impact, in the aggregate, on reported income. Irrespective of the aggregate impact on the income statement, the individual revenue and expense items that are recognized under SFAS No. 125 will differ substantively from previous practice.

Consider the following simplified example of a credit card securitization transaction. At the beginning of its fiscal year, a firm transfers to an SPE a $100,000 portfolio of receivables bearing interest at 20% per annum. Delinquency of the receivables is four percent. The SPE issues 100,000 of five percent asset-backed securities, sold at par, with no principle due for one year, at which time the issue matures. The transferor agrees to service the asset for a two percent fee. For simplicity, assume no time value of money and costs of service are negligible. Thus a $2,000 servicing asset exists. The transferor receives all excess fees, i.e., the rights to an interest-only strip (hereafter, the I/O strip), valued at $9,000. Again, for simplicity, assume the transferred assets have a life of one year. First, for comparison, consider the income effects if securitization were not used. Assuming no other business transactions, if the assets were not securitized by the transferor, and the firm could finance the sale with borrowings at 5%, the firm would report revenues of $20,000, interest expense of $5,000, bad debt expense of $4,000, and net income of $11,000.

If, however, the firm did use securitization financing, as described above, items would be reported in the income
statement as follows:

Thus, while the individual income items would vary, the net income from the described transactions, in both cases, would be $11,000. However, if the sale occurred at some other time besides the beginning of the fiscal year, the I/O strip would be revalued to fair value at year end, with the difference going to equity instead of income (assuming the security was classified as available-for-sale). Because the amount would be deferred as to income recognition, an income difference would exist in this case. If securitization financing were a constantly growing business activity, this deferral effect would likely also grow and thus be cumulative across time.

Disclosures Under SFAS No. 125

SFAS No. 125, in addition to mandating financial components treatment for all qualifying financial asset transfers (and extinguishments of liabilities), also requires numerous disclosures that primarily relate to the basis upon which financial components are valued.

Asset restrictions and, in the case of any repurchase agreements or security lending transactions, policies the firm has for requiring collateral must be disclosed. Components for which it is not practical to estimate fair value must be listed together with reasons why fair value estimation was impractical. A number of disclosures about servicing assets and liabilities are required, including the following:

* Amounts recognized and amortized during the period;

* Fair values of servicing assets and liabilities recognized and the assumptions upon which fair values are based;

* Risk characteristics of the underlying financial assets used to stratify recognized servicing assets; and

* Activity in valuation allowance accounts for impairment of recognized servicing assets.

The need for disclosure also points to conceptual deficiencies that may affect the ability of the new standard to meet the FASB objective of capturing substance over form. SPEs are almost always established by the transferor. In effect, the transferor can exert future control over transferred assets via the trust structure as opposed to the use of forwards and options. Does this mean the SPE trust should be consolidated into the transferor, so that asset-backed securities become the liability of the transferor? SFAS No. 125 is silent on this issue and defers the problem to the ongoing project on consolidation. For now, the conditions for consolidation are governed by SFAS No. 94, which imposes a control requirement that is implicitly linked, for measurement purposes, to the degree of voting interest one entity has in another. SPEs, however, because they are usually trusts, are not controlled by voting power but instead by contract as administered by an appointed fiduciary. Arguably, transferors can impose control simply by negotiating in power for terms they wish to see carried out over the foreseeable future. Yet SFAS No. 125 does not address this issue, thus leaving a wide discretionary gap available that transferors can use to arbitrarily influence how securitizations and other asset transfers are to be accounted for.

A second conceptual deficiency in SFAS No. 125 is that many of the financial components created from decomposition of transferred assets derive from trust law and do not fit the traditional definitions of assets, liabilities, and equity. Thus, they cannot easily be described solely within existing financial reports. Further, even after decomposition, some components are hybrids that contain both asset and liability elements. For example, is the guarantee with respect to a recourse component that the transferor may have provided a future liability similar to warranty expense? If so, then how should residual interests in transferred assets, e.g., the I/O strip, be recognized since they will first absorb any credit losses?

Components often defy balance sheet classification because the legal characteristics and basic structures of trusts are very different from corporations. There are no distinctions, for example, as to equity and liability claims in trust agreements. Instead, there are grantors, beneficiaries, and fiduciaries, each with contractual obligations and rights. How will the rights and obligations that arise through trusts be reported under a corporate-based accounting model? Is the current definition of assets, liabilities, and equity, rich enough for such a task? If it is, SFAS No. 125 may prove to be a very promising approach that can be adapted to a wide variety of accounting issues and problems caused by growing business complexity and hybridization. If it is not, the new standard may point the current debate toward the most fundamental question of all: the relevancy of the accounting model itself. *

Gregory D. Kane, PhD, CPA, is an assistant professor at the University of Delaware.

SIX IMPLEMENTATION PITFALLS YOU CAN AVOID

By Kenneth W. Bosin and Joseph Athy

Pitfall 1

In-Substance Syndications Eliminated

Company A is the lead syndicator on a transaction and sells down at least 50% within 60 days of closing (an in-substance syndication) and expects to get syndication fee treatment. In accordance with Emerging Issues Task Force Issue 88-17 (prior to SFAS No. 125), loan origination fees were taken immediately into income provided the yield to the lead syndicator was not less than the average yield to other syndication participants.

It appears in-substance syndications will not be permitted for transactions entered into after December 31, 1996. Instead loan origination fees would be attributed to the entire amount funded by Company A and then allocated pro rata between the loans sold (less fees paid to participants) and the loans retained by Company A.

Reference

Refer to pages 35 and 36: Impact of FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, on EITF Issues. (A supplement to FASB Statement 125.)

Recommendation

Make sure all impacted areas of the company are aware that "in-substance" syndication accounting may no longer be available for transactions that closed after December 31, 1996. In the coming months, pay close attention to the FASB to see if they clarify their position.

Pitfall 2

A Financing Is Treated as a Sale

Company A thought a transaction was a financing but it really was a sale. Now the assets and liabilities must be removed from the balance sheet with any gain or loss on the transaction included in income.

Reference

SFAS No. 125, paragraph 27 provides guidance. Make sure all of the following conditions are met for financing treatment:

* The assets to be repurchased or redeemed are the same or substantially the same as those transferred.

* The transferor is able to repurchase or redeem them on substantially the agreed terms, even in the event of default by the transferee.

* The agreement is to repurchase or redeem them before maturity, at a fixed or determinable price.

* The agreement is entered into concurrently with the transfer.

Recommendation

Make sure these conditions are met. It is essential to understand the terms of agreements and the types of assets transferred to avoid having sale accounting treatment on a transaction that was intended to be a financing. Be sure agreements, including "boilerplate agreements," are carefully read by your legal, operations, trading, and accounting areas, as well as your internal and external auditors. Literally having the agreement in one hand and paragraph 27 of SFAS No. 125 in the other would be prudent.

Pitfall 3

A Sale Is Treated as a Financing

Company A thought a transaction was a sale with the asset being removed from the balance sheet. Management was anticipating the gain or loss in the income statement. It never happened. The transaction was really a financing since the documentation restricted the transferee from selling. (e.g., Perhaps the documentation imposed transferor restrictions that constrained the transferee's contractual right to pledge or exchange the transferred asset. Perhaps for customer relations or competitive reasons, the agreement stated that the transferee purchased the financial assets but was prohibited from selling them.)

Reference

SFAS No. 125, paragraph 25 provides guidance. For sales treatment--make sure the transferor's permission to sell or pledge... shall not be unreasonably withheld....

Recommendation

Reading and understanding the terms of the agreements cannot be overstated. In the future, if the transferor is concerned the transferee might sell the financial asset to a competitor (e.g., another financial institution), the sales agreement could specifically so indicate. (It should be noted that if the competitor was the only potential buyer, the transferee would be constrained and financing treatment may result.)

Pitfall 4

A Repurchase Agreement to Maturity Equals Sale

Company A entered into a repurchase agreement and met the financing criteria of SFAS No. 125 so that the income statement was not impacted. Wait. The transaction should have been treated as a sale since the maturity date of the repurchase agreement was the same date as the maturity of the instrument.

Reference

SFAS No. 125, paragraph 68 provides--

...transfers that are accompanied by an agreement to repurchase the transferred assets that shall be accounted for as sales include transfers with agreements to repurchase at maturity...

Recommendation

Check documentation to ensure the maturity date of the repurchase agreement is not the same date as the maturity date of the instruments. Otherwise it's a sale. Although SFAS No. 125 does not specifically define maturity, current industry practice is to treat maturity date as the date of maturity of the underlying instrument or a few days before that date.

Pitfall 5

Collateral Appears on the Secured Party's Balance Sheet

Company A, the secured party, receives collateral from a customer and does not record the collateral on its balance sheet, in accordance with pre-SFAS No. 125 industry practice. The collateral agreement reveals that Company A has taken control over the collateral by not allowing the debtor, Company B, to redeem it on short notice. Company A now must reflect the collateral on its balance sheet. Company B must reclassify the asset on its balance sheet.

Reference

SFAS No. 125, paragraph 15 a. provides--

if (1) the secured party is permitted by contract or custom to sell or repledge the collateral and (2) the debtor does not have the right and ability to redeem the collateral on short notice, for example, by substituting other collateral or terminating the contract, then...the secured party shall recognize that collateral as its asset, initially measure it at fair value, and also recognize its obligation to return it.

Recommendation

Make sure the debtor can get the collateral back on short notice. Otherwise the creditor will have an asset to recognize--the collateral. The debtor is also impacted by having the asset on its balance sheet classified separately from other assets not so encumbered.

Pitfall 6

Loans Sold but Servicing Asset and Gain Not Recorded

Company A sold loans and retained the servicing for them. At the time of sale, it never determined the fair value of the assets that included a servicing asset. Consequently, it has been overstating servicing revenue in subsequent periods. In addition, a servicing asset was never recorded.

Reference

SFAS No. 125, paragraphs 35­38 of the statement detail criteria that need to be considered in the area of servicing:

Each servicing contract results in a servicing asset or servicing liability. Typically, the benefits of servicing are expected to be more than adequate compensation to the servicer for performing the servicing, and the contract results in a servicing asset....

Recommendation

Review servicing agreements for loans sold but servicing retained. Determine the fair value of loans, servicing etc. If a servicing asset or liability results, record it.