On June 12, 2009, the FASB issued Financial Accounting Statement No. 166, Accounting for Transfers of Financial Assets ("Statement 166") and Financial Accounting Statement No. 167, Amendments to FASB Interpretation No. 46(R) ("Statement 167") that would change the way entities account for securitizations and special-purpose entities (SPEs). While both Statements have broader applications, this GT Alert focuses on the application of these two Statements to securitization transactions
Both new standards require several new evaluations and disclosures. As a result of these two Statements, which apply not only to new structures but also to existing ones, many companies to which these Statements apply will have to materially revise their existing securitization structures to comply with the new standards or put these structures on their balance sheets. In addition, Statement 166's disclosure requirements must be applied to transfers that occurred before and after its effective date. Thus, numerous existing securitization structures, which have been previously treated as sales, will have to be reviewed and revised.
This Alert outlines some of the key issues discussed in the Statements, and the most important actions that affected companies would have to take to comply with the Statements.
Statement 166 (Accounting for Transfers of Financial Assets)
Statement 166 is a revision to Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities ("Statement 140") and, in general, requires more disclosure about transfers of financial assets, including, in particular, securitization transactions, especially where the transferring companies have continuing exposure to the risks related to transferred financial assets.
As a result, Statement 166 would enhance information reported to users of financial statements by providing greater transparency about transfers of financial assets and a company's continuing involvement in such transferred financial assets.
Importantly, Statement 166 eliminates the concept of a "qualifying special-purpose entity" from U.S. GAAP and changes the requirements for derecognizing financial assets. An SPE in this context is a legal entity previously created by entities to fulfill temporary or specific objectives. For example, SPEs have been frequently used by companies to isolate them from financial risk. Qualifying special-purpose entities (QSPEs) generally are off-balance-sheet entities that are exempt from consolidation. Statement 140, which was issued in September 2000 as a replacement of FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, established conditions that an entity must meet to be a qualifying special purpose entity.
To clarify, if an entity met the previous requirements for being a QSPE, financial assets and related liabilities transferred to such an entity generally were not recorded on the transferor's balance sheet.
Under Statement 166, formerly QSPEs that were off balance sheet will become subject to the revised consolidation and therefore will have to be "brought back" into the company's balance sheet, the result of which will be that the transferor or sponsor of a financial asset to a securitization vehicle will have to record the transferred assets and related liabilities on its balance sheet.
Statement 166 also sets forth more restricted standards for transfers of a portion of financial assets and accounting for the transferred portion of the assets as being sold. In general, a transferor of financial assets (such as mortgage loans) recognize and initially measure at fair value all assets obtained (including a transferor's beneficial interest) and liabilities incurred as a result of a transfer of financial assets accounted for as a sale. If such a transfer does not meet the requirements for sale accounting, the financial assets "transferred" should continue to be classified as loans in the transferor's statement of financial position.
Thus, when a company transfers financial assets (such as mortgage loans) to a securitization vehicle, the transfer should be classified as either a sale of the assets, in which case the loans should no longer be on the transferor's books, or as financing, in which case the loans continue to be on the company's books. Importantly, Statement 166 also removed the special provisions in Statement 140 and FASB Statement No. 65, Accounting for Certain Mortgage Banking Activities, for guaranteed mortgage securitizations to require them to be treated the same as any other transfer of financial assets within the scope of Statement 140, as amended by Statement 166. Thus, if such a transfer does not meet the conditions for sale accounting, the securitized mortgage loans shall continue to be classified as loans. It is expected that many transfers previously treated as sales will not qualify for sale treatment under the new standard. As a result, the transferor company will have to determine whether derecognition would be appropriate.
Under the new standard set forth in Statement 166, a transfer of a portion of a financial asset may be reported as a sale only when the following requirements are met: (i) the transferred portion is a pro-rata portion of an entire financial asset, (ii) no portion is subordinate to another, and (iii) other restrictive criteria are met.
Finally, Statement 166 requires a company to provide additional disclosures about all of the entity's continuing involvements with transferred financial assets. As FASB elaborated, such continuing involvement can take many forms, including: (i) recourse or guarantee arrangements, (ii) servicing arrangements, and (iii) providing certain derivative instruments. The new standard also requires a company to provide expanded disclosures about its continuing involvement until it has no continuing involvement in the transferred financial assets. A company will also need to provide additional information about gains and losses resulting from transfers of financial assets during a reporting period.
Statement 167 (Consolidation of Variable Interest Entities)
Statement 167 is a revision to FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities ("FIN 46(R)") and would change how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. Under GAAP, the determination of whether a company is required to consolidate an entity is based on, among other things, an entity's purpose and design and a company's ability to direct the activities of the entity that most significantly impact the entity's economic performance. Variable interest entities generally are thinly capitalized entities and include many SPEs. A company must consolidate any entity in which it has a "controlling interest."
The primary amendment to FIN 46(R) relates to how a company determines if it must consolidate a variable interest entity. Specifically, under the new standard, if the company has an interest in a variable interest entity that provides it with control over the most significant activities of the entity (and the right to receive benefits or the obligation to absorb losses) the company must consolidate the variable interest entity. Before Statement 167, FIN 46(R) required reconsideration of whether an enterprise is the primary beneficiary of a variable interest entity only when specific events occurred. Statement 167 amended FIN 46(R) to require an enterprise to perform an analysis to determine whether the enterprise's variable interest or interests give it a controlling financial interest in a variable interest entity and, therefore, whether it must consolidate a variable interest entity.
As set forth above, Statement 167 applies to existing strictures, the result of which would be that many SPEs, which have stayed off balance sheet for years, will have to be consolidated. Statement 167 further requires ongoing reassessments to determine if a company must consolidate a variable interest entity and to update its consolidation analysis on an ongoing basis. This differs from the previous guidance, which requires a company to determine if it consolidates a variable interest entity only when specific events occur.
Finally, Statement 167 requires a company to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A company will be required to disclose how its involvement with a variable interest entity affects the company's financial statements. For example, if a company consolidates a variable interest entity and the assets of that consolidated entity are restricted, the company must disclose the nature of those restrictions and the carrying amount of such assets. A company will also be required to disclose any significant judgments and assumptions made in determining whether it must consolidate a variable interest entity.
Both Statements 166 and 167 will be effective at the start of a company's first fiscal year beginning after November 15, 2009, or January 1, 2010, for companies reporting earnings on a calendar-year basis (the "Effective Date"). Nevertheless, they will apply to existing structures, not just new ones.
Thus, for example, while Statement 166 must be applied to transfers occurring on or after the Effective Date, the disclosure provisions of Statement 166 should be applied to transfers that occurred both before and after the Effective Date. Additionally, on and after the Effective Date, the concept of a QSPE is no longer relevant for accounting purposes. As a result, formerly qualifying special-purpose entities should be evaluated for consolidation by reporting entities on and after the Effective Date in accordance with the applicable consolidation guidance. If the evaluation on the Effective Date results in consolidation, the reporting entity should apply the transition guidance provided in the pronouncement that requires consolidation.
With respect to Statement 167, all variable interest entities subject to Interpretation 46R will need to be reevaluated as of the Effective Date. The determinations of (a) whether an entity is a variable interest entity and (b) which enterprise, if any, is a variable interest entity's primary beneficiary, must be made as of the date the enterprise became involved with the entity or if events requiring reconsideration of the entity's status or the status of its variable interest holders have occurred, as of the most recent date at which FIN 46 would have required consideration.
Entities that are required to consolidate a variable interest entity that is currently off-balance must recognize a one time adjustment (on a cumulative basis) to retained earnings for the difference between the amount they would need to add to the balance sheet as a result of the consolidation and the amount previously recognized as an equity interest in the variable interest entity. An opposite adjustment will be required from entities that are required to deconsolidate a variable interest entity. The adjustments will be made at the carrying amount of the interests,
Nevertheless, an enterprise that is required to consolidate an entity as a result of the initial application Statement 167 may elect the fair value option provided by FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, but only if the enterprise elects the option for all financial assets and financial liabilities of that entity that are eligible for this option. This election shall be made on an entity-byentity basis.
The retroactive effect of both Statement 166 and 167 will most likely require the affected enterprise to set aside a loss reserve after it conducted the required analysis and determinations (or re-determination) mandated by the Statements if it results in a determination that the assets must be restated at the transferor's books and records (i.e., following a reconsolidation) .