The Application Guidance provides several illustrative situations in relation to de-recognition. The points relevant to securitization are:
Accounting for Securitization 815
Assume an entity has a portfolio of prepayable loans whose coupon and effective interest rate is 10% and whose principal amount and amortized cost is $10,000. It enters into a transaction in which, in return for a payment of $9,115, the transferee obtains the right to $9,000 of any collections of principal plus interest thereon at 9.5%. The entity retains rights to $1,000 of any collections of principal plus interest thereon at 10%, plus the excess spread of 0.5% on the remaining $9,000 of principal.
Collections from prepayments are allocated between the entity and the transferee proportionately in the ratio of 1:9, but any defaults are deducted from the entity’s interest of $1,000 until that interest is exhausted. The fair value of the loans at the date of the transaction is $10,100 and the estimated fair value of the excess spread of 0.5% is $40.
The entity determines that it has transferred some significant risks and rewards of ownership (for example, significant prepayment risk) but has also retained some sig- nificant risks and rewards of ownership (because of its subordinated retained interest) and has retained control. It, therefore, applies the continuing involvement approach.
To apply this Standard, the entity analyzes the transaction as (a) a retention of a fully proportionate retained interest of $1,000, plus (b) the subordination of that retained interest to provide credit enhancement to the transferee for credit losses.
The entity calculates that $9,090 (90% $10,100) of the consideration received of
$9,115 represents the consideration for a fully proportionate 90% share. The remain- der of the consideration received ($25) represents consideration received for sub- ordinating its retained interest to provide credit enhancement to the transferee for credit losses. In addition, the excess spread of 0.5% represents consideration received for the credit enhancement. Accordingly, the total consideration received for the credit enhancement is $65 ($25+$40).
The entity calculates the gain or loss on the sale of the 90% share of cash flows.
Assuming that separate fair values of the 10% part transferred and the 90%
part retained are not available at the date of the transfer, the entity allocates the carrying amount of the asset in accordance with Paragraph 28 as follows:
The entity computes its gain or loss on the sale of the 90% share of the cash flows by deducting the allocated carrying amount of the portion transferred from the consideration received, i.e. $90 ($9,090 – $9,000). The carrying amount of the portion retained by the entity is $1,000.
Allocated
Estimated carrying
fair value Percentage amount
Portion transferred 9,090 90% 9,000
Portion retained 1,010 10% 1,000
Total 10,100 10,000
Accounting for Securitization 817
In addition, the entity recognizes the continuing involvement that results from the subordination of its retained interest for credit losses. Accordingly, it recognizes an asset of CU1 000 (the maximum amount of the cash flows it would not receive under the subordination), and an associated liability of CU1 065 (which is the max- imum amount of the cash flows it would not receive under the subordination, i.e.
CU1 000 plus the fair value of the subordination of CU65).
The entity uses all of the above information to account for the transaction as follows:
Immediately following the transaction, the carrying amount of the asset is CU2 040 comprising CU1 000, representing the allocated cost of the portion retained, and CU1 040, representing the entity’s additional continuing involvement from the subordination of its retained interest for credit losses (which includes the excess spread of CU40).
In subsequent periods, the entity recognizes the consideration received for the credit enhancement (CU65) on a time proportion basis, accrues interest on the rec- ognized asset using the effective interest method and recognizes any credit impair- ment on the recognized assets. As an example of the latter, assume that in the following year there is a credit impairment loss on the underlying loans of CU300.
The entity reduces its recognized asset by CU600 (CU300 relating to its retained interest and CU300 relating to the additional continuing involvement that arises from the subordination of its retained interest for credit losses), and reduces its rec- ognized liability by CU300. The net result is a charge to profit or loss for credit impairment of CU300.
Debit Credit ($)
Original asset — 9,000
Asset recognized for 1,000 —
subordination or the residual interest
Asset for the consideration 40 —
received in the form of excess spread
Profit or loss (gain on transfer) — 90
Liability — 1,065
Cash received 9,115 —
Total 10,155 10,155
Financing treatment and linked treatment
Where the securitization transaction does not qualify for a sale or de- recognition treatment, it is given a financing treatment. In other words,
notwithstanding the legal acceptability of the assignment of receivables, the receivables continue on the balance sheet of the originator and the amount raised by the assignment of receivables is accounted for as a liability.
The financing treatment is premised on the presumption that the form of the transaction may be a legal transfer of the receivables, but its substance is mere financing.
If the transaction is given a financing treatment, the receivables will remain on the balance sheet and would be removed as and when they are collected.
On the other hand, the “liability” on account of the amount to be paid to investors will be recognized at its present value and would be removed based on the amortization of the liability over a period of time.
It may be noted that under the financial components approach, almost every securitization transaction would qualify for an off-balance sheet treat- ment to the extent of the components transferred. The financing treatment is essentially a concept under the U.K. accounting standards. Para 21 of FRS 5 requires a financial treatment when there is no significant change in the entity’s risks and rewards on the transferred assets. Para 22 suggests a sale treatment only when all significant risks and rewards are transferred by the originator. However, most securitization transactions would not qualify for either extreme. There, Para 26 of FRS 5 for linked presentation would apply.
FRS 5 recommends a linked presentation when there is retention of risks and rewards by the originator, but the financing is ring-fenced. Ring fencing arises when the payments would be made out of a dedicated asset or fund, and there is no possibility of a claim against the originator other than the claim against the specific funds dedicated. For example, a recourse obligation to the extent of an over-collateralized receivable would be a case of ring- fencing, but if there is a general recourse undertaken by the originator against his own assets, the case would not qualify for linked presentation.
If a linked presentation approach is adopted, the value raised by assigning the receivables is netted off from the value of the receivables on the balance sheet, that is, the liability is netted off from the asset.
In all other cases, FRS recommends a separate presentation, that is, the asset and the liability will both be recognized as their full values. Text of relevant extracts from FRS 5 is appended to this chapter. FRS 5 incited global attention recently as it was suggested to the FASB36 that the FASB adopt an approach similar to the linked presentation suggested under FRS 5.
Comparative view of sale and financing treatment
If the transaction of securitization is given a sale treatment for accounting pur- poses, the revenue statement of the originator will recognize, on the date of making the assignment, a profit or loss as the difference between the carrying value of the assigned receivables and the amount raised by assigning the receivables.
This illustration is a simplified case where there is no retained interest, nor any asset/liability arising as a result of the transaction.
For example, if receivables of $25 per month, for next 60 months (total nominal value Rs. 1500) were carried at a carrying value of $980 (based on the outstanding principal value), and are transferred for a price of $1,030, there is an immediate gain of $50 ($1,030 – 980). If the said receivables are transferred for a price of $950, there is an immediate loss of $30.
For the sale treatment, the gain or loss is treated as the gain or loss of the accounting period when the securitization takes place and taken to revenue straightaway.
For a “loan type treatment,” the receivables will be carried on the books, as if the securitization had not been effected and the income from which will be accounted for every period as per the accounting policy of the originator.
The “discount” on the issue of the securitized note – the difference between the nominal value of the assigned receivables and the price at which they are sold – will be spread over the tenure of the note so as to represent a fixed charge on the outstanding principal value of the note.
The application of this accounting policy will be illustrated in the following illustration.
Assume the following are the amounts receivable under a transaction for the next five years: Year 1: $320; Year 2: $320; Year 3: $320; Year 4: $320; and Year 5:
$320. As per generally acceptable accounting principles, these receivables should be recognized at their present value computed at the implicit rate of return in the original transaction. If assuming the transaction was based on an outflow of
$1,000, the accounting treatment is reflected in the computations below:
Accounting for Securitization 819
Basic assumptions: The transaction
Outflow −1,000
Year 1 320
Year 2 320
Year 3 320
Year 4 320
Year 5 320
IRR 18.03%
Discounted value after 1 year @ 16% 895.42 Chart showing carrying value/ financing income of original transaction
Ostndg. Installment Financing Capital Carrying
investment income recovery value as
at year end
Year 1 1000.00 320.00 180.31 139.69 860.31
Year 2 860.31 320.00 155.12 164.88 695.43
Year 3 695.43 320.00 125.39 194.61 500.82
Year 4 500.82 320.00 90.30 229.70 271.12
Year 5 271.12 320.00 48.88 271.12 0.00
(Continued) Table 27.7 Example of financing treatment
Disclosures by the originator
FASB 140.17 imposes disclosure requirements mainly dealing with the nature of restrictions on assets transferred and the controls retained on such assets, servicing assets retained, any other asset or obligation acquired and policy for amortization thereof.
Let us say the transaction is securitized at the beginning of year 2 SALE TREATMENT
Carrying value 860.31
as per books
Amount received 895.42
by assignment
Gain on assignment 35.11
Revenue account:
Expenditure Income
Year 1 Normal Year 1 Financing charges 180.31
financing cost
Year 2 Year 2 Gain on securitization 35.11
Loan treatment
Amortization of the securitization instrument
Amount Installment Apprtned Amortization Balance
raised discount
Year 2 895.42 320.00 143.27 176.73 718.68
Year 3 718.68 320.00 114.99 205.01 513.67
Year 4 513.67 320.00 82.19 237.81 275.86
Year 5 275.86 320.00 44.14 275.86 0.00
Revenue account:
Expenditure Income
Year 1 Normal Year 1 Financing charges 180.31
financing cost
Year 2 Apprned discount 143.27 Year 2 Financing charges 155.12 Year 3 Apprned discount 114.99 Year 3 Financing charges 125.39 Year 4 Apprned discount 82.19 Year 4 Financing charges 90.30 Year 5 Apprned discount 44.14 Year 5 Financing charges 48.88
A. For all servicing assets and servicing liabilities:
(1) The amounts of servicing assets or liabilities recognized and amor- tized during the period;
(2) The fair value of recognized servicing assets and liabilities for which it is practicable to estimate that value and the method and significant assumptions used to estimate the fair value;
(3) The risk characteristics of the underlying financial assets used to stratify recognized servicing assets for purposes of measuring impairment in accordance with FAS 140.63; and
(4) The activity in any valuation allowance for impairment of recog- nized servicing assets – including beginning and ending balances, aggregate additions charged and reductions credited to operations, and aggregate direct write-downs charged against the allowances – for each period for which results of operations are presented.
B. If the entity has securitized financial assets during any period presented and accounts for that transfer as a sale, for each major asset type (for example, mortgage loans, credit card receivables and automobile loans):
(1) Its accounting policies for initially measuring the retained interests, if any, including the methodology (whether quoted market price, prices based on sales of similar assets and liabilities, or prices based on valuation techniques) used in determining their fair value;
(2) The characteristics of securitizations (a description of the transferor’s continuing involvement with the transferred assets, including, but not limited to, servicing, recourse and restrictions on retained interests) and the gain or loss from sale of financial assets in securitizations;
(3) The key assumptions used in measuring the fair value of retained interests at the time of securitization (including, at a minimum, quantitative information about discount rates, expected prepay- ments including the expected weighted-average life of prepayable financial assets and anticipated credit losses, if applicable); and (4) Cash flows between the securitization SPE and the transferor, unless
reported separately elsewhere in the financial statements or notes (including proceeds from new securitizations, proceeds from collec- tions reinvested in revolving-period securitizations, purchases of delinquent or foreclosed loans, servicing fees and cash flows received on interests retained).
C. If the entity has retained interests in securitized financial assets at the date of the latest statement of financial position presented, for each major asset type (for example, mortgage loans, credit card receivables and auto- mobile loans):
(1) Its accounting policies for subsequently measuring those retained interests, including the methodology (whether quoted market price, prices based on sales of similar assets and liabilities, or prices based on valuation techniques) used in determining their fair value;
Accounting for Securitization 821
(2) The key assumptions used in subsequently measuring the fair value of those interests (including, at a minimum, quantitative information about discount rates, expected prepayments including the expected weighted-average life of prepayable financial assets, and anticipated credit losses, including expected static pool losses, if applicable);
(3) A sensitivity analysis or stress test showing the hypothetical effect on the fair value of those interests of two or more unfavorable variations from the expected levels for each key assumption that is reported under (2) above independently from any change in another key assumption, and a description of the objectives, methodology and limitations of the sensitivity analysis or stress test. [See earlier – extracts from annual report of GE showing the above disclosures];
(4) For the securitized assets and any other financial assets that it manages together with them:
(a) The total principal amount outstanding, the portion that has been de-recognized, and the portion that continues to be recog- nized in each category reported in the statement of financial posi- tion, at the end of the period;
(b) Delinquencies at the end of the period; and (c) Credit losses, net of recoveries, during the period.
Disclosure of average balances during the period is encouraged, but not required.
Accounting for the SPV
The SPV, whether organized as a company or a trust, would need to prepare its own accounts.
The SPV’s basic assets are the initial equity or corpus normally contributed by the originator, and the assets transferred by the originator. The assets trans- ferred by the originator to the SPV would include the receivables, an over- collateralization receivables or cash retention (if transferred by way of a true sale, as opposed to transferred by way of a collateral) and any third party guarantees. On the other hand, the SPV passes on to the investors in form of equity, debt, certificates of beneficial interest, or commercial paper interest in the pool of receivables transferred to it.
While there might be circumstances where the originator may retain the receivables on its balance sheet, it would not be proper for the SPV to de-recognize the receivables from its own balance sheet. For example, even where the originator has retained significant risks and rewards in the receiv- ables, it cannot be said that the SPV would not account for the asset or corre- sponding liability on its balance sheet.
However, for pass-through securitizations, where the SPV is acting as a mere conduit, such that the amounts raised by issuance of the notes is no more or no less than the beneficial interest in the assets acquired, then the SPV does
not have to record the assets acquired by it in a fiduciary capacity. Such assets are not the beneficial assets of the SPV; therefore, the SPV does not record either the assets acquired as a fiduciary or the securities issued indicating beneficial interest. In a typical pass-through securitization, the SPV will have no residual interest, no leftover or no asset that is not passed through to investors. In such a case, the SPV may elect not to recognize the asset on its balance sheet. Hence, grantor trusts for pass-through transactions do not usu- ally prepare any books of account for the assets transferred by the originator.
On the other hand, if the securities of the SPV are construed as debt-type securities, the SPV will record the assets acquired by it as its assets, and the corresponding certificates/securities issued to investors as liabilities.
Consolidation of SPV accounts with the originator
The issue of consolidation of SPV accounts with the originator is in itself a very sensitive issue. It would be easy to appreciate that the very purpose of off-balance sheet treatment of securitization would be frustrated if the SPV’s accounts are consolidated. What goes off-balance sheet as a result of securiti- zation comes back on-balance sheet of the originator by way of consolidation.
Where the SPV is the subsidiary of the originator, consolidation would be required in all such countries for which group accounts are required. [Group accounts are currently not required in India.] Even where the SPV is not a direct subsidiary, there might be situations when it might be treated as a quasi-subsidiary. FRS 5 [Para D18] gives the following guide to treatment of quasi-subsidiary: If the originator has residuary interest in the SPV – if the net assets of the SPV belong to the originator or if the originator has risks in the net assets of the SPV – the SPV will be treated as the quasi-subsidiary of the originator. FRS Para D19 says: “In general, where an issuer’s activities com- prise holding securitized assets and the benefits of its net assets accrue to the originator, the issuer will be a quasi-subsidiary of the originator. The issuer will not be a quasi-subsidiary of the originator where the owner of the issuer is an independent third party that has made a substantial capital investment in the issuer, and has benefits and risks of its net assets.”