FASB - Somerset CPAs - Indianapolis, Indiana

2010 Developments

Financial asset transfers and consolidation of variable interest entities
On June 12, 2009, the FASB issued two new standards that will have a significant impact on many enterprises beginning in 2010. Under ASC 860 (formerly FAS 166), companies will have to meet more stringent criteria in order to treat the transfers of financial assets, such as trade receivables and loans, as sales rather than secured financings. Under ASC 810 (formerly FAS 167), more special purpose entities (SPEs) and variable interest entities (VIEs) will be consolidated.

ASC 860 and 810 were updated to address concerns of Congress, the SEC, and users of financial statements regarding the accounting for transfers of financial assets and a perceived lack of visibility into off-balance sheet arrangements that were previously exempt from consolidation. Although FASB deliberations centered on the accounting by financial institutions, the changes apply broadly, not just to financial institutions. Significant changes to ASC 860 include:

Elimination of the QSPE – Qualifying special purpose entities (QSPEs) are passive entities designed by companies to facilitate securitizations. In the past, financial assets transferred to a qualifying special-purpose entity were not recorded on the financial statements of the transferor. The new standard eliminates the QSPE concept. In addition to prospective transactions, all existing QSPEs will be subject to the new consolidation requirements in ASC 810 and, as a result, many will be consolidated by the transferor.
Restrictions on transfers of portions of financial assets – The new guidance narrows the circumstances in which portions of a financial asset transfer can be treated as a sale. An asset cannot be divided into component parts unless all of the component parts meet the definition of a participating interest. The derecognition criteria must be applied to transfers of an entire financial asset, groups of entire financial assets, or transfers of a participating interest. A participating interest is defined as a portion of a financial asset with all the following characteristics: (i) it is a proportionate ownership right in an entire financial asset; (ii) all cash flows from the asset, except for
compensation paid for servicing activities, are divided among the participating interest holders in proportion to their share of ownership; (iii) it is not subordinate to other interests and it has no recourse to the transferor or other participating interests; and (iv) no party has the right to pledge or exchange the entire asset unless all participating holders agree to pledge or exchange the entire financial asset.
Legal isolation – All arrangements made in connection with a transfer be considered in the legal isolation analysis. In addition, the new standard clarifies when a transferor should obtain a true sale opinion from its attorneys and that the financial asset must be isolated, not only from the transferor, but also from its consolidated affiliates other than those that are bankruptcy-remote.
Transferee’s ability to pledge or exchange a transferred asset – The transferor must surrender control of the transferred assets to be eligible for sale treatment. To meet this condition, the transferees must be able to freely sell or pledge the assets. Because the new standard eliminates the notion of QSPEs, it requires a transferor to look through a SPE when the SPE is solely engaged in asset-backed financings or securitizations. If the transferor determines that the transferee or beneficial interest holder does not have the right to sell or pledge the
asset, derecognition/sale treatment would be prohibited.
Initial measurement of a transferors’ beneficial interest – All beneficial interests or other assets obtained and liabilities incurred in transfers accounted for as sales are initially recognized at fair value. On transfer of a participating interest that qualifies for sale accounting, the guidance requires that the portion of a financial asset retained by the transferor be initially measured on the basis of a relative fair value allocation of the previous carrying amount of the asset transferred.
Transfers of mortgage loans to a guaranteed mortgage securitization – Prior to the update to ASC 860, a transferor was permitted to reclassify a loan to a security, even if the transfer did not meet the conditions for sale accounting under ASC 860. The revisions eliminate the ability of a transferor to reclassify a mortgage loan to a security when the guaranteed mortgage securitization does not meet the criteria for derecognition.
Additional Disclosures - The new standard requires additional disclosures aimed at improving the transparency of any continuing involvement with transfers of financial assets, the nature of any restrictions on the transferor’s assets that relate to a transferred financial asset, and how a transfer of financial assets affects the company’s balance sheet, earnings and cash flows.

ASC 810 was updated to improve financial reporting by enterprises involved with variable interest entities. It addresses the impact of the elimination of QSPEs under ASC 860 and constituent concerns about the application of ASC 810, including those relating to the determination of which enterprise (if any) is the primary beneficiary, the frequency of reconsideration events, and the sufficiency of disclosures regarding an enterprise’s involvement with a VIE. The update to ASC 810 retains many of the principles in the variable interest consolidation model, but there are some significant changes:

Elimination of the QSPE – As noted above, the concept of a QSPE was eliminated by the update to ASC 860. One of the changes to ASC 810 was to remove a scope exception that excluded QSPEs from a consolidation analysis. Upon adoption, the new guidance requires that existing QSPEs be re-evaluated to determine whether entities are VIEs and consolidation is required.
Identifying the primary beneficiary – Previously, companies often assessed their involvement with a VIE by determining if they would absorb a majority of the VIE’s expected losses and/or residual returns, which is a quantitative method that is difficult to apply. The new guidance requires a qualitative assessment when determining the primary beneficiary. This assessment will require judgment and consideration of all facts and circumstances. If the enterprise has the (i) power to direct the activities that most significantly impact
the economic performance of the VIE, and (ii) the obligation to absorb losses or the right to receive benefits of the VIE that could be potentially significant to the VIE, then it would be considered the primary beneficiary. In performing the analysis, only substantive contractual and noncontractual terms, transactions, and arrangements need to be considered. Kick-out rights and substantive participating rights are ignored unless the rights are held by a single enterprise.
Previously, if more than one party in a related party group had a variable interest and, as a group, they would be considered the primary beneficiary of a VIE, the enterprise most closely associated with the VIE would consolidate it. Under the revised model, if one party in the related party group individually meets the primary beneficiary conditions, that party consolidates the VIE. Only when an enterprise concludes that neither it nor its related parties has both characteristics, but the related party group as a whole does, does the party within
the group that is most closely associated with the VIE become the primary beneficiary. When determining whether an enterprise has the power to direct the activities of a VIE, an enterprise is still required to assess whether it has an implicit financial responsibility to ensure that the VIE operates as designed.
Shared power – Under the revisions to ASC 810, if the power to direct the most significant activities of a VIE is shared with unrelated parties, there is no primary beneficiary and no party consolidates the VIE. Power is considered shared if two or more unrelated parties together have the power to direct the activities that most significantly impact the VIE’s economic performance and if decisions about those activities require the consent of each of the parties. If multiple parties have power over the same significant activities (such as multiple loan servicers for a single trust), but the power is not shared, the party (if any) with the power over the majority of the activities has power over the VIE. If power is not shared and multiple unrelated parties have power over different activities, the party with power over the activities that most significantly impact the entity’s economic performance has the power over the VIE.
Ongoing assessments – ASC 810 previously required an enterprise to reassess whether an entity is a VIE and whether it is the primary beneficiary only upon the occurrence of a specific events. The new guidance requires ongoing assessments of which enterprise is the primary beneficiary of the VIE. Reconsideration of VIE status is still based on the occurrence of specified events. However, when considering whether the entity is a VIE, the new guidance adds an additional reconsideration event that requires enterprises to determine if changes in facts or circumstances cause the holders of the equity at risk, as a group, to lose the power to direct the activities that are most significant to the economic performance of the entity. The new guidance also eliminates the exemption for reconsideration of status as a VIE or determination of the primary beneficiary upon a troubled debt restructuring.
Fees paid to decision makers and service providers – The revised variable interest model combines and changes the criteria that determine whether fees paid to decision makers or service providers are variable interests. Under ASC 810, such fees used to be evaluated under separate criteria to determine if they were variable interests in an entity. The most significant change relates to cancellation provisions and kick-out rights. It is no longer necessary to consider whether kick-out rights exist to determine that fees paid to a decision maker are not
variable interests. The requirement to consider customary cancellation provisions in other service contracts is also eliminated.
Additional disclosures – The updated guidance requires additional disclosures that are designed to illustrate an enterprise’s involvement with VIEs and any significant changes in risk exposure due to that involvement. The disclosures also require an enterprise to explain any significant judgments and assumptions made in the consolidation analysis.
Presentation – An enterprise must separately present on the face of the balance sheet (i) assets of a consolidated VIE that can be used only to settle obligations of the consolidated VIE, and (ii) liabilities of a consolidated VIE for which creditors (or beneficial interest holders) do not have recourse to the general credit of the primary beneficiary.

After the updates to ASC 810 were issued but prior to their adoption, several users of financial statements of investment managers continued to express concerns about the usefulness of those statements if the fund managers were required to consolidate the funds they manage. In addition, there was a conflict with the International Accounting Standards Board (IASB)’s deliberations to date on evaluating principal and agent relationships that would result in a different consolidation conclusion for investment funds compared with US GAAP. Since the FASB and the IASB have a joint project to develop a single converged accounting standard on consolidation policy, the FASB decided that the effective date of the amendments should be deferred for the affected investment funds so both Boards could develop
consistent guidance on a joint basis. An exposure draft was issued in December 2009 for this purpose, which the FASB plans to resolve in the first quarter of 2010.

Mergers and acquisitions of NFP entities
The FASB issued guidance in 2009 that takes effect in 2010 which determines whether a combination is a merger or an acquisition, and applies the carryover method in accounting for a merger. Alternatively, it applies the acquisition method for an acquisition. It also amends the guidance in ASC 350 (formerly FAS 142) to make it fully applicable to NFPs.

Financial Reporting News is provided by Somerset’s Assurance Team for our clients and other interested persons upon request. For additional information on the issues discussed, please contact us. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review.

These articles were written by and published herein with the permission from professionals of BDO Seidman, LLP. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.

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